Beware of ‘Risk On’ Enthusiasm

Introduction

Confidentially I will let you in on a big secret as long as you don’t tell anyone. The secret is that I can not predict the future and have serious doubts that others can sequentially. I view my responsibility as an investment manager is to review the possibilities of future events and attempt to refine them into logical probabilities and to determine whether these opportunities are priced rationally. I try to follow the precepts of strategic military intelligence, if that is not an oxymoronic belief. A strategic as well as a tactical commander should be supplied with an array of potential future events. The commander then makes the judgment as to which are probable and makes his/her plans accordingly.

Enthusiasm Risk

As regular readers of these blog posts may recall, I have taken the position that most stock markets top out with a demonstration of excessive enthusiasm. As we have not seen an example of this for some time, I have not been worried about a strategic decline. Historically these happen once in a generation and cause the general stock market levels to fall by 50% from their peak. For my long-term oriented accounts I have witnessed several tactical declines every decade in the order of 25%.

Too many of us think about only stock markets. This often is a mistake. Historically, elements of the bond market have performed the ‘canary in the mine’ function of warning about oncoming stock declines. Possibly a chirp could be heard this week. Having observed estimated weekly net flows by mutual funds and ETFs, I can see substantial inflows into both High Grade Corporate and High Yield (Junk) bond funds. In light of both the popular view of an eventual rise in interest rates when we exhaust the lower for longer phase plus current corporate operating data, bond investors could be subscribing to more risk which will be discussed more fully shortly.

This week on the equity side of the ledger there were also signs of growing enthusiasm. Forty out of forty-four global markets tracked weekly by The Economist showed gains. Further, the transacted volume of JP Morgan Chase^* shot up from 17.7 million shares on average in the first two days of the week to 27 million shares on average in the last three days of the week.  One important element of caution for novice investors in bank shares is there is a second way to read the apparent discount between a bank’s stock price and its tangible book value. The market may be suggesting that the historic tangible book value is overstated. A proper analysis of a bank’s assets and liabilities, including contingent liabilities, could mean that current prices of many banks are appropriately priced and are not the bargain that the discount implies.

^* Shares owned personally.

There may be another class of enthusiasm that should be identified. For about a year the US auto industry has been reporting close to historic sales levels of 20 million units. Even at last month’s rate of about 17 million, some of these gains are due to the fact that the average car on the road is 11 years old and the average light truck is 13 years old. However, some industry and financial professionals point out that the decline in gas prices has helped to fund purchases and many do not expect lower prices. At the same time the length of both leases and sales contracts have lengthened beyond past levels. Part of the growth for these has been characterized as sub-prime loans. The smarter banks have been cutting back on these loans. If one switches to sales dollars as distinct from unit sales the increases in SUV and light trucks has been meaningful and possibly replacements for lower priced and lower profit margin sedans.  (One of our two cars is an SUV purchased more than five years ago.) The car buying public has shown a bullish belief in our future.

Capacity Utilization and Productivity Warnings

At the same time that the level of industrial production is published each month another statistic is released and may have more impact on future profitability than production numbers. Capacity utilization measures how much of a plant’s capacity is utilized in that month’s production. The latest reading is 74.8%. This is 5% below the monthly average since 1972. This is significant for many plants an 80% utilization generates optimum operating margins. (Higher utilization rates will produce larger aggregate profits, but the last bits of capacity often are outmoded and produce lower margins.)

Profits are the direct result of the level of production and the productivity of labor. The risk to bond holders and particularly high yield holders is that revenues are currently growing at best very slowly if at all and wages are starting to rise. Moody’s believes that the default rate on non-energy High Yield bonds will rise this year as some of these companies’ profits will be squeezed between flat sales and rising wages.

Why are wages rising for new employees?  In order to survive, companies have been replacing manual labor with machine labor and in many cases not using outmoded plant capacity, which is written off when the plants are closed rather than on a contemporaneous basis. Regardless of the accounting niceties, the new machines require more skilled labor. These as a class are in short supply and hence result in high hiring costs.

Part of the reason for the shortage of highly skilled labor is the failure of our educational system, starting with the home and going all the way to the formal educational system including our PhD programs at elite universities. We are producing students who not only don’t possess adequate knowledge, more importantly many job seekers don’t have the right attitudes. They are not prepared for the workplace culture of integrity and cooperation. We are not producing people who are skilled at reading others in a group or individual basis, so they lack sales ability. (In any group of two or more, sales ability is needed to get optimum results.)

What to do?

Since I have let you in my secret, here is what I recommend for your portfolio under the current circumstances:

First, I recommend for consideration the development of timespan buckets or portfolios similar to the TIMESPAN L Portfolios^®.

Second, one should make small and somewhat frequent portfolio changes, perhaps in one timespan bucket at a time.

Third, have sufficient diversification so one has appropriate hedges, in case some of the expected future trends don’t work out as expected.

Fourth, we live in a global world, whether we like it or not. As we can not escape from many global trends, keep that in mind in your selections of managers and securities.

Fifth, continue your learning process as we are trapped in a dynamically changing world and we need to wisely adapt.      

Question of the Week: Are you watching bonds to help with your stocks?

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Exploring for $1/Gallon Gasoline

This is the season that the great religions of the world celebrate the past and look forward to a rewarding future. Analysts should also study the past and look to the future by thinking the “unthinkable thoughts.” Today’s blog seeks to do exactly that. I am exploring the possibility of $1 per gallon gasoline. Like most prospectors and researchers, our work is a series of explorations, not of successful predictions. Whether we will ever see $1 gas is dependent on many of the variables to be discussed. As with successful prognosticators to the public, I should not predict both a direction and timing; but I suggest that if you choose to save these thoughts, it should be for your children or probably your grandchildren.

An incomplete list of the variables:

Taxes

No government that I am aware of will let a major stream of energy move from its source to its consumption without layering on taxes. (The main differences between our close to $4 price and Europe’s about $9 price for the same amount of auto fuel are the taxes imposed. There are some governments that subsidize the retail price, but find other ways to collect tax revenues.) Thus, the final price that we pay is dependent on tax distribution policies of host countries.

Technology

Due to my biases as a US Marine Corps communication officer, a securities analyst of tech companies, and most of all as a trustee in close contact with Caltech, I admit to being in awe of technology. Fundamentally, most forms of physical energy are found in nature and converted to power through various mechanical steps. Just as wars have spurred on the development of much of what is considered to be modern medicine and organizational management practices, I suspect that our exploration of space will lead to material changes in finding sources of energy, the extraction of energy as well as the processing, distribution and safe use of energy. Already, major oil deposits have been found through the use of manned and unmanned satellites. In order to accomplish our mission of exploring the planets, various remote techniques have been developed that deal with dangerous gasses and techniques for probing and “mining” from land surfaces. Some of the technological developments from space such as efficient payload management and global positioning systems (GPS) found use here on earth.

Technology is at work uncovering more efficient and safer ways of developing our natural resources; bringing into economic production energy sources that today look to be too expensive and too dangerous. Clearly we will utilize more fuel efficient vehicles on land, sea, and air in the future. Homes, offices, and manufacturing/processing plants will manage their usage of energy better. There are many other ways in which technology will both help give us more bang for our energy buck, and will also make us even more dependent on the increasingly efficient use of energy. Thus technology will affect both sides of the supply/demand equation.

Oil, natural gas, coal and nuclear

Ever since I first started looking at the economics and politics of energy in the 1950s, I have heard about reaching “peak oil production,” as we are not finding oil as fast as we are using it. I recall that some believed that we would have found all the oil the Earth had to give us by the 1960s. In each decade since, the peaking date has been reestablished, and in each decade more “juice” has been found. For both commercial and regulatory reasons, the size of these discoveries has been downplayed. Further, I suspect secondary drilling through the use of advanced technology will be more productive than is currently believed. In this season of heightened religious belief, I believe that there is more productive oil out there than most others believe, and a good bit of it in or near the US.

Natural gas was a waste product in the days of early oil production; it was just burned away at the wellhead. Through the use of technology and higher prices for oil, the governments and the people of the world have begun to appreciate the economic advantages of natural gas. We are addressing the concerns about fracking in terms of environmental dangers. Actually, at the moment we have too much natural gas, and this week we hit the lowest recorded price for this commodity in ten years. To me, it is only a matter of time and some technology until we have a significant expansion in the use of “NG” (No longer standing for Not Good, but for Natural Gas.) Thus, I see that the available supply of energy will rise and at some point impact the price of oil.

Coal

We are all aware of how dirty coal is. We are conscious of the dangers of manned mining and the effects of coal burning on our once pristine environment. Because of these issues and to some extent unwise government regulation, coal in all its forms has lost share of market. However, as a firm believer both in technology and the eventual power of economics, I do not think we have experienced the last of the beneficial use of coal on a global basis. In South Africa, I have seen the conversion of coal to oil to meet a politically-driven need, which demonstrates the creativity of some of the coal business leaders.

Nuclear

If you don’t want coal burning in your backyard do you want to have an atomic reactor quietly producing energy? The tragedies both in Japan and Russia were caused by faulty locations and poorly constructed facilities. Little publicity is seen on the safe use of atomic power in Europe, US, and elsewhere. After a period of twenty years, the US government has authorized the first new non-military use of a reactor. (The US Navy and others have been successful users of atomic power for a couple of generations.) Will procedures be developed to reduce the odds of fatal accidents? Yes.

Thus, I believe that with technology’s help, we have sufficient potential supply of energy.

The demand side

The Saudi Arabian government and others are vitally aware that the price of energy is, in the end, driven by demand. One of the best ways to measure the level of economic development in a country is to track its use of energy. (Some of the political leaders in China are more sensitive to the level of electricity use than they are to the softer calculation of GDP.) While the price for oil will have an impact as to the costs of a society to produce a particular standard of living, Saudi Arabia’s fear is that too high a price will drive substitution efforts even faster. On a long-term basis they should be worried. (As mentioned above, there are energy alternatives and technology is making them safer and cheaper.)

Habit changes

Slowly we are becoming more efficient consumers of energy. However, this is being offset by our growing demand to use more energy by our various appliances, including computer and entertainment devices. Some governments recognize that gradualism won’t work to bring energy demand into better balance. As an Easterner I hate to admit it, but the government of California has a useful idea. A recent Wall Street Journal article, entitled “California Declares War on Suburbia” suggests that a more efficient use of resources would be to gently move people into the cities, which is what is happening in China. Not only could this improve our use of energy, but could significantly improve the overall level of education and safety available within the cities. If it were to happen, then the number of energy consuming cars is likely to drop.

Two other considerations

Our current world is, as always, a balance of power. The current fulcrum of power is in the amount of energy that is produced both for internal and external use. If we had a world with a more balanced use of energy, various forces would likely cause changes of political leadership, and perhaps even the composition and identity of various countries. Many political leaders are not blind to these possibilities.

The second consideration is the monetary value of energy. At the wholesale level, energy today (particularly oil) is priced in dollars. This is a historic accident of past wars, economic development and relative stability of the value of the US dollar. At the moment, I believe the US society is committed to inflation, therefore at some point the rest of the world will wish to price things in dual, if not multiple currencies to protect from politically-inspired deficit spending by the US government. Thus, perhaps I should amend my search for $1/gallon gasoline to a level commensurate with about a $1700 per ounce price of gold.

Investment afterthoughts

Consider the following on how to put these thoughts into practice:

1. You should not bet that the price of oil will always be a good inflation protection.
   
   
2. Inflation is a product of global excessive spending relative to saving, and is likely to continue
   
   
3. View some of the large international oil companies as akin to investment banks. If they choose investment wisely within their circle of competence, they can have good results. (Interestingly, both international oil stocks and those of investment banks are low price/earnings ratio groups. The difference is that the oil companies have higher dividends and yields.)
   
   
4. Find technology producers that have a pattern of producing labor and energy saving devices, particularly those that can be applied to finding, extracting, transporting, processing, and using energy.
   
   
5. Watch for useful lessons from space activities in terms of uses of energy on earth.
   
   
6. Bet on increased urbanization, some of which will be cajoled by the government, which will lead to better primary and secondary education and safer streets.
   
   
7. While $1/ gallon gasoline is not an “odds on favorite,” it could happen and that may not be a good thing
   

Does any of this make sense to either discuss with your children/grandchildren or to pass it on to them at some future point?


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