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Caveat Emptor

Let the buyer beware. It has been five years now since the market hit bottom in 2009. Investors who didn't lose faith have reaped substantial gains. Cheap money and strong corporate earnings have driven the S&P 500 to a historically high level. And, as I discussed in the year-end letter, there has been a revival in the industrial sector due to exploitation of cheap, abundant domestic energy.

Many are surprised, ourselves included, that the market has shrugged off so many of the challenges it has faced: Congressional grid-lock, an anti-business president, lack of tax reform, little desire to address long-term fiscal deficits and looming federal debt, a destabilized international order, Russian invasion of Ukraine, civil war in Syria, chemical weapons, a nuclear Middle-East. There have been so many crises in recent years that market participants have become complacent. We view this as a negative going forward.

The economy probably hit a soft patch in the first quarter of 2014 due largely to extreme and persistent winter weather. Shoppers could not get to the stores. Transportation was a snarl. Home buyers postponed looking at houses for sale. Nonetheless, much of this activity has been merely deferred and should show up in future quarters. Typical forecasts call for GDP growth to accelerate towards 3% by the end of this year and continue into 2015. If this is so, it should be good for corporate earnings and perhaps for the market.

The question is whether the stock market has already discounted this outlook. Some measures like the "cyclically adjusted price-to-earnings ratio" suggest the market is now richly priced. Other more traditional measures put valuations at fair to somewhat elevated levels. We know of no valuations that make the market look cheap. Indeed, some sectors of the market such as social media stocks, bio-tech and some of the newly abundant initial public offerings are selling at mind boggling valuations. We consider this a warning sign for caution.

We spend a good deal of time investigating potential new investments. While our current investments continue to do well as the market maintains its momentum, we are finding very few new investable ideas today. We consider this another sign for caution. As for strategy, there seems to be little sense in taking profits in high valuation stocks and reinvesting the money in similarly high valuation investments. It is therefore likely that proceeds from sales we may make will remain idle for the time being.

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We have written about natural gas many times in our quarterly letters. The subject seems timely once again. The ramp-up of domestic shale gas production using horizontal drilling and fracturing technology caught the market by surprise two years ago, resulting in a collapse in the natural gas price due to excess supply. The price fell to under $2/mcf in 2012 from over $10/mcf in 2008. This resulted in a decline in the number of rigs drilling for gas. A price fall usually results in increased demand. But the natural users of gas are large, capital-intensive industrial companies such as chemical plants which require long time periods to bring new capacity online. Projects to export gas similarly require many years from start to finish. This has resulted in a mismatch between short-term excess supply and longer-term growing demand. Hence, the fall in price.

That may soon change. The recent winter was harsh, creating record demand for gas to heat homes. This demand, coupled with a lower level of production due to the low price, resulted in a drawdown in inventory to extremely low levels, prompting a spike in prices. One company in Alberta claims to have received prices as high as $28/mcf in the first quarter of this year.

We believe that the outlook for the price of natural gas is positive going forward. Low inventory levels will not be so quick to rebound as we go through the summer months. It takes about nine months to go from permitting a gas well to when it is ready for production. So, supply cannot move sharply and quickly higher to meet the demands of an inventory build for next winter. Should next winter be a replay of this year, prices could rise sharply. Should hot weather prevail this summer, prices will rise. Hot summers use a lot of natural gas as electric utilities fire up gas turbines to supply electricity to run air conditioning. This could make it more difficult to rebuild adequate inventories to meet next winter's demand. Indeed, we could be entering a period of robust pricing for natural gas.

Higher gas prices would naturally be good for gas producers. Look for higher cash distributions from natural gas focused royalty trusts. Exploration and production companies that do not hedge production would similarly shine.

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As a Registered Investment Advisor regulated by the Securities and Exchange Commission, P.R. Herzig & Co is required to offer our clients copies of our form ADV Part 2. This form describes in plain English our business and how we operate. The form can be found on our website, Hard copies are available upon request. There have been no material changes in the past year.


Tom Herzig


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