Time to Get Back into the Market

I hate market timing. It’s expensive, it’s disruptive to fundamental investment practices, and it often does not work. But in early January I felt that exceptional circumstances required action. So I stepped aside for a few weeks, as I described at the time. I’m glad I did. While the EIS portfolio declined 4.4% for the month, that compares favorably with energy indexes (Oil Service HOLDRs ETF (OIH) down 16.7%) and the broad market (S&P 500 (SPY) down 6%).

The exceptional circumstances, as you know, were the interrelated problems of a global credit meltdown and the bursting of the U.S. (and British) housing bubbles. Together they offered the prospect of not just a normal economic slowdown but a possibly catastrophic economic and market decline. The world’s financial institutions were not sure how to value their own assets and with housing prices falling on top of weak consumer fundamentals the worst case could have been a vicious cycle of interconnected contractions between the credit markets and the real economy.

Stock markets can have a lot of bad days when they think the economy is headed toward a standard recession. But when the market smells the fear of an unknowable risk, it can go south with breathtaking speed. The unwinding of derivative credit instruments based on sub prime mortgages presented just such a possibility for unknowable risk. The idea of leverage upon leverage – possible bankruptcies of credit insurers causing institutions to suddenly find their assets worthless in quantities that even they could not realistically estimate – was enough to cause investors justifiable fear. That’s what I smelled in the trading patterns of the first few days of January and why I decided to step aside.

All the old problems still exist and there are new ones like the fact that states’ attorney’s general will sue some major financial institutions for gigantic sums because they sold mortgage securities without disclosing the risks of which they were aware. The FBI is investigating mortgage brokers and banks, which could lead to other lawsuits. But now the markets are saying the situation will be controlled, that credit market losses will be contained. I don’t know exactly how the problems will be resolved, but the Fed is on the case as are regulators and legislators of all stripes. Mechanisms are being debated to resolve the home loan default epidemic equitably. People who need to act are doing so. And the stock market has resumed a normal trading pattern. So I think the crisis is over and it is now safe to have a moderately aggressive investment posture.

That is not to say there will be no more surprises, no more bad days, no weak economy. There will be all of that. Count on it. But there will be no abyss. It is not likely that the system will collapse. There may well be a recession, but there will not be a depression.

Moreover, as Carlos Ghosn has told us, the coming U.S. economic weakness will not stop the huge engine of growth that is powering all the economies of the world: globalization. It will not stop the progress of literally billions of human beings from desperate poverty to a modicum of middle class status, as that is variously defined around the world. Developing economies are powering ahead because globalization is allowing entrepreneurs in Chindia to hire peasants to make goods and to provide services for people living in OECD countries and to get paid for it in wages that begin to approach OECD levels. That’s the engine.

The engine will continue to power the global economy forward despite the U.S. economy falling into recession. Average U.S. corporate earnings, especially the financials and anything related to housing, will decline, but companies will prosper to the extent they engage globally rather than just nationally. Have stock prices fallen enough to discount the earnings decline to come? Nobody knows that answer. They may have to fall further. Certainly there will be some bad days and weeks ahead.

Normally stocks first decline ahead of a recession and then stabilize when a slowdown is obvious enough that the Fed begins to lower interest rates and recession symptoms like unemployment start to make the popular press. The market only starts to rebound strongly when the rate of change in the economy turns positive, and that happens at the very bottom of a recession. It’s the second derivative, stupid, to coin a phrase.

Right now we seem to be at the market stabilization stage, when it goes up and down for a while. The market appreciates that lower interest rates make stocks more attractive compared with bonds and help produce an eventual economic recovery. But the direction of change in the economy is still toward weakness and political uncertainty is high. So it seems likely there will be some further stock market weakness. Maybe Pakistan will have a political calamity. There may well be a re-testing of the 11,700 level on the Dow 30. My guess is that such a retest, if it happens, will be successful. You can wait for it to happen before investing, but that’s called “market timing.” I’d rather get back to investing.

Incidentally the fact that the stock market is usually booming by the time a recession is doing its greatest damage tickles my sense of irony. I can’t wait to hear Jon Stewart at that point in this economic cycle, which should be coming up in about six months. He’ll probably do a show about plant closings from the steps of the NYSE and alternate between talking with laid off plant workers by remote hookup and interviewing a happy broker on his way home from trading. It happens in every recession but now we have a new way of appreciating the news, The Daily Show. Even Orwell could not have invented that.

Oil: Home on the Range

The price of oil seems to be making a series of lower highs and lower lows, apparently headed in the southern direction. I’ve said before that I think OPEC will take steps to stop a decline when it gets near $80. Recently OPEC has begun to lay the public relations groundwork for a cutback in production, probably in March. Another force that will limit any fall in oil prices is the high marginal price of oil production, as indicated in EIA data that I recently posted.

If oil stops declining somewhere above $80 it will have established a range of $80 - $100. It could move around in that range for a long time, but I suspect it will move out and to the upside sometime before the weather gets too cold next fall. We’ll see.

Meanwhile, none of that really matters too much if we continue to see a trend toward “contango” in the long dated oil futures. Contango is when futures prices are higher in later months than earlier months. It suggests the market thinks oil will become more expensive as time goes on. That is the essential thesis of the energy investor. We own many of these stocks because we think the price of oil is going to continue to rise.

The market is now starting to say the same thing, and that is comforting despite the fact that the near term oil price is falling. The difference between the current oil price and the price twenty-four months out has gone from nearly $10 a couple of weeks ago to only $2 now. And the price in 2015 is now almost $3 higher than the price in 2010. That suggests to me that people are starting to believe peak oil will become the sort of problem I’ve been describing. If they really believed it, the price of long dated futures would be much higher. But they are starting to believe it.

As I’ve said for some time, the closest you get to being able to steal money legally these days is to buy a contract to buy oil in 2012 or 2015 at around $90 a barrel. There is no way that the oil price will not be multiples of that number by those dates, in my opinion. If you do the arithmetic on buying an option on such a futures contract, which I did in a previous letter, you’ll see that the economic opportunity offered by this anomalous situation in the futures market is extraordinary.

Oil Stocks Don’t Care About the Price of Oil

I just said that to get your attention. Of course they care about the price of oil, but just not today’s price. They seem to care more about the direction in which the current price is expected to move and on that subject equity investors and futures traders do not always agree. When the price of oil was hitting its head on $100 a little while ago, many of the oil stocks, especially oil service stocks, were sinking. I interpret that to mean equity investors thought the price would soon be moving down. It turns out they were right about that.

Many of the service and drilling stocks have dropped so far that their price reflects a very low earnings multiple. So now the major deep sea drilling companies like Transocean (RIG), Diamond Offshore (DO), and Noble (NE), all of which are in the EIS portfolio, can be had for less than 10 times earnings – not to mention cash flow – which is growing at 20+% per year. In fact, Noble is 7.5 times earnings. That’s 2008 earnings, not 2009. Sorry to yell.

Anyway, I think we will see some of those companies being bought wholly or in part by sovereign country funds and/or significant Middle Eastern investors. Let’s remember that cash reserves in oil exporting countries are continuing to mount every day. The pile of cash accumulating is looking like that old cartoon of Scrooge McDuck and his swimming pool of money. Something must be done with all that cash (which is another reason that the stock market may have stopped falling).

Meanwhile, existing and about-to-be-completed deep sea drilling rigs are contracted for years in advance. And you can’t just go out and order a new rig. They take many years to build and you can’t order them in great quantity. If you need just one rig in a few years, you may be able rent it. But if you need 20 rigs – like the Brazilians do – fugetaboudit. And getting the skilled personnel to operate these extremely high technology new rigs is even harder.

So, as the Omar of Bloody Arabia looks out at the world he sees a few things. He sees that nearly all the new oil being discovered is off shore and lies miles below the surface of the ocean, usually under many layers of rock and nasty stuff. Thus, he sees that getting oil to flow in the future from such deposits will be a much greater technical challenge than it has been before. He also sees that crude is getting increasingly scarce and expensive as time goes on. So he understands that in a few years some countries will kill for the right to have a deep sea drilling rig – a very scarce high technology asset – deliver their oil from its hiding place under the sea. Given all this, why wouldn’t he want to own some or all of, say, Transocean? RIG would be a reasonable value at twice its current selling price for a strategic buyer like the Omar.

True, it would take $80 billion to buy Transocean, the largest drilling company, for twice its current stock price. But, heck, the Saudis are getting about $700 million flowing into their treasury every day from oil exports, of which more than $500 million is profit. RIG at twice the current price would cost them only half a year’s profits and they probably could get it for less. Of course, there could be a political barrier to the Saudi’s buying out RIG. It would be like a nuclear bomb in the oil business. So maybe they start by buying 5%. Or they take a run at Noble, which is now valued at only $12 billion. It would let their money do double duty, both as a good investment and as a way to have a lot more say in what happens in the global energy business.

I think we may very well see some sovereign funds, or proxies for them, trying to take influential positions in some strategic oil services companies. I also think that whatever minority positions are acquired will only be the first move in a longer chess game. The drillers and service companies make up nearly 30% of the EIS portfolio. They have not contributed much so far, but I suspect their value will be appreciated sooner rather than later by private investors if not by the public. OIH is the ETF that best reflects them.

Final Timing Comment

Why buy stocks now if they are likely to bounce around and re-test lows before they go much higher? There are two reasons. The first is the essential view of a value investor, to whit that nobody can really time the market successfully. If stocks are selling cheaply to their intrinsic value we want to own them because we cannot know when they will start moving up.

The second reason is to build a tax basis. You need to own a stock for a year to get preferred tax rates on its sale. So, like wine, stocks are better when they have been “aged” than not. In one sense, a stock appreciates in your portfolio each day for the first year you own it even if the price does not go up. That’s because it gets one day closer to being a long term holding and thus being an actually or potentially more valuable stock, depending on whether its price has gone up yet or not.

Well, in closing, January was an “interesting time” in the sense of the Chinese curse. Let’s hope the rest of the year brings us a stock market – and a world - that is not so “interesting.”