Austin Powers, International Man of Mystery. The long awaited correction in the world financial market has occurred since May 23, 2015 market high in the Dow Jones Industrial Average of 18,286 to the recent 16,000 level, or 12.5%. Hidden within this market decline is a more broadly based decline with many of the industrial company declines exceeding 40 and 50%. The major catalyst for such a decline is the perception that our economy will slow based on the slowdown in the Chinese economy. China has fast become the greatest consumer of fossil fuels which include coal and crude oil. The decline in commodity prices allows China to accumulate excess fuels at dramatically lower prices putting “a Tiger in their Tank!” at a 60% discount from 12 months ago. China remains the biggest environmental polluter while the rest of the free world is closing down coal generated power plants and switching to government subsidized alternative power sources costing billions extra. China is currently buying coal from Kentucky at $48 per ton when it cost $120 a ton in 2012.
Caddy Shack.. Royal Dutch Shell recently scratched its $7 billion Alaska oil project as current economic conditions make it very unprofitable to produce. Literally hundreds of wells are being scratched around the world as the oil industry flooded itself with oil from around the world. The US currently has 100 million barrels more than needed to adequately supply its daily consumption of 22 million barrels per day. More recent data indicates that the oil producers have cut supply levels as the oil rig count is below the 800 level. Coincidentally, the glut in oil supply is occurring with a potential slowing economy in the US. The recent 25 year lows in oil service companies and integrated oil stocks suggest that the bottoming out process is occurring.
Animal House. The greatest myth going in our financial system is that nine banks are too big to fail! The sheer size of the financial derivatives on each of these banks’ balance sheet remains larger than each of their stated capital. The investment banking activities of these institutions continues to prevent these banks from being good investments. The very same risk for our economy exists in the amount of risk banks continue to take in derivatives these banks issue. The estimated total of said financial derivatives is $1.2 quadrillion or 1200 trillion which is collectively on the banks’ balance sheets. In 2008, the credit derivative swaps triggered the financial meltdown in Bear Stearns, Lehman Brothers, and Merrill Lynch. That exposure still exists!
Superbad. The iconic German automobile company Volkswagen has added a microchip to its diesel autos that underreports its emissions of toxic pollutants to the atmosphere. In other words, the management has deliberately lied about its emissions levels to the U.S. and ECB environmental agencies regarding diesel cars. The discovery was made by a West Virginia college research group being funded by an independent research organization. The negative implications of this contributed to lower stock prices throughout Europe, especially the German Dax Index.
Dumb and Dumber. The U.S. housing market remains in modest recovery mode. The difficulty of obtaining mortgages for lower to middle class Americans is the stumbling block for an ownership bubble occurring. The Millennial Generation (under 35 years of age) is less enamored with traditional suburban lifestyles and choosing to rent high, if not overpriced, apartments in the larger urban areas. The record setting prices being paid to live in the metropolitan areas has spawned record amounts of financing by large institutional investors to pay bubble-like prices for apartment complexes. We believe the apartment investing cycle is at an all-time high and would avoid such investments. The current 1.0 million annual housing start number for residential housing may never recover to the 1.5 million level of 2006-2007.
Dr. Strangelove. The Presidential market cycle appears to be in full operation. The current decline in all world stock markets is forecasting a modest slowdown in economic activity. The jury is still out on whether it is long lasting or short-term. Recent Federal Reserve actions still points to continued monetary accommodation for the foreseeable future. Great energy has been given by Fed watchers to the timing of raising interest rates. Maybe they raise rates, maybe they do nothing!. With history as our guide, we believe the policy makers know that it is too early to tighten money supply. We agree with a few outlier economists that interest rates will remain low through 2020. Interest rates will not be set by central bankers but the free-floating yield changes for fixed income securities. More recent deflationary data made fixed income securities more attractive for investors driving yields back down. For interest rates to rise, the large institutions which include public pension funds, large insurance companies, sovereign investment funds and yes, the Federal Reserve would dump the longer duration bonds immediately if inflation became apparent. We remain more concerned about Deflation in 2015.
Airplane 1980. Kmart Shoppers, stocks have been marked down! We believe that a new economic cycle (or an extension of the one that began in 2009) is going to occur from the current market correction. Our palates have been cleansed. We believe the Dow Transport index short-term peak back in December 2014 signaled the current economic slowdown in 2015. The Transport index is down 13% since December indicating weakness in overall shipping. If the airlines stocks were removed, the rails and trucker companies have fallen even more. We believe the rails and truckers offer some attractive investment opportunity. Suffice to say, we like most industry groups at this juncture. We find the cash flow opportunities in telecommunications, chemicals, technology, and energy are most attractive at these levels.
Anchorman: The Legend of Ron Burgundy. We believe the market will withstand an interest rate increase by the Federal Reserve. Investors must come to grips with the fact that zero percent short-term interest rates implies the financial system remains dysfunctional at best. The systematic problems which caused the 2008-2009 market melt-down have not completely been fixed. The financial leverage of the large banks has been reduced but not eliminated. We believe that a more normal functionality will result from a rise in the overall interest rate structure. Just remember the holders of our debt will determine when that occurs!
Monty Python and the Holy Grail. We would outline four reasons for positive investment returns for the next five years. First, we believe interest rates remain low for the foreseeable future. Second, many of the larger U.S. corporations have taken excess cash flow and bought back their own company stock. Third, the low corporate borrowing rates have provided ample refinancing of existing corporate debt. Finally, we believe the surprise for corporate earnings is substantially higher in 2016 from flat 2015 levels.
Blazing Saddles. We remain very constructive about the prospects for investing for the foreseeable future. We look forward to continue to serve you as your investment manager.
Russell L. Robinson
Robinson Investment Group
5301 Virginia Way, Suite 150
Brentwood, Tennessee 37027
(Titles: Top Ten Comedy Movies, http://watchmojo.com/video/id/129381/)