Greek Fallout, China’s Stock Market Bubble, NYSE Freeze
This week’s commentary is one we are personally excited about, and hope you’ll feel the same. We put a lot of extra research into a few specific pieces this week, and hopefully this will show through. It was a challenging week in the world with the fallout from Greece (mostly characterized by broad uncertainty), the continuing collapse of China’s bubblicious stock market, a complete and total freeze of the New York Stock Exchange on Wednesday that lasted nearly four hours, and then the preparation for earnings season (which could be the most important piece of all). It was a challenging week for market performance, but not as distressed as we thought it was going to be at the beginning of last week.
We are dedicating a lot of space to MLPs this week because, for clients looking over their portfolios from the first half of the year, they may possibly notice that the price performance of MLPs was really the only substantive drag (in what was otherwise a fine couple quarters featuring some particularly strong individual stock performance around certain names). In other words, MLPs got hit in late 2014, and we can understand why many of you may want to know what is going on. Expect a real MLP education in this week’s commentary. With that all said, let’s get into it…
China, Greece, NYSE shutdown – it could have been a lot worse than it actually was. MLP prices (we use the term “MLP” to denote the Master Limited Partnerships – publicly traded partnerships – in the midstream oil and gas pipeline space) are not historically correlated with commodity prices. Recent weakness related to a host of factors including the nature of the investors who jumped into the asset class in 2013 and fear of project completion. Historically MLPs have done quite well – not poorly – in periods of rising rates. We own them due to their high current income and growth of yield; that is the story. The future of natural gas in both our domestic story and the overall global story is a future we want to be invested in, and pipelines are a huge part of that investable story. The persistence of their rising dividends is what will reverse this current market dislocation. Fear of market volatility does not in and of itself argue for greater allocation to bonds and/or cash; fundamentals and valuation driving a disciplined approach must dictate such things. Q2 earnings season to go a long way in determining the next leg of the market; thus far earnings growth ex-energy has been quite impressive. Best sector out of a Fed rate hike cycle has been Energy; worst, Utilities and Consumer Discretionary. Forecasting interest rate movements is not possible, and not even most important thing – it is yield curve forecasting (what maturities are affected in what way by interest rate changes) that differentiates bond managers. We are not focused on that which we cannot control – a P/E ratio going higher (price-to-earnings), but rather buying companies with a growing E (earnings), and then a growing D (dividends) from those E (earnings). Greece exit strikes us as inevitable. Wouldn’t the pain be worse later than now?
Before you get into your MLP stuff, tell us what to make of last week – China, Greece, a NYSE freeze on Wednesday, triple digit moves down and triple digit moves up – are we okay?
There really could have been much more volatility behind some of the headline gravity. The Thursday rally (which fizzled quite a bit throughout the day) seemed very misplaced to us – there is total limbo with Greece and all China did was use the power of the state to disallow investors from selling securities! Some of us remember a ban on short sales in financial stocks pushed through here in the states in September of 2008, a quick rally in response, and then the bloodbath that ensued after the fact. No amount of manipulation of freedom-reducing government policy can keep a bubble from bursting. What is the actual impact to the Shanghai stock bubble popping? Very little. China’s true economy matters far more. The Shanghai stock market was up 400% before this recent 25% selloff and it had no impact on American markets. Ultimately, the Shanghai story, the situation with Greece and Europe, the tech glitch at the NYSE – these are all the things news headlines and day-to-day market volatility are built on. The earnings and fundamentals will drive the real returns.
Are MLPs correlated to crude oil prices or not?
Here’s the thing: If the drop in oil and gas pipelines in Q4 of 2014 was related to the crude oil drop, why have MLPs not recovered in Q2 2015 as oil prices are up nearly 40% from their lows? (In fact, they have weakened further.) The historical correlation between commodity price movements and MLPs (especially those of the midstream pipeline variety) is very low. Whether this is what all investors are looking for or not, the MLP model is an extremely boring one – a space all about cash flows, and growing cash flows. If commodity price movements affected those – the cash flows of MLPs – then yes, there would be a reason to believe these things were correlated, but that is not the case.
So, is some explanation of the recent weakness in order?
We are not sure that that is true. There have been irrational moves up and irrational moves down in various sectors of the marketplace for centuries. We lost count how many times in our careers rather sudden movements one way or the other took place in a given sector or asset class that never did provide an explanation. Now, with that said, distress in a heavily-owned space like MLPs does require us to investigate and re-investigate and thoroughly challenge our own perspective. You can rest assured we have diligently done that on a weekly basis for about nine months now. The general explanation we can offer about MLP price weakness in recent times is that there continues to be a purging of the type of investors who bought MLPs for the wrong reasons in 2012-2013. From 2010-2011, the space exploded upwards in price for the right reasons – its cash flows were growing like crazy and therefore its cash flow dividends to investors (called distributions). This caused a flood of “dumb money” (the not-so-polite term we use) to enter the space in 2012 and 2013, often with leverage. In reality, those buying MLPs for sexy price appreciation will almost always be disappointed – it’s a strategy focused solely on, “high current income with growth of that income.” That’s it. That is all we own it for, and that is what the fundamentals of the space call for. There appears to be owners who are misaligned and this is a likely cause of some price discrepancy. The distribution announcements we face in the weeks ahead (late July, early August) will do a lot to settle the space, in our opinion.
Won’t rising interest rates cut into the dividends MLPs can pay out because they borrow and will have higher borrowing costs?
Only 13% of MLP borrowing is in short-term, floating-rate debt. The vast majority of pipeline operators have taken advantage of these low rates to lock their borrowing costs. Over a 20-year period, MLPs have outperformed Treasuries during periods of rising rates seven out of seven times.
So you’re saying the price drop is largely about the investment IQ of the sellers?
Not exactly. We do believe there are some fearful of an interest rate increase and that has weighed on other rate-oriented equity sectors, too (REITs, Utilities, et cetera). But that is the least of our concerns, being keenly aware of the total non-correlation between MLPs and interest rates historically. There is likely a combination of factors, mostly fear-driven and technical, and the one with a legitimate timing function is those fearful that future projects will be cancelled calling into question the future distribution growth. This is wholly unrelated to current yield, by the way.
So are you saying MLPs are really “coupon clipping” investments?
Absolutely! We have never said anything but that. The caveat, though, is that coupons grow year over year over year. And, oh yes, we do believe volumes will continue increasing, and as coupons increase, it sure seems logical that share prices would, as well. We simply have to focus on that income and let the market sort itself out. What has been the nature of that income since the energy market freefall last autumn? Uninterrupted dividend payments, and dozens of dividend increases. Exactly what we buy it for. Obviously we want to avoid project delays and certainly project cancellations (which would limit volume which limits fees which cuts into cash flows), but that process has been nearly flawless so far. If recent MLP weakness is about fear of project slowdowns leading to cash distribution slowdowns in 2017 or 2018, we think the reaction has been dramatically overdone.
Where does Natural Gas fit into the conversation about MLPs?
The one issue not brought up enough in the midstream space is how crude oil and natural gas get treated as if they are one phenomena instead of two totally separate phenomena with their own characteristics. It’s a ballpark estimate, but we believe no less than 65% of our midstream pipeline exposure is natural gas related (vs. crude oil). Yet, the dialogue almost always focuses on the oil side of the equation. At the end of the day, the calculus around this goes back to the white paper David wrote in the fall of last year – the shale revolution in our country (horizontal drilling and hydraulic fracturing of shale rock) opened up floodgates of opportunity in natural gas, and the seemingly unending uses for liquefied natural gas is driving this further and further.
The obvious natural gas use is in electricity generation and the replacement of coal in that function, but the exporting of liquefied natural gas is a huge part of the story. (Incidentally, whenever critics of natty gas point out that replacing diesel trucks with natty gas has not been the massive success some hoped for, they neglect to mention that it represents less than 5% of the planned growth for liquid natural gas anyway, and, in fact, is tracking to do much more than that). To be bearish on the future growth of MLP projects means you have to be bearish about the outlook for natural gas growth (not price growth – usage growth), and we would argue that being pessimistic about the future usage of natural gas is highly irrational and defies economic logic. The export story around liquefied natural gas is utterly huge. (We should write an entire commentary about this subject.) This story is playing out, and the infrastructure needs to transport and store this gas is incredible.
What pulls the MLP space out of this price distress and into fair valuation?
We are not able to say exactly when this will end nor what the particular catalyst will be. Part of us selfishly prefers it NOT be the mere stabilization of energy markets (higher energy prices leading to greater confidence in energy infrastructure leading to more speculative and uninformed investors heavily participating in the space). This is a strategy we love because of high current income, combined with high growth of that income. The rest is windowdressing. So a macro energy confidence renewal would likely be a catalyst (demand from China, higher commodity prices, etc.), but ultimately the real catalyst we prefer is that investors see the stability and sustainability of the distribution growth and buy accordingly. That is the thesis which has us in the space, and we will not be shaken out of that thesis by sentiment, psychology, or a couple quarters of unfavorability. We owe you better than that.
In the face of pending stock market volatility, what would be the reason NOT to increase exposure to cash and to bonds?
One of the key words here is “volatility”, because if we start off acknowledging that is the fear we have – volatility, vs. loss – we can deal with it in any number of ways. But cash as an antidote to volatility must first presuppose the skill of timing, a skill we have not yet found in any layman or any professional. Using valuation as a guide in one’s asset allocation is the best way to mix opportunism and risk aversion. Where we sit now, many commonly-voiced concerns against equities are equally valid concerns for the bond market. The reality is that the blending of non-correlated asset classes around an intentional strategy (income objectives, volatility tolerance, liquidity, timeline, tax treatment, etc.) is the best strategy.
How worried are you about earnings growth overall?
We’re very curious how Q2 will play out. The strength of earnings growth if evaluated ex-energy is really impressive, despite macro impressions we previously had.
What sectors of the stock market have typically done best in the past when the Fed returns to raising interest rates?
What bond strategy do you think will perform best when rates do begin to rise?
The bond manager who will do next is he or she who best forecasts where on the yield curve rates are most affected. We call this dynamic steepening vs. flattening. Basically, low short-term rates and high long-term rates is a steep yield curve; what maturities are affected in what ways is the forecasting work reserved for very smart people (assuming they are good at it, which very few are). We think assuming the rate hikes (whenever they begin) will be all felt in one maturity or another is very dangerous, and that properly managing yield curve dynamics will be very important the next several years.
What do you believe is next for Japan in their quest to overcome deflation with inflationary and debt with currency depreciation?
We think a negative policy rate is very likely as Japan continues to struggle to create inflation even with the globe’s largest-ever quantitative easing experiment.
How challenging is the situation in China?
Let’s put it this way: There have been 10 interest rate cuts since 2011, yet growth has slowed each year. The stock market surged as margin debt is up 437% year-over-year, yet a stock bubble has not goosed rate of growth. A study we read this week indicated 6% of new stock investors were fully illiterate – not economically illiterate, but like completely, really, actually illiterate. There is a credit bubble, an investment bubble, a margin bubble, and a real estate bubble. The outlook continues to be for decelerating but still positive growth. The way in which the unwinding of excesses effects the global economy is the subject of great attention.
So, do we need a growing P/E ratio or growing earnings to give us stock market returns?
A growing P/E ratio gives positive stock market returns in temporary bursts, but it gives those returns back if that P/E ratio growth (what we call “multiple expansion”) is above its average. In other words, P/E ratios do expand past their historical averages and they do contract, and to try to play those things up and down is a fool’s errand. We believe in reversion to the mean, and believe that P/Es which are under averages generally come back (though this can try one’s patience, we assure you), and that P/Es which end up exceeding their natural averages end up reverting as well. What we favor is the second half of your question: Getting our returns from growing earnings, but then also the other piece your question does not address: growing dividends from those earnings. What this does is focus on the two things that we can actually manage with hard work and fundamental research (companies growing earnings and companies growing dividends), and leaves out as a focus point the one issue no one can control or exert any impact over – P/E expansion. We can tell you that when an investor is looking at his returns on a day-by-day, week-by-week, or month-by-month basis, he or she is nearly always just looking at whether or not the P/E ratios expanded in that period – a metric that is immaterial to long-term success and, of course, uncontrollable, as well.
Are you saying that where P/Es are across the market does not matter?
No, because in a macro sense, they do! In early 2009 when P/Es were between 8 and 12, there was both the possibility of growing earnings (which have come about like manna from heaven), but also a cheap market that would at some point become fairly valued. Of course both of these things took place. Inversely, buying at periods of high and excessive P/E ratios across a whole market can generally lead to a sustained drag on performance, the most notorious example being the 2000 bubble which saw P/Es north of 25 that had to come back down to reality. We remedy this in two ways at The Bahnsen Group: We are very valuation-conscious in our overall asset allocation decisions, tilting equities higher in periods of lower valuations and tilting them lower in periods of higher valuations; but we also avoid stocks that are more susceptible to absurd P/E bubbles, instead operating mostly in a space of more fundamental stock-moving metrics.
Do you have anything you want to say about Greece?
There has actually been very little news since the referendum, other than that European policymakers and Greek leadership are set to re-engage talks. As we write this (late Thursday), Greece has just sent their latest proposal to the Eurozone for consideration but the details have not been released (yet). Our personal reading of the situation, informed by hundreds of pages of reading per week all of which feature differing opinions and perspectives, is that Germany is perfectly prepared to tell Greece, “No, we will not haircut the debt, but we will work on emergency facilities and reduced austerity requirements.” However, should Germany believe they could haircut Greek debt without a repercussion with Italy, Spain, France, etc., we do wonder if even that would end up being on the table. The best advice we can offer for those of you hoping Germany does punt this thing out later: The ultimate market disruption now will likely be far less (for a GREXIT) than it will be later.
QUOTE OF THE WEEK
“Courage is not simply one of the virtues, but the form of every virtue at the testing point.”
– C.S. Lewis
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