Fund flows will always beat fundamentals. This was rarely more evident than in the performance of MLPs last year. Throughout 2018, earnings reports from pipeline companies were generally in-line, with positive guidance. Operating results contrasted with stock prices, which confounded investors and management teams as they sagged. Negative sentiment worsened late in the year, not helped by broader market weakness caused by trade friction, Fed communication mis-steps and the Federal government shutdown.

JPMorgan calculates that there is $38BN invested in open-ended MLP and energy infrastructure products, across ETFs, mutual funds and exchange traded notes. In spite of peaking in August 2014, the sector saw inflows during the three subsequent years. This reversed dramatically late last year, as retail investors liquidated holdings. November and December saw $1.9BN in net outflows, enough to depress prices regardless of news.

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Looking back over several years, the period looks like a selling climax, with no similar episodes visible.

Conversations with redeeming investors revealed many unwilling sellers. Taking tax losses motivated some, while others confessed to exhaustion with poor stock returns in spite of apparently improving fundamentals. Like all money managers in the sector, we were faced with little choice but to sell on behalf of such clients.

Interestingly, MLP-dedicated funds received a disproportionate share of redemptions. This makes sense, given their flawed tax structure (see MLP Funds Made for Uncle Sam). The drag from paying corporate taxes on profits has been substantial in past years of good performance.

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Hinds Howard of CBRE Clarion Securities recently noted that, “MLPs are less than half of the market cap of North American Midstream, and the number of MLPs continues to shrink.  This is ultimately a good thing for those public players that remain, who will achieve greater scale and competitive bargaining power.” Many big pipeline operators are corporations, so an MLP-only focus makes less sense because it omits many of the biggest operators.

Howard went on to add that, “…it has significant ramifications for the asset managers with funds designed specifically to invest in MLPs.” This is because such funds are faced with an unenviable choice between sticking with a shrinking portion of the overall energy infrastructure sector, or dumping most of their MLPs in order to convert to a RIC-compliant status (see The Uncertain Future of MLP-Dedicated Funds). These are additional marketing headwinds on top of last year’s weak returns.

2018 fund flows suggest that investors in MLP-only funds are beginning to realize this problem, and are acting accordingly. The biggest such funds saw $2.6BN in net outflows during 2018’s latter half, 88% of the total, although they only represent 55% of the sector’s funds. Investors redeemed from tax-burdened MLP funds at almost twice the rate of the overall sector.

Many feel the sector is due a good year, and if it is, corporate taxes will lead to correspondingly high expense ratios for MLP-focused funds.

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Early signs in 2019 are encouraging. The outflows abruptly ended at year-end, and investors we talk to are turning more positive. Strong January performance has helped. From where we sit, inflows dominate and new investor interest has increased sharply. Valuations remain very attractive, with distributable cash flow yields of 11%. We expect dividend growth in the American Energy Independence Index of 7-10% this year and next. Momentum seems to be turning.

We are short AMLP.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

Short sellers are a breed apart. Because they’re going against the trend, and numerous stakeholders, they possess a tenacity and conviction that can be breathtaking. When I was investing in hedge funds at JPMorgan, I especially enjoyed meeting with bearish managers. For a start, they do some of the best research. And while a long position might require only modest upside to justify its inclusion, shorts are often believed to be fraudulent, or to have fatally flawed business models. A short seller’s pitch has passion laced with a paranoid suspicion of authority, financial statements and basic human goodness. It can be exhilarating to hear such well-constructed certainty that much you believe right in the world is wrong. These people are fearless, the ones you’d want with you in that foxhole.

In The Hedge Fund Mirage I recount meeting with short-seller Marc Cohodes, who was convinced that men’s clothing store Joseph A Banks was misreporting its financials and would soon collapse. He brandished ads offering “Buy One Suit, Get Two Free” as evidence of an unsustainable promotional strategy. That was over fifteen years ago, and they’re still in business. Examples of such bets gone awry are easily found. For a while, Marc Cohodes was disillusioned with the business (see A Hedge Fund Manager Finds More to Like in Farming), but has since returned (see The World According to a Free-Range Short Seller With Nothing to Lose).

Conversations with hedge fund managers are rarely boring, but they’re especially absorbing when discussing short positions. The depth of research and unshakeable conviction are awe-inspiring. Even though many are wrong, the notion that an apparently successful company is really a house of cards remains riveting.

Nonetheless, shorting profitably is harder than making money on long positions. Almost everyone else involved wants the stock to rise, and because short positions grow when they’re moving against the short seller and shrink when the price is declining, they’re harder to manage. I often used to ask hedge fund managers why they bothered shorting stocks at all, instead of simply shorting index futures and investing all their effort in long ideas. I never received a satisfactory answer – when companies or sectors do collapse, such as Enron, sub-prime mortgages, Lehman Brothers or Valeant, those who called it draw immense satisfaction, media accolades and more clients.

Some of it is marketing. Investing is one of the few areas where delivering a product (i.e. investment returns) that are inferior (i.e. lower) than others can still be valuable, if the returns are uncorrelated. Holding something that will reliably zig when others zag is better than holding cash in a bear market. There’s a chronic shortage of such opportunities. Short-seller Jim Chanos has cleverly exploited this with a performance fee on his hedge fund that’s calculated based on the inverse S&P500 return. So if the market is up 20%, anything he delivers that is better than down 20% draws an incentive fee, on the basis that improving on a simple 100% short index futures position is worthwhile. In a rising market, even holding treasury bills with this fee structure can be profitable.

The Economist recently profiled Soc Gen’s strategist Albert Edwards, a “steadfast prophet of gloom”. Edwards might be described as a “permabear”, constantly regarding the glass as half empty. The appeal of such thinking is that, while investing is built on a cautiously optimistic worldview, considering a contrary opinion is stimulating and can engender protective wariness. We’ve endured a two year bear market in energy infrastructure that just possibly ended last month. We often find the more interesting conversations are with investors who have avoided energy entirely. They clearly assessed the sector differently. When the uninvested become bullish, as some are, higher prices soon follow.

The Economist said of Albert Edwards, “…his talent for imagining the worst is valuable. If you have a vague anxiety, Albert will give it form.” Edwards has been calling out excessive leverage, ruinously low interest rates and China’s precarious GDP growth for years. He’s been wrong on all three, but the strategist almost never runs out of time because, unlike a hedge fund manager, he doesn’t run out of other people’s money with which to bet.

James Grant, founder of Grant’s Interest Rate Observer, retains a loyal following. His writing flows effortlessly off the page, both stimulating and entertaining the reader. It’s as well he possesses such talent, because his relentlessly bearish views on bonds during a career-length, secular bull market have only been tolerable because of their erudite wrapping. Grant’s career as a money manager would have been brief; he has made sensible choices.

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Albert Edwards is well known among European clients of Soc Gen for predicting the break-up of the Euro. In 2010 he criticized the Greek bailout as delaying the inevitable. Today he cites weak Italian productivity as a growing source of instability. Since Italy is “locked in the Eurozone”, its “effective exchange goes up because its labor costs are rising.”

The Euro is arguably behind Brexit – by staying out of the Euro, Britain’s economy grew faster. This attracted more east Europeans seeking jobs and contributed to politically unacceptable levels of immigration, fueling populist outrage and the vote to leave the EU.

In the 1990s a trader working for me insisted that the Euro (then not yet formed) was a failed concept that would never be realized. Unlike Soc Gen’s Edwards, this trader did run out of money to maintain losing bets against currency convergence in the Euro’s run-up. I spent too much time with him listening to why the proposed single currency was a bad idea destined to fail.  In recent years, I’ve often thought I should send a plastic bag of Euros to his home in Florida.

Albert Edwards has sensibly avoided the constraining allure of managing money, which is why he can still challenge us to contemplate the unthinkable. Along with a break-up of the Euro, he’s predicting a U.S. recession and an “unraveling in China.”

These are not consensus views, and not our forecast either. But the attraction of bears is to get you thinking about surprises. Import taxes (i.e. tariffs) and the continuing Federal government shutdown are not conducive to strong U.S. growth. Both are easily fixed in Washington, but while they’re not, the risks of an economic slowdown rise. It’s why bearish views are gaining attention.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

Kinder Morgan (KMI) kicked off pipeline company earnings last week. Their results contained no big surprises. Distributable Cash Flow (DCF) for the year came in at $4.73BN, up 5.5% versus 2017’s $4.48BN. Leverage finished the year at 4.5X (Net Debt/Adjusted EBITDA). KMI has argued previously that their diversified business could sustain a 5.0X ratio, something not always supported by the rating agencies. The sale of their TransMountain pipeline to the Canadian government (see Canada’s Failing Energy Strategy) created a cash windfall that they used to pay down debt. KMI now expects to remain at 4.5X for this year.

Like many investors, we think KMI’s continued investment in its CO2 business is a drag on value. Because Enhanced Oil Recovery (EOR) doesn’t generate the same recurring revenues as pipelines and terminals, we think the market assigns little value to the approximately 10% of DCF this segment represents. Moreover, the $1.6BN in capex planned for CO2 is 28% of the total backlog and three times what the company spent buying back stock in 2018. The commodity sensitivity of this segment is an unwanted distraction. If they can’t sell it, they should at least reduce the new cash deployed there.

Using a real estate analogy — if building and running pipelines is like constructing and owning rental property, then EOR is more akin to building houses and flipping them. For flippers, what matters is the net profit and not proceeds from each sale. Rental income (i.e. pipeline tariffs) are stable; profit from building and selling properties (i.e. oil production) is not. So DCF is the wrong valuation metric for the CO2 business, and basing a dividend on such unpredictable cash flows is inappropriate.  Midstream investors are not fooled by this, which we believe explains KMI’s persistent low valuation.

The uncertain recurring nature of the CO2 business causes many to overlook it. This lowers the DCF yield by about 1/10th to 11.2%, which is nonetheless still very attractive.  Considering KMI’s incredible position in natural gas pipelines, the market is applying a hefty discount.  When asked, management typically responds that selling its CO2 business would be dilutive, because in a sale it would command a lower EV/EBITDA multiple than KMI as a whole. But we think the company’s valuation remains burdened by a business segment that doesn’t obviously belong there. We were happy to see reports late on Thursday that KMI was exploring its possible disposition.

Putting that aside, we still think KMI is cheap. DCF is analogous to Funds From Operations (FFO), a common metric used in real estate and one we discussed in a video last year (see Valuing Pipelines Like Real Estate). It’s the cash generated from their existing business before growth projects. KMI is forecasting $5BN, or $2.20 per share in DCF for 2019, which is a 12.5% yield (11.2% ex the CO2 segment). However, they’re planning to invest $3.1BN in new projects during the year, and since this will be funded internally their Free Cash Flow (FCF) will be lower by this amount.

KMI’s $0.80 annual dividend is expected to rise to $1, a 5.7% yield. The company has projected another increase in 2020, to $1.25. Yield-seeking buyers will increasingly take note.

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They will need to forgive the past. Prior to 2014, KMI and its former MLP Kinder Morgan Partners (KMP) were owned for income. The conflict between a high payout ratio and ambitious growth plans resulted in the absorption of KMP’s assets by KMI. In the process, KMP units were each replaced with 2.2264 KMI shares. KMI’s $2 dividend worked out to be $4.45 per KMP unit, 20% less than the $5.58 they were receiving previously.  There was a cash payment of $9.54, but KMP unitholders also suffered that infamous adverse tax outcome, which many regarded as more costly.

Moreover, the $2 KMI dividend, which was promised to grow at 10% annually, was instead slashed by 75% a year later.  For many companies, such a dramatic reversal would reflect poorly on the finance function and result in management changes. However, KMI’s CFO Kimberly Dang was subsequently promoted to president. Sell-side analysts won’t highlight this for fear of losing access, but that track record isn’t a positive for the stock. Regrettably for the company’s founder, being “Kindered” is now a widely used term when your promised distributions lose out to a company’s growth plans.

The Shale Revolution continues to be a fantastic success story for America, but increasing oil and gas production requires new infrastructure to gather, process, transport and store it. Like many companies afterwards, KMI ultimately chose to direct more cash towards growth projects and correspondingly less to shareholders.

Therefore, the drop in growth capex is a critical development. Five years ago as midstream energy infrastructure embraced a growth business model, it soon became clear this was incompatible with high payout ratios, and the income-seeking investors they had sought. We are now coming down the other side of the capex mountain, which is supporting a resumption of dividend growth. For KMI investors it’s been an unpleasant journey, but a DCF, or FFO yield of around 11% (after backing out the CO2 business) is substantially greater than REITs, a sector with which MLPs used to be compared.

In 2014 KMI had a five year backlog of $18BN in projects under way, which was financed in part by the reduced dividends. Today they expect $2-3BN in annual growth capex, and have $5.7BN in projects at various stages of completion.

KMI’s rising dividend should support growing realization that energy infrastructure stocks are returning more money to shareholders. Its yield is rising to a level that should attract new income-seeking investors willing to forgive past mistakes by management.

We are invested in KMI.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

A few years ago Vanguard invited me to their campus to give a presentation on my just-published book, The Hedge Fund Mirage. Vanguard’s business model is the antithesis of the hedge fund industry, and they were curious to hear from that rare breed, a hedge fund critic. The company’s frugal culture runs deep. As I joked during my presentation, the only German car in the parking lot was mine. Lunch was in the “galley” (cafeteria), where my host reached into his pocket to buy my sandwich and fruit cup. This is a company whose products are usually appropriate ways to access a desired asset class.

So it was in character for Vanguard to recently ban leveraged and inverse ETFs from their brokerage platform. Such products have long been criticized because their only plausible use is for extremely brief holding periods of a few days or less. Because of their daily rebalancing, over time compounding drives their value to zero. To visualize this, imagine if you owned a security which rebalanced its risk daily so as to maintain constant market exposure. A 10% down move followed by a 10% up move would leave you down 1%. Time and volatility work against the holder, except for those able to successfully predict the daily fluctuations and time their trades accordingly. Only those seeking profits in a hurry, or trying to temporarily hedge more risk than they’d like, find them attractive. Neither resembles a long-term investor.

Vanguard’s philosophy prevents creating leveraged or inverse ETFs of their own, but now they’ve taken a logical further step to increase the distance between their clients and long term value-destroyers. They correctly noted that such products are, “generally incompatible with a buy-and-hold strategy.”

This is a popular area, with soaring volumes in recent years. It’s another example of the excessive focus on short term market direction. Consumers of financial news want to know where the market’s going today, and media outlets duly respond. But prospectuses routinely warn that leveraged ETFs will probably decline to zero over time, which means the average holder will lose money. On this basis, one might think the SEC would find banning them easily defensible. So far, while individual commissioners have voiced concern, they haven’t moved further. Finance is not short of regulation, and a philosophy that allows consumers to decide appropriateness for themselves allows innovation, and is more right than wrong. However, it works best when the products financial companies offer to their least sophisticated, retail clients are designed with good intentions. Hedge funds and other sophisticated investors can be expected to properly understand how to use leveraged and inverse ETFs – like prescription medication, their availability should be carefully controlled.

We’ve been critics of these products for years (see Are Leveraged ETFs a Legitimate Investment? from 2014 as well as The Folly of Leveraged ETFs and recently FANG Goes Bang).

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In May 2016 Credit Suisse issued a 2X Leveraged ETN linked to the Alerian index. Since then it’s down 55%, while the index is down 12% (including distributions).  Losses are only limited to two times the index over very short periods. This type of long term result is common. It’s unrelated to the index and invariably worse, which Credit Suisse, and Alerian (who allowed their index to be licensed) would have known at the outset. Either name attached to an investment should give the buyer pause. It’s why these products shouldn’t be offered to retail investors.

Energy infrastructure remains one of the most attractively valued sectors around. The American Energy Independence Index yields 6.75%, and we expect dividends to grow 6-7% this year. This is attractive enough for the long-term investor, and isn’t available as a leveraged product.

On Wednesday, January 16th at 1pm Eastern we’ll be hosting a conference call with clients. If you’re interested in joining, please contact your Catalyst wholesaler, or send an e-mail to SL@SL-Advisors.com.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

Energy infrastructure roared higher during the first six trading days of January. After four days, the sector had recovered December’s losses. Two days later, it had almost recouped all of 2018. It was a complete reversal of last month, when slumping equity markets dragged pipeline stocks lower.

It’s looking increasingly likely to us that automated trading strategies relying on complex algorithms (“algos”) are at least part of the reason.

Last year MLPs had already been laboring under the weight of serial distribution cuts. For example, AMLP’s payout is down by 34% since 2014. Incidentally, this must be the worst performing passive ETF in history. Since inception in 2010, it has returned 4% compared to its index of 25%. Its tax-impaired structure is part of the reason (see Uncle Sam Helps You Short AMLP).

For the first nine months of last year, crude oil and energy infrastructure moved independently of one another. Investors who painfully recall the 2014-16 energy sector collapse complained that rising crude prices didn’t help, but as the chart shows, they rallied together in the Spring but parted company in late Summer as the oil market started to anticipate the re-imposition of sanctions on Iran. Crude and pipeline stocks are intermittently correlated, because their economic relationship is weak. Crude sometimes drives sentiment, which can quickly change.

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However, when crude dropped sharply following the Administration’s waivers allowing most Iranian exports to continue, energy infrastructure followed. Pipeline company management teams routinely show very limited cash flow sensitivity to commodity prices, and 3Q18 earnings reported in October/November were largely at or ahead of expectations. Nonetheless, an algorithm incorporating the 2014-16 history would expect MLPs to follow crude when it drops sharply, and would act accordingly. Trading systems bet on falling MLPs following crude, and sold.

In late December crude reversed, and trading systems at a minimum are closing out short pipeline positions if not going the other way. Hence the blistering early January recovery. The fundamentals were good in December, and remained so in January. Any change was imperceptible.

This is conjecture. It’s impossible to obtain hard data to support or refute this theory of market activity. So consider our perspective as a money manager in the energy infrastructure sector, in daily contact with clients and potential investors discussing the outlook. In December, callers were frustrated. The apparent disconnect between fundamentals and stock prices was confusing, troubling. What were they overlooking? What were we missing? Many held, but some didn’t. Frustrated at losses they couldn’t explain, having lost faith with repeated bullish analysis, the sector saw more outflows than inflows. Potential buyers noted compelling values, but usually were dissuaded by continued sector weakness. Unable to comprehend the inability of good financial performance to boost prices, many opted to wait. Tax loss selling towards the end of the year exacerbated.

The turn of the calendar coincided with a modest bounce in crude oil, as reports surfaced that the Saudis were sharply reducing crude exports to the U.S. Current prices are creating for them a substantial fiscal gap.

Conversations with clients and prospects have completely turned. Now callers want to know if there will be a pullback. Is the rally for real? Flows have also reversed. One day last week inflows to one of our funds outweighed outflows by 100:1. In December there were no buyers. In early January there are no sellers.

I was prompted to consider events in this light by a recent article in the Financial Times (Volatility: how ‘algos’ changed the rhythm of the market). Philosophically, I’m inclined to believe that automated trading simply does what humans do, just better and more cheaply. However, there is a less benign feature in that algos are also exploiting the inefficiences of humans. Michael Lewis showed this in Flash Boys by examining how high frequency trading systems will see market orders placed and race to snatch the best price before the limit order is executed. This happens in fractions of a second. But humans can also be outwitted over longer periods. December saw the biggest ever monthly outflows from mutual funds, capping an unusual year in which almost every market was down.

There was some bad news. The trade dispute with China is slowing growth there, and S&P500 earnings forecasts are being revised lower. The government is shut down. Fed chairman Powell sounded more hawkish before walking back his comments (see Bond Market Looks Past Fed). But these developments scarcely seem to justify record mutual fund outflows. There have been far worse environments for stocks.

Hedge fund veteran Stanley Druckenmiller said, “These ‘algos’ have taken all the rhythm out of the market, and have become extremely confusing to me.” Philip Jabre closed his eponymous hedge fund, complaining, “…the market itself is becoming more difficult to anticipate as traditional participants are imperceptibly replaced by computerized models.”

The Financial Times quoted a senior JPMorgan strategist as saying that, “…we just have to accept that equity markets are almost fully automated.” JPMorgan estimates that only 10% of trading is generated by humans.

The Wall Street Journal reported that trend-following trading systems shifted “…from bullish to bearish to a degree not seen in a decade, according to an analysis of algorithms that buy or sell based on asset-price momentum.”

The WSJ also blamed volatility in commodity markets on computerized trading, citing a report that “…Goldman Sachs attributed the recent volatility to algorithmic traders exerting more influence in the oil market.”

The growth in algorithmic trading seems to be coinciding with a drop in discretionary trading by humans, which probably reflects that computers are beating humans in certain areas.

On one level, algos are designed to exploit human frailties by anticipating them. Perhaps they even cause them. It seems many people had little reason to sell in December beyond fear of losing money. Successful algos by definition attract capital, increasing their ability to move markets and hunt for more inefficiencies. Humans, at least those who adjust their positions too frequently, are becoming prey. One result could have been systematic shorting of pipeline stocks in response to crude’s sharp drop, because it worked in 2014-15. Sector weakness certainly couldn’t be traced back to recent earnings reports. Investors who sold during this time because they tired of losing money added to the downward pressure, reinforcing the trend. This would also have provided confirmation to the algorithms that the signal worked.

Since computerized trading isn’t going away, survival for the rest of us lies in being less sensitive to market moves. Examining fundamentals and staying with a carefully considered strategy that doesn’t rely on the market for constant confirmation of its correctness is the human response to algos.

Energy infrastructure remains attractively valued. Free cash flow yields before growth capex (i.e. Distributable Cash Flow) are over 11%. We estimate dividends will grow on the broadly based American Energy Independence Index this year by mid to high single digits. The long term outlook for the sector remains very good.

We are short AMLP.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

Last week Fed chairman Jay Powell walked back his earlier, clumsy comments which had implied several additional rate hikes in 2019. His words at the press conference following their December 19 meeting were poorly considered, “Maybe we’ll be raising our estimate of the neutral rate and we’ll just go to that, or maybe we’ll keep our neutral rate here and then go one or two rate increases beyond it.” That sounded as if rates could move 1% higher.

Many analysts focus on the “blue dots”, a graphical representation of individual FOMC members’ rate forecasts. The Fed’s been publishing these for seven years now, and the increased transparency of which they are part is most welcome. But it’s important not to confuse what the FOMC says they’ll do with what actually happens. The bond market is far more accurate at forecasting Fed policy than the Fed itself.

The long-run equilibrium rate, or neutral Fed funds rate, has been sliding lower for years. Bond investors never believed that the Fed would eventually increase short term rates to 4.25% back in 2012 when the first blue dots appeared. The yield on ten year treasury notes represents the average short term rate likely to prevail over the next decade, and it hasn’t been above 4% since the 2008 financial crisis. The market has maintained its disbelief, and FOMC rate forecasts have been steadily revised down to converge.

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December was a particularly bad month for equity investors everywhere, and Powell’s comments provided another reason for sellers to act. Press reports suggested that the softening global growth and market turmoil weren’t factors in their deliberations.

However, two year treasury yields, a good indicator of market expectations for near term Fed policy, barely rose on the day of the press conference before resuming their downward trend. So the Fed chair bowed to the inevitable, and moderated his public position to reflect what the bond market already knew, “We’re listening carefully with – sensitivity to the message that the markets are sending and we’ll be taking those downside risks into account as we make policy going forward,”

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The point here is that equity investors seem to be more scared of the Fed than bond investors. Fixed income markets never priced in Powell’s clumsy comments, even while stocks dropped at the time. The growing history of the blue dots reveal a welcome insight into FOMC member thinking.

Years ago, when Alan Greenspan personified the mysterious Fed chairman as oracle, speaking but rarely providing much information, markets believed the Fed knew more than anyone. Their superior access to data on current economic performance meant that Fed comments on growth were likely informed by data unavailable to others. The truth is that JPMorgan Chase and Amazon probably have better real-time data on the U.S. consumer than the Fed.

It’s helpful to know what policymakers expect to do, which is why the blue dots, or “dot plot” are interesting. Although Jay Powell has argued that they’re individual forecasts and not meant to represent a consensus, it’s hard to interpret them any other way. The median of fourteen individual estimates clearly reflects group consensus, no matter how much he may try to downplay it.

What we’ve learned over the seven years of blue dots is that the Fed’s consensus is terrible as a forecast. The bond market is better at predicting Fed policy than the Fed. With the two year treasury yield at 2.5%, the market is expecting little change in Fed policy this year. And with ten year yields at 2.7%, below the FOMC’s equilibrium rate, the peak in the rate cycle isn’t far away.

With the Fed likely on hold for a while, the Equity Risk Premium continues to show stocks are cheap (see Stocks Are the Cheapest Since 2012). Energy Infrastructure, in spite of its strong start to the year, is still lower than where it was a year ago even while every financial metric (EBITDA, leverage, volumes) is improving.

Comments from Fed officials shouldn’t be confused with policy actions. Equities remain very attractive.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

Blog pageviews and comments help us gauge how relevant our topics are. Writing is more enjoyable when readers engage. This blog gets reposted across many websites, including Seeking Alpha and Forbes.com. The feedback from subscribers often leads to a useful dialog and informs later choice of topics. Below are the themes that resonated in 2018.

The name Rich Kinder strikes a raw nerve with many. Kinder Morgan: Still Paying For Broken Promises revealed the depth of feeling among many investors. This is because Kinder Morgan (KMI) began the trend towards “simplification”, which came to mean distribution cuts and an adverse tax outcome. To get a sense of the betrayal felt by some, peruse the comments on the blog post on Seeking Alpha where readers can let rip in a mostly un-moderated forum. It becomes clear that cutting payouts has severely damaged appetite for the sector, something we realized through this type of feedback.

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A similar post examined how Energy Transfer (ET) had lowered payouts for certain classes of investor, (see Energy Transfer: Cutting Your Payout Not Mine) and drew an even bigger response (272 comments). ET CEO Kelcy Warren is a controversial figure. Our post showed that while original Energy Transfer Equity investors had avoided distribution cuts, holders of Energy Transfer Partners, Sunoco Logistics and Regency Partners hadn’t fared so well.

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Kelcy Warren inspired our most colorful graphic in August, when he said, “A monkey could make money in this business right now.” (see Running Pipelines Is Easy). ET’s stock has lost a quarter of its value since then, even though their financial performance has justified his comments.

Last year was a testing one for those convinced the Shale Revolution should generate investment profits. In Valuing MLPs Privately; Enterprise Products Partners we laid out how a private equity investor might value the biggest publicly traded MLP. It wasn’t controversial, but many readers communicated their appreciation at this type of analysis.

The problem for the sector has always been balancing high cash distributions with financing growth projects. We think current valuations focus too much on Free Cash Flow (FCF) without giving credit to Distributable Cash Flow (DCF). FCF is after growth capex, while DCF is before. We illustrated this with a short video (see Valuing Pipelines Like Real Estate).

Early in the year we wrote several blog posts highlighting the tax drag faced by most MLP-dedicated funds. Because they pay Federal corporate taxes on investment profits, 2018’s bear market didn’t expose their flawed structure the way a bull market will. We won’t repeat the argument here, but it’s laid out in MLP Funds Made for Uncle Sam.

A related topic we covered several times was the conundrum facing MLP-only funds, given that many big MLPs have converted to regular corporations. MLP-only funds can no longer claim to provide broad sector exposure, since they omit most of the biggest North American pipeline companies. But the funds themselves can’t easily broaden their holdings beyond MLPs, which creates some uncertainty for their investors. We explained why in Are MLPs Going Away? and The Alerian Problem.

We returned to the tension between using cash for growth versus distributions in Buybacks: Why Pipeline Companies Should Invest in Themselves. The industry continues to reinvest more cash in new infrastructure than is justified by stock prices. In many cases, share repurchases offer a better and more certain return than a new pipeline. Trade journals are full of breathless commentary on the need for more export facilities, more pipelines, more everything. It’s not pleasant reading for an investor, but this is the world inhabited by industry executives. More mention of IRR would be welcome. Pipeline investors are hoping that the Wells Fargo chart showing lower capex in the future will, finally, be accurate.

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Fortunately, there are signs of better financial discipline. Leverage continues to drop and dividend coverage is improving, which will support a 6-8% increase in dividends on the American Energy Independence Index in 2019. As the year unfolds, we expect investors to cheer a long overdue improvement in returns.

We are invested in ET and KMI.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

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Fear of foreigners dumping U.S. bonds has periodically resurfaced for as long as most market participants care to remember. One country’s trade deficit is another one’s surplus (although they puzzlingly never net out globally). In the U.S., we import more than we export, and conveniently the surplus dollars our foreign trade partners accumulate are partially reinvested back into U.S. government bonds, which helps finance our Federal budget deficit.

China and Japan have historically been the biggest foreign investors in U.S. debt, each holding over $1Trillion for the past several years. Last year, China replaced Japan as our biggest foreign creditor. From time to time, some commentators have warned that China retained the ability to inflict havoc on America’s bond market if they decided to sell a chunk of their holdings. Their willingness to maintain such substantial holdings of government bonds presumably contributes to today’s historically low long term rates.

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Trump has imposed tariffs on Chinese imports with little regard for such concerns. Following the 2016 election, China increased its U.S. bond holdings substantially. Japan was more cautious. But both have been reducing them over the past year. China’s moves have been more recent, and coincide with the growing trade spat. Interestingly, there’s been no discernible impact on bond yields.

China owned as much as 22% of all our foreign-owned debt five years ago, and is now down to 18%. Since May they’ve shed almost $60Billion, with no visible market impact.

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The idea of the U.S. as supplicant to foreign creditors never made much sense to me. China owns what they own because it suits their purpose. They clearly perceive enormous value in U.S. sovereign debt, because they’re not earning much interest. So the idea that they’d sell a large chunk because of a dispute has never seemed logical, as I wrote in Bonds Are Not Forever; The Crisis Facing Fixed Income Investors. If you owe a trillion dollars, your creditor has much to worry about.

Sure enough, there’s been no mention of foreign bond sales during the recent bout of trade friction. China has quietly reduced its holdings with little fanfare. Interest rates have remained low, even with the Federal Reserve raising short term rates and unwinding quantitative easing. The fear of foreign sellers driving up U.S. mortgage rates has even less basis than in the past.

Although the Fed is expecting to raise rates twice next year, bond yields continue to forecast less than that. For fixed income investors, it continues to be hard to beat inflation after taxes. Equities are cheap as shown recently by the Equity Risk Premium (see Stocks Are the Cheapest Since 2012). The American Energy Independence Index yields 6.9%. Bonds are unlikely to provide much value.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).

MLPs have become more attractively priced compared with other income-oriented sectors. One way to see this is to compare the trailing four quarter yield. REITs and utilities have remained within a fairly narrow range, while MLPs rose sharply during the 2014-15 oil collapse. After a partial recovery, weakness over the past year or so has caused MLP yields to drift higher again.

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For many years prior to the 2014 sector peak, MLP yields were around 2% above utilities. Currently, they’re around 5% wider. This ought to attract crossover buying from income-seeking investors, switching their utility exposure for MLPs, but so far there’s limited evidence of this happening. Although the yield advantage over REITs isn’t quite as dramatic, the same relative value switch exists there too.

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The broad energy sector has remained out of favor. MLPs used to track utilities and REITs fairly closely until 2014 when they followed energy lower. However, even compared with energy, midstream infrastructure remains historically cheap. Research from Credit Suisse shows that on an Enterprise Value/EBITDA basis, pipelines are the cheapest vs the S&P energy sector they’ve been since 2010.

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The Shale Revolution has challenged the MLP model in ways that few anticipated. Increasing U.S. output of crude oil, natural gas liquids and natural gas is creating substantial benefits for the U.S. Improved terms of trade, greater geopolitical flexibility and reduced CO2 emissions underpin America’s greater willingness to buck the global consensus. However, investors are still waiting for the financial benefits. This is partly because the capital investments required have demanded more cash. E&P companies had to fund investments in new production, which drew criticism that they were over-spending on growth. Similarly, MLPs pursued many opportunities to add infrastructure for transportation, processing and storage in support of new production. All this left less cash to be returned to investors through buybacks and dividends. It remains the biggest impediment to improved returns.

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Unlike MLPs, both utilities and REITs have both been increasing dividends. Even the energy sector has raised payouts, although this was achieved in part through less spent on stock buybacks, which has led their investor base to insist on improved financial discipline. MLPs have both increased cash flows and lowered distributions.  Oil & gas executives seem unable to turn down a growth project.

By contrast with the income sectors with which MLPs used to compete, they have been lowering dividends. This makes yield comparisons less reliable, and likely explains why there’s been little evidence of shifts away from lower-yielding, traditional income sectors.

It’s why the biggest pipeline companies have dropped the MLP structure in favor of becoming corporations, so as to access the broadest possible set of investors. However, that hasn’t always worked out either, as the history of prior distribution cuts continues to weigh on sentiment. Williams Companies (WMB) is an example of a corporation that combined with its MLP, Williams Partners (WPZ). WMB CEO Alan Armstrong claims to be puzzled by persistent stock weakness. Meanwhile, legacy WPZ investors well recall the multiple distribution cuts they endured along the way (see Pipeline Dividends Are Heading Up).

In our experience, one of the issues that makes current investors nervous and gives new ones pause is that they don’t understand the continued weakness when volumes are up and management teams bullish. In December most sectors were down sharply, and global growth concerns depressed the energy sector along with most others. But for most of 2018 and certainly the second half, the disconnect between strong operating performance and poor security returns has perplexed many.

We’ve sought to explain this, and regular readers will know we’ve concluded that reduced distributions are the most important factor. The investor base was originally drawn for stable income, which in recent years MLPs have failed to provide. The Shale Revolution, perversely, has so far been a lousy investment theme even while it’s been terrific for America.  The charts in this blog post present a narrative now familiar to many.

Next year we expect rising dividends for the companies in the American Energy Independence Index to draw increasingly favorable attention to the sector. Although the MLP model no longer suits most of the biggest operators in the industry, midstream energy infrastructure offers compelling value. The best way to participate is by investing in the biggest companies, which are mostly corporations but do include a few MLPs. When the sector begins its recovery, it’ll start from far below fair value.

We are invested in WMB.

SL Advisors is the sub-advisor to the Catalyst MLP & Infrastructure Fund.  To learn more about the Fund,  please click here.

SL Advisors is also the advisor to an ETF (USAIETF.com).