As I sit down to write this letter we are only six trading days into 2015 but it already seems like nearly an eternity. The U.S. stock market experienced a unique sell off during the last two trading days of 2014 and the first four of 2015. This is usually a very strong time period for equities. Bearish prognostications for the rest of the year appeared everywhere except for the big brand name Wall Street firms.
Those firms have year-end targets for the S&P 500 that range from 2050 to 2350. The low end of that range means the market will be essentially flat for the year. The high end of the range means the market could move up about 14%.
Most of the "Off Wall Street" firms we follow are much more bearish. Some think that 2015 will usher in a new global bear market in stocks.
Both the "Wall Street" and "Off Wall Street" crowds believe that 2015 is likely to be a much more volatile year than 2014. Everyone seems to be bracing for bigger swings in price. Whether you are a bull or bear we think it is a fair assumption that volatility will increase in 2015. There are lots of reasons to worry about equity prices this year. A few of those include:
- U.S. stocks are not cheap. At current prices there is little margin for error.
- It will take us a while to understand the consequences of a 50%+ drop in oil prices.
- Europe seems to be slowing again and deflationary pressures are mounting
- Russia seems to be an economic basket case.
- China is finally decelerating.
- Yields are collapsing around the world signaling more economic slowdown.
- Commodity prices are collapsing possibly signaling weak demand.
There are also some reasons for optimism about stock prices. A few of those include:
- Historically low interest rates
- Inexpensive energy
- A U.S. manufacturing renaissance
- Technological innovation
- Decelerating U.S. deficits
- A confident consumer
- More robust demand for residential real estate
For the past two years we have been using GURUFOCUS.com as a resource for U.S. and global stock market data and information. We have found it to be a valuable resource. It is a subscription service.
"GuruFocus.com was founded in 2004 by Charlie Tian, Ph. D. on the philosophy that investors would make a lot fewer mistakes investing if they were to select stocks from the ones that have been researched by the best investors in the world.
GuruFocus tracks the stock picks and portfolio changes of the best investors in the world.
GuruFocus.com is dedicated to value investing. As employed by Warren Buffett, the greatest investor of all time, value investing is the only winning strategy for the long term. GuruFocus hosts numerous value screeners and research tools, and regularly publishes articles about value investing strategies and ideas."
...From the GuruFocus.com Home Page
The table at the left provides an overview of projected annual returns for the world's 18 largest stock markets. It is updated daily.
Note that GuruFocus.com is currently forecasting a return of only 1.4% for U.S. stocks over the next year. On the other hand they are projecting returns of 7 to 31% for a basket of countries that includes Singapore, Australia, Korea, Italy, China, Russia, India, Brazil and Indonesia
This may seem counterintuitive, particularly if you look at some of the current charts of these markets. Many look like they have already entered bear markets. China would be the exception. While the charts look bad, these markets are all selling at valuations that are much lower than the U.S. "Value investing" is based on buying things that are cheap and selling them when they are expensive.
Both our Mendocino and ORCA models are considered "tactical" as well as "strategic". We are starting 2015 with an allocation of about 50% to equities in both.
We will be building an allocation in Mendocino to many of these countries by using a basket of exchange-traded funds (ETF's) that represent their major market indexes.
Cape Lookout holds shares of three mutual funds that are diversified internationally and that hold some stocks from countries listed on the table. Those funds are Dodge & Cox International Stock Fund, Blackrock Global Allocation Fund and American New World Fund. These funds were in Cape Lookout in 2014 and tended to under perform funds holding U.S. stocks.
If GuruFocus.com turns out to be right they may outperform their U.S. counterparts in 2015.
ORCA will remain more focused on individual stock picks.
We think the very short-term trend for global equities is more likely down than up. We are not predicting any kind of disaster at the present time but lower equity prices in the short term would not surprise us.
Having said that, trying to call a top in the U.S. equity market has been a fool's game. We are not trying to call a top. We simply think conditions are right for more selling here and abroad. We will attempt to use weakness to average into lower prices should they materialize.
We will also be using any near term strength to trim positions in stocks that are higher risk positions. We will be favoring "value" in 2015.
We will also continue to favor stocks that pay solid dividends over ones that don't. If the market does move down this year, or remains flat, we will be well paid by the stocks in a model like Dividend Diamonds.
Commodity Outlook: Oil
The first commodity on everyone's mind right now is oil. West Texas Intermediate Crude (WTIC) sold for $108 per barrel in June of 2014. It closed at $48.75 yesterday. We are currently seeing price targets as low as $33. Given the pace of the collapse it could get there in days.
CNBC ran an interesting report about the collapse of oil yesterday. WTIC has dropped more than 50% five other times since 1980. It happened in 1987, 1991, 1999, 2002, and 2008.
Six months after those events, the S&P 500 was up four of the five times, with an average gain of 3.7 percent.
Perhaps more importantly, WTIC was positive six months later all five times, and was up 52 percent on average.
Bob Pisani opined, "That should give some comfort to those who have argued, as I have, that oil is more likely to be in the $50s or $60s in the second half of the year than it is to be in the $30s."
He went on to say, "None of this answers the big questions: What's causing the drop?
I mean, nothing else is down 50 percent. This seems very specifically related to oil, not so much the global economy. The conventional explanation that this is a "supply issue"-with a small part of the drop due to lower global demand from a slower China and Europe-makes some sense on the surface.
The problem is there's something that smells funny about both these explanations. Supply and demand certainly makes sense, but this fast? Oil was $100 in August. It dropped 50 percent in 5 months, because supply was suddenly stronger?
I understand all the people who feel that manipulation of the oil market by nefarious traders must be a factor in this drop. I do understand their feeling, but I don't think that's the primary factory.
I think the primary factor was a dramatic change in rhetoric from Saudi Arabia. The leadership made it clear it was not going to support the price. There is a global shift in production, and Saudi Arabia is not going to cut output. That shifted everyone's thinking.
One thing's for sure: This isn't 2008, when we saw oil go from $145 to $35, a 75-percent drop. It certainly isn't driven by a weak U.S. economy. Consumer confidence is stronger, and the job market is too."
One of the oldest and most useful adages in financial market jargon is "Don't try to catch a falling knife". That would certainly apply to oil right now, as we simply don't know where it will bottom out. We will be looking for oil stocks to bottom ahead of the price of oil. There are likely to be some real bargains.
Commodity Outlook: Gold & Silver
Gold and silver tend to move in tandem. They move up and down together.
Gold peaked in September 2011 at $1924 per ounce. It moved all the way down to $1130 and has bounced to $1211. Noted market cycle analyst Charles Nenner has recently introduced a new "buy" signal on gold.
He also has a new "buy" signal on silver. Silver peaked at $49.82 per ounce in April 2011. It dropped to $14.15 recently and has bounced to $16.53.
Both gold and silver are still on confirmed sell signals in our weekly and monthly charting regimen. But they have triggered very early buy signals on daily charts using our methodology.
We also noted this commentary from Peter Boockvar of The Lindsey Group LLC in Fairfax, VA. It was published this week. Peter is a strategist we have long admired.
"I'm of the opinion that this is the last leg of the commodity bear market that has taken the CRB index near it March 2009 lows. Gold prices will be the first to recover. The U.S. Dollar had a great 2014 but gold as stopped going down. (5T adds: The price of the U.S. Dollar and gold are often in an inverse relationship. As the dollar rises gold goes down. That relationship has recently broken.) Oil prices will be the last to recover. The entire (commodity) space has been bombed out. Focus first on precious and industrial metals and agriculture. Energy will lag for up to two years."
5T has initiated small positions in SPDR Gold Shares (GLD), Market Vectors Gold Miners (GDX) and Newmont Mining (NEM) for our tactical models ORCA and Mendocino.
We have also initiated a small position in McEwen Mining (MUX) for ORCA. This is a very small "junior mining" company and the stock should be considered very speculative and very volatile. It is not for the "faint of heart". But if gold does enter a new bull market this will be one of the biggest winners.
The gold mining stocks have virtually collapsed in the past few years. A good friend of ours recently sent us this chart along with the comment "the precious metal (PM) mining companies continue to be the most out of favor sector I have ever witnessed."
The chart is showing us that gold miners are selling at the lowest "price to book value" ratio in history. Even if you don't know exactly what that means you can intuitively understand they are cheap.
The only problem is that if gold turns around and prices start to drop again these stocks will get cheaper. Therefore we have them on a "very short leash".
We have been planning to add Toqueville Gold Fund to Cape Lookout but have not done so yet. Since it is not very liquid and can't be traded easily we have been waiting for a more solid buy signal on gold.
We also initiated a position in Freeport McMoRan (FCX) today in Mendocino and ORCA. Years ago FCX was in the metals mining and oil and gas businesses. They spun out the oil and gas business into a separate entity. In 2012, after 18 years, they announced that they were getting back into the oil and gas business through the purchase of McMoRan Exploration Co. and Plains Exploration & Production. They paid $9 billion for the combined companies. At first it looked like a brilliant move. Recently it has looked more like a boondoggle.
The stock traded for $38.66 in July 2014. Recently it visited $20.94. That is a 46% drop in price.
In December 2014 a vice president of the company made two separate purchases of the stock. He bought 50,000 shares, or about $ 1.10 million worth of stock, at $22.15 per share. He also bought 500,000 shares, or $11.80 million worth of stock, at $23.60 per share. Paying up for $12.9 million of company stock is significant.
Today we bought stock at an average price of $22.83 for ORCA and Mendocino.
Commodities in General
Commodities are cheap. The CRB Commodity Index is most widely quoted and referred to when looking at a broad spectrum of commodity prices.
It currently is made up of 19 commodities.
The 19 commodities are: Aluminum, Cocoa, Coffee, Copper, Corn, Cotton, Crude Oil, Gold, Heating Oil, Lean Hogs, Live Cattle, Natural Gas, Nickel, Orange Juice, Silver, Soybeans, Sugar, Unleaded Gas and Wheat.
Here is a chart that shows the price movement of the index for the past several years. Clearly prices imploded in 2008 and have never fully recovered. That is in sharp contrast to the prices of U.S. stocks that not only fully recovered, but broke out to new record highs.
Prices of commodities are imploding again while U.S. stock market prices remain near record highs. The divergence between the two suggests "Something is rotten in the state of Denmark". (Spoken in Hamlet, Marcellus to Horatio)
The "Off Wall Street" bears point to this chart in particular as the reason to expect U.S. equity prices to turn down. The interpretation of this chart is that it is showing a deflationary trend and indicative of a global slowdown in demand for all of these 19 commodities.
That is probably true. But we would also point out that this index is more "oversold" than any time since late 2008, in the heart of the biggest financial crisis we have experienced since the Great Depression. Our base case, at this time, is that Peter Boockvar is right. The "bear market" in these commodities should be near an end.
When this "falling knife" hits the ground we will use exchange traded funds (ETF's) related to sectors of the commodity market to buy "value" at rock bottom prices.
- U.S. stocks are overvalued by many historic standards. The most likely case is that returns will be very modest this year.
- Specific foreign equity markets may present better opportunities in 2015 and we will be diversifying Mendocino and Cape Lookout to hopefully take advantage of the opportunity.
- Commodities, across the board, are approaching 2008-2009 financial crisis pricing. This is probably an opportunity to buy an asset class that is wildly out of favor and cheap by historic standards
- Gold stocks are at historically low prices on a price to book basis, even though gold remains over $1200 per ounce. Gold stocks may represent tremendous values and are being added to Mendocino, ORCA and Cape Lookout.
- We are "on guard" and watching for a major sell off in U.S. stocks, but it is not our base case that it will happen.
- We still favor "value" stocks that pay above average dividends. Returns are enhanced year in and year out by rising dividend income in Dividend Diamonds.
Part 2 of this report will focus on real estate, currency and interest rate trends in 2015. It will be released next week.
All the best,