Quarterly letter High Valuations and the Case for MLPs

Three market indicators suggest that the stock market is approaching peak valuation levels. The Cyclically Adjusted Price Earnings (CAPE) ratio, championed by Nobel Prize Winner, Robert Shiller, is at its third highest level ever. The CAPE was only higher in 1929 and 2000. The total market capitalization of the U.S. stock market to U.S. Gross Domestic Product also suggests we are near peak valuation levels. Lastly, the ratio of the total amount of margin debt to gross domestic product is near market peak levels of 2000 and 2007. (See charts and comment below.) We are in the process of forming a market top that could lead to a bear market. Market peaks are not caused by high valuations, but they are often one of several factors that coalesce and lead to a break in prices.

Three Market Indicatorsovervaluation 4.14.14

Three factors trouble us: the ending of the Federal Reserve’s easy money policies or “the taper”, rising geopolitical risks resulting from the Russian annexation of Crimea, and weak price action in the markets. The last five years have enjoyed unprecedented monetary stimulus; and, now, that stimulus is being slowly withdrawn. The Federal Reserve is still buying $65 billion in mortgages and Treasuries each month, but it intends to reduce these purchases to zero by year’s end; and then, slowly begin to raise short term interest rates. Since many of the world’s markets enjoyed extraordinary returns in 2013 due to the unparalleled easy money policies of central banks worldwide, the reversal of these policies should lead to market weakness.  Last year’s 31.6% S&P 500 total return was supported by a measly 6% increase in earnings. This suggests that the market is supported by ephemeral monetary stimulus. Further, the Japanese Nikkei 225 Index which rose 57%, in 2013, is retreating this year with their reduction in monetary stimulus. The Russian annexation of Crimea suggests that the world may see more land and military confrontations in the future. Broadening geopolitical crises translate into a retraction of the “peace dividend” which helped to underpin the bull market of the 1990s. With the first utterances of a “taper” last May, the Japanese market put in a top, bonds broke, and income stocks sank. The first quarter saw many growth stocks and growth sectors decline sharply, like Netflix, Tesla, biotechs, social media and Chinese internet stocks, respectively. These sharp declines eliminated many market leaders needed to drive the market higher.

One place which still offers value is Master Limited Partnerships (MLPs). MLPs offer attractive tax advantaged income and growth prospects in an environment which does not offer many attractive choices. Ironically, the Russian invasion could increase demand for natural gas.  Europe should seek to immunize itself against an unpredictable supplier of natural gas and petroleum. Russia is already raising gas prices to the Ukraine. Further, the U.S. would be wise to promote hydrocarbon development as a strategic economic weapon.

Our shale boom is creating a huge natural resource arbitrage, whereby our low natural gas prices are driving further development as well as domestic and international demand. MLPs will fund the infrastructure to transport, processing, store, and export this massive natural resource. U.S. energy infrastructure should double in the coming decade or two, and this will lead to more revenue and cash flow to distribute to MLP unit holders. We have an excellent record in this space and over thirteen years experience in this attractive market sector.

At this time, we recommend reviewing your portfolio risk and asset allocation. A more conservative tilt is appropriate after five years of a bull market. We greatly appreciate your patronage.


Tyson Halsey

Managing Member