By Brian Nelson, CFA
It was Thursday afternoon, February 11, crude oil prices just hit a 13-year low, and the S&P 500 (SPY) was about to break below key technical support. Then, just as the markets were to fall further, rumors again emerged that OPEC may be scheduling a meeting to curb crude oil output, driving crude oil prices from the depths and the market higher off technical support. A barrel of crude oil continues to trade below the $30 mark, but it was quite the “save.” From where we stand, the market hasn’t been this fragile than at any time during the past decade or so, including during much of the Financial Crisis. Optimists may be whistling past the graveyard.
The S&P 500 is already 15% off its all-time highs, and it’s hard to make the argument that we won’t see more profit-taking in light of the market’s tripling from the March 2009 bottom. Valuations aren’t particularly attractive, and the global economic outlook is far from encouraging. We’ve been outlining our worries about slowing economic growth in China (FXI), the impact on its banking system via the collapse in commodity prices (and the credit quality of producers) and the “crashes” in the country’s local equity markets (Shanghai, Shenzhen). It’s hard to ignore the potential calamity that falling housing prices and deflation would have on China’s banking sector and the spill-over effects on the British banks, HSBC (HSBC) and Standard Chartered, and the US ones, namely Citigroup (C) and JP Morgan (JPM).
Europe’s financial system appears to be on the brink, at least from recent market action. We’ve witnessed a collapse in the equity of Germany’s largest financial institution, Deutsche Bank (DB), with shares falling nearly by half in past month alone. Germany (EWG) is supposed to be the pillar of strength in the European Union, and it is disturbing that the equity of one of the world’s biggest banks is facing immense pressure, almost to the degree that we saw bank equities tumble in the US during the Financial Crisis. That’s not all. Credit Suisse’s (CS) shares have almost lost half of their value since October, and CEO Tidjane Thiam has gone on record saying that it’s “not a great time to be a bank.” Credit Suisse’s shares have plunged to a 27-year low, and weak performance has spread to France’s Societe Generale (SCGLY), which missed fourth-quarter estimates amid a large drop in investment-banking earnings. The negative interest rate environment in the EU isn’t doing much to help
Brazil (EWZ), once a source of emerging market strength, may be entering its worst recession in economic history, while most other commodity-dependent export nations from Canada (EWC) to Australia (EWA) face slowing expansion (if not negative), with the former perhaps not escaping the recession from earlier this year if it weren’t for the “overproduction” of crude oil. Russia (RSX), another BRIC nation, is under immense stress from commodity-price pressure, while China could be on the verge of a prolonged period of low-single-digit economic growth, even if we can trust such numbers, a far cry from the go-go days of 7%+ growth. Currencies across many emerging countries are nearing what we would describe to be dislocations, perhaps no better illustrated via the South African (EZA) rand, which continues to trade around “currency crisis” lows.
If that weren’t enough, the US may be facing a “tidal wave” of energy loan defaults in the upstream space, as shale oil independents experience a drubbing from the collapse in the price of the black liquid. We’ve already witnessed more than 40 exploration and production entities fail so far through this downturn, and the industry itself may need a half trillion dollars of capital to make it to the other side, financing that may not be available. The credit rating agencies are expecting a surge in defaults among the energy and mining sectors, and implications on job growth and loan quality on the books of the domestic banks could be uncomfortable, to put it nicely. CEO Jamie Dimon in mid-January said, even after JP Morgan doubled its loss provisions in the fourth quarter due to “bad” energy loans, that he’d “put up more (loss provisions) if he could.” Perhaps most troubling, BNP Paribas (BNPZY) noted that it is “pulling out of the business of reserve-based lending, a vital source of liquidity for many oil and gas equities.” This could signal the beginning of the end for many weak upstream entities.
Not everything is bad, however, and investing is not so much about sizing up the global macroeconomic environment as it about identifying strong, undervalued equities with solid dividends, where applicable, and whose share prices are going up, revealing support by the market and added conviction to the internal valuation process that the company’s equity is “truly” undervalued. In that light, things have been pretty good. Newsletter portfolio holdings Cisco (CSCO), Michael Kors (KORS), PayPal (PYPL) and Visa (V) put up fantastic calendar fourth-quarter results recently, and their equity prices have been charging higher as of late, while some of our tried-and-true positions in Altria (MO) and Republic Services (RSG) have been holding up very well despite broad-based weakness. We’ve parted with legacy eBay (EBAY) after a fantastic run (with it holding PayPal), and we no longer hold Gilead (GILD), an equity we may scoop up later at a lower price once political risk regarding exorbitant drug pricing fades and we get a better feel for the impact of yet another cure for hepatitis C on the market, this one from Merck (MRK). The 35% cash weighting in the Best Ideas Newsletter has been a tremendous source of risk-adjusted alpha and has helped to mitigate some of the weakness at Teva (TEVA), the latter putting up disappointing Capaxone sales recently, and Buffalo Wild Wings (BWLD), which has been hammered by one-time items and concerns over the norovirus damaging its reputation to the same degree as Chipotle’s (CMG).
We expect the markets to catch a technical bounce in coming weeks, thanks in part to the well-timed OPEC-meeting rumor, but needless to say, our guard is up. The question on investors’ minds, especially income investors and financial advisors that serve them, is whether they can afford yet another 15% erosion of capital or more over the next 12-18 months to gather an income stream that would amount to but a fraction of the capital loss. Conventional wisdom works, on average, for most people, but it may not work for everyone. If, for example, you’re concerned about even greater stock market declines, it may be worth having a good conversation with your financial advisor to see if your investments are aligned with your goals and risk-tolerances. It’s your hard-earned money.
I hope you enjoy this edition of the Best Ideas Newsletter. It is one of my favorites!