Is Recent Rally in Oil Prices Sustainable?
Market “corrections” of 5-10% happen all the time; market corrections of 20% or more are almost always valuation-driven or recession-driven. We do not believe the 5% variety are: a) avoidable), or b) concerning; we defend against the malignant kind with asset allocation and valuation awareness. The U.S. dollar is the primary catalyst right now both in terms of cause and effect – big, short-term impact in commodity and rate markets. QE in Japan IS not going away any time soon, but is no substitute for organic growth. Invest for organic growth, and validate that growth through dividend practices. Yields in Europe are modestly up despite QE, and this should be no surprise to us here in the states. Floating Rate bank loans have appreciated in value 36 of the last 42 times that interest rates rose .2% or more. Energy markets face political catalysts, particularly around crude oil export restrictions and liquefied natural gas exports. Oil prices have rallied a lot, and people are stunned that U.S. producers didn’t die. Their resilience can be explained by the strongest capital markets in the world. For contrarians, recent stock market outflows from retail investors are a bullish sign.
What is your strategy for dealing with the next “market checkback”?
It depends on what one means by “market checkback.” The drops of 5-10% or so, for example, are what most people mean, and each time such a period happens the media (and many investors) do respond as if the black plague has come upon us. A mathematical fact, though, is that over the last six years we have had twelve (that is not a typo) separate incidents of a 5-20% drop (all but two of those being 5-10%), and yet the market is up 258% (also not a typo) in that time frame. The 5-10% type drops are: a) Never going to go away, b) as untimeable and unavoidable as weather, and c) of no threat to a single client’s carefully constructed portfolio. Therefore, I do not “deal” with a market checkback other than celebrating the reduced entry point they provide us via our dividend reinvestment. Now, if one means more severe “checkback” (the 20-50% variety), my “strategy” is to be very valuation conscious, to be contrarian, wary of bubble formations, concerned by risk complacency, and a research hawk around potential recession causation. “Black swan” events though – the very rare market drops out of simply invisible issues in the marketplace – are, by definition, unseeable. History tells us that a focus on risk and valuation is the best defense.
What is the most important SHORT-TERM catalyst in market action right now (bond market, rate market, stock market, and even overseas markets)?
I don’t see how anyone could answer anything other than the U.S. Dollar. That actually isn’t a very helpful answer, because it begs the question as to what actually drives the U.S. dollar, but from commodities to the Euro to interest rates to equities, there is a lot hinging on what the Dollar is doing (either as cause or effect). Is the Dollar inversely correlated to the U.S. stock market as many would have you believe? The answer is an emphatic no. Note the large rally in the Dollar in the chart below and the more recent selloff – both periods have included large U.S. stock market moves to the upside. The longer term “inverse relationship” is even more fictitious. We want a strong U.S. Dollar as American investors, and yet we also know that the Dollar and its relationship to commodity prices (oil among them) and global markets (the Euro among them) is a major factor in Fed thinking and risk markets. One thing you should know as much as you know anything: The Dollar will confound you if you try to expect a logical relationship to world events.
Why do you believe quantitative easing will continue in Japan for the foreseeable future?
One could make the argument that this logic I am about to present could be applied to a lot more places than Japan. But Japan is sort of the poster child for fiscal policy run amok, and I would argue the poster child for what happens to no-growth societies regardless of fiscal and monetary policy. Japan, like most developed countries, runs large deficits. In Japan’s case, if interest rates were to rise a very modest amount (say 2%), they would be spending 100% of tax revenues on mere debt service. So, they can’t see rates rise – period. However, it isn’t that easy to keep rates down. You have to control the demand (by being the buyer) and this is what QE is all about. It is a way to keep rates down. That’s it. The idea is that if they monetize their own debt long enough eventually they can let rates rise. This assumes they get their fiscal budget under control, and the only way to do that is by raising revenue and/or cutting expenses. Too much expense-cutting means decreasing GDP which means you’re back to where you started; increasing revenues by tax increases means decreasing GDP which also undermines the point. So, whether you are Japan, Europe, or the United States, the single variable by which all of this can be improved (not completely solved, but improved) is the idea of organic growth. Real, old-fashioned, wealthbuilding, innovation-based growth. Readers may decide where that growth is most likely to come from – I am unwilling to posit that it will come from Japan or Europe – but all the fiscal talk, monetary talk, QE talk, and Fed talk in the world is not going to replace this basic reality: Growth will be the antidote, or there will not be an antidote.
How is this applicable to our portfolio management?
Central bank experiments, episodes of quantitative easing, discussions of deficit expansions and deficit reductions – these all create volatility and market movements and warrant understanding and preparation. BUT longterm investors should be focused on where growth can and will come from. Profits create growth, and growth creates profits. It is the most non-vicious cycle in all of economics. And it is at the heart of our investment worldview at The Bahnsen Group.
So are rising rates in Europe these last three weeks a good thing or bad thing?
It depends on your perspective, but I will say this: The Mario Draghi-led European Central bank embarked on an all-in quantitative easing type program this year to systemically save the Euro and avoid European collapse by creating negative interest rates while key Euro countries attempt to find their footing. Yields did collapse (part of their objective) and the Euro currency did crater (part of their objective). My above paragraphs would indicate that all of this is for naught if they do not create organic growth in the years ahead, but no one would disagree that they are at least trying to can-kick now with lower interest rates and a weaker currency to stimulate growth and keep the world turning. I don’t agree with the policy prescription, but that doesn’t mean it isn’t the policy prescription – it certainly is – and if they prove unsuccessful at keeping rates down even with unprecedented low yields, I would suggest that European markets are in for a world of hurt.
What do you believe is in store for energy markets from a political standpoint?
This is a great question, as so much of what we focus on in terms of energy sector impact is economic (global growth) and currency related (dollar movement), when in fact so much of the impact on the asset class comes from political activity. There is talk right now that the proposed deal the Obama Administration has on the table with Iran would free up Iran to export as much as 500,000 barrels of oil per day on world markets. I am not convinced this would happen, and frankly not convinced the whole deal will happen. I would suggest that a very interesting 2016 election issue which is highly unlikely to be a headline issue but will have a lot of weight behind the scenes is the state of future crude oil exports here in the states. Should there be a growing swell of interest in one party or the other (or one candidate or the other) in lifting and/or easing the ban on exporting crude oil, the implications could be profound. Beyond Iran and crude exports, I would point to the perpetually significant fact that the exporting of liquefied natural gas (not banned legislatively but regulated by the Department of Energy directly) is becoming more and more frequent. Approvals are not being provided quickly enough, but they have accelerated quite a bit (and this is very positive for infrastructure related gas investments). Finally, I am paying attention to chatter about how Congress and the President address Master Limited Partnership (MLP) structures. Earlier attempts in this administration to lessen the tax benefits of MLPs for oil and gas pipelines didn’t go anywhere, and bipartisan support shot them down. I am now reading that rather than try to damage the tax structure of MLPS benefits to oil and gas, there is a political effort to offer an MLP type structure for alternative sources of energy. Could be interesting.
Do you believe this recent rally in oil prices is sustainable?
I definitely do, but that is very different than saying that oil prices will not drop further. The recent increase to $60 off a low $40s price was quick and dramatic, but it also has left oil still 40% off 2014 highs. The reality is that Saudi manipulation of supply still has a profound effect on where oil prices can go and it remains to be seen whether or not Saudi Arabia has had enough of the forced pain on oil producers (themselves amongst that group). If one believes that their intention was to inflict pain upon U.S. producers so as to force a drop in production (and that was never my theory, as you know), it doesn’t seem to have worked much. U.S. energy profits are way down, obviously, and at least the oil services sector has seen some layoffs, but strong capital markets in the space has prevented the need for a catastrophic decrease in production. Production has come down, but overall the U.S. producers have hung strong which has likely forced some of the OPEC hand that they will not be creating a paradigmatic change in world energy production and pricing any time soon. Another big move down could very well shake up this situation, but for now it is clear that the refiners and infrastructure plays have been the relative winners whereas the drillers and servicers have been the most affected by oil prices.
If you could think of one data point that analysts and pundits continually get wrong from a macro standpoint, what would it be?
If you go back to some of my writing in 2009 you will see my beginning to flush out this line of thinking, but I have for some time now been mystified by the aspiration of analysts to use the consumer as an indicator of, well, anything whatsoever. Consumer confidence and sentiment has proven to be a very poor indicator of actual activity. Consumer behavior has often failed as both a leading and lagging indicator. The argument is that consumption still represents about 70% of GDP, which is true enough, but I think what pundits seem to miss is the immutable reality that consumption is a permanent part of our DNA, and that more important variables to both analyze and forecast data actually exist around Fed policy and corporate profits than they do consumer activity.
Contrarian reflection of last week?
If one was looking for a reason to be optimistic about the sustainability of this bull market, I would suggest this chart is as good as any for contrarians (like us):
Quote of the Week
“Education is simply the soul of a society as it passes from one generation to another.”
— Gilbert K. Chesterton
It is a very interesting time in the markets right now, but perhaps I always think that because I eat, drink, sleep, and breathe in it all day, every day. It seems to me right now that the media is, even more than normal, really tripping over themselves to generate some drama. And I will be the first to say: They do such professionally – it is hardly new. However, I have noticed a real particular frustration lately out of financial press that they can’t seem to figure out if the big story is “the blow-up of the market,” or “the thriving new highs of a rallying market.” Their agenda is not well-served by the present environment, or the call of this environment, which is poise, patience, modest adjustment, and no overreaction. We are more focused on tuning out media noise than we have ever been. Real life markets give us enough noise.