But first, thanks to everyone that has downloaded our our new iPhone app! We’ve had over 200 downloads so far, and a few more trickle through every day. My programming skills are pretty mediocre, so the app is nothing fancy. But it does a clean job formatting the newsletter and makes it really easy to read while you’re on the go. Go download it if you haven’t yet.
Also, I was recently honored with the opportunity to write a guest post for Alex Lawrence’s The Entrepreneur’s Blog. Alex does a nice job over there and if you own a small business or are interested in entrepreneurship, his blog should be part of your regular reading. Alex is a Partner with Funding Universe, a hub for matching entrepreneurs with investors and banks. If you’re a startup in search of funding or if you’re an investor looking for fresh opportunity, it’s worth checking out. Their platform is really cool and they’ve facilitated a ton of deals.
Anyway, you can read my article right here.
Alex was kind enough to let me write about anything of my choosing, and so I told our own little story of entrepreneurialism, the story of how we survived the financial crisis and founded a brand new business in the process. It’s an honest look inside our company. Those of you small businesses and entrepreneurs might find it even sounds a lot like your own experiences.
This is probably one of the biggest bits of news in the last few weeks.
We talked about it a few weeks ago, right here, if you missed it. We outlined a little seasonal energy strategy, and provided some history on how March, April, and May tend to be good months for energy commodities and energy stocks. Hopefully you didn’t ignore that history. Crude oil has gone straight up since late March.
A lot of it does have to do with these natural seasonal forces. But underneath that is what could be a new round of brewing global speculation. I saw a good chart from the NYMEX earlier this week showing a new high in speculative positions in crude oil.
One of the real experts in this sector is Stephen Schork, publisher of the highly-respected and ridiculously-expensive “Schork Report”, and over the last several months I’ve been listening him detail the very bearish fundamentals for crude oil. There’s a ton of supply at present. Inventories have risen pretty much every week and there are tankers full of oil that are literally parked out on the ocean because there isn’t enough room to store it onshore. Despite all that, last week he said that we could get to $95 before we know it and that there’s “a reasonable chance of hitting $110 by the end of June.”
It seems as though Wall Street may have taken control of the crude oil market once again, with a new round of speculators driving prices higher. When interest rates are so low, investors are forced to put their money somewhere, and so pension plans and hedge funds and bank trading desks all pile into the energy markets, as sure a bet as any for long-term price appreciation. We’ve seen this movie before. But does it go back to $145/barrel? Who knows.
Schork did make another interesting point. Last year, Exxon lost a millions of dollars per day trying to refine $70 oil. They couldn’t do it. None of the big refiners could take $70 oil and turn it into a profit. Knowing that, it’s hard to see any kind future for crude below those levels. Coincidentally, the market traded down to $70 twice in the last six months and bounced sharply off of that level. $70 was also basically the midpoint of where it traded all through last summer. As we look forward, that should be a very stable floor.
So with the future fundamentals of constrained supply and growing demand, and increased speculation at present, the world seems tilted towards higher energy prices. A few weeks ago I pointed out $80-85 as a very important level in crude oil. If this thing keeps moving up, it could get ugly in a hurry. We’re already on the threshold of the point at which demand destruction could start to take place. And if that starts taking place here in the U.S., it’ll take place in Europe and China as well.
What does all this mean for you?
The obvious effect is that higher crude oil prices translate to higher energy prices throughout the entire chain. It’ll cost you more to drive your car, to fly the family to Disneyland, and cruise up the coast in your yacht.
In aggregate, this is a drag on consumption and a drag on the global economy. It won’t take much higher prices to effectively knock out all the effect of the government stimulus measures. This is another one of those secular headwinds that Mohammed El-Erian is always talking about.
Bonds: the beginning of the end…of low rates
Bond yields have jumped up in the last few weeks, finally breaking out of their 3-month range. That’s bad news for bond prices, of course. Here’s a chart of the 10-year yield.
Two weeks ago we had a shockingly bad 2yr treasury auction. That was followed up by an awful 5yr auction. And then a lousy 7yr auction. You might be wondering what kind of person watches the action in Treasury bond auctions. The answer is: really dorky people watch treasury bond auctions. That’s me, and I thought these terrible auctions qualified as “big news that nobody is talking about.” Loyal readers know that’s my favorite kind of news.
Could it be that demand for US Treasuries has finally tapped out? Now that the Fed has officially stopped injecting money into the banking system via quantitative easing and its trillion dollar Mortgage Backed Security purchase program, does the world finally have enough Treasury bonds?
You guys remember how quantitative easing works, right?
Mr. Bernanke has bought over $1 trillion of mortgage-backed debt in the last year, a lot of which undoubtedly qualifies as “stinky.” As the Fed buys this stuff from banks and big investors, they give them actual money in return. The dollars just magically show up in their bank accounts and their dodgy debt disappears. In the past year, these banks and such have had to do something with all these magic new dollars. As you guys all know, cash doesn’t yield anything right now, so this money has to go somewhere.
In the last year these banks have purchased a whole lot of Treasury bonds. It makes a lot of sense that now that the Fed has stopped exchanging real money for stinky debt, these banks aren’t in such a rush to buy new stuff. Or maybe they’re just buying crude oil instead.
A couple weeks ago Bill Gross was on CNBC and he said that bonds may have seen their best days. This is pretty remarkable. Bill Gross and “bonds” are synonymous and for him to talk against his what his firm built its reputation on is a little startling. It’s sort of like Steve Jobs telling everybody to stop buying iPods.
I know nobody listens to Alan Greenspan anymore, but in a recent interview he too expressed great concern about the United States’ fiscal situation, and said that rising treasury yields are the “canary in the coalmine.” Incidentally, he also endorsed the idea of a VAT, a federal tax on consumption, as a short-term fix for the current fiscal problems. We’ve been discussing for a while on here. It was one of our 10 Predictions for 2010 – not that we’d actually get one, but that the debate would heat up. On my Bloomberg podcasts, I’ve started to notice at least one or two of the interviewees per week talk about this as well.
Yeah, I know Bernanke and the rest of the Fed (except inflation-fighting, cult-hero Tom Hoenig!) is on record stating that rates will remain low for a long time. As long as necessary. But that’s the rate that they have control over, the Fed Funds rate. Any rates set by the market are going to have some powerful winds lifting them up, especially now that the Fed has stopped it’s purchase program, which for all of last year acted to keep those updrafts at bay.
What does this mean for you?
Obviously, it’s bad news if you already own a bunch of government bonds. Rising rates mean falling prices. So maybe now it’s time to cycle into something else. You can follow Bill Gross into countries who are in a better fiscal situation than we are, ones that aren’t so highly levered like Germany, Australia, or Canada. Or you can take a little more risk in the corporate space.
I still like TIPS for the inflation protection that they’ll give you over the next 10-20 years. Now is probably a good time to mention that the latest TIPS auction was an absolute barn-burner. 3.43 bid-to-cover! That basically means that there were over three times as many bids as there were bonds. The guy on Bloomberg said it was the best auction since 1997. Perhaps a few others out there are starting to tool up for long-term inflation protection as well.
Rising rates are also bad news if you own a house or want to buy a house. Higher rates mean higher monthly mortgage payments, which is the thing that really controls how much money buyers can spend on a house. When mortgages get more expensive, home prices tend to fall. If you have an adjustable rate mortgage or are carrying credit card balances, it means that the interest expense associated with that is about to get bigger. That’ll hurt your cash flow.
If you’re one of those responsible folks who have been listening to us over the last year, saving your money, paying down your debt, and cleaning up your household balance sheet, you are about to enter an environment where you’ll be rewarded. You will have shielded yourself from the damage of rising rates and you’ll have cash available to jump on the great deals to come in the bond space. And other spaces too.
Stocks: Overbought & Overvalued
Stocks right now are overbought and overvalued, but that condition won’t last forever. I don’t like to buy things that are expensive and if they are things that fluctuate in value (like stocks) I am happy just being patient until they get cheap again. Don’t worry, they will get cheap again. The history of the stock market is one where it moves in big cycles from “expensive” to “cheap” and back again. When stocks do get cheap I’ll go shopping. Until then, I’m avoiding the risk and saving myself the heartburn.
The trend right now in stocks has clearly been “up”, and I understand how tough it is to not chase performance. As counter-intuitive as it may seem, chasing performance is bad. I’ve got a stack of white papers in my drawer showing that it’s not a very good investment strategy. Just because something has been going up doesn’t mean it’ll keep going up.
Regular readers will remember this chart, one of my all-time favorites:
That came from this newsletter, Long Term Investors: What to Expect, which goes into detail about exactly what that chart means. Basically, it relates the present valuation of the market (whether the market expensive or cheap) to the future 10-year return. The chart should make it pretty clear that when you buy an expensive market you don’t make as much money over the long run as you do if you buy it when it’s cheap. This might even be one of the only true things one can say about the stock market.
Back in December we were at 20.4. Today we’re at 21.7. On a historical basis, that’s very expensive.
With the exception of the bubble 90’s, the stock market has never had a positive 10-year return that began from valuation levels like the present. That’s not to say that stocks will go down over the next decade. They could go up. These are crazy times! We addressed that possibility in that newsletter last December and our analysis shows that, all things considered, stocks are priced to deliver returns that should average 2-4% per year for the next 10 years or so. Not too exciting, especially considering you can get the same yield from risk free Treasuries without all the volatility
You might be wondering: when will I buy stocks again?
That’s a good question! Thank you for asking. I’ll always buy specific names here and there, even in an environment like this one. Right now I like companies with good balance sheets that pay juicy dividends. Companies like that didn’t rally the way the junky stuff did in 2009, but should the market get spooked again, solid companies do a better job hanging in there than the junky ones. I’ll get a little more aggressive and allocate a higher percentage of my total portfolio to stocks when that red line in the chart gets back in the 10-15 range.
But if that red line ever gets below 10, I am going to load the freakin’ boat with domestic equities. It will be a long-term trade, and the bad news is that it’s the kind trade that most investors get only one shot to make in their entire careers. It’s like buying stocks in 1908 or 1933 or 1947 or 1982. I wasn’t in the business in 1982, so I’m still waiting for my chance. It will come, but I can tell you right now that it won’t be an easy trade to make. The world will feel like it’s ending and people will hate stocks with a violent passion. Stocks will sell for 8 or 9 times the previous decade’s earnings and everybody in the world will think they should be selling at 4 or 5x. It’ll take serious cojones.
I know this all might sound like common sense to most of you, that investors should buy cheap markets and avoid expensive ones. But every day I listen to all sorts of smart people who believe that investors who buy an expensive stock market will be rewarded. True, many of these people manage mutual funds or professionally advise clients on which stocks to buy, so they don’t get paid if people don’t buy stock or invest in their funds.
As some of you may know, our real business is managing a family of hedge funds. We house all our proprietary trading inside our Draco Fund, and we have an interesting fee structure, one that is becoming scarce in the hedge fund sector and doesn’t even exist at all in the land of mutual funds. We only get paid if we make money for our investors. Since we’re not a big firm that can go out and raise a ton of fresh capital if our fund blows up, it also shackles the level of risk we take with the money we manage. We can’t bet the farm, Lehman-style, and are actually forced to be prudent.
So what this compensation structure means is that we have direct financial incentive to make money as often as we can and not lose it. It’s how we maximize our paychecks over the long-run, and coincidentally, this happens when we put forth the best investment product we can, one that makes good money over the long-run without too much risk.
We believe that there should be more investments out there structured in this fashion. Most funds are set up in such a way that the manager gets paid more money when the fund gets bigger. No surprise, these managers spend a lot of money on advertising and telling everybody how awesome they think their fund is, even if the fund is so crappy they won’t put their own money in it! You may have heard that almost half of all equity mutual funds report zero manager ownership. It gets even worse with international equity and bond funds. These guys should be ashamed of themselves. It’s like that commercial where the salesman from Other Insurance Company is shopping in the Progressive Insurance store. What do these mutual fund managers have against their own products?!
Anyway, you have more important things to do this week than listen to me rant about mutual fund managers. If you want to continue that discussion you can hit me up at Feedback@TheDraconian.com or learn more about how much these guys invest in their own funds from articles like this one. I’ll spoil the punch line, though: the best fund families also report the highest level of manager ownership (Oakmark, First Eagle, Dodge & Cox, T. Rowe Price, Royce) while the worst fund families report the lowest level of manager ownership (Wells Fargo Advantage, BlackRock, Schwab, Goldman Sachs, AIG).
Somebody get Ken Feinberg on the phone.