Wednesday, March 11, 2015

Oil Going to $10 Per Barrel - Really?

From the Desk of Joe Rollins

Before I begin my rant about the outright absurdity of so many financial headlines, I need to review what was, by all counts, an extraordinarily good February for the financial markets. Despite the almost daily headlines regarding markets being overvalued, once again February's returns were nothing short of superior. The financial headlines just cannot seem to resist scaring investors. They simply refuse to consider basic economics or any type of quantitative analysis; they only consider shock value and their ability to get their name printed in the electronic media.

For the month of February, the Standard & Poor’s index of 500 stocks had a great month, earning 5.7%, and year to date has returned a nice profit of 2.6%. More importantly, this index has returned 15.5% over the last 12 months, 18% over the last three years and 16.2% over the last five years. And for those critics that scowl at the long-term returns of the S&P 500, this same index has returned an 8% annualized return over the last 10 years. Just for the sake of full disclosure, that 10-year period included 2008 when the S&P 500 was down a cool 37%. I wish I could tell you how many clients we visit with on a regular basis who sold in 2008 and never reinvested, thinking they had outsmarted the market. Yes, they avoided the downside, but in doing so they missed a tremendous opportunity for upside performance.

It was an equally good month for the other indexes of the broader market. The NASDAQ Composite was up 7.2% for the month and up 5% for 2015. The Dow Jones Industrial Average was up 5.9% for February and up 2.1% for the year. As you would suspect with interest rates rising, the Barclays Aggregate Bond Index was down 1.1%, but is up 1.1% for 2015, thus far.

For those readers who like to compare the basic performance of stocks and broader market indexes, the S&P 500 Index is up 15.5% for the one year period ended February 28th, and the Barclays Aggregate Bond Index was up 4.9%. For the three-year period, the S&P 500 Index is up 18%, the bond index up 2.6%. For the five-year period, 16.2% for stocks, 4.1% for bonds. And for the 10-year period, 8% for stocks, 4.5% for bonds. Once again, even with the huge correction in the market in 2008, stocks have almost doubled the annual return of bonds, even with that huge loss year included.

For the first time in many years, the international indexes have actually outperformed the U.S. market. As an example, the diversified international fund managed by Fidelity Investments is up 6.9% through the end of February. While the S&P Index is up only 2.6% through the month of February, virtually all of the bonds, other than high-yield, had a negative rate of return. For the first time, the dollar has stabilized in international commerce and the European markets that were so beaten down have rallied to the occasion. It is not that the U.S. market is overvalued, but the international markets have suffered through so many years of inferior performance that they are suddenly beginning to look attractive.

Interest rates are moving up dramatically. The 10-year Treasury bond started the year at 1.69% and recently was quoted at 2.21%. That is a dramatic movement in a short period of time in bonds. This increase in interest rates will have a negative effect on utilities and real estate investment trusts; both of these asset classes tend to trade like bonds and over the last several years have performed well beyond their expectations.

It would not surprise me to see both utilities and REITs this year generate returns actually less than their coupon dividend rates. Therefore, it does not seem that interest rate-sensitive sectors like bonds, utilities or REITs are likely to perform well in 2015.

Let me divert your attention for a minute...

(Ava dressed as "Super Girl")

Returning back to my rant on misleading financial headlines, let's discuss oil prices. This week, the financial headlines were screaming “Look out for $10/barrel of oil!” A major headline read something along the lines of, “No wonder oil prices are falling - we have nowhere to store it!” I have absolutely no problem with anyone expressing their opinion on this subject. However, the difficulty for me is that many readers of these financial headlines do not have the capacity or ability to evaluate that information, and therefore are misled. They assume that just because it appears in major bold headlines that it must be accurate, or is at the very least, a forecast made by someone with knowledge. The uninformed then become misinformed. But let us focus on oil for just a second.

First off, the financial headlines indicate that the reduction in oil prices is somehow a negative economic event. While unquestionably it is a negative for the 8% of the population that work in oil-related production and services, it is very much a positive for the rest of us who consume oil. The reduction in price of gasoline is significant, but it will take time to work its way through the economy. People do not buy gasoline every day. The dramatic increase in net income of major corporations will enhance stock prices and consumers’ abilities to spend more, buy more, travel more and will make the profits of consumer-driven companies more pronounced. Frankly, all of that is just perfect and good for the U.S. economy.

But $10 a barrel – really? In a capitalistic country, prices are based upon supply and demand. When you have oversupply, prices go down. When you have under-supply, prices go up. Businessmen are not so stupid to continue to produce when they cannot make a profit. They will reduce capacity until additional shortages occur. Any close reading of the financial markets would dictate this is already occurring.

As an example, as reported in Barron’s this weekend, the number of rotary rigs running in the U.S. and Canada is down a stunning 37% over the last 12-month period. That means 37% of the capacity of producing oil has been stopped from producing. While it certainly may be true that storage facilities are full, the supply that backs up that capacity is dropping exponentially. It is only a matter of time until the under-supply of oil will force a shortage and the prices will increase. It is hard to actually explain how anyone could come to a forecast that oil would fall to $10 a barrel. You may rest assured that no U.S. manufacturer would produce at that level and incur the absolute financial disaster that would occur.

Also, consider the position of Saudi Arabia. There is no question that Saudi Arabia wants prices to decline, forcing U.S. producers out of competition. Frankly, I am in the camp of “buy theirs, save ours”. I think it is perfectly fine if we can buy oil from Saudi Arabia at a bargain price and leave our oil in the ground for future production. Absolutely none of this is a negative for the U.S. economy, and frankly, all of it is a positive.

February also brought the U.S. some good economic reports. For the month of February, it was recently announced that the unemployment rate had dropped to 5.5, but the most important aspect is that there are almost 3 million workers that had jobs in February that did not have jobs 12 months ago. The numbers on 3 million workers are amazing. These are 3 million people who now have jobs who buy groceries, get their cars fixed and support their families. The trickle-down economics of this number is a very positive indicator going forward.

There is no question that the labor participation rate in the economy is terrible. There are way too many people on government subsidy, such as unemployment, disability and food stamps. However, the more people get back to work and the more money they spend to support their families, the better for the U.S. economy. Even more encouraging is that corporate America is advertising for jobs in an accelerated fashion; a clear indication is corporate America wants to hire, but they cannot find anyone to hire. It seems that new job openings have been running at 20% year-over-year levels. That means that corporate America is seeking more and more employees in these jobs that have not been filled. It is clear that even Walmart is having a hard time hiring employees, and has recently increased starting salaries for new job openings. There is absolutely nothing that could be more beneficial for the US economy than more employees working.

Yes, there are also negatives in the economy. With the U.S. dollar strengthening, it means that exports out of the United States will be at a severe disadvantage to goods produced in Europe and other countries. However, the effect on earnings of this increase in the dollar is a one-time occurrence. Once the currency has adjusted and stabilized, U.S. companies will learn to compete at lower levels. While there is no question that this trend should benefit European manufacturers, it is hard for me to get my arms around how this would be a long-term disadvantage to U.S. corporations.

We often forget much of the manufacturing for these companies is already located outside the United States anyway. While these companies may be based in the United States, production occurs in countries around the world in many currencies. This a natural hedge against major moves in the value of the dollar. In the old days, manufacturing was primarily based in the United States and exports would be hurt by the strong dollar. That has not happened in the last 20 years and anyone making that assertion is quite naïve in their assessment of the economy.

The biggest worry for the stock markets is an increase in interest rates. In early March, the market sold off because employment numbers were too good. Really? Greater employment numbers are absolutely great for stocks. Why did the market sell-off? It seems that the daily traders on the market are so paranoid of higher interest rates that they cannot evaluate economic data for what it is. We believe interest rates should be going up this year, and have believed that for a long time. When interest rates move up, investors should underweight interest rate sensitive investments and wait for interest rates to stabilize. The benefactor of higher interest rates at the current time would be stocks and then a transfer from stocks into interest sensitive investments when they stabilize.

The major question I get on a daily basis is, “How far do you think interest rates can move up?” First off, one of the reasons why the interest rates in the United States are so low is because interest rates in foreign countries are even lower. The 10-year German Treasury is yielding an unbelievable rate of 0.4%. In Japan, it is only 0.3%. To put that in perspective, in Germany you could invest in a 10-year Treasury earning 4/10 of 1%., when inflation in the United States is running in excess of 2%. Therefore, you would lock in a guaranteed loss in principal each and every year for those 10 years.

So what is happening at the current time is money is rushing around the world into the United States in order to buy our interest rate sensitive instruments. Principally, money runs where it is treated best, and that currently is in the United States. Therefore, the upward movement of interest rates will be greatly muted by this flood of investment capital into the U.S. While I certainly expect that interest rates will be increased by the Federal Reserve later this year, it appears to me that the markets have already adjusted to that reality.

In summary, all is good for now and the future looks excellent for stock investing. That does not mean you are not going to have volatility as the year progresses, but my projection of a return of 10-12% in 2015 remains firmly intact after the first two months of the year. But stay tuned – things could change quickly.

We would love to meet with you and discuss your financial assets, your financial goals, and financial future. Please call our office and schedule an appointment.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best regards,
Joe Rollins