Our growing concern over market participants’ lackadaisical approach to what will inevitably become a contractionary monetary cycle has been evident for months. The US market crash of August 24 has disrupted the comfort levels of many investors, however, but it has not derailed the confidence of long-term planners, nor has it interrupted the conviction of optimists that believe the sky is the eventual limit for equity prices in their lifetimes. We take a more measured and cautious view of risky assets at Valuentum, and we’ll never tell investors to ignore the information contained in market prices.
The risk of a recession in the US beginning this year is remote, but concerns are mounting for 2016. US gross domestic product continues to expand at a nice pace and the US employment rate is sitting at the lowest level it has been in years, while job openings approach multi-year highs (or a “new series high,” according to the BLS). Times are great in America, but the rest of the world is not so lucky. Chinese equity prices (FXI) have collapsed, though many with tremendous hindsight vision say this was obviously going to happen, even if the recessions in commodity-dependent countries such as Brazil and Canada may not have been equally predictable. Brazil’s credit rating is now junk-rated, according to S&P, South Africa’s GDP is shrinking and the rand is setting currency-crisis lows. Nigeria’s economy, the largest on the African continent, is slowing considerably as a result of the slide in crude oil.
Peculiarly, we felt the air come out of the equity markets in January, either as investors opted to de-risk in advance of the sixth year of this bull market or a result of the collapse in the energy resource price environment, both equally plausible explanations. It is quite feasible that the investors who had bought into the “peak oil” thesis, theorized by Shell geoscientist Marion Hubbert and defined as the point in time after which the rate of production would enter into terminal decline, finally threw in the towel. Originally predicted that annual production would peak in 1970, the “peak oil” theory had been somewhat accurate for years, and energy price “bulls” did their best to make the case that “peak oil” had already occurred up through late last decade, propping up energy stocks as the story proliferated. “Fracking” in the shale rich regions of the North Dakota Bakken, South Texas Eagle Ford and Niobrara formations have changed all of this thinking, however—or at least it should have. Some are still holding on.
Many investors are hurting. The largest energy stocks (XLE), believed to be stalwarts even during the toughest times, have given up large gains. The strongest of the strongest, Exxon Mobil (XOM) has fallen to ~$70 per share from over $100 in 2014, Chevron (CVX) has dropped to the mid-$70s from over $130 over the same time, and ConocoPhillips (COP) has performed equally as poorly. Midstream giant Kinder Morgan’s (KMI) shares have collapsed to our $29 per share fair value estimate after the bold call in early June, and the bottom in the energy complex is still nowhere in sight, at least from our vantage point. Commercial crude oil inventories are the highest they’ve been for this time of year in more than 80 years, and Saudi Arabia is not letting up even in the face of “desperate” pleas from weaker member nations of OPEC, namely Venezuela, which continues to deal with runaway inflation.
The world is drowning in crude oil (USO), and the latest prognosticators believe the next stop for the price of the black liquid will be in the $30s and then the $20s. The cash cost of bringing a barrel of oil equivalent to the surface rests in the low-teens (after fixed “sunk” costs), and it has been less than two decades since crude oil prices averaged ~$12 in 1998. With OPEC’s new strategy of fighting tooth and nail for market share instead of operating with intentions to support the price, a revisit to levels of the late 1990s cannot be ruled out. The price of a barrel of oil is not set by the all-in, cycle cash costs of extracting a barrel of oil equivalent, but by supply/demand characteristics of the marketplace. The price of crude oil cares very little about how many US domestics it sends into Chapter 11 protection, even if the natural result of failures is lower production.
The planned production cuts by US-based domestics are encouraging, but the plethora of asset write-offs and capital spending reductions may not be enough if the world economy catches China’s cold. South Korea already has, Japan’s slump in machinery orders in July is somewhat eye-opening, and deflation in China is a potential reality (producer prices in China sunk the most in six years in August). Both supply and demand for energy resource pricing are moving targets, and should supply begin to slow, demand will have to hold to see any relief. That’s far from guaranteed in light of major economies entering or nearing recession.
Still, not all is terrible. The shock of the abrupt drop in the S&P 500 in late August drove the credit markets to a near-standstill in the last weeks of August, according to Moody’s and Franklin Templeton, but they’ve normalized a bit during the past week or so. According to Informa Global, September 9 was the “second-busiest day of the year,” though it remains to be seen whether such a snap-back move was merely pent-up issuance from the evaporation of previous weeks. Even a few weeks of “missed” growth opportunities may be enough to impact gross domestic product in 2016. The “animal spirits” of risk-taking haven’t been completely eliminated, however.
Consensus estimates are calling for the second consecutive quarterly decline in earnings in the third quarter, the first time this has happened since the depths of the Great Recession in 2009, and analysts continue to push earnings estimates lower, according to FactSet’s tally on September 11. The forward 12-month price-to-earnings ratio is ~15.3 times, above both the 5-year and 10-year averages, implying that there is still risk to the downside with respect to broader equity valuations, especially if earnings estimates are further revised downward. The stronger US dollar will continue to pressure the pace of reported multi-national earnings expansion and dollar-denominated commodity prices.
We continue to like the US markets (SPY, DIA) for equity exposure, where currency headwinds and economic deterioration have been absent thus far. One of the largest mispricings in the market continues to be Apple (AAPL) at less than 9 times earnings, excluding net cash, though it generates a large percentage of revenue from non-US markets. The latest reading, however, suggests that pre-orders for Apple’s flagship iPhone are the highest they’ve ever been, though comparisons to previous iterations are muddied with the inclusion of China in recent data. Michael Kors (KORS) is trading significantly below our estimate of its intrinsic value, and the company’s expected growth prospects and strong net cash position on the balance sheet speak to an interesting proposition, but not one without substantial “fashion” risk.
Buffalo Wild Wings (BWLD) has found its way back into the Best Ideas Newsletter portfolio after we took substantial profits in the position earlier this year. With most of its growth potential still residing in North America, we like its potential strength in the face of global economic weakness, particularly as the restaurant chain capitalizes on a variety of demographics, namely families—something one wouldn’t expect from a concept focused on “beer, wings and sports.” We provided 5 counterpoints to a well-publicized piece on concerns that Alibaba’s (BABA) shares may fall another 50% from here, and while we believe the company is underpriced, sentiment on China’s economic growth and key constituents tied to consumer spending in the country have perhaps never been worse.
As the world turns, we’re keeping a close eye on a number of things. First, we’re monitoring property prices in Shanghai and in other larger Chinese cities to assess the potential calamity that falling housing prices and deflation would have on the country’s banking sector and the likelihood of contagion via the British banks, HSBC (HSBC) and Standard Chartered, and the US ones, namely Citigroup (C) and JP Morgan (JPM). Second, we’re watching the price of crude oil closely, as its fall will have huge implications on the earnings trajectory of companies that benefit (airlines, restaurants) as well as the ones that suffer (upstream and energy services). The net effect of falling crude oil prices has thus far been negative for S&P 500 earnings, but this may change as the energy sector becomes an ever-smaller part of index construction. Third, who can forget about the Fed, the expected duration of any tightening monetary cycle, and the resulting implications on dividend-paying stocks as Treasury yields rise?