How to Invest for S&P 5559 on a Central Bank Bubble
None of the potential black swan events like the Hong Kong riots, the Brexit from the EU, the US-China trade dispute, the US impeachment inquiry, the Saudi Arabian oil refinery attack and the global industrial slowdown materialized to topple the US equity market in the notoriously scary month of October. Despite massively high debt levels, negative interest rates and high valuations, strong US consumer spending, supported by low unemployment and high consumer confidence, continues to buoy the US economy and the US stock market.
With the growing prospect of a “Phase One” US-China trade agreement, both superpowers can save face and resolve the largest immediate global economic headwind. Add in further trade agreements like the USMCA, deficit spending, a less restrictive Federal Reserve to a US Presidential election cycle, there remains the potential for global economic reacceleration which can drive equity markets higher.
The dual overvaluation of bonds and US equities remain a long-term risk worthy of thoughtful evaluation. Most investors lose money because their perspective is based on past performance chasing strategies that lack foresight. For the last 10, if not 37, years, stocks and bonds have been consistently rewarding financial asset classes. Since both stocks and bonds are near historically high valuations, we continue to allocate our portfolios towards out-of-favor value sectors and commodity assets.
Historically High Equity and Bond Valuations:
Warren Buffet’s so-called favorite indicator, shown in the chart below, is the US Total Market Capitalization “TMC” relative to the Gross Domestic Product “GDP”. It shows today’s stock market is near all-time high levels and comparable to the equity market peak in 2000.
Source: Guru Focus
Another US equity market valuation model, championed by Crestmont Research, in the chart below, shows that the S&P currently trades at levels comparable to past market peaks including 1907, 1929, 1966, 1987 and 2000.
Source: Advisor Perspectives
Nobel Laureate Robert Shiller’s CAPE or Cyclically Adjusted Price Earnings ratio–which uses the last ten years of earnings—illustrates, in the chart below, that the US stock market trades at valuations comparable to the 1929 stock market peak, but below the technology bubble of 2000.
Equity valuation analysis is not a market-timing tool. Valuation tools only reflect how much downside risk potentially exists. We also evaluate the Fed Model to gauge earning momentum and interest rates when studying the stock market. Below is the Fed Model.
The Upside Scenario:
The current Fed Model Risk Premium suggests the stock market can go higher. Its current 3.95% risk premium reflects an attractive score for equity investors because the 10-year US Treasury yield of 1.728% is far below the S&P 500 Earnings yield of 5.68%. However, because of the massive global central bank accommodation, since the 2008 Financial Crisis, we are hesitant to embrace this model due to its artificial foundation.
The Fed Model Risk Premium chart composite shows the S&P 500 over the last two decades. The current risk premium of 3.95% is attractive. The critical factor which tipped off the 50% declines in the S&P 500 in 2000 and 2007 was the steady decline in earnings which commenced in July 2000 and July 2007. (See the red line in the middle chart.) Through 2019, we have observed a flatlining of earning momentum as the tax-cut enhanced earnings gains in 2018 were anniversaried.
With the Federal Reserve now lowering interest rates, trade tensions poised to deescalate and the global markets having endured a global slowdown, a reacceleration in earnings based on a global economic recovery is poised to happen. With President Trump’s outspoken views on the stock market and Federal Reserve Policy, his powers incumbent as President and his desire for a second Presidential term, 2020 could be a strong year for the economy and the stock market.
To assess how high the market can go we looked at the Risk Premium of 1.2% at the peak in 2007 and calculated how high the S&P must rise on current trailing earnings of $163. The answer is 5559 on the S&P 500, an irrationally exuberant increase 81% over today’s prices. We also calculated how much the 10-year US Treasury yield must rise to reach the 1.2% Risk Premium of the 2007 peak. The answer is 4.47% on the 10-year Treasury. We both appreciate Chairman Powell’s desire to unwind the financial balloon of the last 11 years and President Trump’s desire not to starve the slowing economy of its financial lifeblood.
Below is a spreadsheet showing Risk Premiums, S&P 500 Prices, 10-yr Treasury Tields, Trailing and Forward Earnings Estimates and PE ratios at in 2000, 2007, yearend last year and in recent weeks.
Beyond the valuation conundrum of current historically high equity valuations, we are concerned that current 10-year US Treasuries yields of 1.73% are near their historic lows. If rates were to begin to rise, not only would it be bad for bond markets, it would hurt equity markets too.
Tops and major cycle changes can take years to occur. At Income Growth Advisors, LLC, we are taking a conservative view that equities may continue to rise with a resurgent global economy heading into the US 2020 presidential election, but believe it is important for investors to reduce their historic 60% equity and 40% bond allocations to include alternatives including commodities and precious metals: gold, silver and precious metals stocks.
The trade negotiations with China throughout 2019 show China to be a fierce global competitor not only economically but militarily. In combination with Russia and nuclear aspiring North Korea and Iran, the global economic and militaristic harmony of recent decades could become stressed and result in rising commodity prices. Strategic military planners will seek to control natural resources which could lead to higher commodity prices. This could become an offset to the massive benefit from technological efficiencies that have occurred over the last three decades through productivity gains.
If a new cold war scenario with China or other countries develop this commodity versus S&P 500 rotation cycle could kick in in earnest. The September attack on Abqaiq, the world’s biggest oil-processing facility, in Saudi Arabia, which is widely believed to have been orchestrated by Iran, may be a sign of future provocations. One cannot predict what will happen geopolitically, but black swan scenarios are precisely the unanticipated fact sets that could tip the commodity vs. S&P 500 performance cycle back to commodities.
The chart below shows the performance of the S&P 500 to the Goldman Sachs Commodity Index “GSCI”. Either a new cold war or a Middle East War could prove to be the catalyst that will promptly reward those who have added commodities or commodity-linked assets to their portfolio.
Project Harpoon and MLP Performance:
Since 2014, when oil prices peaked, the oil sector has been a laggard. This has hurt all sectors of energy.
The chart below of the VanEck Oil Services ETF (OIH) shows that the sector has been in a long-term decline since 2008 and it has declined 77% since June 2014, from 51.77 to 11.71. “Nuclear winter” might describe the energy sector today. MLPs are one of its casualties.
The five-year chart of the MLPs below suggest that the sector is near the end of a long-term decline. Psychology is morbid and fossil fuels are decidedly unpopular.
The Alerian MLP Total Return index is down 40% from 1896 to 1124 since August 2014. The reason for the performance differential compared to the OIH oil services index is the high stable distribution income that accrues to MLP unitholders.
Unfortunately, that distribution benefit was taken away from American Midstream Partners, LP (AMID) unitholders in the last year to the significant expense of our unitholders and on terms we find most infuriating, costly and unfair. ArcLight bought the units for $5.25 after AMID cut and then eliminated the distribution under conditions Craig Thomas laid plain in his public letter of January 9th, 2019 https://www.globenewswire.com/news-release/2019/01/10/1686063/0/en/Concerned-Unitholder-Encourages-AMID-s-Three-Independent-Directors-to-Reject-Publicly-Sponsor-s-Take-Private-Bid-and-Immediately-Implement-Other-Steps.html
and as chronicled in several monthly letters on our website starting in January 2019: https://www.incomegrowthadvisors.com/the-china-factor-and-activists-on-amid/
The board of directors failed to stand as the last line of protection for our clients and the many retired and older investors who trusted in the representations of CEO Lynn Bourdon III, AMID’s management and the AMID’s Independent Board of Directors:Mr. Peter A. Fassulo, Mr. Donald R. Kendall Jr. and Mr. Gerald A. Tywoniuk.
The argument that the cashflows were hurt and were a credible and fair basis for the distribution cuts was debunked by the Delta House operator, LLOG’s CEO Philip Lejuene, who stated on January 14th 2018, “at our Delta House FPS, our continued discoveries and new well productivity has exceeded our expectations, resulting in our Delta House platform currently operating at maximum capacity.”
The board did not respond to our letter nor many others. As one professional investor said, “they are bean counters and realize that even if they get sued, they will write a check and still walk away better off.” Auto companies’ bean counters are known to assess the economic damage of settling lawsuits where a defective auto leads to loss of life and choose to let people die while fully cognizant that their behavior will lead to a better financial outcome than recalling millions of cars, saving lives and correcting the problem.
For years, I have defended the capital markets believing that they are fair, and the system is not “rigged”. It is hard for me now to recommend a small cap MLP since the SEC did not react even when retired individuals suffer large losses while energy operators’ game the system.
Five poignant takeaways:
1: “In every contract, there exists an implied covenant of good faith between the parties.” Dunlap v. State Farm Fire & Cas. Co., 878 A.2d 434, 442 (Del. 2005).
I don’t see the good faith.
2: Consider the SEC’s focus on transparency and elder abuse, with the SEC’s Chairman Jay Clayton, saying on June 6, 2019 on CNBC “Let’s just be clear. When you speak to investors and you are a senior part of an organization, you have to be candid and you have to be fair.”
Some people say what they mean, but don’t mean what they say. Perhaps Mr. Clayton does mean what he says and that with $73 trillion in transactions to police with only a 4500-man operation it has a reasonable excuse. Unfortunately, we know that some of these executives already sport trophy mansions and just got richer at the expense of the little guy who trusted them and believed in the system. Or at least I did.
Mr. Peter A. Fassulo, Mr. Donald R. Kendall Jr. and Mr. Gerald A. Tywoniuk you should clearly understand that you have hurt many good people. It is unfortunate that your disgraceful conduct will probably go unpunished and few will ever know the degree to which you hurt those retired individuals and benefitted yourselves. This comment from “Phil from Oklahoma” says it all.
4: Shneur Gershuni, CFA from UBS gave a $6 price target to AMID on November 8, 2018, but former UBS MLP investment banker Bradley Olsen wrote the board of directors of AMID on October 4th 2018 “We believe AMID’s fair valuation is $15 to $20 per unit, with median valuations in the MLP market closer to the high end of that range.” Further, “the proposed offer of $6.10/unit for AMID would be the most value-destroying takeout of an MLP in years based on premium analyses.”
And that detailed analysis preceded the December 31, 2018 distribution elimination that Brad later told Bloomberg on January 4th, 2019 “‘The pattern and behavior of the second bid is obviously the same pattern and behavior of the first bid,’ Recurrent Investment Advisors co-founder Bradley Olsen said by phone Friday. ‘The initial read of the second bid is it seems to be using a set of circumstances that were created by an ArcLight board and ArcLight-appointed management team as an excuse to lower the bid.’”
5: What kind of organization would call an operation like this “Project Harpoon?”
MLPs make sense as they are cheap, but we will be challenged to enthusiastically invest in them when conflicts committees’ commitment to LP Unitholders are as bad and non-responsively as Mr. Peter A. Fassulo, Mr. Donald R. Kendall Jr. and Mr. Gerald A. Tywoniuk have treated AMID shareholders. The energy sector is one of those out of favor sectors we like and MLPs do offer a great value, but we will not be trusting in MLP managements in the future.
We welcome any and all comments.
We also wish you and your families the best during the upcoming holidays.
Tyson Halsey, CFA