The View from Bannerstone Capital by Biff Robillard
Volume 7 No. 3 November 2014
Brian Kelly, Phasianus colchicas and Milton Friedman
“We are running the risk of another oil crisis when demand outstrips supply around 2014 or 2015. There won’t be enough oil and gas by the middle of the next decade.”
—Christophe de Margerie, CEO of Total, September 2009
Speaking of oil, a barrel of crude is about a third cheaper than when I tapped out the June issue of The Coteau. It was down something like 14 percent this week. I can’t think of anything more fundamental to the real economy than the cost of energy other than perhaps a World War. Perish the thought. Oh, crude was $147 a barrel when Monsieur de Margerie of French oil giant Total uttered his plaintive cry quoted above. That’s a 55 percent drop in five years, unadjusted for inflation. Keep in mind he was a CEO of the Evil Empire (i.e. a “Big Oil” company), not some alarmist and wool-loving Peak Oil advocate. How do the Malthusians find the energy (forgive the utterly accidental pun) to maintain their dour fortitude in forecasting imminent collapse into a post-fossil-fuel Dark Age (ugh, two accidental puns in the same sentence)? They haven’t been right yet, nor has Reverend Malthus, but I do admire their faith, if not their perspicacity. Meanwhile, there is now too much oil. I don’t mind. I like stocks. Here’s why:
The last time gasoline went into a secular bear market, stocks entered a secular bull. Maybe it’s time.
The Dow Theory folks are happy: The Dow Jones Transportation Average and the Dow Jones Industrial Average continue their hand-in-hand stroll up and to the right on my screens here. Recall this sturdy old market indicator relies on these two averages “confirming” the other’s accomplishments by matching them. A high water mark for one must be soon accompanied by a high water mark by the other. Both pulled off an all-time high this week. This is a soothing backdrop for the intermediate term, further affirmed by the surprising increase in the revised GDP number: The Commerce Department raised its estimate for Q3 to 3.9 percent. They claim the GDP grew at an annual rate of 4.6 percent in Q2. These are the best two back-to-back quarters since 2003.
This acceleration in economic activity has not changed interest rates much: Bonds are definitely not in the tank. This suggests to me there is more money available to borrow than there is demand for the money. Ah, supply and demand. It seems to work for everything. It still looks to me like long U.S. interest rates finally bottomed in 2012. Long-dated high quality bonds have had an astonishing year, but they are still less valuable than in late summer 2012.
Long Bonds Have Rallied: Still Below the All Time High of 2012
Unless you have been watching college football (ahem) all month, you have doubtless recently heard the axiom, “The cure for higher prices is . . . (wait for it) . . . higher prices.” This was recently very much on my mind, as well as the future of Coach Kelly at Notre Dame (Brian Kelly supply may exceed demand in South Bend). I was flying along high above the Amber Waves of Grain of South Dakota with a good friend in the left seat up front. I’ll call him Warren. Warren was skillfully piloting some friends and me (and some of my friends are dogs, let’s be clear), aboard his Magic Carpet (aka his plane) to central South Dakota. This was an academic research effort to conduct our annual economic survey, among other things. The first part of our survey confirmed our consensus: There is a lot of corn out there. Years of high prices have indeed cured high corn prices. The stuff is everywhere. Even from 10,000 feet, the great yellow mounds at prairie grain elevators announce abundance. But our work continued. We also eventually confirmed that Mother Nature has her own ideas about supply and demand and yes, Phasianus colchicus, the ring-necked pheasant, was also in more ample supply compared with 2013. Our annual economic survey conclusion: Supply and demand dance in an endless cotillion, an essential feedback loop on the dance floor we call Planet Earth. This is the same conclusion as last year’s survey, by the way. Anything for science, as Warren cheerfully exclaims.
Of course, as a species, we frequently forget that scarcity sows the very seeds of future abundance and abundance sows the seeds for eventual scarcity. Maybe we should write this down for next time. Anyway, oil at $147 a barrel had a lot do– shall I say had everything to do–with the shale gas and oil revolution. Have you been to western North Dakota in the past five years? You’ve been to a gas pump. High prices mean powerful incentives. Incentives mean action. Action has outcomes. Sometimes you can put these outcomes in your gas tank. Sometimes these outcomes influence stock prices.
Stocks have had a pretty good year so far. Last issue, way back in June (it’s been busy around here) when oil was about 35 percent richer than it is today, stocks were about 6 percent cheaper. The S & P 500 was up about 6 percent YTD in June; now it is up almost 12 percent. So, despite the October swoosh in stocks, when the intraday low on October 15 temporarily wiped out the entire year’s gains, the bull trots on. But two significant factors may be influencing what happens next in this bull market: the dollar and oil, and next is what matters now. Both provide ample evidence, perhaps, that the commodity Super Cycle is truly dead and U.S. stocks are back in a secular bull market. It even suggests what parts of the stock market might work best and worst.
As for the indexes, the largest cap indexes may again begin to disappoint relative to the midcaps and even the small caps after outmuscling the little guys all year. This is not to say they will decline, they may just fall to the back of the convoy. The Russell 2000 has outperformed both the Dow and S & P so far in the fourth quarter by 35 percent, after lagging for 18 months. I expect more of this and we are positioned this way in Thales, our all-capitalization total return strategy.
Okay, the dollar: The dollar is just about where it was 20 years ago, just before I sent my first email, but this can be misleading. Like everything about the U.S. economy and markets over the same period, the tale of the dollar is complicated with big persistent swings. The dollar made a 20 year high in 2000 and a 20 year low in 2008. When you think about it, the stock market made a 20 year high in 2000 and a 20 year low in 2008 (and early 2009). A picture is worth a thousand words, so here you go, the trade-weighted Dollar Index:
Dollar Index: 2012 to Present
Experts love to rant about the inevitable extinction of the dollar. I suppose it’s more fun because the audience is rarely equipped to take the views on in an informed way. Dollar panic talk always sort of amazes me because it just doesn’t seem to happen. Conclusion: QE did not debase the dollar. In the absence of QE, the dollar is still not collapsing and in fact seems to be in a just-evident secular bull market. We are preparing accordingly. This disappoints the Perma-Bear crowd, who prefer gold to enterprise profits, and fear to production, but I just report the news, I don’t make the news. For the past two decades, to my eye anyway, a bull market in the dollar has coincided with strong U.S. stocks, lower interest rates, tame inflation, droopy commodity prices and a Teflon president. Democrats tend to call it the Clinton Era. Republicans tend to call it the Internet Boom.
A droopy greenback, either in a bear market or a long wobbly consolidation, on the other hand, coincided with giant bull markets in commodities, especially gold and crude oil, significant bull markets in emerging economy equities, rather poor U.S. stock markets and grumpy presidents. If I am right about the current state of the U.S. dollar — and no guarantees there — it strongly suggests to me to remain long U.S. stocks, generally avoid emerging markets, fade most commodities, especially gold and oil, and expect an inexplicable improvement in the public approval of the future president, whatever her name is. Take a peek at the following charts. Tell me a rallying U.S. dollar is the friend of commodity producers, I dare you:
Copper: 2012 to Present
Gold: 2012 to Present
Sweet Crude: 2013 to Present
That’s enough about the dollar. How about oil? To my way of thinking, oil is the dollar, in many ways, just upside down and shipped in 42 gallons per barrel. Both are fungible. Both dominate international trade. By this I mean what drives the dollar, especially in multi-year secular bull or bear markets, moves oil exactly the opposite way. So I will spare you more expounding on the strong dollar, which is merely expounding on weak oil. Both will have important influences on the stock and bond markets ahead, and we aim to use this to our advantage.
Are we on the cusp of another 1980’s and 1990’s oil glut? If we are, this is probably good news for investors in anything but oil. Below is an inflation adjusted chart I stumbled upon that might help convince you of the possibility. In real terms, a gallon of gas has been at 1980-1981 prices since 2004. In the early eighties, this same level eventually created lots and lots of supply. I remember. I was there. And it provided, eventually, much lower prices and much prosperity. It is striking how similar the recent high prices have persisted in recent years versus the Oil Embargo era: about 10 years. Has this similar long imbalance in supply and demand created another massive economic response in the form of vast new supplies? Maybe.
So what do we do now?
Stay long stocks. There is the seasonal tailwind through March. U.S. economy improving, and the consumer loves a pay raise: Cheaper gasoline is better than a tax cut. The benefits aren’t once a year on April 15, they are immediate. Fade most energy stocks. Fade most commodities. Crude is unlikely to turn tail and get this giant decline back quickly. The psychology doesn’t appear to support it. Large multinationals will be perceived to have to contend with the strong dollar. Exporters’ share prices may face the same psychology. Shares of midcap and small cap companies doing a lot of domestic business may do best. They have picked up in relative performance recently after lagging all year. I like technology but I always do. Technology shares, even giant ones, did nicely in the last dollar bull market.
In Thales I recently added Alibaba (BABA), we stick with Apple (AAPL) and I refuse to give up on the acquisitions potential of GlobalStar (GSAT). In Alloy, I am delighted we dropped Leucadia (LUK) and added asset managers Janus (JNS), new employer of Pimco’s Bill Gross, and Legg Mason (LM).
Consumers get happy with cheap fuel and jobs. In fact, perhaps a good place to start is to reinvestigate the truly great industry groups of the mid to late nineties, a project underway here now. The current King Dollar, cheap oil, low interest rates trifecta may be most similar to those halcyon days of yore. I remain calm and confused about the bond market. Oh yeah, and not very right. My hat off to the bond bulls who have eked out yet another profitable year in what seems like a 300 year old bull market, but is only 35 years old. It is an amazing period where the demand for bonds has, on balance, exceeded supply. Thirty five still seems like a big number and I am on the record—the bond bull ended on 2012. I know, I know. Look at that dead bull eat grass. But change is afoot, whether it’s a bull’s foot or not is anyone’s guess. I have one.
Dollar Index Since 2000 If USD Supply Equals Debasement, Where is It? Is the Greenback Smiling?
I have this hunch economists still have a lot to learn about inflation. Something tells me they are going to work with behaviorists during the next wave of enlightenment, but that’s for a different conversation. The recent absence of inflation worldwide has been mystifying for the economics community at large. I have always admired Milton Friedman’s intellect and his pithy instincts. There is no question in my mind he was always smart. But perhaps not always right, despite a heroic batting average. His most famous inflation quip “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output” has to be reexamined in the context of the recent explosion in money and the dearth of inflation. Or maybe it is being ratified by the notion today’s modern economy closes Keynes’s “output gaps” practically instantaneously. At least soon enough to snuff out a price rise.
Inflation must be fundamentally like head coaches, pheasants and stock prices: subject to the indefatigable forces of supply and demand. Has the modern economy become so adept at meeting demand that prolonged bouts of inflation for goods and services are simply more rare? Does the World Wide Web prevent serious imbalances between dollars chasing goods? Perhaps it is prolonged inflation that is necessary to instill the once-dreaded “inflation psychology,” the expectation that inflation will erode the value of one’s money? Is the persistent absence of inflation a signpost of global economic efficiency, where information, capital, goods, labor, talent, and profits rapidly seek equilibrium refereed by the profit motive? Does this scarcity of understanding explain why a world flooded with dollars has not drowned in inflation?
Answers are still scarce and questions remain abundant. There will be outcomes to be sure. Scarcity sows the seeds of future supply. See? I wrote it down for next time.
This publication does not constitute, in any way, investment advice. The views described may have changed by the time you read this, anyway. Use your head, for crying out loud. Craig Cox is our editor. Thank you, Craig. Bannerstone Capital Management, LLC is a registered investment advisor. Phone number 952.249.8888. We are on the web at bannerstonecapital.com