Value Doc

Long/short equity
Value Doc
Long/short equity
Contributor since: 2013
Hi Ray,
You do a good job of analyzing the granular information in a balanced manner. One big picture question though: have you ever had any concerns over the "sniff test" with ETE (i.e. the serial M&A activity, excessive financial engineering/complexity, and excessive leverage (both debt and IDRs)). I'm sure you've been around the block long enough to know that this whole story has a Tyco smell to it, and that these are historically big red flags?
I mean, no one would dispute that MMP and EPD are extremely well-run MLPs. If the Kelcy Warren model is so great, why did EPD and MMP never move in that direction (levering up, maintaining IDRs, and buying everything in sight)?
At this level, the risks are probably in the price by now. But, did that ever concern you several months or a year ago? When I looked at the parabolic trajectory of white-hot things like ETE, TRGP and PAGP a couple year ago, I was scratching my head. It really did feel like a bubble, and not surprised there has been symmetrical (and then some) payback on the downside for these names. Leverage is a double-edged sword.
Yes, management is responsible for excessive M&A activity and financial engineering and lots of leverage--historically, companies engage in this to overstate/obscure the true economics of the business and garner a higher valuation from naïve investors (aided by Wall Street enablers who make big $ on the advisory fees). Think Tyco in the late 1990s (or the conglomerate boom in the '60s) as a prime example.
How it all shakes out, and what ETE/ETPs true sustainable cashflows will be over the next few years is hard to pin down. Obviously, there are a lot of moving parts and an unstable environment.
However, I would just caution everyone that ETE/ETP has always had a lot of red flags (these warning signs mentioned above), and I'm not at all surprised that MLPs like ETE and TRGP have tanked FAR more severely than their more conservatively run brethren such as EPD and MMP. That's no coincidence. EPD and MMP (i) are not serial acquirers; (ii) have lower leverage levels; and (iii) no IDRs (which are essentially another form of leverage).
Yet, no one on this board seems to connect the dots or make these comparisons, and simply assumes that the extreme drops are market irrationality. The magnitude of the drops (relative to EPD and MMP) reflects that ETE is far riskier than EPD and MMP. Now, if the environment for pipeliners turns more benign, then it's true that ETE has more upside from current levels. If the environment stays difficult for a long time or worsens, then the equity will be far more distressed with a higher likelihood of BK (or massive dilution through toxic convertible issuances) at some point in the future.
Perhaps. Or perhaps those that know about the workings of the business are the ones who have been selling (and short-selling).
You know the old saying, "those who talk, don't know. Those who know, don't talk."
I will say that I never trusted Kelcy Warren--when you encounter a swash-buckling deal addict who loves complex financial engineering, it's best not to commit capital. History isn't kind to these types of companies--very poor stewards of shareholder capital. He's like a Rich Kinder on steroids.
Just checking in on this discussion from two months ago. Is everyone enjoying their ETE & ETP stock? Has the irrational pessimism dissipated yet in favor of the obvious wisdom of those commenting on this board? Is ETE a good stock for conservative "dividend growth" investors?
China needs to come out with a big, one-off devaluation. Felix Zulauf in Barrons' Roundtable the other day has a pretty good prognosis for the market this year--bear market with the S&P down at least to 1,600, possibly as low as 1,200-1,400, and RMB ends the year at 8 to 1 (i.e. 20% devaluation). Potential buying opportunity in the fall after this happens, as CBs will rush in with more QE programs to try to put a floor under it and prevent a 2008-magnitude collapse.
1,600 not particularly cheap, but should be a decent time to leg into value strategies (rather than the index). Specific stocks will likely get compelling at this point if you choose carefully.
The problem with oil stabilizing or even bouncing up to $40 or $50 is that the bad debt in the energy sector and EM is still going to go bad even at those higher prices not to mention that energy equities are still overvalued at those prices (i.e. they've never really priced in $30 oil). Sure, there will be a knee-jerk rally, but the problems from the oil price shock will all still be out there.
Also, we've got a massive overhang of a sharp RMB devaluation (like 20%) likely coming sometime this year that will put markets in a tailspin.
At the end of the day, this year has started out identical to 2008 (actually, it's even worse as we haven't even started a sustained 5-6% bounce yet). Also, 2015 was very similar to 2007 in many ways (average stock down, S&P flat due to indexed money & momentum bidding up a few mega-cap names, yield-chasing vehicles starting to blow-up). Finally, earnings, credit & economic data sharply deteriorating, and even with recent decline, S&P is at 21x trailing GAAP earnings (which are on record profit margins and deteriorating).
I would take a flyer this year, at least until the fall (and only with much lower valuations), and avoid all net long exposure at this time. Talk about another 5-10% downside is very optimistic given that the last two bear markets involved peak-to-trough declines of 50% and 60%, respectively. How about if oil and China stabilize for a few months, and we rally 5-6%, then decline 40% in the fall when new shocks come out, things have continued deteriorating, and the wheels really come off the wagon?
What will make the market "safe" will be much lower valuations (though it won't feel safe when we get there!), not improved news flow. Markets are "safe" precisely when they feel unsafe and the newsflow is bad.
Reading through Bahamas1 comments, I think I have a good idea for the SA editors. Perhaps an "alternative" version of SA is in order.
http://onion.com/1ng5bwa
Agree on all that. In 2011, valuations weren't too bad either though they were high in 1998. I like market neutral, diversified L/S strategies here. I think there are good opportunities to play the dispersion. There is a significant shade of 1999-2000 right now in that many "old economy" stocks have already been whacked hard while speculative stocks have barely started to correct. Also, we've just completed a 7-year "momentum over value" cycle, much like in 2000. These types of L/S market neutral strategies crushed it in 2000-01. I don't think the opportunity set is quite as rich as in 2000, but it's still very good, and better than in late 2007, which was the end of a multi-year "value over momentum" cycle. Fat returns available without taking any directional risk, credit risk or stock-specific risk. Especially compelling if you consider the ZIRP environment and financial repressions make cash and money markets a non-option if you want any return.
Typically, bull markets end when you have a combination of (i) historically high valuations and investor leverage and (ii) a lot of capital misallocation (e.g. bad debt).
We now have both of those, the markets have recognized this, and it's just starting to unwind. The capital misallocation is in energy (and even junk bonds more generally), emerging markets, and tech bubble speculative stocks (i.e. huge valuations on companies that don't make money and burn cash and will disappear within a few years--reminiscent of 1999 albeit less extreme and widespread).
I noticed that Jim Rogers the other day seems to see this as well: he specifically mentions junk bonds and tech stocks as his two areas to short.
It's interesting, this cycle has a combination of excesses like 1999 and 2007. That makes it hard to predict whether the bear market will be a slow multi-year grind like 2000-02 or a sharp crash like 2008. I'm leaning more toward the former--don't think we have the huge impairment of money center banks and I-banks like we had in 2008. Just a lot of mis-pricing and speculation in the liquid markets.
I suppose there's always the possibility of one more blow-off bubble top (what James expects), but I think it's unlikely. Feels like the top is in, and the party is over. Numerous indicators suggest 2015 was more like 1999 or 2007 than 1998. Also a good chance we get at least a mild technical recession and a steep profits recession (like in 2001).
Fed model (stocks vs. Treasuries) has no predictive value for long-term returns. Why don't you compare the PE vs. junk bond yields instead?
Not to mention that margins are much more stretched than they were in 1999, and the degree to which they can be sustained over the coming years is open to debate. Certainly, there will be at least some cyclical pull-back in margins.
I was noting, for example, the poor performance of long/short value strategies in 2015 (e.g. Joel Greenblatt/Gotham Capital's rules-based strategy). They had a poor year in 2015, and I understand that the only other two years like that in the past 20-30 were 2007 and 1999.
Ditto with Seth Klarman (only his 3rd negative year in 30 years), and ditto with Warren Buffet (down double-digits last year despite the S&P not being down at all).
There are other indicia:
- Buying only companies that lose money would have generated a positive return of between 20% and 50% last year--massive outperformance;
- 80% of IPOs are money-losing companies (nothing comparable save 1999);
- Huge performance spread between Morgan Stanley value and momentum indices;
- Top 10 performers in the S&P (FANGs, etc.) responsible for something like +6-8% total return while the remaining 490 responsible for -6% return, etc. Much like 1999 or the 1972-3 Nifty Fifty.
This is all top-of-the-market stuff that has historically preceded huge bear market wipe-outs--it's not mid-cycle or even later-cycle behavior (even prior to significant corrections)--it's end-stage/early bear market extreme behavior. Nothing at all like that in 2011.
Leuthold Group (Doug Ramsey) has a couple of good interviews on Bloomberg yesterday that also note relevant cycle patterns along these lines.
James,
As to where we are in the market/economic cycles, what do you make of the fact that we had a narrow, momentum-dominated run in 2015? Historically, that only occurs at the very end of a major market cycle. We didn't have anything like that into H12011. You don't take this as a cue that we've now started a big bear market? The other times that has happened were 2007, 1999, 1972-3.
James,
From a cyclical markets-driven (rather than economy tea leave reading) perspective, here's my take on where we may be. Your thoughts?:
1997=2013: Broad-based rally with value strategies outperforming. Everything up 35%.
1998=2014: Market starts to get frothy with excesses in "cool-kid" speculative stocks (remember Einhorn's comments at the start of 2014?). Profit cycle peaks, credit cycle peaks. Stocks have a sharp autumn correction that's cut short by central banks. Oil collapses. Small-caps are flattish on the year while the S&P rises strongly.
1999=2015: Very narrow speculative advance with parabolic moves in small-cap biotechs & software companies; triple-digit moves in small number of "New Economy" mega-caps. IPO cycle peaks early in the year. Old economy stocks out-of-favor--value strategies badly underperform and Warren Buffett, Joel Greeblatt and Seth Klarman each down double digits despite no bear market. Toward the end of the year, Fed starts hiking rates.
2000=2016: Start of long-term bear market?
Hi James,
Some interesting thoughts set out there. On the recession / no recession call that is at the heart of you relatively sanguine outlook:
1. Do you have any concerns over what Soros would call the "reflexivity" of financial market feed-back loops? I think it seems clear that over the past 20 years (i.e. the period where we've had a highly leveraged, financialized system), the asset price boom/bust cycles seem to drive the economy. In other words, asset price declines trigger the recession, not vice-versa as your analysis assumes.
Stock prices peaked in early 2000 while the economy was great, and we didn't have a recession until early 2001. Yet, early 2000 was the start of an eventual 50% bear market decline with no new highs in the interim (while you expect a new high this time). Consumers weren't over-leveraged in 2000-01 either, if memory serves.
Housing prices peaked in 2006 while the economy was great; no recession started until the very end of 2007.
2. In a similar vein, your analysis seems to focus on short-term catalysts (i.e. China) and overlook the impact of the credit cycle which arguably peaked in mid-2014. Historically, the credit cycle tends to drive the markets and economy especially over the past 20 years. Domestic-focused US small-caps have very little direct connection with the Chinese economy (or oil/commodities)--yet, they're being taken out and shot and have been dramatically weaker than large-cap multinationals since middle of last year when our market troubles (supposedly catalyzed by China and energy sector) began.
Thoughts? How does this square with your notion that US consumer health=no recession=equals no big bear market? If it's all about US autarky and consumer health (rather than credit condtions / investor risk aversion), shouldn't the small-caps be outperforming?
3. You seem to equate "recession" with a relatively severe, sharp economic downturn. Early 2001 technically had a "recession" (it was very mild), and of course, the entire 2000-02 period can be considered a 50% bear market. Are you saying that we don't even get a 2001-style borderline/mild recession in 2016/17?
I would say that the combination of corporate leverage and speculative excesses (tech and biotech Silly-con Valley stuff reminiscent of dot.com) suggests that we have a period resembling 2000-02 ahead of us--not a meltdown or severe Main Street pain--but stock market + NY/Silicon Valley/Boston-focused pain (corporate profits decline and financial assets decline). Thoughts?
Hi MFITZ,
What would be the ramifications of a 5 yr QE program? Would it create a huge bubble, or would it sort of buoy the markets and create a broad, multi-year trading range market like the 1970s?
Hi MFITZ,
What do you mean by a "full correction"? Perhaps 1,500-1,600 on the S&P? Also, won't they try more forward guidance before they do QE, and if so, will it arrest the decline?
Interesting. That implies that it could end up being more 2008-like after all. I think the psychology has suddenly changed, and everyone knows the jig is up. That means there will be no slope of hope to moderate the decline.
Amazing how rigged and phony everything is. I hope Bridgewater and Citadel get their heads handed to them in the next meltdown (I know Citadel got whacked in 2008). No systemic bailouts either. Just let the markets flounder around at depressed levels for a couple of years and then liquidate their asses.
MFITZ,
I think it declines in a more measured, but relentless way for 2-3 months or so and then a tepid tradeable rally for awhile before an even worse decline in the last summer/fall (i.e another leg down). I also expect mo-mo stocks to take the brunt of the declines.
Historical parallels would be 2001 and 2008 (though not saying that the fall decline will be as big or precipitous as fall 2008 or cause a financial crisis). Think of H12008 and H12001 though. Both early stage bear markets after the initial "warning crack" and rebound rally had already happened.
This year will be a big (though not apocalyptic) down year, but it will then be interesting to see what transpires in 2017. Perhaps at that point we have more QE going to try to keep things broadly sideways for many years. Or perhaps the bear market continues (perhaps even with QE, i.e. maybe QE will be unable to generate more than a short-term rally, and that will scare the s*it out of people), in which case it ends up as a severe wash-out (at least as bad as the last two) without out-of-control negative feedback loops.
Oh where, oh where has the liquidity gone,
Oh where, oh where can it be?
With its dip buyers eager
And the downside cut short,
Oh where, oh where can it be?
I think it's hiding until QE4,
To see, what Yellen might bring.
Well, did you see that Fed governor come out today with comments that "four rate hikes this year might not be enough"? Not exactly like the 2014 Bullard stick-save. And Dick Fisher's stunningly frank interview two days ago?
Goes into my "outgoing administration" theory on the timing of bear markets. You know, 2000, 2008, 2016 . . . what a coincidence!
I think the jig is up. Anyway, my market neutral L/S fund had a nice big positive spread today, so not complaining. Sure is tempting to get net short though!
I get the feeling they're going to let the bear market happen this year just like in 2000 and 2008 because it's inevitable, after all. Don't you find the timing of the bear markets curious? (Election year with new presidential administration, plus old Fed chairman once again leaving six months before market peak)
It's sort of like the way corporates take "big-bath" write-offs especially during a recession or when a new CEO comes in. Let it all burn down and blame it on the last guy (the last administration, and the last Fed chair, etc.), then reflate the bubble after it pops.
Those comments by Dick Fisher yesterday are also quite amazing--admitting they blew a big bubble for wealth effects and now it has to pop! Not exactly jaw-boning the market higher! I would say it's now safe to short. If history rhymes, this autumn will be really brutal.
Bret,
I note that 2007 was also a year where the S&P was flat due to being held up by a very small number of leaders while the average stock was down (IWM down -5%).
2007 was also a year where the most egregious yield-chasing vehicles had already started to blow up, and it was a year where the profit cycle and credit cycle had already started to turn (profits/margins declining; credit spreads tightening). It was also a year where investor leverage peaked and started declining by the end of the year. In other words, all of the things we are seeing this year.
Finally, the median stock valuation is at an all-time high.
Does any of this concern you? What would be the arguments as to why we don't see a traditional cyclical bear market with a 20-30% decline next year? I think if you look at all the factors, it suggests we're in an early-stage bear market.
He-he! Well, technically, you're correct, of course. What I meant was that there was a huge collapse in equities first. Major difference between 1993/1998 and 2000, for example, in terms of investment strategy.
We are living in interesting times--it should be wild next week! :-)
I remember in 2000-01, as the bubble burst and the market started sliding, Greenspan kept coming out with these surprise rate cuts, and the market would have a sharp, short-lived rally and then continue heading down again. Ditto with the easing crap they started doing in late 2007 once it became clear the music had stopped.
That's probably what will happen this time. I think, at the end of the day, they recognize that a bear market is inevitable, but will try to make it a "managed" bear market like 2000-02 rather than a terrifying financial crisis like 2008. Back in 2007, they had originally hoped to make the real estate/stock bear market a managed decline but were unsuccessful due to the surprise Lehman shock.
My sense is that we're more likely to have a long, drawn-out 2000-02 type experience, with the CBs fighting it the whole way, than a 2008 type of experience. Either way though, I think the arrow is down from here.
Incidentally, the brunt of the pain (though the pain will be widespread) will be in the two areas of great excess over the past few years: (i) yield-chasing (seeing it already with junk bonds, EM debt and MLPs) and (ii) 1999-style "growth" stocks (tech, biotech & M&A roll-ups). As in 2000, old economy "value" and EM has already done poorly for years and will go broadly sideways for the next few years while everything else tanks.
That's not really true. In 2000 and 2007-08, they attempted to contain the collapse of the asset bubbles, and it did NOT create a bigger one (not immediately, anyway). Instead, they were unsuccessful, and the bubbles simply collapsed (before being re-inflated in new ways a couple of years later).
The Fed is not all-powerful--once risk aversion, de-leveraging and negative feed-back loops get started, they can't just turn the tide like flipping a switch.
Therefore, the question is whether they will be successful at this latest juncture? In other words, is the "big top" (i.e. 2130 on the S&P 500) in or not? Even if they calm the panic in junk bond redemptions, I think the sentiment is damaged, i.e. spreads will stay wide and perhaps widen further, and equities will fall. At the end of the day, profits and macro are deteriorating, and the Fed can't mandate the course of the US profit cycle.
If the Fed was that all-powerful, then why do they allow these 50-60% S&P bear markets every 8 years or so? (It's like "if there's a God, why does he allow poverty, warfare and famine"?).
There's also a political dimension to this--people are sick of bailouts and business-as-usual, and this is an election year (the last two being 2000 and 2008--what a coincidence!). I wonder whether that may make the Fed hesitant.
Why do they need to do anything? Just let it all go down. We're going to have a bear market sooner or later anyway--let's just get on with it.
Let bad debt go bad--not like it's the end of Western Civilization or anything.
If they do provide liquidity, it sure as hell shouldn't be at 0%. Charge double digits. Why lend at 0% against sub-prime / junk collateral?
Also, why should they encourage the banks to buy this garbage? Will just jeopardize their balance sheets. It's probably a good thing that it's currently held in hedge funds and mutual funds--let them eat the losses.
This whole debacle is going to result in a massive credit tightening anyway, even if they do provide liquidity. Only question is whether it's a sharp freefall panic or a more managed tightening as credit losses materialize and risk aversion rises. Do you really think people are going to have a renewed appetite for junk debt even if the Fed provides a bailout? Emerging markets certainly didn't come roaring back in 1999-2000.
I don't see a reply of 1999-2000 with the FANGs. It was more than just Fed liquidity--it was investor embrace of risk in tech and large-cap indexing--emerging markets were a relative sideshow back then. That was fed by a legitimately booming tech sector and strong US economy (and retail investor delusion). We're probably heading into a recession now. Facebook and Netflix are not going to provoke another euphoric up-leg.
Yes, the institutional investor community is certainly not absent of poor analysis / investment decision-making either. However, I believe there are a lot of academic studies showing that individual investors, on average, do a terrible job with their stock-picking (i.e. massive negative alpha) and would do much better with any type of diversified passive strategy (preferably dollar-cost averaged).
Most of the comments on SA evidence a complete lack of securities valuation / financial analysis literacy. Now, there's nothing wrong with that in the sense that a lot of people (really, all of us!) come to this site to learn things and become better investors. Nonetheless, it's clear that a lot of clueless people are out their trying to personally manage their retirement savings by picking stocks. Very difficult and dangerous especially for the uninitiated.
James,
I think this comment nails the key risk that people aren't seeing--the music has stopped in this industry, and investors haven't completely woken up to the potential downside posed by this new reality. It's unclear to me that we're going to have several years of secular declines in the cashflows of the asset base, but it's very possible if commodity prices stay depressed. That would be in line with the history of past leveraged boom/bust cycles in other industries.
Most of the individual investors on SA just don't get it--they don't see the forest for the trees. It's truly sad, because I'm sure, like for past boom/bust cycles (e.g. tech and real estate), a lot of people are going to be financially devastated by this. The longer I follow the markets, the more I feel that most individual investors have no business playing around in the stock market or managing their own portfolios--most people don't have the ability/skills and/or temperament and sooner or later become victims. It's OK at a poker table having some fun with it, but retirement planning is a high-stakes endeavor.
Actually, they would look more like MMP which is mostly FERC-regulated refined products pipelines.
You only discovered that just now? Most of my MLP portfolio from 2012-14 (before I exited all MLPs at the top in summer of 2014) was in EPD and MMP. Though admittedly, I also had some KMI, WMB, SXL and PAA.
Lack of growing unit count (i.e. funding through internal cash) was a key indicator of conservative financing/management (i.e. less risk under a macro or sector downturn, such as we are now entering).
If you were in MLPs that issued a lot of units, you weren't really in an equity--you were in a junk bond that didn't have creditor protections (because management could suspend the dividend--though the trade-off was that you got a little bit of coupon growth). A lot of people didn't understand this.
EPD and MMP are like C-corp equities. KMI, WMB, TRGP and ETE are like heavily leveraged C-corp equities. PAA, NGLS, KMP, etc. were/are like junk bonds.
Nope, entire equities market had collapsed by early 2009 with pessimism/despair rampant. Better comparison is tech in late 2000. Nasty, sudden, shocking declines focused on that one sector (while fundamentals were only starting to show signs of deterioration that had not yet been widely acknowledged) while rest of market and economy was holding up relatively well (early stage bear market). Psychology was shock/denial/rationali... thinking. Much like what is displayed in most of these comments.
Well, there were more severe declines to come over the next couple of years, with tech fundamentals cratering and the entire stock market ultimately joining in.
C'mon, read through these comments--does that sound like capitulation to you? Just because something goes down sharply doesn't mean the market is being irrational.
Correct me if I'm wrong, but doesn't FERC set only maximum rates? In other words, they don't guarantee minimum business / rates. Also, only some business lines are FERC-regulated; I believe others (including crude oil rather than refined products and nat gas trunklines) are not, correct?
KM has always listed re-contracting as a major risk in their business model. On take-or-pay, you're just talking about the initial term of new projects--KM has a gargantuan network of legacy assets on which their cashflows are based.
"The US decides to end its energy renaissance"--I thought it was market forces (and maybe the Saudis) who have been making this decision?