Was last Tuesday’s 350-point rally the beginning of the end of the bear market or just a false “bear trap?” And a related question: “Did oil bottom at $33 and will it get re-tested?” Let’s see what we know.
Some things we know
Sometimes the objective observable facts can yield fairly clear conclusions. Usually that’s not the case. Usually you can use the available facts to make a decent argument in either direction. But sometimes the facts seem fairly clear.
For example, there should have been clarity about being at a turning point in 1982 - I think it was in September. We knew that interest rates were at historical highs, put there deliberately to try to strangle inflation out of the economy. High rates were strangling the economy as well as inflation. Then Paul Volker - the man who determined the direction of interest rates - actually told us in a magazine interview that interest rates were not going to go any higher, that the interest rate squeeze was over. So we could pretty well know that interest rates were going to head down. Falling interest rates are nearly always good for equities, and at that point nothing would have helped the economy as much as lower interest rates. So by the Fall of 1982 there were very good reasons to anticipate a strong, sustained upward movement in stocks.
Now we know interest rates are low. Short rates are almost zero. Even long rates are assuming only about 1% inflation, about as low as a healthy economy could go. So if we think that eventually the global economy will recover and become healthy again then clearly interest rates can only rise somewhat. If we think as some do that the huge cash injections and deficits being run by the U.S. government will eventually cause inflation, then rates could rise a great deal. If foreigners start to refuse to buy more U.S. debt as the Chinese hinted they might consider last week, then interest rates could go much higher. Rising rates are not generally good for stocks. In fact they are a heavy wind in the face of equities.
Here’s what else I think we can know with a fair degree of certainty:
- Financial stocks have been in panic mode partly because of a silly “mark to market” rule that makes no sense when there is no market to mark to for huge quantities of bazaar derivative-based securities; thus this rule has caused everyone to mistrust the banks and probably to underestimate the real value of their assets. That problem seems like it’s about to go away. Let’s pray.
- Speculators have been able to short down the stocks of companies with any whiff of unknowable risk in part because the “uptick rule” was abolished by the S.E.C. in 2007. The uptick rule is about to be re-established, so that problem is about to go away too.
- Banks are making healthy interest rate spreads on their loans.
These three facts are very bullish for financial stocks, which were selling at historically oversold prices. They’ve jumped but still seem cheap. I remember when Viacom sold for $2 per share in 1974. Eventually it got up to about $50. Could Citibank (C) be in a similar position today? I wonder what Citi’s global brand franchise and presence just by itself is worth.
On the other hand we also know that
- the economy is in the toilet and there is likely to be more pain for some time to come,
- consumer spending is unlikely to become robust for many years to come because people have lost a lot of their asset base and the appetite to resume their borrow-to-spend consumption habit,
- there is a lot more manufacturing and retailing capacity in the U.S. than the economy will need for many years to come, so capital spending is likely to be restrained for a long time,
- some major loan categories such as commercial real estate, car loans, and credit card loans still have a lot of write-downs to come,
- Eastern Europe is in worse shape than the U.S. and could cause financial strains for the Euro countries that could exacerbate global economic weakness. Some developing countries are in even worse shape.
The sum of all the above “facts” leads me to two conclusions:
1. We are likely to see more of a “relief rally” as it becomes increasingly clear that the government has finally unlocked the banking sector so that it can start to function more like normal. That success will reflect more optimism on the broader economy. A relief rally could extend for months and could bring the market back to Dow 10,000.
2. But a sustained long term bull market - lasting for years - is unlikely because stocks will be fighting a headwind of inflation concerns, higher interest rates, and sluggish fundamentals of demand - both consumer and capital spending. More important (or maybe the same thing), corporate earnings will be fighting the same headwinds for a long time.
So my guess - and I cannot exaggerate the humility and reluctance with which I offer this guess - is that after some kind of rally, we will enter into a period of general trendlessness, what is called “a stock-picker’s market.” That’s when stock averages fluctuate without direction. In such a market some individual stocks do well based on the ability of the company to succeed in a weak economy. Here is where Peter Lynch’s old concept of investing in companies you know and have confidence in should pay off.
What about energy investments?
The broad categories of energy investing are
- alternative and renewable energy
- coal
- natural gas
- oil
I don’t follow coal and I pay little attention to solar, wind, geothermal and other alternatives because the stocks tend to have speculative technology risks and rich pricing. I think SQM, a quasi-alternative energy play, is attractive now that it’s price has come down into the mid-20’s because it has an established cash flow in several good commodities (including iodine) and is a leader in lithium, which could see an explosion in demand from next-generation cars.
Natural gas is in a long term over-supply situation because of the vast discoveries of non-standard sources like shale. Natural gas could see a pop because $4 is too low to sustain production. The price could bounce dramatically based on very low rig counts, as some analysts now believe. But there is no reason to think that longer term natural gas in North America will sell much above $6 for very many years unless some national policy is adopted to promote its use to power cars and/or trucks. So I don’t own companies heavily tied to natural gas, other than some gas pipeline companies that offer attractive yields and Devon, which is an exceptionally well run company and a potential acquisition target.
Oil is the interesting energy commodity, in my opinion, as it has been for the past few years because of the large and increasing decline rates for existing fields. Oil is interesting from two viewpoints - as a supply-and-demand matter and as a currency hedge. On both scores there is reason to feel that the bullish forces are gathering again and may have their way over the course of the next few years. I think the potential rewards from being long oil and oil stocks are starting to become very interesting.
Some things we know
Sometimes the objective observable facts can yield fairly clear conclusions. Usually that’s not the case. Usually you can use the available facts to make a decent argument in either direction. But sometimes the facts seem fairly clear.
For example, there should have been clarity about being at a turning point in 1982 - I think it was in September. We knew that interest rates were at historical highs, put there deliberately to try to strangle inflation out of the economy. High rates were strangling the economy as well as inflation. Then Paul Volker - the man who determined the direction of interest rates - actually told us in a magazine interview that interest rates were not going to go any higher, that the interest rate squeeze was over. So we could pretty well know that interest rates were going to head down. Falling interest rates are nearly always good for equities, and at that point nothing would have helped the economy as much as lower interest rates. So by the Fall of 1982 there were very good reasons to anticipate a strong, sustained upward movement in stocks.
Now we know interest rates are low. Short rates are almost zero. Even long rates are assuming only about 1% inflation, about as low as a healthy economy could go. So if we think that eventually the global economy will recover and become healthy again then clearly interest rates can only rise somewhat. If we think as some do that the huge cash injections and deficits being run by the U.S. government will eventually cause inflation, then rates could rise a great deal. If foreigners start to refuse to buy more U.S. debt as the Chinese hinted they might consider last week, then interest rates could go much higher. Rising rates are not generally good for stocks. In fact they are a heavy wind in the face of equities.
Here’s what else I think we can know with a fair degree of certainty:
- Financial stocks have been in panic mode partly because of a silly “mark to market” rule that makes no sense when there is no market to mark to for huge quantities of bazaar derivative-based securities; thus this rule has caused everyone to mistrust the banks and probably to underestimate the real value of their assets. That problem seems like it’s about to go away. Let’s pray.
- Speculators have been able to short down the stocks of companies with any whiff of unknowable risk in part because the “uptick rule” was abolished by the S.E.C. in 2007. The uptick rule is about to be re-established, so that problem is about to go away too.
- Banks are making healthy interest rate spreads on their loans.
These three facts are very bullish for financial stocks, which were selling at historically oversold prices. They’ve jumped but still seem cheap. I remember when Viacom sold for $2 per share in 1974. Eventually it got up to about $50. Could Citibank (C) be in a similar position today? I wonder what Citi’s global brand franchise and presence just by itself is worth.
On the other hand we also know that
- the economy is in the toilet and there is likely to be more pain for some time to come,
- consumer spending is unlikely to become robust for many years to come because people have lost a lot of their asset base and the appetite to resume their borrow-to-spend consumption habit,
- there is a lot more manufacturing and retailing capacity in the U.S. than the economy will need for many years to come, so capital spending is likely to be restrained for a long time,
- some major loan categories such as commercial real estate, car loans, and credit card loans still have a lot of write-downs to come,
- Eastern Europe is in worse shape than the U.S. and could cause financial strains for the Euro countries that could exacerbate global economic weakness. Some developing countries are in even worse shape.
The sum of all the above “facts” leads me to two conclusions:
1. We are likely to see more of a “relief rally” as it becomes increasingly clear that the government has finally unlocked the banking sector so that it can start to function more like normal. That success will reflect more optimism on the broader economy. A relief rally could extend for months and could bring the market back to Dow 10,000.
2. But a sustained long term bull market - lasting for years - is unlikely because stocks will be fighting a headwind of inflation concerns, higher interest rates, and sluggish fundamentals of demand - both consumer and capital spending. More important (or maybe the same thing), corporate earnings will be fighting the same headwinds for a long time.
So my guess - and I cannot exaggerate the humility and reluctance with which I offer this guess - is that after some kind of rally, we will enter into a period of general trendlessness, what is called “a stock-picker’s market.” That’s when stock averages fluctuate without direction. In such a market some individual stocks do well based on the ability of the company to succeed in a weak economy. Here is where Peter Lynch’s old concept of investing in companies you know and have confidence in should pay off.
What about energy investments?
The broad categories of energy investing are
- alternative and renewable energy
- coal
- natural gas
- oil
I don’t follow coal and I pay little attention to solar, wind, geothermal and other alternatives because the stocks tend to have speculative technology risks and rich pricing. I think SQM, a quasi-alternative energy play, is attractive now that it’s price has come down into the mid-20’s because it has an established cash flow in several good commodities (including iodine) and is a leader in lithium, which could see an explosion in demand from next-generation cars.
Natural gas is in a long term over-supply situation because of the vast discoveries of non-standard sources like shale. Natural gas could see a pop because $4 is too low to sustain production. The price could bounce dramatically based on very low rig counts, as some analysts now believe. But there is no reason to think that longer term natural gas in North America will sell much above $6 for very many years unless some national policy is adopted to promote its use to power cars and/or trucks. So I don’t own companies heavily tied to natural gas, other than some gas pipeline companies that offer attractive yields and Devon, which is an exceptionally well run company and a potential acquisition target.
Oil is the interesting energy commodity, in my opinion, as it has been for the past few years because of the large and increasing decline rates for existing fields. Oil is interesting from two viewpoints - as a supply-and-demand matter and as a currency hedge. On both scores there is reason to feel that the bullish forces are gathering again and may have their way over the course of the next few years. I think the potential rewards from being long oil and oil stocks are starting to become very interesting.
Commentaire