Letter - January 2016

 

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Cross Currents

After five years of rising prices, the stock market took a breather in 2015. Even though the averages ended the year with a small gain, there were many turbulent cross currents which produced gains for a minority of issues and losses, many large, for the balance. As the Financial Times of London put it (1/4/16):

“Apart from a handful of stocks that are doing very well, the US markets are in a slump. Such narrowing of investor enthusiasm has raised fears that a lengthy post-crisis rally has run its course.”

Cross current: In a world of 2%-2.5% economic growth, well below the long term trend, many companies struggled to produce revenue and earnings growth in 2015. As a result, corporate managements pursued a strategy of focusing on cutting costs to improve profits. One result was heightened merger activity which exceeded $5 trillion dollars in 2015, a record. Make no mistake about it, this activity has been about cutting costs, euphemistically known as synergies, including large scale lay-offs of good jobs. Another prominent tactic was the so-called tax inversion merger. Here, companies pursued mergers with foreign partners domiciled in a low tax jurisdiction. Upon merging, the new company locates its domicile in the low tax, foreign country thereby cutting its overall tax bill substantially.

Cross current: Commodity prices continued their race to the bottom. As we know from the headlines, oil in particular has been in a destructive bear market. While low oil prices have been seen as a positive by many who use oil, the adjustment to lower prices has been uneven, tumultuous and disruptive.

It has been estimated that lower gasoline prices have saved US consumers $800 billion, but as a whole they have been reluctant to spend that windfall. Many have chosen to pay down debt instead, resulting in more subdued GDP growth than otherwise would be expected.

One would think that low oil prices would be a boon to manufacturers such as petrochemical companies that use oil and gas as a feedstock. However, much of the benefit has been offset by a strong dollar which dilutes revenues and earnings earned abroad.

We remain flummoxed that the price of gold continued its three year decline in 2015. It remains curious in the face of the Federal Reserve’s historic stimulus ($4 trillion dollars of bonds purchased in the open market with newly printed money) that there is little inflation and gold has failed to perform. Perhaps the government inflation statistics are faulty. Anecdotally, the cost of living has been rising in our experience. Perhaps the time is not yet right. History shows that gold is ultimately sensitive to the debasing of the purchasing power of a currency.

Cross Current: Sovereign wealth funds, set up by many oil producing countries for a rainy day, are starting to be liquidated to cover budget short-falls resulting from declining oil revenues. It is estimated that Russia and Saudi Arabia need $100 oil to finance their budgets. If this continues, it raises the specter of billions of dollars of investments being thrown on the markets in an unsettling manner.

Cross current: Geopolitically, the world is a mess. The Middle East is in flames. Saudi Arabia and Iran are fighting a proxy war in Yemen and Syria as the Saudi embassy in Tehran is attacked. ISIS seems to be more on the defensive in Iraq so it strikes out with terror attacks on the Western world as in Paris. Russia is increasingly aggressive. North Korea claims it exploded a hydrogen bomb. Some speculate that China is headed for negative GDP growth.

The world is ever in turmoil, a fact of life. So the markets have priced in conflict to some extent. What we do know is that the lubricants of peace — economic growth and prosperity — are underperforming.

Cross current: Bulls say that corporate earnings, a fundamental driver of stock prices, will rise more than expected in 2016 as commodity prices bottom out in the first half of the year. As they do, the earnings of commodity producers, currently a drag on overall corporate earnings, will begin to contribute positively to earnings, helping support or push stock prices higher.

Furthermore, as pointed out by the Financial Times quote above, the market has been undergoing an internal bear market correction as many stocks have performed very poorly in 2015. We think there is merit to the argument that we will see rotation from last year's winners into last year's losers.

Our predictions for the year: Commodities, especially oil, will bottom out in the first half of 2016 causing commodity stocks to rally from deeply depressed levels. Budgetary stress and military conflict could motivate Saudi Arabia and Russia to curtail excess production of oil, setting off a spike in the prices. As there are few signs of impending recession in the US, GDP will continue its slow grind forward but at a continued unsatisfactory rate of 2%. Corporate earnings will continue to rise slowly, supporting modestly the overall market. In sum, the future looks a lot like the recent past.

For over a year now, we have argued that the stock market in general has been fully valued, if not over-valued. We have cautioned patience and have maintained unusually high cash balances as a cushion against volatility such as we have witnessed since the new year began. We continue to counsel patience.

2016 could witness the re-emergence of value stocks while growth stocks, growth at any price, should take a breather. Intellectually and philosophically, we have always had a bias towards value vs growth. We expect that bias to be rewarded this year.

We were notably wrong about the extent to which oil would fall in 2015 and the extent to which that would be disruptive. However, we are optimistic that sometime in 2016 oil will bottom as supply and demand begin to equalize. We patiently maintain our investments in oil and gas stocks.

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

Tom Herzig


 

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