Both S&P 500 earnings estimates and the US economy are accelerating. This combination of improving fundamentals revives the prospects for another leg up in the stock market and potentially Jeremy Grantham’s 50-60% melt-up scenario1. Since last October, we have cautioned on the hazardous combination of “irrational” stock market speculation, historically high equity valuations and rising interest rates. While the structural risks of computer driven markets and record margin debts could quickly end this nine-year old bull market, the “Fed Model’s Risk Premium” of 3.03 combined with improving earnings could push US and global equity markets higher.
This month’s letter will review the capital market risks and prudent ways to invest.
In our January letter, we cautioned that the accelerating rise in both the 10-year US Treasury Note interest rate and the stock market was unsustainable. Echoes of 1987 Crash: Derisk Your Assets with MLPs, Sector Rotation and Options. Since January, stock market volatility has increased and the US equity market has corrected and consolidated. S&P 500 forward earnings estimates jumped on The Tax Cuts and Jobs Act in the first quarter and then flatlined. However, in the last few weeks, S&P 500 earnings estimates have begun to rise at an increasing pace. The table below shows 2019 S&P 500 earnings estimates' rising trend.
This pick up in earnings estimates was concurrent with the 4.1% second quarter US GDP growth report on July 27th. This healthy economic growth rate ends the “New Normal” and “Great Recession” psychologies and suggests the US economy’s aging recovery has been revitalized. The chart-combination below show the Risk Premium of the “Fed Model” in the 3 range, comfortably above the negative or 1.2 levels which marked the major market peaks of 2000 and 2007.
With both earnings and economic growth accelerating, one might speculate that this sets the stage for a melt-up as the reknowned strategist Jeremy Grantham conjectured eight months ago. However, given the modest size of the earnings increase relative to the healthy increase in second quarter GDP growth, a melt-up does not appear at hand. However, if the administration’s hard-nosed trade policy gambit prevails, especially against China, we could see psychology and earnings improvements which could create an “exuberant” end to this bull market.
Another scenario we are monitoring is the possibility a commodity bull market leading to a spike in inflation. Inflation would be problematic for both bonds and equities. As examined2 in earlier letters, a commodity bull market cycle could offer an alternative asset class with a history of moves on the order of several hundred percent. The chart below shows significant cycle turning points between commodities and the S&P 500.
Below is the chart of S&P 500 to Goldman Sachs Commodity Index ratio and suggests a rotation in asset class performance is turning from stocks to commodities.
Oil is a major commodity index component that is highly inflationary. Oil’s bear market has ended and the case3 for higher oil prices appears imminent. Inventories have been drawn down to normal levels and global economic demand is picking up. Further, oil supply disruptions from Venezuela and Libya and rising tensions with Iran could drive higher oil prices. In recent weeks, Saudi Arabia, the world's top oil exporter, temporarily suspended all oil shipments through the Bab-el-Mandeb Strait following attacks on two crude-carrying vessels by Iranian sponsored Houthi rebels from Yemen. Additionally, environmental restrictions such as International Maritime Organization “IMO 2020” which mandates an 85% reduction of sulfur limits in bunker fuel have led some analysts to predict higher much oil prices. Dr. Philip K. Verleger, Jr.’s July letter suggests oil prices could rise to $200/bl4.
Allocating to commodities is an increasingly logical diversification strategy that could significantly impact future returns. Diversifying into alternative asset classes is a proven defensive strategy that has been successful employed by top performing Ivy League endowments in recent decades. These alternative allocations helped these endowments to avoid the significant drawdowns during market declines of 2000-2003 and 2007-2009.
One simple way to allocate to commodities is to own commodity stocks like oil stocks. Energy stocks are trading at cyclically low-price ranges with historically low valuation levels. The chart below shows that energy stocks, as a percentage of the S&P 500, is at a cyclical low.
This disappointing behavior of the energy sector has weighed on Master Limited Partnerships (MLPs). MLPs have been in a 4-year bear market since oil peaked in 2014. Oil has now turned the corner and is in a bull market after bottoming at $26/bl in January 2016. However, in 2017 and 2018, MLPs lagged even as oil and the energy sector have rebounded. Two factors have held MLP performance back. The first was MLPs’ balance sheet restructurings, in response to the oil bear market, that led to distribution cuts to facilitate deleveraging. Secondly, MLPs have been under pressure due to tax law uncertainty throughout most of 2017. Concerns that the proposed Trump tax cut might disallow MLP favorable taxation status—no corporate taxes--kept a lid on MLP prices. The Tax Cuts and Jobs Act not only did not change the favorable safe harbor regarding of MLPs, today’s lower tax rates further benefit MLP investors. This was described in The Wall Street Journal5 by Jason Zweig in details and we were also cited.
Unfortunately, on March 15, 2018, the Federal Energy Regulatory Commission (FERC) released a widely misinterpreted ruling on MLPs which prompted a 10% intraday decline in MLPs. These negative pressures have been relentless to our MLP advocacy. Two weeks ago, FERC issued a clarifying statement on its March ruling which not only reversed the March negative ruling on MLPs, the final decision was an improvement to the pre-March tax status.
Below is a four-year chart of the Alerian MLP ETF that shows the MLPs sharp decline, retest, and two FERC decisions. The chart looks to be constructive and consistent with a multi-year bottoming process for the sector. MLPs are a solid income investment which should benefit from rising oil prices.
On July 27, American Midstream Partners, LP, (AMID) an MLP which we bought in 2016 that nearly tripled for some of our accounts, cut its distribution by 75% leading to a decline of 42% in the units. AMID was attempting to acquire Southcross Energy Partners, L.P. and Southcross Holdings, LP, “Southcross”, but due to the company’s leveraged balance sheet, required additional capital and regulatory delays, the company slashed its distribution. AMID made this announcement without a conference call. However, the quote below suggests to us that AMID may have been seeking to extricate itself from the acquisition. Southcross terminated the merger agreement on July 30th. The quote below suggests that AMID has a growth path going forward, and for this reason, we added to more aggressive accounts on the plunge.
"Exclusive of the potential combination with Southcross Energy Partners, L.P. and Southcross Holdings LP, the Partnership has identified attractive organic growth projects across all core segments. These opportunities will enable the Partnership to continue building an integrated midstream company with greater scale and density in its core operating areas as well as expanding its reach across growing resource developments. The identified projects will focus on the continued development of infrastructure along the Gulf Coast, which would further the Partnership's ability to participate in the growing export market offshore and to Mexico. The aggregate of non-acquisition related growth opportunities ranges from $200 to $300 million through 2020 at a blended multiple near 5-times expected EBITDA."
Last December, we attended the Wells Fargo MLP conference and met with AMID’s management, including CEO Lynn Bourdon and IR Mark Schuck. They have consistently made confident comments to me and in subsequent calls and conference calls which led me to believe the distribution would hold. This was especially true with ArcLight Capital Partner, an 18 billion dollar energy private equity firm, as a major AMID shareholder that provided capital when cash flows were strained which historically allowed AMID to maintain its distribution.
This week I emailed Bourdon and Schuck on Monday and suggested that they should provide clear guidance on the operating impact of their acquisitions and take a 75% salary cut to share unit holders’ pain. AMID will have a conference call on Wednesday, August 9th, 2018. I hope to be on the call and have some questions answered then. In their defense, in situation like this, their attorneys may advise them to avoid discussions. On July 31, Moody’s indicated that the deal termination was a positive for AMID. On August 1, AMID closed on a sale of marine products terminals generating $210mm in cash to be applied to its $1.2 billion in debt. In the best case, AMID will continue to deliver and execute on accretive capital projects with an estimated cost of $200-300 million. Given an estimated $195mm in EBITDA and an equity market capitalization of $320mm, AMID is one of the cheapest MLPs in the universe.
Often when an MLP cuts its distribution, an MLP will fall into the deep value range, since the large number of retail investors who bought the stock for the distribution only rush to sell it without regard to valuation. While the AMID situation is unclear, we think the stock could return to over $9/share by springtime and carries a yield of 6.7%. Bourdon has a reputation of a good deal maker in the energy patch. However, between the lack of communication and his effusive confidence around the Southcross acquisition, the situation leaves us guarded. Given the consequence of their dramatic distribution cut, I hope the management takes meaningful steps, like taking a salary cut or buying stock, to demonstrate that the management is a good steward of their unit holders’ capital.
Kayne Anderson MLP Investment Company (KYN) is an attractive MLP closed end fund that employs some leverage and can be owned in retirement plans. This is a diversified vehicle to own in this attractive space and yields 9.3%. We own KYN for some clients and it should do well in an improving MLP, energy and commodity environment.
Tyson Halsey, CFA
1. Jeremy Grantham, Founder and Chief Investment strategist at GMO. Zero Hedge January 3, 2018 Jeremy Grantham Warns: "Brace Yourself For A Near-Term Melt Up"
2. Jeffrey Gundlach, CEO DoubleLine Massive Gains in Commodities Are Coming Says Jeff Gundlach
4. July letter. PK Verleger, LLC.
Disclosure: I am/we are long AMID, KYN.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.