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Encore...?

The stock market registered gains in 2013 not seen since the late 1990s. Investors have cause to be thankful. Looking forward, the question is, "Can we do it again?"

There is precedent for multiple years of double-digit returns. Starting with 1995, the market registered returns in excess of 20% for six straight years. Much of the excitement was in the exploding field of technology. The Internet was young but coming of age. Companies like Microsoft, Oracle and Intel were growing rapidly, reshaping the economy by developing technological tools that were previously unimaginable. The supply of new technology created its own demand. Products became available that people didn't realize they needed until they were available. It was a heady time.

Government policy was conducive to a bull market. Congress and the Executive Branch worked together in a bi-partisan manner, notably reforming welfare. Also, the fiscal condition of the nation was rapidly improving to the extent that the federal government was recording budget surpluses. With the exception of a wobble in 1998, brought on by a Russian sovereign debt default, the crisis of the Asian Tigers, and the demise of Long Term Credit, a large hedge fund, it was a time of optimism and prosperity.

Bulls say that there are parallels today with the years approaching the turn of the century. Technology continues to advance with social media leading the way. Google, Facebook and Twitter impact the lives of billions of people, letting them interact as never before, enabled by powerful smart phones and tablets. We would say, however, that the real game changer today is the revolution in the domestic energy business. The development of cheap shale oil and gas production and reserves using horizontal drilling and hydraulic fracturing is radically changing the cost structure of US industry.

Cheap, abundant shale oil and gas is transforming the Unites States into one of the most competitive countries in the world in which to invest and operate a business.

The price of natural gas in the US is a third to a quarter the price in international markets. As a result, billions are being invested in export facilities that well ship domestic gas overseas in order to capture the price differential.

US based chemical companies which use natural gas extensively as a key input, are now amongst the most competitive producers internationally. This opens the door to exporting production while also inviting foreign capital investment in US capacity.

Natural gas is a key component in the production of fertilizer. Cheap gas has lowered prices to farmers while at the same time enticing foreign companies to invest in US capacity.

Infrastructure spending is booming, responding to the demand for pipelines and rail cars to move shale oil and gas to market.

The low relative price of natural gas versus oil incentivizes the build-out of a fueling network to allow cars and trucks to run on natural gas. We note that transportation is the major user of oil in the US. Switching to natural gas would lower costs, creating savings for consumers nationwide. Not incidentally, harmful emissions would be reduced, as gas burns cleaner than gasoline or diesel.

Foreign investment in the US is accelerating due to lower operating costs, which increases competitive advantage. According to The Financial Times (1/21/14), the cost of electricity in the US, much of it generated by natural gas, is half that of the European Union.

Less dependence on foreign oil increases energy security and helps lower the trade deficit. This should support the value of the US dollar, mitigating inflation.

Jobs, good paying jobs, will be created as the shale revolution unfolds.

The above developments, and others we have no doubt left out, should be transformational to the US economy. This could help underpin a bull market in stocks for the foreseeable future. The combination of abundant oil and cheap natural gas promises to lower operational costs, spur capital expenditures and bolster corporate earnings and jobs growth to an extent that the market has not yet appreciated.

Despite the promise of the shale revolution, we point out that unlike the 1990s, there is little comity in Washington. The federal government is running unsustainable deficits. Barring a change in spending habits, long-term entitlement obligations are a serious threat to the well being of the country, a situation that could send shivers of fear down the spines of investors at some point. Short-term, Congress needs to approve a rise in the ceiling on government borrowing by February 7. There might be a fight yet.

In the near term, bears point out that after a five-year bull market, stocks are not cheap, that by being forward-looking, markets have discounted what appears to be a strengthening economy. We are sympathetic with this point of view. However, we note that it was 1996 when then Fed Chairman Greenspan scolded investors about "irrational exuberance"; the markets rallied into 2000. The lesson: markets, both bull and bear, go to extremes on the up side and down.

So, while we would not be surprised by a meaningful correction in the short-term, we remain optimistic as we look further into the future. An encore is not out of the question.
 

Tom Herzig


 

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