Trump’s Odds

The positive Presidential Covid test has provided plenty of material for the media. Trump’s known physical disposition is being compared with tables of statistics to assess his likely prognosis. The Financial Times noted that he is in the “vulnerable” population, and gave him 20% odds of requiring hospitalization with a 5% risk of death. Regardless of politics, writing about a living person’s chances of dying strikes me as rather tasteless, although inevitable since it’s the president and the election is a month away.

More interesting than mortality tables was the reaction on PredictIt, a website that allows modest wagers on numerous electoral outcomes. Many believe that betting markets offer more accurate forecasts than opinion polls, presumably because people are more thoughtful when money is tied to their view. PredictIt showed that the odds of Trump dropping out of the race before November 1 had soared from 4% to as high as 17% on high volume, following his positive Covid test.

This seems odd, because it’s hard to conceive of any sickness that would cause Trump to withdraw. And if he really does succumb to the virus, his name will remain on the ballot. The only plausible way he’s withdrawing by November 1 is if he concludes an overwhelming defeat is inevitable, when he might declare the entire election a sham hopelessly distorted by mail-in ballot fraud, paving the way for a challenge of the results. This has nothing to do with Covid, and the reaction of PredictIt shows that even the commitment of modest sums of money doesn’t assure a rational view. The Robin Hood trading platform offers another rich source of financially irrational actors.

The 5% Case Fatality Rate (CFR) referred to by the FT relies on a study from OurWorldInData, which estimated the CFR for different age groups by looking at just four countries (South Korea, Spain, China and Italy). This limited data set took no account of any pre-existing conditions (“comorbidities”). A study in June from the Center for Global Development (“CGD”) took a more precise look, and found that a male aged 70-79, with at least one co-morbidity living in a rich country, had a CFR of 4.35%. Take away any pre-existing condition and the CFR drops by 89%, to 0.48%.

Trump’s pre-existing health conditions, if any, are unknown. He claims to weigh 235lbs, which for his height puts him on the threshold between overweight and obese but well short of severely obese. The 4.35% CFR doesn’t differentiate between one or several co-morbidities.

Trump’s debate performance didn’t show shortness of energy, regardless of whether you found the content appealing or not. There’s little public evidence that he’s chronically sick.

Moreover, the CDG study is from June. CFRs keep improving – although infections are rising again in many countries, fatalities are not. More testing, better treatment and a less fatal strain of the virus are among the possible explanations. It’s likely the CDG study would produce lower figures if the data was updated. And Trump will be receiving the best care available.

On Friday, stocks and crude oil both fell on the news. Pipeline stocks surprised by moving higher, perhaps showing that attractive valuations are finally overwhelming negative sentiment.

The absence of any formal training in virology has not prevented us from offering a data-based view on Covid. So for Trump, the odds are high that he’ll emerge from self-quarantine reporting a mild case easily handled, confirming his assertion that widespread popular fear of the virus is unwarranted.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

Risk and Return Part Ways

More risk more return is a truism of finance, and much else besides. It makes intuitive sense (why bungee jump unless the rush of near-death exceeds the actual risk?) and also has a place in finance, via the Capital Asset Pricing Model (CAPM). This formalizes the relationship between risk and return, allowing securities to be priced, or shown to be mis-priced, relative to one another.

Finding fault in elegant algebraic solutions to markets occupies the minds of many. CAPM has long been known to be flawed – in reality, it turns out that investors pay more than they should for risky stocks, and pay too little for more stable ones. Many of Warren Buffett’s holdings exploit this inefficient bias.

Since taking more risk for less return should leave an investor poorer over time than following CAPM, why does he do it? An explanation that we’ve always liked relies on the misalignment of interests between many asset managers and their clients.

Funds flow in the direction of performance. It’s much easier to find new clients when things are going up, and in that environment it doesn’t pay to deliver middling performance. The simplest way to beat a rising market is to take more risk – hence, actively managed funds are generally found to have a beta above 1.0 (the market’s beta is 1.0).

Such funds should correspondingly underperform when markets are falling – but since it’s harder finding new clients in such an environment, poor relative performance doesn’t hurt much. The  asset manager’s asymmetric business model (“heads I win big, tails I lose a bit”) doesn’t match the investor’s, for whom ups and down of equal magnitude cancel out.

The solution is for clients to reject fund managers who aren’t heavily invested alongside them. This ensures that the linear exposure to market returns is felt by the fund manager and clients, creating a proper alignment of interests. Not surprisingly, your blogger’s fund business fits this model, otherwise you wouldn’t be reading this article.

Recent market performance has turned this relationship on its head – investors seeking more risk are being handsomely rewarded, while those holding more stable names are watching them languish. It’s like CAPM on steroids – not just more return for more risk, but much more. Low vol stocks are delivering less than half of the returns of the market with slightly higher volatility.

This can be seen by comparing the S&P500 Low Vol High Dividend index (LVHD) with the S&P500.

Through 2016, they mostly tracked one another, with LVHD’s underperformance roughly commensurate with its lower risk. Over the next three years the gap widened. Starting in January, perhaps not coincidentally around the time Covid-19 entered into common conversation, the relationship shifted dramatically. Since then, the S&P500 has made new highs, while LVHD remains 20% off its best levels.

The second chart takes the ratio of returns between the two indices, and volatility (defined here as the average daily move over the prior year). Prior to 2016 the two lines roughly matched each other, confirming the risk/return symmetry of CAPM. Since then, and most dramatically this year, the relationship has broken. Supposedly less risky stocks are moving more than they should relative to the market, and more risky stocks are over-delivering good returns.

It’s well known that the extreme social distancing and other steps to impede virus transmission favored technology stocks, and anything that helps people live without proximity to others. The winners are not low vol stocks, and the recent shift towards growth has been dramatic.

In the late 1990s, tech stocks generated very strong outperformance against the market as investors grasped the internet’s enormous potential. LVHD doesn’t extend back that far, but other work we’ve done shows the same lagging results of stable stocks. Berkshire’s portfolio was among them.

The subsequent 2000-02 bursting of the internet bubble reversed everything.

The market’s inconsiderate recovery since the lows in March (see The Stock Market’s Heartless Optimism) has been driven by the pandemic’s economic winners, even though many find this an incongruous concept during a severe worldwide recession. Nonetheless, as improving treatments and immunity, eventually aided by vaccines, restore much of our former lives, the market will re-sort the winners and losers. Stable businesses with reliable dividends will be back in vogue.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance

The Great Reversal?

Last week the Centers for Disease Control (CDC) told state health officials to prepare for vaccine distribution as soon as November 1. “My fellow Americans, our long national nightmare is over.” was first spoken by President Gerald Ford following Nixon’s resignation under threat of impeachment in 1974. But it could equally apply to Covid in 2020.

The pain has been unevenly distributed. Since March, stocks have defiantly marched higher in the face of relentlessly bad news. Hundreds of thousands of lives have been lost, and billions turned upside down. Yet people have adapted, and technology stocks such as Apple (AAPL) and Amazon (AMZN) have benefited enormously from the shift to socially distanced living. Tesla (TSLA) has shown that stock splits are bullish, even if caused by prior huge gains (see Tech Stocks Have Energy).

The market’s gains have reflected the distasteful reality that the economic impact of Covid is driven by our efforts at mitigation. Public understanding of the actual numbers reveals huge misconceptions (see Covid Exposes Innumeracy) about its lethality and who is really at risk. Recently, the CDC quietly added the following to Table 3 of its Covid website (Conditions contributing to deaths involving coronavirus disease): “For 6% of the deaths, COVID-19 was the only cause mentioned.” In other words, 94% of Covid victims had a pre-existing condition (a “co-morbidity”) which may have contributed to their outcome. It’s still tragic for each person, but as we learn more the seeming randomness of Covid becomes less so.

For an interesting perspective on mitigation efforts elsewhere, see Brazil – Not the Disaster We’ve Been Led to Believe.

Last week’s sharp market reversal around the CDC’s announcement was probably no coincidence. U.S. hospitalizations are down by a third from their recent second peak. Fatalities never reached the levels of early April, and in former hotspots like New York and New Jersey, hospitalizations are down by 95% from the peak.

A vaccine will accelerate the progress towards herd immunity that seems to be already underway. The possibility that the near future may see a modified return of our former lifestyles has hurt technology stocks but breathed new life into stocks like Carnival Corp (CCL). A resumption of cruising might be the final confirmation that we’re post-Covid, that the hospitality business no longer faces quite the same existential threat.

Few will be surprised that the outperformance of energy stocks caught our attention. The least liked and therefore most undervalued sector doesn’t suffer like AAPL from the loss of momentum investors, because there were none. The rubber band between liked and hated sectors is stretched taught. If the imminence of a vaccine has triggered a great unwind, pipeline stocks have substantial upside.

Tech Stocks Have Energy

Relative valuations are provoking comparisons with past episodes that ended poorly, such as the late 1990s tech bubble. Tesla (TSLA) has risen 75% since announcing its 5:1 split on August 11th. Apple (AAPL), and their 4:1 split caused Exxon Mobil (XOM) to be dumped out for the Dow (see The Dow’s Odd Construction).

There are plenty of articles comparing growth with value. For an energy flavor, consider the comparison with pipeline company Enterprise Products Partners (EPD). As recently as early last year, like AAPL, it traded at under 10X cash flow. Their paths soon diverged, and this year’s Covid-inspired tech rally has led us to the surreal moment at which EPD would need to increase in price by 4.5X, or AAPL drop by 78%, in order for their cash flow multiples to be synchronized once again. AAPL’s net income over the past five years has varied between $46BN and $59BN, with $56BN expected this year. A reduced sharecount due to buybacks makes the EPS figures look better but, unsurprisingly with $50BN+ in anual profit, AAPL is no longer a high growth company.

Technology has been hot to be sure, but in spite of what a cursory glance might suggest, the energy sector has not been completely abandoned. Investors who purchased EPD’s 5.1% 2045 maturity bonds issued in February 2014 have been handsomely rewarded – at least by the extremely modest standards which bond buyers have long accepted. At the time, the cash flow yield on EPD’s stock was modestly higher than the bond yield, which probably convinced some that the bonds, with their fixed coupons and no participation in EPD’s future cash flow growth, weren’t cheap enough.

Those original investors have received their 5.1% coupon and enjoyed some modest price appreciation, since their bonds are now priced at around 120. This is in spite of making their purchase less than six months before energy stocks peaked. Since then, the Shale Revolution has been ruthlessly crushed, leaving energy stocks in disorderly retreat and sweeping EPD down with the rest. Since few bond investors have the flexibility to leap down the capital structure no matter how compelling the opportunity, the holders of this debt with 25 years yet remaining must regard EPD’s equity as altogether divorced from reality.

The change in valuations has been stunningly swift, and when the relationship between EPD’s stock and almost every other non-energy equity security is reverting to the mean, it will have all seemed inevitable. Until then, we can simply gaze at charts like these and wonder how the CFA curriculum will one day turn this into a teachable moment.

We are invested in all the components of the American Energy Independence Index via the ETF that seeks to track its performance.

The Dow’s Odd Construction

Last week’s ejection of Exxon Mobil (XOM) from the Dow Jones Industrial Average looks like another indication of the declining relevance of energy stocks. XOM had been in the Dow since 1928, and until 2013 was the most valuable publicly listed company. Its market cap peaked with oil prices in 2014 at $446BN, and is now around $171BN.

Pfizer (PFE) and Raytheon Technologies (RTX) were also dropped along with XOM, and these three were replaced by Salesforce (CRM), Amgen (AMGN) and Honeywell (HON).

Being dropped from an index is never good. For the much maligned energy sector, it’s tempting to regard this as the bell ringing at the market bottom – the sign that sentiment is so irretrievably poor that the only way from here is up. But the list of such past signals is already long.

The quirky construction of the Dow is the cause of these changes. The Dow may be “venerable”, and still the most widely followed index, but nobody would create anything quite like it today.

This is because it’s a price-weighted index, rather than market-cap weighted like most indices. This means that the price of a stock determines its importance in moving the Dow. Apple (AAPL) is the highest weighted stock in the Dow by virtue of its price. Because of its impending 4:1 split, its weighting is about to drop by around three quarters – for market cap weighted indices such as the S&P500, a stock split has no impact on the weights of the components.

If Berkshire A (BRK-A) was in the Dow, at $326K per share it would dominate the index.

Perhaps when Charles Dow and Edward Jones first published their eponymous average in 1896, calculating the average daily price of twelve stocks without a calculator was already enough work for two financial reporters. But their simple approach remains with us today.

The tables below illustrate the shortcomings. Perhaps the biggest is that a price-weighted index doesn’t reflect market cap weighted moves in its components. This makes it less representative. From next week moves in AAPL’s value will have much less impact on the index. An investor wishing to track the Dow Jones has to sell most of her AAPL’s shares, even though it’s still in the index. Tracking the Dow is more difficult and costly because it requires frequent rebalancing. That’s why there’s far more money invested in products linked to the S&P500, and they have much lower tracking error.  Market-cap weighted indices by definition reflect the experience of all the money invested in their components, and are more easily tracked by portfolios invested in them.

One result is that although the recent rebalancing reflects the biases of the committee that oversees the Dow Jones, the smaller size of Dow Jones-linked funds limited the rebalancing trades by investors tracking the index.

Energy investors can console themselves that XOM’s ignominious ejection is due to AAPL’s meteoric rise and subsequent split. Several big companies have had a sporadic relationship with the Dow. General Electric (GE) has been spurned three times, most recently in 2018. Since then, GE has lost almost half its value. Given valuations, energy investors are likely to do much better.

Covid Exposes Innumeracy

Labor Day weekend heralds the traditional end of summer in America. School starts shortly thereafter. For the past several months, school districts across the country have been wrestling with modified in-person versus fully online classes.

It’s the most consequential set of decisions of the pandemic. 50 million students attend school from kindergarten through 12th grade. In March, schools abruptly switched to online learning. Few will be surprised that it failed students and piled stress on teachers as well as working parents.  Children are collateral damage, “…many students are struggling and falling far behind where they should be” reported the head of the Los Angeles Unified School District (see The Results Are In for Remote Learning: It Didn’t Work).

The effectiveness of lockdowns is increasingly being questioned – New York City’s was imposed by Mayor de Blasio on March 20th, and infections continued rising for another three weeks. Deaths peaked after four weeks. By early May, two thirds of hospital admissions were from people who had been sheltering at home, in compliance with the lockdown.

Moreover, cases continued to fall and have stayed low after some restrictions were eased, suggesting that the spread had reached its break point without government intervention. We may slow infections temporarily, but ultimately the virus moves through the community.

Lockdowns have turned out to be a “blunt and economically costly tool” according to a recent article. Sweden’s modest restrictions were widely criticized, but its fatality rate is lower than the UK, which imposed tougher controls. Sweden’s Nordic neighbors have done better, but that’s partly due to Sweden’s more expansive definition of a Covid death.

The UK is seeing a 40% jump in non-Covid deaths, suggesting people are delaying seeking medical care. The government has pleaded with citizens to “protect” the National Health Service, by not getting sick. We haven’t yet started to count the cost of mitigation.

It turns out there are such enormous gaps between public perception and reality that statistics ought to be a core requirement for a high school diploma.

Two surveys illustrate: one from Kekst CNC polled 1,000 adults in each of five different countries. The average rate of infection estimated by U.S. respondents was 20% — 66 million people, or 20X the number of CDC-confirmed cases at the time. Serology tests that look for the presence of Covid anti-bodies show that the actual infection rate is many times higher than the number of positive tests, so this result might imply the respondents have a more sophisticated understanding.

Their estimate of deaths shows otherwise, with an average response of 9% of the population. If 30 million Americans had died, rather than 180,000, that would suggest an Infection Fatality Rate (IFR) of 45%. Estimates put it at under 0.5% for all ages and perhaps 0.1% for those under 65.

The Covid IFR is tragically high for the older population, those with co-morbidities, and worse if you’re old and have health problems. But here, another survey shows that people underestimate the proportion of deaths inflicted on older age groups. A Franklin Templeton-Gallup survey found that respondents estimated 58% of deaths were among people 55 and older, whereas it’s 92%. It also found that, “The misperception is greater for those who identify as Democrats, and for those who rely more on social media for information.”

Covid has been the top news story almost all year, feeding or fed by these misperceptions depending on your view. There’s no better example of the primacy of fear over facts than Andrew Cuomo’s upcoming book, American Crisis, which promises an inside view of his handling of the pandemic.

Cuomo’s oversight of the nation’s second worst fatality rate (topped only by New Jersey) is less recognized than his sober daily press conferences.

Dispatching infectious but stable patients back to nursing homes to free up hospital beds that were never needed was leadership that led to thousands of avoidable deaths. A skilled communicator of bad news can dodge accountability.

A poor understanding of the figures is about to infect the nation’s schools. Virtual classes are inferior for everyone, but the impact is most severe for younger children. There are over 35 million students in K-8th grade. Their education will likely be compromised. 27 children aged 5-14 have died from Covid. These are all heartbreaking – as are the 2,793 children who have died from non-Covid causes over the same period.

Clearly teachers are more at risk, depending on age and health. A scared teacher won’t teach well, and there are legitimate cases for older teachers and those with compromised health to opt out. But with entire school districts planning for online instruction because of insufficient staff, our collective failure to understand the numbers has millions of young victims.

If you regularly visit The Covid Tracking Report, the Worldometer Coronavirus pages and Covid-19 Data from the CDC, you’ll find most mainstream news media of little use.

Instead, try Twitter where we’ve found some fact-based reporting, including by Alex Berenson, Florian Krammer, Kyle Lamb and a few others hidden behind pseudonyms such as the Ethical Skeptic and el gato malo.

We also found this quarterly letter from David Capital Partners insightful.

The reason stocks continue to march higher is because investors are collectively processing the data and overlooking the popular mood. The gulf between Wall Street and Main Street was never wider.

Stocks Look Past The Recession and Growing Debt

At Berkshire’s virtual annual meeting recently, Warren Buffett mused that their cash hoard of $135BN didn’t seem that much. Stanley Druckenmiller said, “The risk-reward for equity is maybe as bad as I’ve seen it in my career.” The New Yorker thinks stock investors have lost their minds.

To not be bearish is to be insensitive – as if to dismiss the deaths and pandemic as economically meaningless.

Being negative is easy. Just think of all the closed stores, restaurants and sports events that have dramatically reduced options for leisure. I rarely need to visit the ATM because all I’m buying is gasoline, about once a month. It’s cheaper too, although I’d need to drive to a couple of planets for the savings to offset recent losses on my energy investments.

The S&P500 is -8% for the year, a performance seemingly divorced from reality. Following  last year’s +31.5%, it might have been down 8% without coronavirus.

From a top-down perspective it’s usually easy to be bearish. There’s always something to worry about. But S&P500 earnings are estimated to be -20% this year and +27% in 2021, taking them back above last year’s. This is based on analyst estimates from early May, so for the most part reflects first quarter earnings and full year guidance. It’s hard to reconcile with the jump in the unemployment rate from 4.4% to 14.7%, but we must assume that’s incorporated in all those earnings forecasts.

The Equity Risk Premium (ERP, S&P500 earnings yield minus ten year treasury yield) still makes stocks look reasonably attractive. This is partly because interest rates are so low. But even if ten year treasury yields move up to 2% next year, equal to the Fed’s long term inflation target, the expected rebound in earnings will compensate.

If in fact earnings do rebound as forecast, it’s hard to see interest rates staying this low. For years bond investors have seemingly held a less optimistic view than equity investors, but the dichotomy seems as stark as it’s ever been.

To illustrate, Williams Companies (WMB) issued ten year debt at a yield of 3.56%, substantially below the dividend yield on their shares of 8.2%.  Like many big pipeline companies, quarterly earnings were better than expected (see More Solid Pipeline Results). WMB’s quarterly payout is up 5.3% year-on-year.

Although the ERP shows stocks to be cheap, Goldman’s forecast of $44 in 2020 S&P500 dividends is only a 1.5% yield .

We’re heading into a period with no obvious historical precedent. A shut down of large swathes of the economy along with a big increase in debt is most analogous to war. The Committee for a Responsible Federal Budget now expects a Federal deficit of $3.8TN (versus $1.1TN pre-Coronavirus). They expect total Debt:GDP to reach 107% by 2023, exceeding the prior record of 106% hit just after the end of World War II. And these figures exclude any new Federal spending, although the House of Representatives recently passed another $3TN package.

Given the dismal fiscal outlook, the stock market’s recent performance is even more impressive. And if you’re looking for a sector that’s rebounded nicely but is still down over 30% for the year, check out the pipeline sector.

 

It’s Iran’s Move

If one thing’s clear about recent developments in the Middle East, it’s that events defy prediction. Yet timing trades in the energy sector requires the seemingly impossible.

On Monday, we listened to a thoughtful call arranged by RW Baird with Greg Priddy, Director, Global Energy and Middle East, at Stratfor. Greg expects a measured, near term response from Iran intended to be regarded as proportional, allowing for a similar U.S. response (i.e. target a couple of Iranian missile installations), and thereby avoiding escalation. It sounds very neat, and prone to miscalculation.

Greg Priddy felt that the virtual collapse of the Iranian nuclear deal is more problematic over the long run. In its first response to the killing of General Suleimani, the government announced that, “Iran will continue its nuclear enrichment with no limitations and based on its technical needs.” As Iran approaches an offensive nuclear capability, this is likely to draw a response from Israel or the U.S. He put the timeframe as by the summer, which struck us as startlingly soon. Priddy placed the odds of a significant U.S. military attack on Iran this year at 45%.

Ratcheting up the price of crude oil may be one of the few levers Iran holds over President Trump in an election year. So far, oil traders have been surprisingly sanguine about the prospects of supply disruption. Following September’s attack on Saudi infrastructure, oil retraced its initial jump within a couple of weeks, as supply was quickly restored. Some analysts believe that the recent jump in prices won’t be sustained without an actual loss of supply. The Shale Revolution has enhanced America’s freedom to act.

However, given the domestic American politics of rising gas prices, a series of moves to interrupt supply would seem to be one of few meaningful strategies left to Iran. Attacks on fixed targets will draw a U.S. response, but if shipping insurance rates rise and the smooth transport of oil around the world becomes less certain, Iran may yet find it has some leverage and buy it time until the US election.

The problem Iran’s leadership now faces is that it has raised expectations domestically for a robust response, but its choices remain limited. Meanwhile, Trump has shown he’s not interested in nation building or committing U.S. land forces. He  has established a clear red line that the loss of American lives won’t be tolerated. Cruise missiles and drones allow the U.S. to pursue remote yet devastating engagement with minimal risk. Crippling economic sanctions continue to hurt the Iranian population.

Iran’s current approach of low-level, asymmetric attacks has also failed to achieve their goals They may have overplayed their hand, and are now left with few options.  A direct military response risks heavy-handed retaliation, while small provocations through proxies expose Iran’s leaders personally. It’s unclear how Iran’s government can lower tensions, and little evidence they want to.

Trump’s killing of Suleimani highlights how unpredictable the conflict has become. Energy investments are a good insurance policy. The past decade’s underperformance against the S&P500 has left many investors underweight, and lowered the sector’s correlation with the rest of the market. Oil prices don’t yet price much risk premium. Midstream energy infrastructure’s growing free cash flow (see The Coming Pipeline Cash Gusher) is well beyond Iran’s reach, and offers a highly likely outcome in a period of uncertainty.

 

Stocks Have Been Cheaper

We’ve been using the Equity Risk Premium (ERP) as a measure of the relative attractiveness of stocks for many years. The ERP is the earnings yield (i.e. the reciprocal of the P/E ratio) minus the ten year treasury yield. It compares stocks with bonds, allowing today’s relationship to be compared with history. The S&P500’s P/E is currently 18.1, based on Factset‘s 2020 earnings forecast of $178. That’s an earnings yield of 5.5%, producing an ERP of 3.6 when compared with the ten year treasury yield of 1.9%. Since 1960, the ERP has averaged 0.6, so it currently favors stocks.

The Cyclically Adjusted Price/Earnings Ratio (CAPE), another valuation tool, has been disastrous. It’s shown stocks to be expensive, because it compares the current P/E with the long term average. The flaw in this simple approach is that it ignores interest rates. Stocks are historically expensive, but bonds are even more so. CAPE practitioners have missed out on an enormous rally.

We first wrote about the ERP in 2012 (see The Price of Fear) when it was 6.3. It’s been providing a bullish signal for stocks ever since, as we’ve often pointed out. A year ago it was 4.4. During 2019 yields fell, earnings grew and multiples expanded, all of which supported the market’s 31% return.

I was chatting with a friend the other day about valuations, and the ERP. Factset bottom up earnings for 2019 began last year at $174 and edged down all year to $163. That’s often the case – sell-side analysts and management guidance typically open the year with optimism that subsequent events gradually erode.

At the end of 2018, the 2020 earnings forecast was $193. It’s already fallen almost 8% to reach its current level of $178. Although at 3.6 the ERP remains wide compared with fifty years of history, it’s less so over the past decade. If the same downward path to earnings forecasts continues, 2020 will come in close to 2019 at around $164. That would push the ERP down to 3.2. A 1% jump in long term rates, always a possibility and more likely than a 1% drop, would move the ERP to 2.2.

Stocks remain a good investment, although they have been substantially more attractive at different points over the past decade. Bonds continue to be an extremely poor long term bet. But it wouldn’t take much for equity valuations to be mundane. One exception might be energy, especially pipelines and other midstream infrastructure, where low valuations should provide more downside support if the broader market takes a tumble. In Pipeline Bond Investors Are More Bullish Than Equity Buyers, we highlighted how cheap pipeline stocks are compared to bonds. Energy was the worst performing sector of the past decade. One result is that it’s far cheaper than the broader equity market.

Wishing all our clients and readers a happy and prosperous 2020.

Natural Gas Profits Remain Elusive

Coal is by any measure an environmental and climate disaster. The world relies on coal in various forms for 27% of its primary energy, and it’s responsible for  40% of its CO2 emissions from fuels. Although it possesses lower energy density than oil or natural gas, coal is relatively easy to transport and store which explains its widespread use. It powered the industrial revolution before rich countries started switching to cleaner-burning natural gas due to local pollution. Today, China consumes half the world’s coal.

A big idea to combat climate change is for the world to phase out coal, replacing it with natural gas. This is already happening to some degree in the U.S. for power generation. Natural gas provides 37% of U.S. power, up from 34% last year. Coal’s share is 25%, down from 28% last year and heading to 22% in 2020.The recent bankruptcy of Murray Energy is a consequence.

Coal has its proponents, including all the industrial users of coal who have invested in processes that rely on it, as well as the coal producers themselves. But the math is that if the 150 billion BTU-equivalent of primary energy generated from coal was instead produced with natural gas, it would roughly halve the CO2 emissions per unit of energy. This would in turn reduce global emissions by 6.6 Gigatons, around 17% and more than the total emitted by the U.S. Climate extremists focused on solutions would push for even greater exports of cheap U.S. natural gas, perhaps supported by the sale of U.S. gas-fired power plants. It’s not as radical as moving to centrally planned economies running on solar and wind, but has the significant advantage of being feasible with today’s technology. Abundant natural gas offers a huge opportunity.

Moreover, coal causes local pollution wherever it’s burned, including sulfur, mercury, lead and arsenic. It emits high concentrations of very fine particulate matter, which cause respiratory damage. Estimates of annual coal-related deaths in the U.S. range from 7.500 to as high as 52,000. For comparison, the U.S. experiences around 40,000 auto-related deaths annually. In China, which burns six times as much coal as the U.S. and has less restrictive pollution rules, estimates of smog-related deaths are as high as 670,000.

America’s enormous success in producing natural gas has crushed the stock prices of many E&P companies.

Chesapeake (CHK) was the poster child for the Shale Revolution and natural gas under the late Aubrey McClendon. In an SEC filing the company warned that low natural gas prices “raises substantial doubt about our ability to continue as a going concern.”

Range Resources (RRC), Comstock Resources (CRK), Southwest Energy (SWN) and Antero Resources (AR) are among those who have destroyed vast amounts of investor capital in producing abundant natural gas.

Almost a decade ago we were following RRC, SWN and CRK more closely, meeting with management and examining the growth story. Production success has been a poisoned chalice. Increasing output has weighed on prices, recalling the early days of dot.com businesses who sought to cover operating losses by increasing volumes.

Nonetheless, production continues to increase. In the Permian in west Texas, the two most active drillers are Exxon Mobil (XOM) and Chevron (CVX), validating the opportunity of shale as long as it’s exploited by companies with low production costs and strong balance sheets.

Natural gas is increasing its share of the world’s power generation, providing access to cheap energy and lowering emissions. It’s just not clear that the early, smaller E&P companies will survive to benefit.

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