A Bullish Bear?
“Large amounts of money aren’t made by buying what everybody likes. They’re made by buying what everybody underestimates.”
- Howard Marks
It was not a boring end to 2019 for the Aspera family. We had to put our Stress Management Guru, Bella, to sleep after 14 years of loyal service. As much as I’d like to blame the Federal Reserve for this, the fault instead lies with the ravages of old age. It’s lonelier in the office these days, and I miss her ability to remain calm and centered regardless of what the markets are doing, where gold is trading, or who the U.S. is assassinating in the Middle East.
On a happier note, our Junior Research Analyst won her elementary school spelling bee. She represented her class three years in a row and improved each year. I have clearly improved my gene pool as the best I could muster in elementary school was a single school-wide appearance that met with an ignominious end on the word bicenntenial…bysentennial… bissentennial…whatever. She was not exactly excited about prepping for the school bee, and she wasn’t thrilled to learn that the reward for her victory is the opportunity to study a much larger and more challenging list of words for the upcoming regional bee. Nevertheless, she was treated to an arts supply shopping spree, and she has been promoted to Senior Junior Analyst and Chief Editor. So, although the content of these missives may seem nonsensical or downright asinine at times, you can at least rest assured that they’ve been adequately spellchecked.
Unwinding The Unwindable
The investing and economic landscape has been no less eventful, and we can blame the Federal Reserve this time. One of our long-held core beliefs has been that the Federal Reserve would never be able to completely unwind its post-2009 stimulus. Financial markets have become dependent on stimulus, and the “need” for even more stimulus would grow with every ensuing downturn. The Fed had promised that Quantitative Easing (QE) and 0% interest rates were merely a temporary response to the 2009 crisis, but temporary turned into 6 years. The Fed finally attempted to remove the juice by very gradually raising short-term interest rates beginning in early 2016. At the beginning of 2018, they also began the process of unwinding some of the QE. The financial markets didn’t implode during this “normalization” simply because other global central banks were still more than offsetting the Fed. It wasn’t a coincidence that the U.S. stock market and various credit markets suffered their first major pullback just after central bank stimulus dried up globally in the back half of 2018.
Fed Chairman Powell reacted to that late-2018 scare just like every Fed Chair since Paul Volker. He balled himself in a designated “safe space” at headquarters and started rocking gently to the pan flute version of Bob Marley’s “Everything’s Gonna Be Alright.” Then he promptly reversed monetary policy. He began with the standard rhetoric in January of last year, stating that the Fed “will be patient.” This was sophisticated economic code for “We have no idea what’s happening, but we need to project confidence and SAY SOMETHING to stop the stock market from falling before Trump starts mean-tweeting us again!” This was escalated in March when the Fed announced that Quantitative Tightening (QT) would be ending in September despite assurances a few months earlier that it was on autopilot. At the end of July, the Fed followed through and cut the Federal Funds rate. In addition, they announced that QT was going to end even earlier now. The two charts below tell the story. The top chart shows that it took the Fed 3 years to raise the Fed Funds rate from 0% to just under 2.50% and 4 months to lower it back to 1.50%. The bottom chart shows that the Fed added (printed) $3.60 trillion in assets (QE) to its balance sheet following the last crisis but was only able to remove $0.75 trillion.
Not only did the Fed make little headway in reducing its balance sheet, they didn’t even pause to high-five each other before cranking up the printing presses again (“Here We Go Again!” on the bottom chart). This time the culprit was the seizing up in September of what’s known as the repo market. This is very short-term lending between financial institutions. The details of why exactly that market seized up are still being debated. The ultimate cause is less important than the fact that the fragility of our financial markets was once again laid bare, and the Fed once again affirmed that it would soil itself every time the markets whimpered. The Fed has repeatedly stressed that this latest balance sheet increase is not QE, but the $400 billion they pumped into the system these past 4 months sure has a strong QE stink about it.
It should be increasingly clear to everyone by now that there is no escape for the central banks. They’ve blown huge bubbles, encouraged massive debt growth, and fostered the creation and sustenance of chronically money-losing businesses. The economy can’t sustain much higher interest rates without suffering a devastating recession, and the financial markets can’t stand on their own merit. Any attempts to raise interest rates or reduce their balance sheet will fail. The practical follow-on is the issue of how the financial markets would react to the realization that more stimulus was coming. Stock investors have been trained for a decade to react in a Pavlovian fashion to any stimulus from the Fed, so the latest rally in the stock market is far from surprising. The counterargument is that the last two market collapses occurred despite aggressive easing by the Fed.
But is this latest stock market boost the beginning of a new bull market or the final blow-off rally of the bubble? The stock market is more overvalued today than in 2000 or 2007, with the overvaluation rivalling that of 1929. The “market” is being driven higher by fewer and fewer companies, with the largest 5 companies in the S&P 500 accounting for an all-time high 18% of the total index value. This concentration is now greater than the 2000 peak. At the same time, 40% of U.S. listed companies lost money over the past year. These aren’t signs of a healthy, well-supported bull market. Ultimately, you either believe that this madness will meet the same demise as every bubble in the history of homo sapiens, or you believe that some way, somehow this time it really is different and the laws of economics, finance, and psychology have been sufficiently and permanently altered in a fashion that henceforth prevents bear markets. Of course, it’s a bubble, and of course it will end. The heavier the partying, the worse the hangover. The only real question is when, and this is impossible to pinpoint as bubbles are marked by a mass temporary insanity which precludes rational analysis. Your guess on timing truly is as good as mine (better for the less rational among you). Fortunately, despite the overall stock market being very unattractive, there are some narrow yet tremendous pockets of opportunities within the market. But first…
Gold Shining A Little Brighter…Finally
The clearest implication to me of the inevitable resumption and permanent nature of Fed stimulus was that gold was a must-own, long-term asset in such an environment. Gold was a stellar performer from 2002-2012 but suffered a 3-year bear market from 2012-2015. I cautioned in 2011 that gold and silver were getting ahead of themselves and that a healthy pullback was overdue, but the ensuing 3-year pullback lasted a bit longer than I expected. Nevertheless, it was reasonable in a historical context. The great 10-year gold bull market of the 1970s saw gold run from $35 to $850 over a decade, but right in the middle of that amazing bull market was a two-year “hiccup” that saw gold fall over 45%. Our more recent (current) gold bull market ran for 9 years before suffering a 3-year pullback of 44%. We’ve already seen gold climb from its pullback low of $1060 to $1550 over the last few years with little fanfare. Given human nature, I suspect we’ll see much more interest in gold from the average investor at $2000/oz than we saw a few years ago at $1100. Note that gold would have to climb to $6,000/oz to equal the 1970’s bull market gain. Ultimately, the peak gold price will depend on how far central banks can push markets before they break, and no one has that answer. We’ll monitor and adjust as we go.
One of the key reasons investors temporarily abandoned gold this cycle was their belief that the Fed really was in control, had managed to save the day, and would be able to withdraw its emergency QE and raise interest rates without serious consequence. We knew this was false, but perceptions matter. If perceptions were going to shift, it seemed logical that the sudden reversal by the Fed back to more stimulus from the start of 2019 would be the catalyst. We tackled this shift from the Fed and its implications for gold in our June 2019 piece entitled, “Here We Gold Again.” In that, I wrote that we were likely to see gold break through the stubborn $1350 level soon as the Fed had made it clear that its “extraordinary measures” were here to stay. We knew that these measures couldn’t be reversed, but the broad investment community needed to grasp this. I had conversations with many of you in which I confessed that I’d have to reevaluate my thesis if gold didn’t move higher on this renewed Fed easing. Fortunately, it was just a matter of days after writing that piece before gold finally broke through $1350 decisively (see chart on the right) and quickly moved on to the $1400 and $1500 level.
The reasons to own gold today are as strong as ever, and I expect higher prices in the years to come, primarily because of gross incompetence on the part of the major central banks. Precious metals will remain a core holding until a precious metals bubble develops or until we have a reset of the monetary system. I still favor the mining equities and silver-related plays given their leverage to higher metals prices, but they will certainly be more volatile. We’ll continue to opportunistically trade around our core position while managing an appropriate position size. We took some gains off the table during the summer rally as our overall weighting grew a bit too large (good problem). We’ll also pare this position back as needed to fund other compelling investments we uncover. Speaking of which…
About Those Tremendous Pockets…
Analyzing entire markets is quite simple, but our asset allocation isn’t driven directly by my top-down view of the world. Most of my time is spent researching individual securities and industries (bottom-up). Not surprisingly, the two approaches tend to line up well. When a market is attractively valued, I tend to find plenty of opportunities. In 2009, I had the wonderful problem of choosing from a long list of compelling securities. I’ll put the same effort and hours into research during a bubble, but I pass on almost every idea because they're simply too expensive. Nevertheless, in every prior bubble I’ve been able to find at least one compelling investment idea that wasn’t correlated with the general market.
This cycle had been playing out differently and more frustratingly until recently. I had trouble for a few years finding anything compelling beyond the precious metals space. We had a global bubble, and investors the world over were infatuated with chasing stocks, bonds, real estate, commodities, cryptocurrencies, blockchain, art, electric scooters, money-burning electric car companies run by narcissistic fraudsters (you know who I’m talking about), cupcake shops, companies even tangentially related to the “cloud”, Korean boy bands, and anything avocado or Jenner. Nothing made sense, and I’m far too uncool and disciplined to chase the crowds.
Most of what I research today still falls into one of those “uninvestable” categories, but the investment universe isn’t as monolithic as it was a couple of years ago. The S&P 500 may be a bigger bubble today than it was two years ago, but outside of the largest companies and the technology sector lies a growing pile of discarded gems. I’ve mentioned uranium in the past, and I’m more bullish today on that space than I’ve ever been. We’ve been slowly building our exposure as the industry searches for a bottom, and it’s now the second largest exposure in most accounts. I can’t time the exact bottom, but I can’t think of a better risk-reward proposition over the next 5 years.
The other compelling pocket is new to us in recent months…crude oil and products shipping. Another sexy industry, right? We’ve been building our position in this space since the fall. Unlike uranium, this industry has already had its first move higher off its lows after a long and brutal downturn. Few believe this recent rally will persist and every pullback sparks investor concern, but there are some powerful catalysts that could and should drive these shares much higher this year and possibly for 2-3 years.
The uranium mining and oil shipping industries share some key attributes. For starters, they’re both unloved, small, and abandoned. The best opportunities are found where no one else is looking, and nobody cares about these homely wallflowers. Even Jeffrey Epstein is rumored to have found them distasteful (Epstein didn’t kill himself.) Both industries have suffered a decline lasting over a decade, and you’d be hard-pressed to find anyone other than a handful of maladjusted introverts to offer a kind word to either. The entire market value of uranium miners has fallen from $130 billion in 2007 to $8 billion today with the number of uranium miners dropping from about 400 to 40. $8 billion is about the market value of Kohl’s. The oil and oil product shipping industry is larger…barely. There are about 20 public companies with a combined market value of $20 billion. That’s roughly the market value of Best Buy. You could own two boring retailers, or you could buy the entire public uranium mining and oil shipping industries.
The business model for each industry is straight-forward, the competitive landscape is easy to understand, and the accounting isn’t indecipherable. Both industries are ultimately driven by supply and demand, and we have good data and resources available to monitor this balance for both industries. Demand typically grows slowly but steadily. Supply can change more dramatically, but there is big lag that we can monitor. It takes well over a decade to explore and develop a new uranium mine. These don’t just sneak up on you. It can take two years to build and deliver a new oil tanker, and we can monitor how this order book unfolds.
Both industries are predictably cyclical, marked by long busts and spectacular booms. During a bust, many companies will go out of business, reducing supply. The survivors see their share prices decimated, their cash flows dry up, and access to capital disappear. Uranium mining companies reduce output and close mines. Shippers scrap ships and order few new ones. Eventually, supply and demand come back into balance and the price of their product and service starts to stabilize and gradually increase. After a long bust, however, companies are justifiably hesitant to bring on any new supply. Even if they wanted to, investors and banks are reluctant to provide attractive capital for expansion. During the first phase of the upturn, nobody believes it’s real or sustainable. In time, the staying power of the rebound proves itself, Wall Street gets bullish, and investor start bidding shares higher. Because of the lag in bringing on new mines or shipping supply, the industry starts to enjoy strong pricing power as customers scramble to secure supply. Eventually, management gets greedy, projects good times far into the future, and starts ramping supply. This either ends the boom and/or exacerbates the next bust.
Cheap stocks can stay cheap for a long time, so we need catalysts to get them moving. The shipping companies are already in the first phase of their upturn. Day rates (revenue) have soared, and share prices have had a solid move off their lows. The industry is benefitting from a tightened supply-demand balance, new environmental regulations, steady oil demand, and longer shipping routes. There isn’t a lot of new supply coming to the market in the next couple of years, and older ships will be retired. Most companies are promising to return a good portion of future profits to shareholders in the form of dividends and buybacks. These companies will report huge earnings and cash flow in the coming quarters, ship values are increasing, and dividends are about to pop. The outlook is robust, but this is a volatile little industry and share prices are going to post big swings, not unlike gold and silver mining stocks.
As for uranium, the industry has been feeling out a bottom for the past 6 months. Mines are closing and supply has dropped, global nuclear power plant growth continues, inventory is being whittled away, the environmental movement is waking up to the benefits of carbon-free nuclear power, and the U.S. is exploring ways to help our hollowed-out uranium industry. 14 net new reactors are scheduled to come online this year with 37 more under construction. Currently, the supply of uranium is running 60 million pounds short of demand with inventories and secondary supplies making up just half the shortfall. Nuclear power plant operators will need to secure longer-term supplies soon, and they’ll be paying 2-3x current spot prices in order to encourage idled supply to return and ultimately new mines to be built. The handful of remaining uranium miners should see their stock prices soar many times over before the cycle ends.
It’s a fascinating, exciting, and uneasy time in the markets. We have a clear raging bubble in the stock market with bonds offering no great bargain. At the same time, we finally have enough dispersion within and across certain markets to be able to find some beaten up gems. Fortunately, our three key active investment theses are not correlated with the broad market, the economy, or with one another. This is about as optimistic I can be with a portfolio so late in the cycle. Still, we are virtually guaranteed to lag whatever insanity is left in the bubble given our innate revulsion to paying exorbitant valuations in the hopes that an even less discerning and greedier fool will eventually cross our path. It’s the next part of the cycle that we tend to shine brightest, following the market peak through to the next bout of overvaluation. The cycle has lasted so long, it’ll feel like a…bycenteniel celebration when it finally peaks!
Ken, CFA, CFP, MBA, Wannabe Wailer
The Market Rubbernecker is associated with Aspera Financial, LLC, an investment management and financial planning firm based in the Cary, Raleigh, and Durham area of North Carolina. This and all Market Rubbernecker missives and musings (written, oral, or mimed) are subject to the disclaimers, disavowals, and hindquarter-coverings found at www.asperafinancial.com/aboutrubbernecker.