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
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
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
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.
Please read our important notice
about these letters and the securities they mention.