The Trump Put

Last week President Trump tweeted, “Dow just broke 25,000. Tremendous news!” It wasn’t the first time the Dow had risen through that threshold. On July 14th, the President tweeted, “The Stock Market hit 25,000 yesterday.” A year ago, on January 4th, 2018: “Dow just crashes through 25,000. Congrats! Big cuts in unnecessary regulations continuing.”

The Trump Put

This president probably cares more about short term moves in stocks than any predecessor. He has adopted it as a report card of how his administration is doing. Past presidents have generally positioned themselves above the fray, concerning themselves more with economic data such as GDP growth and unemployment. These are important to President Trump too, but the Dow provides a real-time gauge of his performance, reflective of today’s social media supported news.

His cabinet colleagues clearly recognize this. We winced at Treasury Secretary Steve Mnuchin’s comments in December that banks had “ample liquidity”. Stocks were very weak, largely because of problems caused by the government. The trifecta of growth –inhibiting tariffs, a looming federal government shutdown and Fed chair Powell’s communication missteps were the main cause (see Problems Made in DC Can Be Fixed There). But nobody had questioned banks’ liquidity until Mnuchin’s amateurish intervention.

Compared with the Goldman colleagues who preceded him, this betrayed the absence of a deft touch, and briefly raised more concerns than it settled. But it reflected the attention this administration pays to any substantive moves in equities.

President Clinton’s former campaign manager, James Carville, once commented that in his next life, “…I would like to come back as the bond market. You can intimidate everybody.” He also coined “The economy, stupid.” This phrase came to symbolize Clinton’s campaign singular focus and its improbable victory over George H. W. Bush.

GDP reports are too slow in providing feedback, so movements in the Dow offer more immediate information. Given the Tweets that follow when it reaches milestones (even if those milestones have been reached before), you can assume Trump badly wants to brag about the market going into next year’s election. Policies that are good for the economy must be good for stocks; therefore, when the Dow signals dismay, it’s likely to draw a reaction.

That doesn’t guarantee economic policies that will support stocks – the trade frictions with China are an example. But it does mean that there’s limited overall tolerance for pursuing policies that damage the market. The federal government shutdown lasted longer than expected.  It quickly ended, without the wall that was its purpose, once a major airport had to shut because of missing air traffic controllers. This likely won’t be repeated, and emergency action to build the wall will be tied up in the courts where it’ll be symbolic and harmless.

Trade friction is taking its toll. U.S. objectives are broad but not specific. We are approaching March 2nd, when the U.S. is set to impose additional import taxes on $200 billion of Chinese exports. As the deadline nears, expect Trump to find a way to claim victory and avoid the inevitable market swoon that would otherwise follow.

For years, the ‘Greenspan Put’ provided investors some comfort that the Fed would rescue them from economic weakness. Much of what moves stocks today emanates in Washington DC. As attention turns to the next presidential election, equity investors are likely to see the ‘Trump Put’ become the ultimate arbiter of what is administration policy.

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).

 

Problems Made in DC Can Be Fixed There

The Federal Government is Moving Markets

The Federal government has been moving markets of late.

Venezuela is the latest issue to watch. The U.S. is currently aligned with most of the world in seeking the overthrow of leader Nicolas Maduro. The sanctions look significant, with almost all Venezuela’s hard currency coming from oil exports, half of which go to the U.S. Finding new buyers won’t be easy, because even non-U.S. buyers will be wary of transacting through the U.S. financial system, potentially violating U.S. law.

In addition, Venezuela’s exceptionally heavy, viscous crude requires blending with condensate before it can be shipped. That condensate is imported from the U.S., so Venezuela will also need to find alternative supplies. So far, global oil markets have reacted calmly to the possible loss of Venezuelan crude, partly because years of inept management have reduced production to around 1 million barrels a day (MMB/D). Six years ago it was as high as 2.5 MMB/D. However events play out, it’s unlikely to be bad for the U.S. given our rapidly growing oil production.

Last year’s corporate tax cuts propelled the S&P500 to a 22% return in 2017, as markets anticipated the jump in profits. Like the prior year’s gains, the slump in December was also made in DC, resulting in a 4.4% loss for 2018. Tariffs (i.e. import taxes) imposed somewhat capriciously, and the unresolved trade negotiations with China led to a slowdown in Chinese GDP growth as well as downward revisions to corporate profits. This was followed by White House complaints about high interest rates, met with Fed chair Jay Powell’s confusing comments suggesting rates may move much higher. Independence asserted, his comments were soon walked back, although equities responded sharply in the meantime.

Last week the federal government reopened, to widespread relief. Press reports described it as a loss for Trump, which naturally raises the likelihood he’ll reject whatever negotiated compromise Congress presents on February 15th. Markets rallied on the agreement, and later weakened as tweets made clear the dispute over a border wall isn’t yet resolved.

Predicting how each episode is resolved isn’t easy, which makes a defensive posture attractive. The confusion over interest rate policy has sorted itself out, with the Fed likely on hold for now. However, the disagreement over the wall that shut the government for 35 days may burst open again.

But it turns out that the President isn’t Emperor, and Congress has different powers that are intended to give it equal status. Although Trump will complain, Republicans are unlikely to have much stomach for a second federal government shutdown. This might leave the president turning to emergency powers to erect a physical barrier. That’ll be held up by challenges from Congress, or in the courts, or both. For the equity investor, there’s good reason to assume that this stand-off has lost its ability to move markets.

On trade, the negotiations with China drag on interminably. But unlike the wall, there’s no promised tangible objective. So the White House could at any time decide it wants some positive press and accept whatever China is offering, claiming victory.

This is the risk with not holding equities because of current uncertainties. The problems are all made in Washington, which means they’re easily fixed there. Don’t be surprised to see the budget stand-off and China both recede as concerns. With interest rates on hold and S&P500 2019 earnings growth of 6.5%, the market’s P/E is 15.3. Equities remain a far better bet than bonds.

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).

The Value in Listening to Bears

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.

The Bears are Roaring

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).

China Quietly Dumps Bonds

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.

China and Japan Reduce US Bond Holdings

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.

China and Japan Reduce % of US Debt

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).

Asset Classes: There’s Nowhere to Hide

If you feel like it’s been a tough year in the market, you’re not alone. In 2018, virtually no asset class has provided safety. At -3%, US equities are down less than many other asset classes. Developed market equities have slumped 16%, similar to emerging markets equities (-17%) and energy (-15%). The Trump Administration strategy of using tariffs to alter terms of trade is blamed for growing concerns over global growth. The U.S. economy’s huge domestic market renders it less affected by trade than most others. Nonetheless, lower global growth is having an impact.

No Place to Hide: Asset Classes Down in 2018

In a startling survey, CNBC found that almost half of U.S. corporate CFOs expect a recession to begin within twelve months. 82% expect a recession within two years. One doesn’t normally consider Federal Reserve members wildly optimistic, but in September they revised their 2019 GDP forecast up modestly (from 2.4% to 2.55%). Although they expect a slowdown by 2020, they’re still forecasting around 2%. The Fed is more bullish than corporations.

Bonds have not provided any protection either this year, with returns of -3%. Unusually, about the only asset class to provide positive returns is cash. The last time this happened was 1969.

The recent sharp drop in stocks has led to fund outflows. Last week’s $39 billion pulled from global equity funds was a record, and it was accompanied by $8 billion in withdrawals from investment grade bonds. Asian stock and bond funds are on track for their first year of net outflows since the 2008 financial crisis.

For a while, rising interest rates were felt to be the biggest threat facing the economy. The Fed is still projecting short term rates of around 3.5% next year, but the recent market turmoil has lowered ten year yields back below 3%. Two year yields of around 2.7% show the market thinks rate hikes next year are unlikely.

The Fed continues to unwind its balance sheet.  Beginning with $10B/month in the fourth quarter of last year they’ve increased the pace to $50B/month as quantitative tightening is now in full swing.

That leaves trade tensions as the meaningful source of investor angst. Given how traders react to Presidential tweets suggesting a resolution, a deal with China could provide quite a boost. Although it’s hard to forecast with any confidence, both sides must recognize that they benefit from reduced trade barriers. Given the decision-making freedom afforded both leaders, a compromise could come at any time and be arrived at quite quickly.

Earlier this year, growth concerns were limited to emerging markets, where tariffs and the strong dollar have greater impact. But the S&P500 has fallen 13% since its September all-time high. Although it’s not yet a bear market (defined as down 20%), emerging markets and oil have both passed that threshold.  Within the S&P, more cyclical sectors including financials, materials and energy have also reached that threshold signaling market concern around a slowing economy while the less economically sensitive utilities sector is near its highs for the year.  Although the steady cash flow businesses of midstream MLPs & energy infrastructure companies more closely resemble utilities they have traded with energy stocks.

2019 S&P earnings are expected to grow by 12% according to Factset. Bond yields below 3% scarcely offer much return, and equities continue to look relatively attractive based on the Equity Risk Premium (see Bonds Still Can’t Compete with Stocks). The bearish outlook of corporate CFOs is troubling, but isn’t yet showing up in, for example, lower capital spending. As long as that remains the case, relative valuation will continue to favor equities.

 

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).

Leaderless Britain Stumbles Towards Brexit

Although it’s 36 years since I last lived in England, I retain a deep affection for the country where I grew up, as well as my English accent (so say my American friends, anyway). I’m often asked my opinion of Brexit – I have British friends on both sides of the Leave/Remain divide. While I would have voted to stay in the EU, I can understand the opposite view, even while Leavers willfully ignore the strong economic arguments against their position.

Few Americans would accept the loss of sovereignty required by EU membership. Freedom of movement means in theory all 440 million EU citizens not living in the UK could move there without the government being empowered to stop them. It’s not the only issue, but the biggest. Regulations imposed by Eurocrats in Brussels cover mind-numbingly trivial standards for goods and services, all in the interests of creating a seamless market. Many of them are easily criticized and sometimes stupid. Nonetheless, the EU remains in Britain’s interest, in spite of these substantial drawbacks.

A thoughtful essay in the Wall Street Journal (The Great Brexit Breakdown) insightfully noted that “You can have national sovereignty—and that’s fine. Or you can have economic integration—and that’s fine. But you can’t have both.” America has always been the EU’s vision. Its enormous domestic market and free movement of people are fully integrated, which partly explain faster productivity growth. Texans have no sovereignty (though some in the Lone Star state will disagree). But Europe is older and far more tribal. Texans share more values with New Yorkers than the English do with neighboring France. For an island nation, centuries of repelling European invaders isn’t easily replaced with passive acceptance of rule from “the Continent” (how the British refer to the rest of Europe).

Since Britain voted by 52%-48% to leave the EU in the ill-considered June 2016 referendum, negotiations have plodded forward in a predictable, crisis-free fashion. The UK is not alone of course in drifting towards regional political affiliations. As with the U.S., voting patterns were strongly linked to demographics, income and education. London and other major cities voted overwhelmingly to Remain, embracing Europe because of their ethnic diversity. Rural, older voters wanted to Leave. The more white your neighborhood, the less you liked Romanians arriving in your country, even if you rarely encountered them. It was also Old versus Young; those with less life ahead of them imposed their desire for yesterday’s Britain on others with decades still ahead.

Brexit has already been a most awful own goal. Conservative PM David Cameron called the referendum expecting to win handily, thereby ending a corrosive debate within his own party. His subsequent resignation ushered in Theresa May, who had campaigned for Remain like most MPs. Echoing her predecessor’s poor judgment, she gambled on an early election to increase her parliamentary majority, and lost it completely. Her government is propped up by the votes of a small Northern Irish party whose allegiance was bought with higher government spending in their region.

Theresa May has conceded on the major points, as was inevitable to anyone who considered the two sides’ relative negotiating strengths. The result was that the Brexit deal she negotiated with Brussels united both camps in opposition. Facing overwhelming parliamentary defeat, she cancelled a vote she would have lost heavily. Britain has almost no high cards to play, while the EU can’t tolerate a departing member skipping happily into the sunset. Although it’s hard to imagine how anyone could have made a success of negotiating Brexit, she has failed to reach even low expectations.

If Brexit happens (still not certain), it will be on EU terms. The EU rarely makes crucial decisions without the clock ticking down to midnight. Politically, the March 29th deadline (when Brexit is scheduled to happen) remains a long way off. A wide range of outcomes is still possible, including an early election, a second referendum, reopening negotiations with the EU and even no Brexit.

Few in Britain will care to consider how a Trumpian PM would have handled the issues, but they would not be facing today’s unattractive options. PM Trump would have responded to domestic concern over free movement of people attracting too many east Europeans by imposing a unilateral halt. Disliked EU court rulings would have been ignored. It would have caused a different type of crisis than the current one, but the British would have known someone was in their corner, fighting for them. Instead, Leavers promised what was undeliverable. Theresa May has clung to power at the expense of her principles, while passively negotiating Britain onto a path of permanently weaker growth. The country of my youth has been poorly led. It’s a terrible shame.

 

Steel Tariffs Show Up in Surprising Places

The G20 meeting on the weekend produced a mildly surprising rapprochement between the U.S. and China on trade. Most commentators regard the Administration’s serial imposition of tariffs negatively. Stocks certainly liked the possibility of a lower temperature around this rhetoric.

In spite of the U.S.’s many trade disputes, the economy shows little sign of suffering. Unemployment is 3.7% and interest rates remain supportive, with ten year treasury yields at 3% offering scant competition for equities (see Bonds Still Can’t Compete With Stocks). Consensus expectations are that next year S&P500 earnings will increase by 10%.

Nonetheless, tariffs do have an impact. Steel shipments have been a controversial topic, with many developed countries accusing China of selling below cost (“dumping”). The Administration has imposed tariffs on steel imports from a wide range of countries, on the grounds of national security. Commerce Security Wilbur Ross said, “Economic security is military security. And without economic security, you can’t have military security,”

Tariffs have their effect in subtle ways. They are a form of sales tax, and taxes are borne both by the producer and the customer in proportions determined by their relative elasticities. For example, if a buyer of a product now subject to tariffs had no alternatives available and had to have the product, the price would go up by the amount of the tariff. The more choices a buyer has, the less impact the tariff has on the product’s price, meaning more is absorbed by the producer.

The Federal Reserve Bank of St. Louis shows that steel prices have risen by around 17% since the 2016 election, the point at which steel buyers and sellers might have begun to contemplate tariffs. The tariffs ultimately implemented were 25%, which suggests that buyers have borne more of the cost than producers. Domestic producers were able to raise prices protected by tariffs. Since the 17% increase relates to all steel whereas the tariffs were only imposed on imports, producers benefitted further at the expense of buyers. The Bureau of Labor Statistics forecast that steel prices would rise by 21%, so further price hikes may be ahead.

Steel Inflation

Few of us buy steel directly so the impact appears inconsequential. A recent report by CoreLogic, who advise the insurance industry on construction costs, showed steel prices rising at 14% year-on-year. Property and casualty companies will factor this in to the cost of insurance coverage for buildings that use steel – excluding one-to-four family houses, most other structures require it. So apartment dwellers and office building owners will see an incremental cost increase through insurance premiums higher than they would otherwise be.

Steel Prices Drive Insurance Premiums Higher

Another example relates to energy infrastructure. Plains All American (PAGP) was inadvertently caught up in the tariffs because of specialty steel they had ordered from Greece to complete their Cactus II crude oil pipeline. In effect it was a retroactive tariff, because they’d placed the order long before the imposed tariffs resulted in a $40MM charge. Their appeal for a waiver was denied.

Capacity on the pipeline was fully committed by February, before the tariffs were formally announced.  The increased cost of the pipeline will be borne by shippers, to the extent contracts allow the tariff to be passed on, and the excess by PAGP stockholders.

In both cases the tariffs represent a redistribution of income, from customers to the Federal government (which is why it’s a tax) and to domestic steel producers through higher prices. The effects are both subtle and numerous, as these examples show. The Administration has defended tariffs as a short-term, negotiating tool and not part of a long-term strategy. Whatever the merits of tariffs on domestic politics, equity markets clearly look forward to the time when the goals of tariffs have been achieved.

We are invested in PAGP.

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).

Lower Volatility Stocks Gain Favor

Low volatility is outperforming. In a rising market, taking more risk usually pays off. The recent reversal has investors seeking tangible value.

Nothing exemplifies intangible value, or more accurately ephemeral value, better than Bitcoin. The great Risk On trade began the day of Trump’s election victory, when an overnight market swoon quickly reversed. Bitcoin buyers embraced the new mood more exuberantly than most, running the price briefly as high as $20,000 by last December, from $730 at the time of the election.

Bitcoin Bubble Bursts

As a currency, Bitcoin has spectacularly failed the “store of value” test. Its proponents assert that freedom from government oversight ensures its value cannot be manipulated for political purposes. It’s similar to the argument made by gold investors, although fiat money (what followed when Nixon suspended convertibility of the US$ into gold in 1971) has done pretty well. Bitcoin is a solution in search of a problem. Among the many risks that Bitcoin investors face is that their exchange is hacked, with scant protection from the governments whose protections they skirt.

Bitcoin has now lost 80% of its peak December 2017 value. Wherever speculators take it from here, the case for a new currency free of government control and protected by no-one is lost.

By contrast, low volatility stocks, possessed of more tangible value than Bitcoin, are enjoying a resurgence. The rapid exit from momentum that Bitcoin previewed a year ago is rippling across equity markets (see FANG Goes Bang). The beneficiaries include consumer staples, such as Clorox (CLX), Kimberly-Clark (KMB), McCormick (MKC) and Procter & Gamble (PG). The sector was boring when CNBC was debating the relative merits of FANG stocks Facebook (FB), Amazon (AMZN), Netflix (NFLX), and Google (GOOG), but earnings stability can be attractive too.  The S&P Consumer Staples Index has a beta of 0.69 and dividend yield of 2.75%, whereas the FANG stocks have an average beta of 1.47 and pay no dividends.

Low Vol Stocks vs SP 500

The Low Beta Anomaly examines a weakness in the Capital Asset Pricing Model (CAPM), a widely used framework for valuing securities. It relies on the sensible premise that more risky investments should generate a higher return. History shows this isn’t true, and numerous academic papers offer reasons why. A compelling explanation is that active equity managers, paid to beat the market, are drawn to stocks that move more than the market (“high beta”). New clients are most easily found when the averages are rising, and relative outperformance helps. The result is that in aggregate, investors pay more than a CAPM-derived price for high beta, lowering the subsequent return on such stocks and correspondingly driving up the return on less-sought low beta names.

It’s Wall Street’s version of the tortoise and the hare. Consumer staples stocks are solidly in the low beta, or low volatility category. As the post-2016 election endorphins subside (admittedly, it’s taken a long time), less risky stocks look better. After lagging for much of the year, low volatility has caught up with the S&P500 (which is burdened with a healthy number of high beta names). The new darling sector is the one that grows slowly, albeit reliably. It’s the antidote to Bitcoin and FANG-fueled excitement.

Our portfolio of low volatility stocks has a beta of 0.49 and a dividend yield of 3.2%. Most of the names have decades of consecutive annual dividend increases. Although its yield is half that of energy infrastructure (the American Energy Independence Index has a dividend yield of 6.3%), the absence of high volatility is drawing more buyers.

We are invested in CLX, KMB, MKC and PG

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).

FANG Goes Bang

“FAANG” stocks (Facebook, Amazon, Apple, Netflix and Google, now called Alphabet) were rising for most of the year. For investors who didn’t find that exciting enough, BMO Capital Markets Corp helpfully issued the MicroSectors FANG+ 3X Leveraged ETN (FNGU). As the name suggests, it gives you three times the daily return on these, plus another five for good measure (Alibaba, Baidu, NVIDIA, Tesla and Twitter). That I don’t personally know any buyers reveals more about the sedate company I keep, because there’s clearly a ready market for leveraged ETNs. Last week DGAZ, Credit Suisse’s ETN designed to provide 3X the downside to natural gas, collapsed as natgas soared, losing 81% of its value over the past month.

The Fact Sheet for FNGU warns it’s, “not suitable for investors with longer-term investment objectives.” What other investor types are there? Because such securities maintain constant market exposure, they have to rebalance every day. Leverage magnifies the effect of compounded returns. A stock that rises and falls by 1% on alternate days will lose half its value in 13,860 days. If it moves 2% this only requires 3,465 days, while 5% takes 553 days. You get the picture. One can think about the half-life of these leveraged products – how long would it take them to lose 50% given historic volatility. With daily moves in natgas of 1.2%, DGAZ had a half-life of 1,087 days. The recent spike in prices has hastened its demise.

It’s not only DGAZ buyers who lost big. The author of The Complete Guide to Option Selling posted a video on YouTube in which he tearfully explains why his hedge fund has just been wiped out by the “rogue wave” in natgas.

Leveraged ETFs and ETNs have their critics, and scarcely need one more. SEC officials have individually criticized them but stopped short of withholding approval.

The point is that the violent losses in FNGU highlight far more substantial recent losses for investors in the underlying stocks, and more broadly in growth-style investing. Since the 2016 Presidential election, equity returns have been dominated by a narrow group of growth stocks. At its peak in June, the FANG+ index had risen by 125% from its election-day level. Although the FANG+ group has been in retreat since then, the S&P500 Growth ETF (SPYG) continued to outperform. As recently as late September, SPYG had risen by 52% since the 2016 election, beating the S&P500 Value ETF (SPYV) by 22%.

Growth Stocks Lose Election Luster

Since then, SPYG’s lead over SPYV has been halved. We are approaching correction territory, defined as a 20% pullback from the highs. FANG+ is already there, at -23% from its June high. The Nasdaq Composite Index not far away, down 15% from its high set in August. while SPYG is -12%. The S&P500 has pulled back 10%, with SPYV falling a more modest 8%.

There’s a shift under way. With growth investors certainly having had the better of things in the past couple of years, there are still profits to protect. But it’s rarely easy valuing former highfliers when momentum is turning. Value stocks by definition have firmer valuation support. In addition, their investors are less likely to sell in a falling market. They own what they do because they like the valuation, and are less dependent on others liking it more to generate a return. Low volatility stocks, having lagged the S&P500 by 5% for the year through September, are now outperforming the S&P500 by 4%.

This leads to one of today’s great value opportunities – U.S. pipeline stocks. The names in the American Energy Independence Index offer a 10.9% yield on 2019E Distributable Cash Flow (DCF, which is free cash flow ex-growth capex), up 13% over 2018. This is analogous to the Funds From Operations (FFO) commonly used in real estate, as we showed in a recent blog (see Kinder Morgan: Still Paying for Broken Promises). The index has a current dividend yield of 6.25%, and we expect dividends to grow 8% next year.

Growth stocks may resume their upward trajectory, but the recent volatility has shown how quickly two years of outperformance versus value can quickly reverse.

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).

 

Crude’s Drop Makes Higher Prices Likely

Crude oil just set a record of sorts, by falling for eleven consecutive days (as of this morning). Fears that sanctions on Iran would cause a supply shortage, leading to a price spike, now seem unfounded. Not long ago, many were surprised at the high degree of compliance. France’s energy giant Total’s CEO said it was, “…impossible for big energy firms to work in Iran.”

The big stick America wields on this issue is access to the U.S. financial system. If a company is deemed to be trading with Iran, it can find itself unable to conduct financial transactions in US$. This is a surprisingly powerful tool, since a substantial amount of trade is conducted in our currency. Total concluded that being unable to transact in US$ would be too disruptive to contemplate.

In the summer, the U.S. appeared to be taking an uncompromising approach, and Iranian crude exports were forecast to fall from 2.5 Million Barrels per Day (MMB/D) to as little as 1 MMB/D. Crude oil futures correspondingly rose. Pressure was put on Saudi Arabia to provide offsetting increased output, as the Administration fretted over high gasoline prices before the midterms.

More recently, waivers granted by the White House to eight importers of Iranian crude have calmed fears of a price spike. China and India, who are both continuing to buy Iranian crude as a result, imported over 1 MMB/D last year. As a result, the January ’19 Brent Crude month futures contract has slid from $86 in early October back to $68 where it was in the Spring. For now, it seems that the Iranian sanctions aren’t that significant.

Crude Oil Futures Dec '20

Saudi Arabia probably expected the U.S. to be stricter in following through on sanctions, and was surprised by the waivers. They have just reduced December exports by 0.5 MMB/D. The Saudis surely expected to be selling oil at higher prices a month ago. Recent data shows that Saudi exports to the U.S. have been falling, and floating storage (i.e. crude on tankers in transit) is the lowest in four years. Some believe that Saudi Arabia is unable to sustain production above 10.6 MMB/D or so without damaging their oilfields.

Although the gyrations of the front month futures contract have commanded attention, crude prices farther out have moved much less. The December ’20 futures contract fell from $76 to $70. Fear of sanctions had caused backwardation (near contracts higher than farther out ones), and this has corrected.

Upstream Spending for Big Oil

Investments in conventional oil production are driven by the price of crude expected to prevail over the life of the project. The front month gets the attention, but it doesn’t drive the decision. Because new oil projects take several years to reach production, many in the industry continue to worry that falling investment levels will eventually cause higher prices. The International Energy Agency (IEA) recently released their World Energy Outlook. They warn of a looming supply crunch, with the world seemingly too reliant on increasing U.S. production to meet demand growth. Investment spending collapsed during the 2015-16 industry downturn, and remains more than one third lower than it was in 2014. Discoveries of conventional hydrocarbon reserves are correspondingly down.

Crude oil along the futures curve is still at levels that have drawn repeated warnings of future supply shortfalls. Moreover, Saudi Arabia is finding that the U.S. administration ultimately wants low prices, with Trump recently tweeting, “Hopefully, Saudi Arabia and OPEC will not be cutting oil production. Oil prices should be much lower based on supply!” Expecting Americans to tolerate higher pump prices so as to pressure Iran is an unlikely strategy for any president to pursue. But Saudi Arabia needs higher prices to balance their budget. These conflicting goals will continue to impact oil prices.

Low investment means higher prices are likely over the intermediate term; perhaps sooner, based on the drop in Saudi exports.

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