July 2013 Market Commentary
The U.S. economy is grinding ahead. The third revision of the first quarter GDP was released and revised down to 1.8%. Initial estimates of the second quarter are around 2%. This revision came about the same time the Federal Reserve released its minutes from the June two day meeting. In the subsequent news conference, Chairman Bernanke’s opening statement threw the markets into a tantrum. I quote “If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year; and if subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce purchases in measured steps through the first half of next year, ending purchases around midyear”. The markets, both bond and equity, sold off rather broadly. Interest rates had risen about 60 basis points from May 1 to June 12. That is more than one third of the 10 year yield on May 1. They have started to recover in the last few days. Equity indexes sold off also, however not as severe. They have also started to recover some of their losses. The markets knee jerk reaction was way over done. Nothing has fundamentally changed. The increase in equity prices over the last few years is justified. Earnings per share have doubled in the S&P 500 over the last two years while prices have only increased 50%. The economy is moving ahead in fits and starts as data is released. If the economy does continue on a moderate growth path, the Fed will have to start reducing purchases in order to prevent asset bubbles. The comments of Mr. Bernanke also indicated QE slowing was dependent on the continued expansion of the economy. He also was very clear the Fed did not intend to raise the federal funds rate from its current range of 0 – 0.25% until unemployment had decreased to at leas 6.5%. The increase in equities over the last few years is justified.
The rest of the world’s economies are doing very little to help our growth. China is slowing as their government tries to reign in the explosion in bank lending and reduce the economy’s dependence on infrastructure and home building. The Chinese government is encouraging greater consumption to expand their economy. This should affect economies that are dependent on commodities such as Brazil and Australia. Europe is still mired in recession; however their industrial production rose in April for the third straight month. The U.K. jobless claims fell 8,600 leaving the unemployment rolls at a two year low of 4.5%. The United States, Europe and China are showing signs of short term disruptions in their economies that should return to more normal trends in time. As I have mentioned before, poverty in the developing world has fallen sharply over the last twenty years. Between 1990 and 2010, the number of people on earth living below the poverty line has decreased from 43% to 21%. This represents a drop of about one billion people. This is one of the reasons I believe the world economic growth will return to trend. This trend also allows economies in the developing world to continue to improve without the U.S. and Europe providing the impetus. In addition, this also portends long term growth in products and services that these new consumers will need.
The United States is well positioned to provide many of these items. The proliferation of energy production from tight shale plays is providing the opportunity for U. S. companies to benefit from a lower energy cost as well as lower raw material cost. The U.S. is now producing more oil than it imports. This dramatic increase has narrowed the gap between Brent and WTI prices to about $5.00, this is increasing the earnings of producers while still providing much lower input cost for manufacturers. Expansion of chemical plants to take advantage of lower natural gas and natural gas liquids is continuing at a rapid pace. With the market correction, we are adding to several of our positions. Yields on MLPs have increased since the market selloff, with prices down but their returns have stayed the same. For that reason, we have added to our positions in Kinder Morgan Partners (KMP) and Enterprise Products Partners (EPD). We have also added High Crush Partners (HCLP) to our mix. HCLP has a yield of over 9% and with their resent acquisition they should be able to increase their dividend. In the E&P sector, we continue to like EOG (EOG) Continental Resources (CLR) Oasis Petroleum (OAS) and Whiting Petroleum (WLL ). We have also added a pure play on the Eagle Ford shale play, Sanchez Petroleum Corp (SN). They are dramatically increasing their production. In the chemical sector, we continue to hold LyondellBasell (LYB), Huntsman Corporation (HUN) and Westlake Chemicals (WLK). Their profit margins have shown a greater increase due to cheaper natural gas prices than some of the bigger chemical companies. LyondellBasell produced very large gains in earnings in their first quarter earnings release. The low natural gas prices and very low cost of natural gas liquids are mostly responsible for this. We also feel that heavy equipment manufacturers like Caterpillar (CAT) and Deere & Company (DE) will be good investments over the next few years. Both of these companies are experiencing an earnings slow down due to a decrease of capital investing by mining companies and investment in agricultural equipment due to the slower world growth. We recognize these companies are cyclical and feel that they will have a good chance of growing share price over the next few years as world growth returns and their growth reaccelerates. They have a dominate position in the United States, which is growing, and we are seeing growth in Chinese manufacturing. Also, their PEG ratio is lower than other manufacturers in the heavy equipment sector. We are not increasing our positions in the heavy equipment manufacturers as of now. We do feel as the world economy improves, these two companies will be good investment holdings. As I have mentioned in earlier comments, home builders are showing good signs of growth. We like Toll Brothers (TOL) and DR Horton (DHI). We also hold a position in Home Depot. We still like industrial commodity companies but we are not buying currently. As the world economy begins to expand again, material producers like Cliffs Natural Resources (CLF), Freeport McMoran Copper & Gold (FCX) and the larger coal companies will once again move up in the investment placement arena. However, wait until you see copper, iron ore and coal prices increase.
Just to restate, I believe the economy is expanding in spite of the previously mentioned problems. That is why we are emphasizing investments in companies with good cash flow, good cash distributions and companies that operate in areas where they have a competitive advantage due to much lower energy costs and raw material input costs. We prefer companies that generate good after tax returns. With interest rates at historic lows, even as dividend taxes go up, the after tax returns are higher than most investment grade debt. There is a growing shift from very low yield bonds into equity. With a negative real return on Treasury bonds in the last half of 2012, we are seeing a shift to higher yielding equities. The current P/E on the S&P 500 is 15 which equates to an annual return of 6.67% while the current return of the 30 year Treasury is 3.64%. This should help increase good companies share prices as we go forward. BSG&L is a long term investor. We believe if you are patient, build cash and buy good companies on pull backs, your portfolio will have good growth over the long term.
Ben Dickey CFP/MBA/CHFC
BSG&L Financial Services LLC