As such, there are lessons to be drawn from the October rout. First and foremost, there was no apparent trigger for the correction. Various culprits were designated a posteriori, such as Brexit tensions, the escalating US-China trade dispute or Italian budgetary issues, but none of these can be considered new developments. What this implies is that markets can turn at any moment – making it exceedingly difficult for investors to time an exit.
Second, selling was indiscriminate. This, we attribute to the current predominance of mutual and exchange-traded funds over active investing. As fear mounts, expensive and cheap stocks are sold alike, with the amount of accumulated profits mattering less and less in the decision to cut a position. Rather than valuation, it is liquidity that determines how badly a stock gets hurt. As such, value investors like ourselves need to be able to sit out a correction and be comfortable with holdings on a long-term basis – in effect adopting a private equity-like approach.
Third, selling begot selling. By and large, the hedge fund community is momentum-based, very short-term oriented and leveraged. As such, whether human- or machine-driven, it reacts to a price drop by selling further and cutting exposure. Note that, prior to the Great Financial Crisis, the focus would have been on net exposure (long positions less short positions). But the brutal 2008-2009 period taught hedge funds that shorts do not necessarily deliver the intended protection – gross exposure also has to be reduced to better withstand a market downturn.
Last, gold and US Treasuries were no safe havens in October. Although they did not actually lose value, they were not able to offset equity losses. Simply put, investors had nowhere to hide – also an important (and worrisome) observation for portfolio construction.
We have discussed many of these market structure issues, separately, in prior investment letters. But seeing them come into play all at once was, we must admit, a scary experience. More than ever, portfolio risk should be contained, which in our opinion means no exposure to long term government bonds (until rates reach the tipping point). Opt for short duration bonds and or floating rate notes and pay careful attention to credit quality. Prefer a selection of cheap asset- or brand-backed equities, with a long-term perspective.
A final word on the US mid-term elections which have effectively delivered what polls were suggesting with Democrats gaining control of the lower house and Republicans keeping the Senate. We think the cohabitation between President Trump and next House Speaker Pelosi might prove more electric than the initial public perception suggests.
Shale oil stocks - A case in point
Shale oil stocks were among the worst hit in October, with losses far greater than warranted by fundamentals. At the climax of the correction, they had shed some 30% and were trading at levels that we deem consistent with a USD 45 – rather than the actual USD 65 – WTI oil price.
Unfortunately for shale oil stocks, they check a number of the aforementioned boxes. They display limited liquidity and, because of their still small weight in US market indices, are almost exclusively a playing field for short-term oriented hedge funds.
Yet, from an operational point of view, shale producers are delivering on their promises. There have so far been no disappointments in reported third quarter results. Companies are also moving into free cash flow territory, which should make dividends and/or share buybacks possible in the future. The industry is clearly here to stay and can continue to grow at a 20% rate for a number of years. Indeed, US refineries and port authorities are actively seeking VLCC (the acronym for Very Large Crude Carriers) tanker capacity, so as to be able to export all the US-produced oil that is not needed domestically. Incidentally, this might ultimately be the key to resolving the trade dispute with China.
True, there is currently a pipeline shortage in the Permian basin, which is constraining output growth and forcing shale producers to find alternative (and much more expensive) ways to transport their oil to the Gulf of Mexico. But this is only a temporary problem, which stands to be resolved within the next six to nine months. And all producers are not impacted equally, some of them having secured sufficient pipeline capacity or sold forward their oil at a fixed price. So why the indiscriminate selling in October?
As long-term value investors, the only risk to our shale oil holdings that we should really be concerned about is that of a severe and sustained drop in the oil price. Which is a very unlikely scenario at this point – rather, the stage seems set for a spike, perhaps already next year. Global inventories continue to shrink, approaching scarily low levels in the refined products space. With the Iranian sanctions having come into effect, other OPEC producers are filling the gap, pumping oil at a near-high of 33.3 million barrels per day just to keep up with the strong demand. And even if this demand were to falter, we would not expect OPEC to inflict as much pain upon itself as during 2014-2015. Production quotas would likely be adjusted down rapidly (as already discussed during last weekend's OPEC+ joint ministerial monitoring committee), limiting the downside on the oil price.
Once US pipeline issues are resolved, shale oil companies should thus be able to increase their production in an environment of (much) higher oil prices than today – and their stock prices to benefit accordingly.
Adapting portfolios for this late-cycle environment
To understand what we mean by “tipping point”, we find this analogy made by BCA Research in a recent report very useful: “economies and markets can undergo disruptive ‘phase transitions’ analogous to when waters transitions to ice. For water, a 4 degree drop in temperature from 6 degrees to 2 degrees produces no discernible effect, but the same 4 degree drop from 2 degrees to minus 2 degrees produces major disruption, as roads freeze over, pipes burst, and so forth”.
In July 2016, the 10-year US Treasuries yield made a historical low at 1.36%. Since then, it has more than doubled, to around 3.2%, but remains in water territory. How much further until the freezing (tipping) point is reached? It may be that ice forms already at the 4% level – and there is no doubt in our mind that markets will have frozen by the time we get to 5%.
Until then, investors will have to go on rowing against the tide of rising rates. Just consider that the US public debt load has doubled since 2008 (so much for the hoped-for deleveraging!) The amount of debt that will need to be rolled over by the US Treasury over the next five years is estimated to exceed 40% of US GDP. And that does not include new debt being accumulated due to ill-timed fiscal stimulus. Finding buyers for all this government paper will require higher rates, there are no two ways about it. In fact, as the Federal Reserve well understands, higher rates are the best way to stop the Trump administration from running the US into bankruptcy – to the extent that it makes budget deficits costlier.
For now, we thus continue to recommend staying out of long term government bonds. What then about corporate bonds? Just like the US government, companies took advantage of the low rate environment during the past few years to take on additional debt. Worse, part of this additional leverage was used not for productive investments but to make share repurchases – fragilizing balance sheets. Rating agencies appear to be seriously behind the curve, meaning that holdings in the corporate bond space should be limited to the higher quality segment. And duration should obviously be kept short, given the underlying uptrend in interest rates. In this respect, floating rate notes make for an attractive option, to the extent that they can help limit transaction costs.
Turning finally to equities, valuations remain rich even after the October “bump in the road”. Too many companies still trade at impossible P/E ratios in our view and, with rising rates also a headwind for stock markets, the time has not yet come to buy high-flying names on dips. Rather, we stick to our approach of investing in companies that offer a combination of value (buying cheap being the first condition for investors not to lose money) and high worth, whether in the form of assets, brand name or market position. We also reiterate the importance of having a long-term horizon on these holdings, overlooking the short-term price volatility.
In summary, the cycle is not over. There are still returns to be earned on financial assets, but the task is becoming ever more difficult. Let us also hope for a quick year-end market comeback, or else the trading algorithms of the hedge funds will start to recalibrate their risk assumptions, further complicating matters.