where to from here?

I’m not a big fan of Lawrence Summers, but he had an interesting op-ed article in the Financial Times early this month.  He observes that, unnoticed by most domestic stock market commentators, the foreign- exchange value of the dollar has steadily deteriorated since Mr. Trump’s inauguration.  Currency futures markets are predicting a continuing deterioration in the coming years.  He thinks the two things are connected.  I do, too.

To my mind, what is happening  on Wall Street recently is that currency market worry is now seeping into stock trading as well.  If someone forced me to pick a catalyst for this move (I would prefer not to), I’d say it was the possibility, introduced in the press investigation of Cambridge Analytica, that what we’ve believed to be Mr. Trump’s uncanny insight into human motivation (arguably his principal redeeming feature) may be nothing more than his reading a script CA has prepared for him.  This would echo the contrast between the role of successful businessman he played on reality TV vs. his sub-par real-world record (half the return of his fellow real estate investors while assuming twice the risk).

 

The real economic issue is not Mr. Trump’s flawed self, though.  Rather, it’s the idea that public policy in Washington generally, White House and Congress, seems to have shifted from laissez faire promotion of businesses of the future to the opposite extreme–protecting sunset industries at the former’s expense.   In this scenario, overall growth slows, and the country doubles down on areas of declining economic relevance.

We’ve seen this movie before–in the conduct of Tokyo, protecting the 1980s-era businesses of the descendants of the samurai while discouraging innovation.  The result has been over a quarter-century of economic stagnation + a collapse in the currency.

 

More tomorrow.

going back up?

As far as US stock are concerned, I don’t know.

As/when the correction is over, however, it’s very important to look for signs of a leadership change.  At a minimum, one former hot industry/sector typically grows ice cold; at least one former laggard heats up.  Figuring this out and tweaking/reorienting your portfolio can make a big difference in this year’s returns.

the state of play in US stocks

down by 12% 

From its intra-day high on January 28th, the S&P 500 dropped to an intraday low of 12% below that last Friday before recovering a bit near the close.

What’s going on?

As I see it, at any given time, liquid investments (i.e., stocks, fixed income, cash) are in a rough kind of equilibrium.  If the price of one of the three changes, sooner or later the price of the others will, too.

What I think the stock market is now (belatedly/finally) factoring into prices is the idea that the Fed is firmly committed to raising interest rates away from the intensive-care lows of the past decade.  That is, rates will continue to rise until they’re back to “normal” –in other words, until yields on fixed income not only provide compensation for inflation but a real return as well.  If we take the Fed target of 2% inflation as a guideline and think the 10-year Treasury should have a 2% real return, then the 10-yr yield needs to rise to 4%  — or 115 basis points from where it is this morning.  Cash needs to be yielding 150 basis points more than it does now.

One important result of this process is that as fixed income investments become more attractive (by rising in yield/falling in price), the stock market becomes less capable of sustaining the sky-high price-earnings ratio it achieved when it was the only game in town.  PEs contract.

Stocks are not totally defenseless during a period like this.  Typically, the Fed only raises rates when the economy is very healthy and therefore corporate earnings growth is especially strong.  If there is a typical path for stocks during a cyclical valuation shift for bonds, it’s that there’s an initial equity dip, followed by several months of going sideways, as strong reported earnings more or less neutralize the negative effect on PEs of competition from rising fixed income yields.

living in interesting times

Several factors make the situation more complicated than usual:

–the most similar period to the current one, I think, happened in the first half of the 1990s–more than 20 years ago.  So there are many working investment professionals who have never gone through a period like this before

–layoffs of senior investment staff during the recession, both in brokerage houses and investment managers, has eroded the collective wisdom of Wall Street

–trading algorithms, which seem not to discount future events (today’s situation has been strongly signaled by the Fed for at least a year) but to react after the fact to news releases and current trading patterns, are a much more important factor in daily trading now than in the past

–Washington continues to follow a bizarre economic program.  It refused to enact large-scale fiscal stimulus when it was needed as the economy was crumbling in 2008-9, but is doing so now, when the economy is very strong and we’re at full employment.   It’s hard to imagine the long-term consequences of, in effect, throwing gasoline on a roaring fire as being totally positive.  However, the action frees/forces the Fed to raise rates at a faster clip than it might otherwise have

an oddity

For the past year, the dollar has fallen by about 15%–at a time when by traditional economic measures it should be rising instead.  This represents a staggering loss of national wealth, as well as a reason that US stocks have been significant laggards in world terms over the past 12 months.  I’m assuming this trend doesn’t reverse itself, at least until the end of the summer.  But it’s something to keep an eye on.

my conclusion

A 4% long bond yield is arguably the equivalent of a 25x PE on stocks.  If so, and if foreign worries about Washington continue to be expressed principally through the currency, the fact that the current PE on the S&P 500 is 24.5x suggests that a large part of the realignment in value between stocks and bonds has already taken place.

If I’m right, we should spend the next few months concentrating on finding individual stocks with surprisingly strong earnings growth and on taking advantage of any  individual stock mispricing that algorithms may cause.

~$70 a barrel crude oil

prices equity investors watch

Investors who are not oil specialists typically use (at most) two crude oil prices as benchmarks:

Brent, a light crude from under the North Sea.  Today it is selling at just about $70 a barrel.  “Light” means just what it says.  Brent is rich in smaller, less-heavy molecules that are easily turned into high-value products like gasoline, diesel or jet fuel.  It contains few large, denser molecules that require specialized refinery equipment to be turned into anything except low-value boiler fuel or asphalt.  Because it can be used in older refinery equipment that’s still hanging around in bunches in the EU, it typically trades at a premium

West Texas intermediate, which is somewhat heavier and produced, as the name suggests, onshore in the US.  It is going for just under $64 a barrel this morning.

 

What’s remarkable about this is that we’re currently nearing the yearly low point for crude oil demand.  The driving season–April through September–is long since over.  And for crude bought, say three weeks from now, it’s not clear it can be refined into heating oil and delivered to retail customers before the winter heating season is over.

Yet WTI is up from its 2017 low of $45 a barrel last July and from $57 a barrel in early December.  The corresponding figures for Brent are $45 and $65. (Note that there was no premium for Brent in July.  I really don’t know why–some combination of traders’ despair and weak end user demand in Europe.)

 

why the current price strength?

Several factors, most important first:

–OPEC oil producers continue to restrain output to create a floor under the price

–they’re being successful at their objective, as the gradual reduction of up-to-the-eyeballs world inventories–and the current price, of course–show

–the $US is weakening somewhat.

 

 

My Lighting class is calling, so I’ll finish this tomorrow.  The bottom line for me, though:  I think relative strength in oil exploration and production companies will continue.

 

EU insurance companies and coal–FAANGs the next step?

Yesterday’s Financial Times had a curious article, one with no immediate investment implications, but one that I thought was noteworthy anyway.  EU property/casualty insurance companies have decided they will no longer offer insurance coverage for new coal mining projects.  Their rationale is that ultimately they will be the ones paying out claims for damage that results from using this heavily polluting fuel.  So it makes no sense to make their situation worse by supporting the projects that lead to big loss payouts.

 

When I was looking for my first stock market job, I asked an interviewer why he had become a securities analyst and what was most satisfying for him in his work.  He replied that the best part of the job was in influencing investors through his reports to apply high price-earnings multiples to socially responsible companies (thereby making it easier for them to raise new investment capital), and low multiples to dishonest or socially irresponsible ones (making fund-raising harder).

Performing an important social service wasn’t what I’d expected to hear.  But over the years I’ve come to believe that, despite the cynical persona most professional investors adopt, very many–me included–think the way my old interviewer did.  This is one reason that tobacco companies, for example, are rarely market stars.

There may be enough problems with fossil fuels that low multiples are already permanently baked into the cake   …and that coal will continue to be a fertile ground for value investing.  I don’t think so, but who knows.

The more interesting question to me, though, is whether this thinking is being/will be applied to firms like Facebook, Google or Apple–serving as invisible anchors to the rise of their stocks.

 

IT: sector advances happen in waves

My first stock market industry coverage responsibility came in late 1978 at Value Line.  A more experienced colleague was poached by an institutional investor (nirvana for a VLer at that time).  Even though I had only a few months’ training, I became the firm’s oil analyst.

This was just as OPEC was repudiating Western colonial control of the world oil supply–the overthrow of the Shah of Iran in 1979 being a main catalyst.  Oil prices tripled.  Oil stocks shook off their typical bond-like torpor and began a raging two-year+ bull market.

The advance didn’t happen all at once, however:

–Small oil and gas exploration companies in the US, for whom rising prices had the most direct positive impact, rose first.

–Then came medium-sized, mostly domestic US-oriented, integrated firms (meaning they refined and marketed oil products in addition to exploring).  Most of these were subsequently acquired.

–Finally, the big Seven Sister-class international integrateds moved up, too.

This whole process, as I recall it, took most of a year.  The exact timing isn’t so important.  The pattern is, though, because it’s one that recurs.  In particular,  I think, it’s a useful tool to assess the massive tech rally we saw in 2017.

Wall Street then paused while it worked out whether there was more to go for.  It said there was.  And the whole three-tier process began again.

At the end of Round Two, the stocks were all fully valued by any conventional lights.  But international unrest continued   …and the three-tier process happened once more.  At that point the stocks were wildly overvalued.

Easy to say in hindsight, you may be thinking.  But there was a company back then called American Quasar that clearly signaled the excessive enthusiasm.  AQ was the exploration firm that discovered the Rocky Mountain Overthrust belt of trapped natural gas and ran tax shelters (always a danger sign) to finance their exploration.  In my view, Round One of the sector advance fully valued AQ’s reserves.  Round Two very fully valued its future exploration prospects, as well (this almost never happens).  Round Three placed a huge multiple on large prospective acreage it had just leased and had not yet drilled (which turned out to be the only parts of the Overthrust not to have any hydrocarbons).

In early 1981, the spot price of oil on commodity markets began to dip, initiating a three-year bear market in which many oil stocks lost 2/3 of their peak valuations.

 

The way I’m thinking about it, IT stocks finished Round One in late 2017.  To my mind, the sharp rise in Intel shares last September-November is like the big international integrateds finally participating back in 1979.  It signals that the valuation gap between firms exposed to the hot areas of IT and the large left-behinds had grown too wide.  Investors thought it made more sense to bet that INTC could lift its game than to buy more shares of an already high-flier.  It’s a red flag.

Now we’re in a wait-and-see period.  My guess is that there will ultimately be a Round Two.  But, as I’ve written elsewhere, IT is already about 25% of the total S&P 500 market cap.  That’s a daunting size.  My guess is that other sectors will have to rally in a way that reduces the IT weighting to, say, 20% before tech before more than the strongest tech names take off again.  But I think IT will ultimately rally.