High Market Volatility is Not Going Away
(Please note that the very surprising announcement in the wee hours of the night last Thurs/Fri morning that the Bank of Japan is adding 80 trillion yen – no typos there – to its monetary base did not leave enough time to process and prepare comments for this commentary; suffice it to say this is a shocking story, and does carry at least one major implication I can share without any of the massive analysis I will do: Central banks outside the United States do not care what our Fed is doing; as we stop QE3, they’re doubling down. It will be easy to look at the huge rally Friday and see this move as a good thing; you may feel differently when you read my next, more exhaustive commentary on the subject.)
My top points of the week, noted with an asterisk (*).
1) Here’s my overall take on the stock market: While October’s incredible up and down volatility is not likely to stay, higher volatility going forward will be the rule, not the exception. Prices are not high when compared to present earnings. Financial leverage is the question mark: Are we subject to panic selling?
2) Read below for a few commandments in evaluating oil prices. Bottom line: Forecasting OPEC1 behavior is ill-advised.
3) Investable spaces in the energy world include the Production companies, Pipelines, Refiners, and Services. Some have short-term exposure to oil prices. Some have no exposure to oil prices.
4) I don’t expect a lot of market implications from tomorrow’s election results as I think the market has largely priced in what it expects to happen. The singular issue in the political spectrum I believe will be a catalyst to a given part of the market. (and this will likely not be this election) is IF and WHEN the political powers that be authorize the exporting of oil and gas – a game-changer for the economy, in my estimation.
5) A big advantage to smaller and more nimble funds is the ability to maneuver without everyone seeing what is being done and following suit (crowding trades, etc.).
* What do you think of the stock market overall right now?
I don’t think it is very bold of me to predict that regardless of whether or not prices move higher or lower, a heavier volatility of price levels is back. I would not suggest that the volatility levels we experienced in October will maintain at that level for the next six months, as October had been perhaps above the expected volatility range, but certainly higher volatility seems probable to me going forward for all the reasons I have written about in the past several weeks. But again, that higher volatility prediction is safe, consensus, easy, and not really why you read this commentary. The big issue in terms of price recovery the second half of October has been a healthy earnings result. So far, with 63% of companies reporting, 62% have beaten expectations (yet again), and only 18% missed expectations (3). You should note that earnings results have not helped the ENTIRE stock market… Some companies saw increases where results were solid but other companies saw declines where results were disappointing. This is my biggest assessment of the stock market going into 2015: More dispersion amongst returns and greater rewards for fundamental stock-picking.
On a macro level, can you explain what we should watch regarding sell-offs and what we should watch regarding rallies and inflows?
If the P/E ratio of the S&P 500 were really high right now (say, 22x), and we experienced a macro hit to the markets (profit warnings, interest rate spikes, geopolitical tensions, etc.), we could see a sudden and dramatic sell-off in stocks because of the excessive valuation. The multiple, or P/E ratio2, though, is NOT excessive, but in fact is right in line with historical averages (close to 16x earnings). So I am not looking at excessive valuation as a catalyst to sudden downside volatility, but I am looking at the risks embedded in financial leverage. If a glut of capital has built up in the financial markets, meaning too much buying with borrowed money (hedge funds, etc.), pressures on prices tends to be exacerbated and could be problematic. I follow the weekly reports of prime brokerage buying, margin levels, flows, etc. These things are not an exact science, but overall financial leverage is always worth monitoring, and leads to real risk-on/risk-off periods.
What about rallies and inflows?
The issue to understand here, and I am the first to admit it is not easy to do so, is the nature of capital. I have often tried to remind clients, “it has to go somewhere”. Being bearish on EVERYTHING is not really an option, because the capital does not dry up and hide under an earthly mattress. I do not believe this greater economic lesson provides much help in very short-term periods of price movement (but who needs help in those periods, for surely clients of The Bahnsen Group know that they are neither meaningful nor of practical import to our investment methodology or your investment results); but in the longer term, this lesson is very important. The RELATIVE attractiveness of stocks to bonds, or say U.S. stocks to European stocks (etc., etc., etc.) matters a great deal. Recognizing the short-term tendency for high correlations and risk-on/risk-off behaviors, I still suggest that the U.S. markets and the stock market in particular are more likely to be relatively attractive in the overall environment of global capital markets for the foreseeable future.
And the shameless but so crucially important reminder?
Once one feels comfortable with their tactical positioning across asset classes (see the preceding paragraph), rather than indiscriminately buying the entire market and praying for a rally, I believe it behooves us to focus on individual company quality as expressed in the above-average dividend of the companies we buy coupled with the high likelihood of growth in that very dividend payment.
* Has your view on the price of oil changed at all last week?
I’m not sure that it is fair to say that I have a view on the price of oil, but no, whatever views I do have did not change last week. I did read an exhaustive research report on the subject from one of the premier research outfits in the country last week (2).They have been calling for prices closer to $150 per barrel for the price of crude oil for quite some time, and now, after dropping from $105 to $80, they changed their target to, well, $80. This impacted markets and oil stocks last Monday quite a bit. Their thesis is reasonable enough in the parts we can project: Non-OPEC countries (at the top of that list being the United States) continue to generate strong SUPPLY growth, and global demand is expected to slightly moderate. However, to justify $75/barrel oil prices, one has to project ongoing heavy production growth from the OPEC countries, and I would be hesitant to project such a thing. I think my clients and readers should know the following:
1) It is tough to put too much stock in the oil price forecasts of anyone who has been perpetually wrong on the same subject.
2) Forecasting anything that relates to the behavior of OPEC countries is not easy to do.
3) There is a bit of a teeter-totter at play economically as the laws of supply and demand wrestle with another. If prices drop because of over-supply, production of new supply then drops as producers await better opportunity, which then pushes prices higher, etc. The amount of these levers that exist and complicated supply-demand variables make it very difficult to forecast a price level on crude oil.
* So in the midst of oil prices that are being talked about between $75 and $95, what is the investable strategy and opportunity?
I believe the OIL SERVICES space has many times that can do quite well anywhere in that range of oil prices (and do better if oil prices increase from current levels). They DO have some price leverage to the price of oil (more so in the short term), as the risk is that producers slow production and the services of these companies are less in need. I think the market has fully discounted this (and then some), and that the name(s) I like in Oil Services are appropriate regardless of oil prices at these levels. I think some selective exposure to the E&P (Exploration & Production) names can be quite appropriate, BUT they certainly have price volatility around the movement of oil prices. There are select REFINERS to look at which may either benefit from oil price moves, or suffer. Let me explain. REFINERS make money when WTI is cheap, but BRENT is expensive, meaning the spread between the bad stuff (WTI) and the good stuff (BRENT) is wide. In other words, refiners are not so much affected by the price as they are the spread between the two. There is price risk here, as spreads are a by-product of two prices, but it is a different dynamic and still investable in a select manner. I only own one refiner name directly in the dividend portfolio at this time. And last but not least, the PIPELINES (midstream part of the energy process) remain the most oil price agnostic opportunity in the energy sector at this time.
(For a recap of what we are doing in the OIL SERVICES space, the E&P space, the REFINERS, and the PIPELINES, please email me directly.)
We get your agnosticism about oil prices in the short-term and we get how you are going about investing in energy at this time. But what are the relevant short-term catalysts to be watching as it pertains to oil supply/demand and consequently, prices?
Should OPEC cut production in November that could have a big impact. It also will be interesting to see how shale production here in the United States responds to recent price moves. Shale production is not likely to be much affected but even a modest slowdown could cause prices to move higher. Demand levels are always a bit unknown and are necessarily forward-looking, meaning unexpected demand increases in the future could cause price increases (and vice versa). I would never try to forecast this last part or let alone monetize it, but a big wildcard in all of this is the posture Saudi Arabia takes regarding their own production.
What are you expecting from the elections this week and its impact on investment markets?
I am not expecting any big surprises and therefore not expecting any impact from the elections on the markets. All polling and punditry seems to indicate the Republicans will re-gain the majority in the U.S. Senate they lost in 2006, though the possibility exists we will not know this until December as a couple states have run-off laws when one candidate does not exceed 50% of the vote total. The GOP stands likely to add to its gains in the House of Representatives though the extent of this is not totally known at this time. How a re-aligned Congress in the second half of President Obama’s second term affects markets is more dependent on him than anything, as we really don’t know if this new political dynamic might lead to any progress in entitlement reform, immigration reform, tax reform, or corporate tax policy.
* Whether it takes place after this election or as a result of a different catalyst, what is the most significant political catalyst you are waiting on?
Obviously, I am very curious what kind of corporate tax reform can be worked out, but I am not sure if that can happen just yet unless the political polarization is dramatically reduced. (I am not holding my breath.) However, I continue to believe that some movement towards lifting a ban on U.S. exports of oil and natural gas is going to come one way or the other, and I expect that to be a major catalyst (if and when it happens) for the midstream space of the energy process, as substantially greater infrastructure will be needed to make this possible (pipelines, storage, etc.). Few issues could have a more dramatic impact on the U.S. economy than arriving at a point where we become a net exporter of energy products.
Do you buy the argument that small-cap stocks have less exposure to global/international conditions and therefore may be more attractive than large-cap multi-national companies at this time?
In theory that makes sense for those of us who see ongoing weakening in Asian and European markets. The problem in acting on it is two-fold:
1) Who says that current large-cap multi-national company valuations are not already discounting this reality? (I would suggest they are); and,
2) Are investors willing to take on the increased volatility that small cap-stocks in inherently live with, and what mechanism are investors comfortable with to avoid the losers in the small cap space?
I am a big fan of the small-cap space in terms of historical performance record, but we must never be cavalier about the potential for downside movement in this space. It is much more severe and dramatic than many investors seem to appreciate. If and when I come back into the small-cap space, it will be out of very low valuations, not the levels we presently see (which admittedly are lower than they were two months ago, but are frankly still quite high).
* What are the advantages of smaller portfolio sizes and funds vs. the mega-large ones famous in the financial services industry?
“Smaller size, in terms of flexibility in trading, idea generation, and the fact that the street doesn’t follow your trail, the bread crumbs to your house – I think it’s a big advantage. An effective investment organization has to be relatively compact, relatively small.” (1)
— Bill Gross, long time manager of the Pimco Total Return Bond Fund. It grew to the $300 billion level at one point before Mr. Gross left Pimco
When you get optimistic about a certain country’s economic growth, why not just buy the ETF of that given country?
There are two reasons. The far more important one is that I am firmly convinced that the economy of a given country (GDP) and its stock market are often quite disconnected. In other words, I am a bottom-up company-oriented investor; not a top-down country-oriented one. But the other factor is that the indexes that underlie so many country stock markets are often very, very top heavy (meaning one or two companies could represent 25% or more of the entire index). When one thinks they are getting mass country diversification and gets just a couple companies from it that can be a big risk problem …
So you do not see gold as a “safe haven” investment?
No, I do not. It can go up, and it can go down, but it would not be a sure-fire hedge for safety in times of turmoil. Consider, for example, how gold has acted over the last several months. Someone shot a plane out of the sky over Ukraine (“someone”?), Russia’s relationship with the western world has dramatically worsened, the U.S. re-engaged significant military action in the Middle East primarily focused on ISIS (in Syria and Iraq), U.S. interest rates have moved down and up a full half point (each), Europe’s economy is showing signs of re-ignited recession, the U.S. stock market experienced its biggest move down in three years (before rebounding), and global fears have surfaced regarding Ebola. In the course of this four-month period Gold has DECLINED nearly 10%, not increased, hedged, or protected. In fact, gold remains down roughly 40% from its high level where it was just a couple years ago. This is in no way a reflection on gold’s prospects as a speculative investment going forward, but it is a good illustration of what can happen when human speculation becomes the only catalyst for movement in a given investment.
What are your thoughts on the market’s sell-off in recent weeks, recovery, and where things could go next?
It is important to remember that when the market has gone so long without a meaningful correction, “weak hands” exist in the market – hot money that is moving around, performance-chasing, but not based on conviction or intelligent investing. I believe a rather minor sell-off a few weeks back turned into a larger one as very naive money (“weak hands”) folded. The smarter folks benefitted from this. Now, I also believe ongoing fundamental risks exist for the global economy. I have written about this extensively. I believe Europe is about to embark on an unprecedented experiment of monetary policy. The United States faces the much-discussed need for tightening their own monetary policy. The extent of China’s slow-down is unknown. This is not time to be complacent. Earnings will continue to trump all else.
1Organization of Petroleum Exporting Countries (OPEC)
OPEC is a cartel that aims to manage the supply of oil in an effort to set the price of oil on the world market, in order to avoid fluctuations that might affect the economies of both producing and purchasing countries.
2Multiple or P/E Ratio
This refers to the valuation of a given stock or a stock index (like the S&P 500). If a company makes $10 of earnings per share, and is trading at $100 per share, it is said to have a P/E ratio (a price-to-earnings ratio) of 10. It is also called the “multiple” – the number that when multiplied by the earnings will equal the price.
QUOTE OF THE WEEK
“The confidence people have in their beliefs is not a measure of the quality of evidence but of the coherence of the story the mind has managed to construct.”
— Daniel Kahneman
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I will leave it there this week and will look forward to next week’s edition which will include both a thorough recap of October and a look at the Tuesday election results. I will actually be in Washington D.C. next weekend for a conference. We shall see if the air is any easier to breathe after Tuesday … =) Enjoy your weekends … Besides the fact that my kids love Halloween so much, this is a fun weekend: Thanksgiving is only a few weeks away!