Tale of Two Bulls

“Bull Markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria.”
— -Sir John Templeton

2016 has truly been a tale of two bull markets. With a nod to Sir John Templeton, we’ve seen a young bull market in metals (particularly notable in the precious metals) born in the depths of pessimism. At the same time the biggest old bull of them all, the global bond market has staggered to new highs as talking-heads muse about “permanently low interest rates” and ask absurd questions (“is inflation too low?”). Investors these days want bonds so badly (euphoria), they are willing to guarantee themselves a loss in order to own them. Astounding!

Gold Bull

Gold began its new bull market back in January of this year. At the time, pessimism toward gold stocks was off the charts. Miners were absolutely hated and had been battered to thirteen year lows. Many of the companies were trading at levels last seen when gold traded near $300 per ounce. From that depressed level the precious metals mining stocks have run dramatically higher dwarfing the performance of other asset classes.

Are precious metals miners over-bought and over-valued now after that tremendous run? While they are certainly due for a breather (and many are in fact correcting as this note is being written), we feel that precious metals mining stocks remain a favorable asset class from a long-term perspective for three reasons:

  1. Their product, gold and silver, have tailwinds. Investor confidence in extreme monetary policy is waning. The commodity bear market has ended with generally beginning to rise as supply cuts take effect. Additionally, gold’s inverse correlation with other financial assets shines in an environment where investors are looking to insure against trouble in their other portfolio holdings.

  2. Mining company fundamentals are improving. The carnage in the sector in recent years forced much needed operational discipline and an emphasis on cost control. These efforts are now beginning to show with improved cash-flows and bottom line profits.

  3. The relative valuation of mining stocks compared to the price of the metal is coming off a 20-year nadir and still has room for substantial upward mean-reversion even after recent price gains. (As an aside, the Producer:Product ratio can be a good long term sentiment indicator. In the case of oil producers, the ratio is high relative to trend indicating some persistent optimism)

Bond Bull

In marked contrast to the young metals bull, the bond market has been going up (with interest rates going down) as long as anyone can remember. That mildly flippant observation isn’t really as much of a stretch as it might initially seem. Imagine a young twenty-five-year-old analyst starting a Wall Street career back in 1981 when the last major bond bear market ended. Our young analyst would now be nearing retirement age having NEVER seen persistently rising interest rates.

The Financial Times reported in early August that the global “pile” of bonds bearing negative interest had reached $13.4 Trillion. We discussed the extreme nature of such events in our late-April commentary (http://www.svanecapital.com/perspectives/2016/4/29/negative-interest-rates) when this number was a “mere” $7.8 Trillion. The degree of enthusiasm and belief in bonds as an asset class tends to take a long time to develop (the bull ages). Thirty-six years ago, in the infancy of the bond bull market, bonds were commonly referred to as “certificates of confiscation” and bond investors were labeled “vigilantes”. It is noteworthy that this disparagement was loudest with bond interest rates in the high teens. In hindsight, those rates proved to be historic bargains and a long bull market was being born.

Recently, the general decline in interest rates, and hence the bond bull market, has continued even as commodity prices, real estate prices, wages, and rents (all directly or indirectly major components of the CPI) have begun rising. Former Fed Chair Alan Greenspan was recently quoted telling Fox Business’s Maria Bartiromo that he suspects inflation is beginning to rise: “I think we are on the edge now of a significant change in the global outlook.  And it’s a very slow and very turgent but very persistent move from deflation to inflation.  We’re seeing the very early signs of a process of inflation rising.”

Time will tell...and that's no bull!

SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISOR.  INFORMATION PRESENTED IS FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. INTERNATIONAL INVESTING INVOLVES SPECIAL RISKS INCLUDING THE POSSIBILITY OF SUBSTANTIAL VOLATILITY DUE TO CURRENCY FLUCTUATIONS AND POLITICAL UNCERTAINTIES. AN INVESTMENT CONCENTRATED IN SECTORS AND INDUSTRIES MAY INVOLVE GREATER RISK THAN A MORE DIVERSIFIED INVESTMENT. THERE IS NO ASSURANCE THAT A DIVERSIFIED PORTFOLIO WILL PRODUCE BETTER RETURNS THAN AN UNDIVERSIFIED PORTFOLIO, NOR DOES DIVERSIFICATION ASSURE AGAINST MARKET LOSS.  ANY GRAPH PRESENTED CANNOT IN AND OF ITSELF BE USED AS THE SOLE DETERMINANT IN MAKING AN INVESTMENT DECISION. GRAPHS ARE HISTORICAL DEPICTIONS AND HAVE INHERENT LIMITATIONS IN MAKING INVESTMENT DECISIONS AND CANNOT PREDICT THE FUTURE RESULTS OF ANY INVESTMENT. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.

Investing Superheroes: John Bogle

John Bogle has been a financial industry pioneer and respected spokesman for over fifty years. As the founder of The Vanguard Group, which specializes in low-cost index funds, he’s had tremendous impact in driving down the costs and complexities of market participation for millions of investors. Many of the standard components of sound investment advice weren’t standard before John Bogle.

Bogle’s Key Strategic Concepts:

  • Bogle starts with the importance of long-term thinking to investment success. “The historical data support one conclusion with unusual force: To invest with success, you must be a long-term investor”. This advice is so commonly heard, that it is easy to overlook the meaning. He continues this thought saying that “In the long run, investing is not about markets at all. Investing is about enjoying the returns earned by businesses.” The long-term investor should be chiefly concerned being invested and earning the cash flow and growth generated by the businesses that he or she owns. The price of this growth and cash flow (to Bogle, “the markets”) will fluctuate and these fluctuations become meaningless over a longer time-frame.

  • “Time is your friend; impulse is your enemy” Bogle urges investors to be patient and to avoid hasty decisions. His advice is similar to the old saw “measure twice, cut once”. In other words, once we’ve started on a solid long-term investment strategy, the best thing we can do as investors is to let time and compounding work for us. Getting impulsive and changing strategies (“the enemy”) can do huge damage to our returns. 

  • John Bogle began thinking about index investing back in 1951 hinting at the idea in his Princeton thesis. The basic concept of index investing is to ignore trying to sort out “good stocks” from “bad stocks” and simply buy a diversified group of stocks as inexpensively as possible. In other words, “Don’t look for the needle in the haystack. Just buy the haystack!” It often sounds promising to try to find the best stocks, and many investors do exactly that. However, this means that the best companies often have the highest stock prices, making them not necessarily the best investments. 

  • Our favorite Bogle quote gets straight to the heart of our investing philosophy at Svane Capital. “Your success in investing will depend in part on your character and guts, and in part on your ability to realize at the height of ebullience and the depth of despair alike that this too shall pass”. Of course we must understand and focus on the long term characteristics of markets and use appropriate investing strategy. But we must also understand the normal short term behavior of markets, and use this to our advantage when possible. Day to day, and even month to month price action in markets, can be thought of as mostly random with inevitable swings from extreme optimism to extreme pessimism. It is at these extremes where the greatest opportunities are found. At these points the right decisions can feel scary or even wrong. Using these times to our advantage depends mainly on our courage, discipline, and understanding that they don’t last forever.

John Bogle had been thinking about the concept of index investing since writing his thesis in 1951. But he credits support received from Nobel prize winner Paul Samuelson, Charles D. Ellis, and Princeton Professor Burton G. Malkiel in creating a business to capitalize on the idea. 

Bogle founded The Vanguard Group in 1975 launching its first index fund in 1976. In 1996 he retired as CEO, but the company he started continued to grow into one of the largest mutual fund companies in the world today.  Two of his most popular books are “Common Sense on Mutual Funds”, and “The Clash of the Cultures: Investment vs. Speculation”.

Sources: www.johncbogle.com, www.vanguard.com, www.investopedia.com

SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISER. INFORMATION PRESENTED IS FOR EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.

Investing Superheroes: Howard Marks

Howard Marks has demonstrated the concept of consistent excellence as an investor, managing portfolios for over forty years. Marks has one of the best long-term track records over this time frame. He has led Oaktree Capital Management since founding the company with five other partners in 1995. 

Key Concepts

  • Markets are random. Investing strategies must take this into account. Howard says, “You can’t tell from an outcome whether or not it was a good decision. Even if you know what is most likely, other things can happen.” Of course this brings to mind the importance of diversification and limiting Portfolio exposure to any single factor. However, this statement also points to the difficulty of knowing whether an investor is good or just lucky. The same concept applies in determining whether an investment plan is on track in spite of initial poor performance. Marks’ answer is to focus on the decision making process rather than the results of this process.  

  • Consistency trumps outstanding individual results over the long run. Marks says, “Be a little bit better than average all of the time.” A study he did over decades of market performance showed that the top ten percent of long term investors showed up in the second quadrant decade after decade, being rarely either in the top group, or below average over those periods. He says that trying to be a top performer, rather than just being consistently better than average, usually requires taking too much risk and relying on luck. 

  • “You don’t make money by buying good stocks. You make money by buying assets for less than they are worth.” Howard is saying that even an excellent company can be a terrible investment. For example, an investor buying Cisco, Intel, or Microsoft in 2000 ended up with poor results even though those companies are still market leaders sixteen years later. Might Facebook, Amazon, or Tesla be similar today? Conversely, Marks points out that truly massive investing profits were made in the 1980’s in bonds that were more likely to default than to pay off. It’s all in the price and he encourages investors to avoid popular investments while giving those that “everyone knows are bad” a second look.   

Brief Bio

Marks started his career as an equity research analyst for Citicorp in 1969. From 1978 to 1985 he served as Vice President and senior portfolio manager focusing on convertible and high yield debt. In 1985 he joined RCW Group and again led he high yield and convertible securities group, but also started one of the first distressed debt funds in a mainstream financial institution. 

Mr. Marks periodically writes his widely read “memos to Oaktree clients” which outline his views on investing the markets and economics. Warren Buffett has remarked, “When I see memos from Howard Marks in my mail, they’re the first thing I open and read. I always learn something, and that goes double for his book”. In 2011, Marks published “The Most Important Thing: Uncommon Sense for the Thoughtful Investor” via Columbian Business School Press. 

Sources: www.oaktree.com, www.wikipedia.com , www.youtube.com 

SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISER. INFORMATION PRESENTED IS FOR EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.

The Long and Short of it

Valuation matters most in the long run...

...but other stuff happens in the meantime

Benjamin Graham famously said “In the short run, the market is a voting machine, but in the long run it is a weighing machine.” A voting machine counts votes. Votes are based on sentiment of people at a given time. Sentiment can change as narratives come and go and is difficult to measure accurately. A weighing machine is much more precise and accurate. The metaphor suggests that in the short term prices are driven by sentiment and the “story of the day”, while in the long term, trends are driven by something you can measure more concretely, valuation.

The overlapping wave graphic above is a simplified picture conceptualizing the interaction between the long term valuation (weighing machine) reversion cycle, and the shorter term narrative (voting machine) cycle. Obviously, this is an over-simplification as the cycles are anything but regular and perfectly predictable, but it demonstrates graphically some important concepts. A few comments:

  • The valuation reversion, or full market cycle is long. Typical equity market cycles follow the business cycle and are 7-11 years. Interest rate cycles tend to follow an even longer generational cycle at 60-70 years. The sentiment or narrative cycle is shorter, typically with a duration less than three years. 
  • It is the longer cycles that “matter more”. Valuation cycles tend to be bigger from bottom to top than sentiment cycles. They are also easier to quantify. Both of these factors are important to us. Buying relatively undervalued asset classes, and then holding them until they are overvalued is a major component of our strategy.
  • “Stacking” of sentiment and value cycles generates the highest highs and the lowest lows. Major buying opportunities always show both demonstrably low historically valuations and terrible investor sentiment. Market tops always show the opposite. Both high prices relative to historical ranges, and also investor optimism that more gains are just ahead.
  • Superimposed on top of the cycles is the constant injection of new information with a large degree of randomness. In the very short term (day-to-day, week-to-week, and sometimes month-to-month), markets routinely do “interesting” things. After the fact, some can be explained, and some can’t. Financial media frequently user the terms overbought and oversold to mean nothing more many days or weeks in a row with prices trending in the same direction.
  • The long term upward bias (due to the market internal return) is not shown in this simplified cycle model. Keep in mind that stocks represent companies that generate profit and bonds generate yield. This return is independent of the cyclical price variation on top of the return. Therefore, these lines should be visualized as sloping upward to the right. This is the feature leading to likely gains for patient buy and hold long-term investors from any starting point, given enough time.
SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISER. INFORMATION PRESENTED IS FOR EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. ALTHOUGH BOND FUNDS MAY PAY HIGHER YIELDS THAN OTHER FIXED INCOME INVESTMENTS IT DOES NOT NEGATE THE FACT THAT THE MARKET VALUE OF ALL BONDS FLUCTUATE DUE TO INTEREST RATE MOVEMENTS AND OTHER FACTORS. INTERNATIONAL INVESTING INVOLVES SPECIAL RISKS INCLUDING THE POSSIBILITY OF SUBSTANTIAL VOLATILITY DUE TO CURRENCY FLUCTUATIONS AND POLITICAL UNCERTAINTIES. IN INVESTMENT CONCENTRATED IN SECTORS AND INDUSTRIES MAY INVOLVE GRATER RISK THAN A MORE DIVERSIFIED INVESTMENT. THERE IS NO ASSURANCE THAT A DIVERSIFIED PORTFOLIO WILL PRODUCE BETTER RETURNS THAN AN UNDIVERSIFIED PORTFOLIO, NOR DOES DIVERSIFICATION ASSURE AGAINST MARKET LOSS. ANY GRAPH PRESENTED CANNOT IN AND OF ITSELF BE USED AS THE SOLE DETERMINANT IN MAKING AN INVESTMENT DECISION. GRAPHS ARE HISTORICAL DEPICTIONS AND HAVE INHERENT LIMITATIONS IN MAKING INVESTMENT DECISIONS AND CANNOT PREDICT THE FUTURE RESULTS OF ANY INVESTMENT. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.
,

The Oil Market Is Back In Balance

,

The U.S. Energy Information Administration (EIA) recently reported domestic crude oil production declined by another 200,000 barrels per day over the most recent six week reporting period. The same EIA report also showed stocks of crude, gasoline, and distillates all falling during the period. In the simplest possible terms, these developments on the supply side mean that supply and demand are finally starting to come back into balance. 

For years OPEC represented essentially the lone source of incremental oil supply.  In fact, an often-used analogy was Saudi Aramco turning on and off the oil spigot to match oil demand. On the other hand, oil demand is fairly inelastic in the short run. Because of these dynamics, OPEC could achieve a large positive price response in exchange for a small reduction in supply.  In the last decade these monopolistic market tendencies evaporated as a new oil market reality emerged with American shale producers creating a market with multiple marginal suppliers. Today OPEC could make a large production cut, only to see American producers increase supply (and profits) at their expense. This is the dynamic OPEC leadership is referring to when you read of their unwillingness to cut supply due to their focus on “defending market share”.

The US oil supply growth of recent years was primarily driven by additional production from tight shale using horizontal drilling, fracking, injections, and other non-traditional methods. These new technologies unlocked access to large reserves that were known to exist, but were formerly thought to be uneconomical. Shale oil supply differs from traditional oil supply in two important areas. The first is that to drill and produce oil from a shale well costs more and therefore requires a much higher price of oil. Recent studies have put this breakeven price point somewhere around $50-$70 per barrel for a typical shale well, versus $20-$35 for a traditional well (this is an over-simplification for example purposes, actual well break-even levels can vary widely from well to well based on a variety of factors). The second difference is the expected production curve of the well. Traditional wells can produce for decades with little production decline, whereas typical shale oil wells expect substantial production declines within 18-24 months. In other words, shale production can be expected to begin declining less than two years after a sustained and substantial decline in drilling rig activity.

Much energy market analysis has focused on the role of OPEC in energy supply and on the recent reported failures of OPEC to agree to curb supply. However non-OPEC supply reductions (i.e. US shale producers) have continued right on schedule. Shortly after oil prices (thin gray line in the chart above) began their sharp drop in the second half of 2014, drilling activity as measured by the Baker-Hughes rig count (the bright red line in the chart above) declined precipitously by nearly 80% from the 2014 highs.

Given the relationship between drilling and production on a well-by-well basis, we might also expect the relationship to hold between drilling activity and shale production volumes in the aggregate. As shown in the chart below courtesy of Ned Davis Research via SPDR, not only does the relationship clearly hold, but the timing is spot on with what might have been our a priori expectation. 

Returning now to the global oil market picture, and remembering ECON 101, as price declines, we expect to see demand increase. Demand growth has occurred as the price of oil has declined. Much of the demand increase has come from the still rapidly growing emerging market economies. The IEA now expects India to begin overtaking China as the main engine of global demand growth, but expects both countries thirst for oil to remain strong. Therefore, we now have reduced supply combining with increased demand and this has now resulted in market flipping from an oil surplus to an oil deficit. The following chart from Goldman Sachs via Bloomberg illustrates the historical and projected market surplus/deficit (using Goldman’s current forward-looking estimates):

We believe that it is reasonable to assume that the oil price lows were reached in the first quarter of 2016. While prices may certainly decline from current levels between $45 and $50 per barrel, the global supply and demand picture demonstrates that a much lower price level would be unsustainable. 

However, while the physical oil markets are now re-balancing, the structural imbalance in the energy capital markets may be yet to reach such a point. While beyond the scope of this memo, it should be clear that drawing the conclusions we have about the state of the oil market is entirely different than drawing conclusions about the profit potential available to an equity investor in an oil producer. Many energy companies still must cope with large debt loads, much of which was incurred at substantially higher energy prices. While the new oil fundamental picture will continue to be constructive for many areas of the energy markets, capital restructuring adjustments may continue for some time.

SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISER. INFORMATION PRESENTED IS FOR EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. ALTHOUGH BOND FUNDS MAY PAY HIGHER YIELDS THAN OTHER FIXED INCOME INVESTMENTS IT DOES NOT NEGATE THE FACT THAT THE MARKET VALUE OF ALL BONDS FLUCTUATE DUE TO INTEREST RATE MOVEMENTS AND OTHER FACTORS. INTERNATIONAL INVESTING INVOLVES SPECIAL RISKS INCLUDING THE POSSIBILITY OF SUBSTANTIAL VOLATILITY DUE TO CURRENCY FLUCTUATIONS AND POLITICAL UNCERTAINTIES. IN INVESTMENT CONCENTRATED IN SECTORS AND INDUSTRIES MAY INVOLVE GRATER RISK THAN A MORE DIVERSIFIED INVESTMENT. THERE IS NO ASSURANCE THAT A DIVERSIFIED PORTFOLIO WILL PRODUCE BETTER RETURNS THAN AN UNDIVERSIFIED PORTFOLIO, NOR DOES DIVERSIFICATION ASSURE AGAINST MARKET LOSS. ANY GRAPH PRESENTED CANNOT IN AND OF ITSELF BE USED AS THE SOLE DETERMINANT IN MAKING AN INVESTMENT DECISION. GRAPHS ARE HISTORICAL DEPICTIONS AND HAVE INHERENT LIMITATIONS IN MAKING INVESTMENT DECISIONS AND CANNOT PREDICT THE FUTURE RESULTS OF ANY INVESTMENT. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.