My New Year’s resolution for 2019 was to write more, share some insights, be heard. Mix it up with the head count… or the Capita Censi as the ancient Romans referred to them.
So far, the few forays into investment writing and stock picking that I have shared on Seeking Alphahave mostly consisted of granular analysis of the energy sector. I make my ends working in the Shale biz and have learned a thing or two about the way it all works over the past 10 years.
It occurred to me that investors in 2019, do not really need advice from an X’s and O’s guy. Sure, individual investment decisions should hinge on that sort of analysis, but something tells me the winds are blowing a different direction in this market. The easy money has been made and now the sharks are circling. They smell blood. Before recommending any stocks- I thought it might be helpful to tell people that now is a good time to figure out which way shore is and start swimming. Macro analysis is not something I usually offer much of. But more so than any time in recent memory, it might be the strongest foundational building block we can endeavor to grasp.
My three-year-old son is obsessed with The Avengers. One look inside our humble abode will reveal a smattering of various sizes and makes of the Incredible Hulk toy series. They almost form a raft of debris which could be traveled on top off. I thought watching Avengers: The Infinity Stone might be a nice way to connect with the little guy. Two minutes in and Thor has electromagnetic pulses coursing through his cranium as Thanos shoots supersonic somethings through the light stone which is attached to his mechanical hand rig thing. So much for the toddler and Avengers. He is screaming in terror and begging for kid friendly YouTube shows. But I was sucked in.
By the end of the movie, Thanos acquires the infinity stone collection and consolidates a tremendous amount of power. It reminded me of the type of consolidation and sway that US monetary policy has aggregated over the stock market in the last 10 years. Most market participants would probably visualize the Fed in the superhero role. After all, this has been a historic bull run mostly fueled by cheap access to capital and credit. Bernanke and then, Yellen mostly enjoyed a peace-time run of asset inflation. The world did not require much superhero duty as most major indices powered ahead at a 45-degree angle. Superheroes without a cape, right?
Meanwhile, in the background, Thanos as played by Jerome Powell was quietly collecting infinity stones.
The real Thanos operated off the audacious premise that half of interplanetary life must be wiped out for the universe to survive. Powell made an equally maniacal statement in September 2018 proclaiming “Assets are expensive.” He then proceeded with a series of rate hikes, tightening of the fed’s balance sheet, and then pretty much snapped his fingers erasing 20% of the value of the S&P by Christmas Eve 2018.
It seemed that the obituary had been written for the stock market. The bad guy won. Thanos sat back on his “chair” and watched a peaceful sunset while the remaining clown car of long-bias mouthpieces cried out for a Santa Claus rally. It turns out the story is not over, Marvel is coming out with Avengers: Endgame sometime this year. Iron Man (played by Jim Cramer) has survived and I suppose he will lead the remaining Avengers on the quest for negative rates.
Most investors understand the superficial elements of the Fed’s role in asset prices. Low rates narrow the breadth of investable asset classes forcing investor’s higher on the risk ladder. Quantitative Easing lengthens the money supply and promotes easier access to credit. On the surface these appear to be reasonable tools that the Fed has invoked to jumpstart the economy after the 2008 meltdown.
It is the knock-on effects of this long-running experiment which (I feel) as though the collective investment community fails to comprehend. Here are some examples to flesh out the idea I am trying to communicate.
I am 67-year-old retiree with under one million in savings. I should not be participating in risk-on asset speculation in a late cycle stock market. Universally low rates make it difficult for me to find a safe investment vehicle which will outpace inflation. A friend of mine tells me about this new company which allows you to take selfies with funny farm animal faces and post it on the internet. The kids all love it, he says. The IPO is oversubscribed, and the chart is a screaming buy. I buy the stock at 100X forward earnings. I have a 2-bagger within 3 months affirming my own bias that I know what I am doing. I am a set it and forget it guy, so I let it run.
Problem: With nowhere to turn for suitable yield, retail investors become enamored with these growth narratives. The easy access to credit and financing allows big-name sponsors to roll out awkward, cash-burning fantasy companies based on the simple promise of endless technology and advertising dollars. Often these companies have: 1. No economic moat. 2. No barriers to entry. 3. No line of site to real earnings potential.
No matter, the algorithmic trading schemes which can dominate short term direction gun these stocks to the moon and break the pricing mechanisms by which the market customarily operates. Retail investors see the price action and jump in without much understanding of what they are buying.
Suddenly, Thanos snaps his fingers. The worm has turned. Quantitative easing has been replaced by quantitative tightening- zapping liquidity from the market. The rate cycle begins to inch higher putting pressure on these high-debt cash-burning fantasy companies. The torrent of momentum driven money leaves first. Then the ETFs push for the crowded exit. The 67-year-old retiree is always the bag holder searching for the door in a liquidity vacuum.
The inevitable implosion of the junk will be a dangerous contagion to the stock market. As a retiree, I can handle a loss in a speculative name. The possibility of a structurally driven crash is far more harmful to me if I am highly allocated to stocks. The S&P dropped 20% in two months on the back of two rate hikes. The Fed Funds rate is still under 3%! Still think this can’t happen?
I am a private Texas wildcatter who took a chance on buying 40,000 acres of oil and gas leases in Howard County, Texas. WTI prices just went to $75 per barrel. I see what benchmark per acre transactions are going for in the offset acreage. I secure funding to drill my position by tapping the public equity markets. I raise a billion dollars in equity and finance the rest with 8% junk-rated bonds. My bank loves this deal because they get to use cheap financing to securitize my expensive financing. They know little to nothing about the long-term economics of my fringe acreage position, but they are well covered in the event of a default.
Problem: My per well economics workout to an IRR of 15% all-in cost at $75-dollar benchmark oil. The banks and equity markets have replicated my situation with 40 other companies who hold similar positions. The stock market values my company on top line growth and gives me a multiple which leaves no room to miss CAGR targets. Me and the other 40 bring on production as fast as we can adding 200 million barrels of extra supply to a market which is already responding to the price signal. The market being forward looking, sells off and crude drops to $50. At $50 WTI, I lose 1.6 Million dollars on every well that I drill.
If more suitable yielding investment classes were available, the banks and equity markets would have never financed this bad bet. They would have payed attention to the field economics and lent their money to the companies who are poised to grow and succeed from high cost, high decline asset bases.
I am the San Francisco Fed. I just put out a public research paper singing the praises of negative interest rates.
Problem: I am writing this on (2/12/2019) which is the 20th anniversary of the Bank of Japan cutting rates to 0%. On one hand, it is a strange example of how long a crisis can be averted by kicking the can. Asset prices in Japan are essentially flat for the past 20 years. However, Japan has a debt to GDP ratio of 236% (highest in the developed world) and the Bank of Japan owns nearly half of the outstanding debt issued by their central bank. Is this the trade-off we want to make in the US? Rocket fuel for the stock market in exchange for endless debt, credit bubbles, and currency risk?
The stock market has bounced back nicely from the December 2018 low. Thanks in no small part to a complete capitulation by the Fed on raising rates and even tightening the balance sheet. At the beginning of the year, I thought there was a fair chance that rates would continue at an upward trajectory. I think the dovish walk-back by Powell and Co. illustrates the severity of the trap that our monetary policy has set.
Continuing to raise rates with the backdrop of a global recession virtually ensures a stock market crash, a non-performing loan cycle, and deflation in commodity prices. These are not really things that anybody wants. But how long before these things take their natural course despite our monetary policies? Neither the Fed nor I know the answer to this question.
It looks increasingly likely that we are in another kick the can year. Maybe rates remain unchanged in 2019. Maybe the Fed cuts 50 basis points. Eventually, something must give. I suspect that it will be the US Dollar. If you look at the global debt to GDP situation and what the various central banks are doing to manage it: a clear picture emerges. The world is fraught with endemic economic weakness and the US just happens to be the strongest weakling.
The US dollar is like your friend in high school that you made do all the dirty work. Throwing a “Rager” at his parent’s house when they went out of town, beer runs, pulling the fire alarm to get the baseball team out of a test they didn’t study for etc. Eventually that guy turns on you once he realizes you really aren’t his friend. Maybe he even punches you in the nose.
The continued manipulation of interest rates to the downside puts pressure on the dollar. A weaker dollar affects dollar denominated asset prices. A decline in the purchasing power of the dollar affects wages, income, and almost all asset classes including traditional safe havens such as real estate. Central bank attempts to control asset prices and keep inflation at “2%” will eventually have a downside that exceeds the useful impact of their meddling. This is a difficult environment for investment. My best advice may be “Try not to get punched in the nose.”
Despite the doom and gloom tone to this letter, I feel that actionable ideas can be explored based on the concepts laid out in this letter. After all, “there is always a bull market somewhere”- Jim Cramer.
Gold has broken out lately and continues to stay above the key technical level of $1300/per ounce. Gold/Gold stocks are a great hedge against central bank malfeasance- especially as it pertains to currency risk. It is also a way to get long without “fighting the tape.” This essentially means you can be long gold as a proxy short against the broader market without having to deal with the headaches and “helicopter parenting” of maintaining a short position.
Gold and gold stocks have been so far out of favor with investors that the miners have slashed exploration budgets to the bone. Little to no exploration and finding of new gold coupled with increased demand is a winning formula.
The energy sector is a volatile and cruel mistress. For those of us who focus our efforts on energy, watching investors panic over a 5% weekly drop in the DJIA is almost laughable. Since the epic crash of 2014/2015 we have experienced 5 iterations of $10 dollar or more price swings in WTI with a handful of consolidation periods that have provided solid and easy to pattern trading ranges. The $50 to $56 level has been a reliable range bound trade until crude decides its next direction.
Expounding upon the Fed dilemma and why it may ultimately lead to a collapse in the dollar- we can project the positive effects this may have on the price of crude. The global crude trade is largely dollar dominated. A strong dollar makes crude more expensive for developing nations especially those that are not large producers/exporters. Weakness in the dollar will allow the rest of the world to buy crude at a discount thus enhancing global demand for crude.
This market tends to vacillate in extreme fashion as price becomes the leading signal and increased or decreased production being the lagging indicator. The violent sell off beginning last year overdid to the downside. Some of it was supply/demand dynamics but a major underlying cause was the prospect of a global slowdown which could impair demand growth.
Money flow in the energy sector tends to start with the strongest names and trickle down to the leveraged shale sector once a new uptrend is confirmed. I expect WTI crude to trade in the low $60’s by driving season once refinery throughput picks up and excess inventory is worked off. Look for strong balance sheets with exposure to BRENT pricing and layer in leverage once a pattern is confirmed.
I do continue to expect weakness in natural gas. I have written extensively about impending supply which will keep a lid on prices despite the growing LNG and Mexico export initiatives. The increasing local gas supply should be a boon for midstream names who are building out capacity and requiring minimum volume commitments from the producers to incentive said buildout.
Eventually a paradigm switch between traditional valuation methods and the “new normal” of growth/momentum investing will take place. Value investing and stock picking prowess will once again become relevant strategies. Now is not a bad time to dust off Benjamin Graham’s “The Intelligent Investor” and start ticking the boxes for deep value sleepers and proven dividend growth names.
I plan to cover some individual names this year and will be out with a few new picks soon. I will revisit this macro thesis around the middle of the year and issue my outlook for the second half of 2019.
Disclosure: I am/we are long KMI, COP, LUKOY, GOLD, WPM, CRZO.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am/we are short Tesla (TSLA) and Micron (MU)