Identifying Short and Long Term Trends for 2008 - Part I
(December 27, 2007)
Dear Subscribers and Readers,
I hope every one of you (and your families) has had a great Christmas. The year 2007 was definitely a tough year for many market participants, but it also provided many opportunities for those who were able to take advantage of the latest housing/subprime crisis, such as the many sovereign wealth funds that invested in Citigroup, Morgan Stanley, and Merrill Lynch (although I am still not convinced that we have seen a bottom yet in these stocks), those who shorted the homebuilders and the various derivatives of low-quality mortgage securities such as many of the ABX indices, and those professional traders who were able to take advantage of the highest amount of stock market volatility we have seen in nearly five years. However, just like 2006, the year 2007 did not bring us a “capitulation low” – despite the popping of the housing bubble in many areas of the United States and the “spillover effects” of the subprime cancer into other sectors of the economy – as exemplified by rising credit spreads, higher borrowing rates, lower-than-expected consumer spending and holiday sales, higher foreclosure rates, etc. The lack of a “capitulation low” has been immensely frustrating for us and for many of our subscribers who are still in cash. I will go out on a limb here and predict that we will witness a “capitulation low” in the US, Western European, and Japanese stock markets sometime in the first half of 2008 – a low that we will enable us to buy our favorite individual stocks and companies that we could hold for the next three to five years. I would like subscribers to send in your favorite ideas, but some of the buy-and-hold names we are pondering include (in alphabetical order): Allied Irish Bank ADR (AIB), Discover Financial (DFS), eBay (EBAY), Fannie Mae (FNM), Freddie Mac (FRE), Gannett (GCI), Home Depot (HD), Nomura's Japanese Small Cap Closed-End-Fund (JOF), Legg Mason (LM), Nomura Holdings (NMR), Pfizer (PFE), Sprint (S), Starbucks (SBUX), Sears Holdings (SHLD), USG Corp (USG), Wal-Mart (WMT), SPDR Homebuilders ETF (XHB), YRC Worldwide (YRCW) (note that this list should not be construed as formal recommendations). Also, note that I have attempted to keep this list of individual stocks to companies either with a good brand name or with high quality earnings. Even though I may bet a small stake in certain “outliers” if we experience a “capitulation low,” I am not going to recommend them in any of our commentaries going forward.
I would now like to take this opportunity to thank you for all your support in 2007, as well as say “thank you” to our regular guest commentators, Mr. Bill Rempel of http://billrempel.com and Mr. Rick Konrad of Value Discipline for making so many value contributions to both our main site and in our discussion forum. Please keep these new ideas flowing in 2008, as we attempt to navigate what will probably be one of the more difficult years next year. Please continue to email me at email@example.com should you want to discuss some market issues or should you have any suggests for our website. My partner, Rex, and I looking to serving you all in 2008 and beyond!
This commentary will be the first in our two-part commentaries where we will outline our investment and economic thoughts for 2008 and beyond. For this commentary, I would like to summarize most of our thoughts over the last few months and outline what I believe would be profitable opportunities in the stock market for 2008 and possibly 2009 – but before I do that, I would like to discuss a couple of important long-term trends – those of demographics and energy supply/demand.
We first tackled these two important issues collectively in our August 29, 2004 commentary (“Economic Survival in the 21st Century”). In terms of the demographical impacts of the 21st century, we not only discussed the inevitable trend of the aging of the population in the developed world and China, but also other important societal impacts, such as globalization, or more specifically, the “global labor arbitrage.” More than three years after we started covering this issue, we continue to be believe that the demographical issue will be “front and center” in terms of societal impact going forward, along with other effects such as unfunded social security and Medicare obligations, unfunded private healthcare obligations (this author does not believe that the GM VEBA will be self-funding going forward, but this is probably the best the union can do under the current circumstances), and the widening distribution of both income and wealth – not just in general, but also across generational and racial lines as well. Over the next few years, there will be many things to watch out for – not only from an investment standpoint but also from an economic and social standpoint as well. These include:
- Over the last few decades, the US labor force has been growing at a rate higher than the general population. Beginning in 2010, this will no longer be the case, as the oldest baby boomer reach the “normal retirement age” of 65. Because of sheer necessity, many of these baby boomers will continue to work well past age 65, but will this alone be able to stem the “retirement tide?” Moreover, the baby boomers' attitude towards work have changed dramatically over the last decade – as many are now choosing to work (mostly on a consulting or part-time basis) after retirement. How will this affect US personal income and wealth levels going forward? And by extension, the US stock market and the US Dollar?
- By most estimates, the population of the “Generation Y” cohort (those born between 1976 and 2000) in the US is over 70 million strong. In general, the“Ygens” are more impatient, skeptical of authority, and more expressive than any other previous generation. They are also quicker to adapt, learn new things, and more technology-savvy. In terms of their professional lives, these all translate to a generation who feel more entitled than any previous generation – especially in terms of salary and promotion expectations, vacation time, flexible work schedules, access to technology, and ongoing education programs (source: Careerbuilder.com). Not only do most HR departments and hiring managers have difficulty in dealing with this new phenomenon, but this is also creating conflict within the workplace, especially with members of the “Generation X” cohort (those born between 1964 to 1976), and who make up less than 25 million people in the US. However, this group is not “lazy”; they are just more likely to accept President Woodrow Wilson's mantra of “self-determination.” This will result in great changes going forward – I believe these will be mostly positive, as in general, they are more likely to start their own businesses, get into an industry they love, and make every effort to get their way. Make no mistake: The “Ygens” are going to be a powerful political and economic force going forward.
- The “Generation X” cohort, on the other hand, has much less economic and political power, not only today but going forward as well. For one thing, the number of “Xgens” in the US totals less than 25 million. Secondly, many of the older Xgens are now hitting the “gray ceiling” – a term stemming from the lack of promotion opportunities resulting from the “top heavy” structure of many organizations today – given the sheer number of baby boomers (approximately 80 million) who are still in the labor force. Moreover, unlike the Ygens, the majority of the Xgens' parents do not have a substantial amount of wealth to pass down to their next of kin – substantially reducing their pursuit of more advanced studies (such as a PhD, JD, or MBA) and risk-taking entrepreneurial activities in general. In other words, the Xgens definitely got the short end of the stick, and it is not clear whether the Ygens will invite them “to play.” For those who work in the HR departments of the Fortune 1000 companies, I would love to hear what your views are on this “generational” gap between the Xgens and the Ygens today. I suspect that we will see substantial differences even with a mere 7 to 8-year age gap.
Going forward, it will be interesting to see how these demographical and social shifts will play out. For example, can we reasonably assume that Xgens will fund the retirement and health care liabilities of the baby boomer generation, despite the fact that their parents never received any substantial benefits from the government or their employers, and despite the fact that they will most likely not receive much inheritance from their “Silent Generation” and the early Baby Boomer parents? Ten years ago, this would not have been much of a social problem, but what about going forward – given the increasing amount of economic opportunities not only in Asia, but also in parts of Eastern Europe and the Middle East as well? For example, the traditional popular destinations for ex-pats – such as Hong Kong and Singapore – have substantially lower income tax rates. Hong Kong has a flat income tax rate of 15% while Singapore has a progressive tax system – where the top tax bracket (for incomes of over US$220,000) is only 20%. Moreover, while Dubai is not totally tax-free, there are many economic zones in Dubai where workers do not need to pay any taxes. Finally, the US cities that will increasingly compete for the educated and mobile pool of talent going forward are exactly those with higher taxes and other social costs (such as crumbling infrastructure, high crime rates in selected parts of the city, etc) – cities such as Los Angeles, New York City, San Francisco, and Chicago. For the less mobile, there are always other choices within the US – such as Austin, Houston, Miami, Tampa, Detroit, Pittsburg, Phoenix, Seattle, Portland, or Atlanta – places with newer infrastructure, less taxes, and in general, lower cost-of-living.
As far as energy supply/demand goes, subscribers may recall that in our August 29, 2004 commentary, when crude oil was still at $32 a barrel, we had “predicted” that crude oil prices should reach $80 to $100 a barrel within five to six years. That turned out to be an overly-conservative assumption, given that crude oil quickly hit $70 a barrel on the heels of Hurricanes Katrina and Rita during the hurricane season of 2005. While oil would ultimately correct back to $50 a barrel in January of this year, it would again rise to and surpass the $80 a mark in September of this year. Crude oil has not hit the $100 level yet, but barring a severe recession in the US or in Western Europe/Japan, I expect it to hit $100 a barrel sometime over the next few years.
There are many reasons for this, but surprisingly, I do not believe that lower discount rates in both the US and the UK are one of them:
- On the supply side, the biggest oil fields that are still producing today were discovered 40 years ago. At the peak of discoveries in the 1960s, oil reserves were increasing at 60 billion barrels a year. Despite the great improvements in discovery and drilling technologies over the last 40 years (from 2D seismic in the 1960s to 3D seismic technology in the 1990s to today's real-time visualization technologies), oil reserves are currently growing only about 10 billion barrels a year. According to the Energy Information Administration (EIA), during 2006 and 2007, world oil production has only grown by a mere 230,000 barrels a day. However, world oil production growth in 2008 is expected to hit 2.5 million barrels a day – an optimistic number no matter how one measures it.
- On the demand side, crude oil consumption is expected to rise 1.4 million barrels a day in 2008 – with the majority of the growth coming from China, non-OECD Asia, and the Middle East, according to the latest update (December 11, 2007) from the EIA. Nearly one-third of this growth is expected to emerge from China, with an expected increase of 400,000 barrels a day in 2008. Worldwide oil consumption totaled only 45 million barrels in 1970. In 2008, this is expected to rise to 87.2 million barrels a day. By 2030, world oil consumption is expected to rise to nearly 120 million barrels a day.
- Expanding on the above point, readers should keep in mind that commodities are now starting to be recognized as an “official asset class” by institutional investors (such as pension funds, foundations, and endowments) and investment consultants alike. Given this recognition, many institutional investors are only now starting to allocate more funds to commodity pools or commodity index funds for the first time – not from an absolute return standpoint but purely from a diversification standpoint. In other words, factors such as marginal cost of production and supply/demand dynamics do not matter a great deal to these investors. Considering that corporate defined benefits plans alone have $2.4 trillion in assets, this flow of institutional money to commodities (and consequently, to crude oil) should continue well into 2008 and possibly into 2009.
- From an inventory standpoint, OECD commercial oil stocks are now at the low-end of its historical five-year range, as documented by the EIA.
Like I mentioned before, barring a severe recession in the US, Western Europe, or Japan, my guess is that crude oil prices will not fall below $60 a barrel over the next few years – given the current supply/demand/inventory situation and given that the marginal cost of production (in the form of Canadian oil sands) is now most probably over $70 a barrel. On the contrary, probability now suggests that the oil price will most probably rise to over $100 a barrel and stay there for a substantial amount of time over the next few years. Note that I am not advocating the theory of “Peak Oil” here. While there is no doubt that crude oil reserves are finite, I firmly believe that we can overcome the limitations of finite crude oil reserves by either conservation or the implementation of new energy technologies, such as solar, cellulosic ethanol, nuclear, and more efficient battery/energy storage technologies. At the present time, however, I don't see any of these “alternative technologies” making a significant dent in crude oil demand over the next few years.
Ironically, I believe (as and as articulated by Jack Treynor) that lower interest rates will eventually lead to lower oil and other commodity prices – to the extent that commodity price inflation is being caused by supply constraints. Why is this the case? Consider a present value or IRR study on a new drilling and development project in the deepwater parts of the Gulf of Mexico. If the planner decides that low interest rates are here to stay, then future projections of both crude oil prices and profits do not need to be as high to make the project feasible to executive management. In such a scenario, oil companies around the world will choose to increase expenditures for exploration and drilling projects, which will in turn increase both reserves and production going forward.
Assuming such an increase in expenditures does materialize, however, it will still take at least a couple of years for results to show – either in the form of increased reserves or production. Because of that, while I believe 2008 will be a tough year for crude oil prices given the inevitable slowdown of the US economy (and potential recession), I also believe that we haven't seen the end of the bull market in crude oil just yet (as an aside, the oil analysts at American Funds – the largest and most respectable mutual fund family in the US – believes that there is a possibility that oil will hit $150 a barrel over the next few years).
As far as the stock market is concerned, we believe that main thesis for 2008 will be a change in leadership in the current bull market as the financials continue to falter. I will get to that in a minute, but as of today, I still do not believe we have seen the worst of the “credit crunch” of 2007 just yet. Many analysts and investors have severely underestimated the wide-ranging effects of the popping of the housing bubble and the ensuing “subprime cancer” – despite the fact that most if not all the lending statistics and stories have been documented since well before the peak of the bubble in 2006. The 2007 credit crisis could well be described as a “slow motion train wreck” that could have been averted for the most part – but the participants, including hedge funds, mortgage originators, regulators, and the subprime borrowers themselves – were simply enjoying the party too much to put a stop to it. Once the party stopped, no one dared to face the music – and for the most part, most are still in denial, despite the fact that we know that subprime resets will experience a major spike and peak in March 2008.
However, subscribers should remember that we not only experienced a housing and subprime bubble, but also in structured finance, junk bonds, M&As, and hedge funds as well, or in other words, a general boom/bubble in the financial industry. S&P is now projecting 2008 earnings for the financial sector to rebound to approximately the peak level in 2006. Given that the mortgage sector will probably not revert back to its “peak performance” for a long time, and given higher borrowing rates and in general, greater risk aversion, it is also doubtful that fees generated via issuing junk bonds and structured financial products, M&As, and hedge fund performance will return to their respective 2006 peaks as early as 2008. In fact, this is naïve. As a rule, it usually takes one-third to two thirds of the “boom time period” for the excesses to be squeezed out of the preceding boom. Assuming (conservatively) that the boom in financials began in March 2003 and ended in February 2007, this lasted for approximately four years. In other words, the current excesses are still being played out as we speak – and will most probably not bottom out until sometime during July 2008 to November 2009. Given the Federal Reserve's intervention via the cutting of the discount and the Fed Funds rate, and given the periodic “injections” of liquidity by the Fed, the ECB, and the Bank of England, my guess is that this will take a longer time to play out that many would think. For example, if it wasn't for the government bailout of Countrywide Financial via substantial lending from the Federal Home Loan Bank of Atlanta, there is no doubt that Countrywide Financial would have already filed for bankruptcy. The $64 billion question for Bill Miller is: Does Countrywide deserve a bailout, or has it already committed too many sins in the previous bull market – such that neither the public nor the government believes it should be bailed out?
Moreover, while stock market liquidity should at least be “neutral” for the rest of the year and going into the second week of January 2008, the market will definitely get much tougher after that, as investment bankers continue to work off their $35 billion IPO backlog and as insiders once again start selling after that. In addition, TrimTabs, which had done a very admirable job of tracking company buybacks over the last six years, is now on the record predicting that company buybacks will no longer be as robust in 2008 as they had been over the last few years, due to lower corporate cash flows and lower personal income levels. Given that a significant portion of the run-up in domestic stock prices had been dependent on LBO liquidity and company buybacks (the retail investor was nowhere to be seen, as many of them opted for international equity funds instead) over the last few years, there is a high likelihood that we will at least remain 50% short in our DJIA Timing System well into the first quarter of 2008.
As for the change in leadership, I believe this will become more obvious as the upcoming economic slowdown in the US, Western Europe, and Japan plays itself out over the next few months. For example, I do not believe the materials and energy sectors will be immune from the inevitable US slowdown – as I don't believe either China or India can completely “decouple” with the US, Western Europe, or Japan. Moreover, even should commodity and steel prices rise further over the next three to six months, we are now also witnessing significant increases in the overheads of companies in the energy and materials sectors as well – especially on the labor side. Specific sectors that I believe will outperform the general stock market include those that have underperformed over the last five years, or more specifically, the consumer staples and health care sectors. From an industry standpoint, I also believe that there will be a “tradable point” on the long side in industries such as the homebuilders, retailers, and the newspaper publishers. Within the financial sector, I believe that many regional banks who do not have any subprime exposure will do well, given the Fed's current easing campaign in the form of a lower Fed Funds rate and periodic liquidity injections. In other words, the “traditional banker” who borrowed short and lent long and who pared back risk over the last two years would do very well in 2008 – not only because of a more favorable profit margin as the yield curve normalizes, but also because it can significantly gain market share from other banks (those that have exposure to subprime securities) who will be forced to pare back their lending activities over the next several quarters.
In my next “ad hoc” commentary, I will devote some space to the foreign equity markets and to the US Dollar. Until then – may we wish you a great New Year's and a prosperous 2008!
Henry To, CFA