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Dislocation

The most startling development of 2014 was the decline in the price of energy. Over the last six months, oil fell from over $100/barrel to less than $50 currently. The decline has caused major dislocations in the world economy. Proximate cause is too much supply due to record production from the newly exploited shale deposits in the US and not enough demand due to sluggish world growth. There has been a spill-over effect on natural gas for many of the same reasons though the decline has been less severe.

The fall in energy prices has created winners and losers. The biggest losers are the petrostates such as Russia, Saudi Arabia, Venezuela and Nigeria. These states depend on $100 oil to balance their budgets, stabilize their economies and provide basic services to their citizens. Should oil remain low for long, they could face civil unrest challenging the legitimacy of their governments.

Another loser is the oil and gas industry. Lower oil prices force a cut to exploration and production budgets for projects which at $100 oil are profitable but which at $55 are not. High cost production includes many shale plays and capital intensive drilling offshore in ultra deep oil reservoirs. As a result, investors in oil and gas stocks have been walloped by the dramatic and unexpected fall in energy prices.

Fortunately, the United States is on balance a winner in the oil derby. Though activity in the oil patch is starting to decline, there are overwhelming positives for the US economy. First and foremost, consumers win as the lower cost of heating their homes and filling their gas tanks has substantially boosted disposable income. Sales of pickup trucks and SUVs–the most profitable vehicles for the auto industry–are booming, boosting profits for the auto manufacturers. Airlines are benefiting too as the price of aviation fuel ¬¬falls, a major part of their cost structure. In fact, anyone who is a net consumer of energy benefits.

On the monetary front, low oil prices help restrain inflation which could allow the Fed to put off or mitigate an increase in interest rates expected for mid-year.

Other dislocations that occurred in 2014 are the Russian invasion of Ukraine which upset the rule of law in international relations, the rise of ISIS in the Middle East which thrust American troops back into combat and the Ebola outbreak in West Africa.

Looking back over the past year, we observe that low interest rates and rising corporate earnings have trumped just about any dislocation. Add to the mix near record corporate buy-backs of stock and rising dividends and one can understand the robust performance of stocks in 2014.

As the calendar transitions from 2014 to 2015, the market is off to a rough start, having fallen roughly 700 points for the four trading days from December 31 to January 6. Looking forward, some of the conditions that have favored stocks over the last number of years are beginning to change. We expect cheap money in the US to become more dear as the economy picks up and the Fed moves to raise interest rates in 2015. The effect of this on the stock market is widely debated. The bears say that previous attempts to let interest rates rise slammed the economy and the market. Bulls say higher interest rates are the result of a strong economy and that corporate earnings will continue to grow robustly supporting equities.

The US economy is growing modestly at between 2-3% but at a pace that far exceeds those of Japan and the Eurozone. This has led to capital flows into the dollar vs the euro and the yen. A strong dollar may well have an impact on corporate earnings in 2015. Approximately 40% of the revenues of S&P 500 companies is generated overseas. A strong dollar means that these revenues and earnings generated in foreign currency convert to lower revenues and earnings in dollars. According to the Wall Street Journal, consensus estimates of earnings growth for the S&P 500 is about 8%. A strong dollar may make this a hard target to hit.

One area of concern is the enormous valuations given selected technology stocks, particularly those addressing the needs of social media. In both the private and public markets, unproven “new tech” companies with few employees, revenues or earnings are supporting valuations in the billions. Perhaps the smart guys know what they are doing; we remain skeptical. This has the smell of a mania. Should it unravel, there could be spillover effects in the wider market.

A final observation: we have long advocated having a position in gold related securities to hedge against what we perceive as reckless dollar debasement by the Fed. To date, this has not been a profitable strategy. Things might be beginning to change, however. For the past number of years, gold has traded like a currency. A strong dollar meant a weak gold price. Recently, though, while the dollar has surged, the price of gold has rallied as well. A true bull market in gold will develop when gold rallies against all currencies. We see hints that this may be starting to happen.

As we look forward into 2015, we have no strong conviction as to where the market may lead. Stocks at year-end 2014 were modestly overvalued, though less so now after the recent sell-off. As 2015 will be a year where the Fed pivots to normalize interest rates at higher levels, we expect turbulence, some of it violent, as the year progresses. We have ample cash reserves to take advantage of opportunities that may arise.

All of us at P.R. Herzig &Co. wish our clients and friends a Healthy and Happy New Year.

 

Tom Herzig


 

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