Market & Portfolio Comments, Winter 2015

With 2014 in the bag, and January behind us, we will take a moment to review the state of things that affect our portfolios, your savings, and most of our lives.

The main stories as we finished 2014 and welcomed 2015 were the return of volatility in stock markets and the plunge in oil prices. We also saw Treasury bonds, especially the longest maturity bonds, touch historic low yields yet again.

Volatility – friend or foe?
Beginning in October, we saw a meaningful acceleration in volatility, measured by something called the “VIX” – which is just an index that measures market volatility. From September 30, 2009 to September 30, 2014, the VIX fell 36%. But from September 30, 2014 through December 31st it rose 17.8% and then another 15% in the month of January alone. This volatility means that stock prices whipped around more – this is bad if investors have forgotten that this is what risk assets – stocks, commodities, real estate – do. It is at these points that we at KilterHowling do our best work. Clients hire us to navigate a less volatile path through the markets.

In January the S&P 500 fell 3% while global stocks, which include the S&P, fell 1.5%. A composite of KH Global Growth accounts rose just a tad under 1%. That our most aggressive account rose during a time when volatility spiked and stocks fell around the world reinforces our risk management mantra.

Volatility can be our friend because it presents opportunities when other investors are driven out, to be long-term focused when others are near-term fearful. We believe that a risk managed approach, applied systematically over market cycles, will prevail in the best interests of our clients.

Oil – a slippery story.
It is not news that oil and gas prices have plummeted. From the end of June through year-end the price of both West Texas and Brent Crude oil declined about 50%. In January the prices fell another 10% and 14%, respectively. At the pump, the retail price of gasoline fell, on average, by 37% from June through year-end, and in January alone they fell another 7%. All told, the average pump price in the U.S. has fallen 43% since their peak in the middle of June.

What’s behind this? We believe that there are several items to mention:

1. Slowing demand: the Chinese economy seems to finally be slowing down, which removes substantial demand for petroleum products. Also, in the developed world, mostly the U.S. and Western Europe, consumption of petroleum products has steadily declined for the last few years – one can blame hybrid and electric cars, improved fuel economy standards and also higher taxes, as much of the West seems to be acknowledging global climate change.

2. Rising supply: On the other side, the rapid rise of North American oil production due to unconventional drilling methods – namely fracking and horizontal drilling – led to a jobs boom, but also pushed a glut of additional oil into a market that is experiencing slowing demand.

3. The Saudis:  Declining demand and excess North American supply are an unhappy situation for OPEC nations, namely Saudi Arabia. Normally, when prices fall in response to the factors above, OPEC nations move to restrict supply and support prices. However, in multiple interviews, the OPEC oil minister, Ali al-Naimi, has said that with a cost of production around $4-$5 a barrel (compared to at least $70 for North American oil and Russian production), they can afford to let prices fall. In short, the Saudis can withstand lower prices while the higher cost producers are eventually forced to cut production.  This is bad for two groups of people, primarily:

1. Anyone profiting from the North American oil boom. We are seeing layoffs weekly now from the oil companies. Rigs are being shut down and jobs lost daily. It costs around $70 to get a barrel of oil out of the ground, prices are sitting around $50 a barrel and the Saudis have indicated they will tolerate a price as low as, and possibly lower than, $20 a barrel. This will be a terrible development for anyone whose fortune and well being is tied to North American oil production.

2. The Russians. In the middle part of the last decade, Vladimir Putin went about building an oligarchy based on oil – a petro-economy, if you will. Unfortunately, this economy has a cost of production also around $70-$80 a barrel. Putin had it pretty good while prices were high – a booming economy, enough cash in the coffers to invade Crimea and support the murderous regime of Bashar-al-Assad in Syria. Some might also say support of rebels who shot down a Malaysian passenger jet over the Ukraine. Combine these three developments, and whether you are French, Italian, Saudi or Malaysian, Putin is not a popular fellow. There are serious incentives for the West, as well as the Saudis, to drive the price of oil low enough to seriously weaken Putin, his regime and the Russian economy. Already, Russian government debt has been downgraded to junk status and the ruble, Russia’s currency, has fallen against the dollar and the euro currencies.

Upside: Gas is cheap, this is good for the American economy, as we have written before. It puts, on average, about $2000 a year in the pocket of an American household. Interestingly, several items of late have noted that low gas prices carry a negative societal cost, such as: more cars on the road equals more traffic deaths. Economists refer to these as externalities. Pollution and the potential for a slower conversion to alternative fuels are also externalities that will emerge. But for now, near term, unless your job relies on the price of oil, this development has been net positive for the U.S. economy. The jury is still out on how serious a geopolitical issue it may become, but it should be interesting times nonetheless.

Those scary old bonds.
A friend recently forwarded an article from the Economist referencing negative government bond yields in many developed countries – that is, you buy a government bond and your rate of return is negative. Meaning you are paying the government to hold your money. This seems crazy on its face, but it has a fairly rational explanation.

The bonds of developed countries with stable currencies, such as Germany, Switzerland or the U.S., are considered almost completely default-proof. This means that they are considered the safest investment short of holding cash. Safer, even, than something like gold, as they generally come with a coupon payment, so you can buy a government bond and know how much you are due at maturity in addition to periodic payments along the way.

Now, because there is no risk of default built into the prices of government bonds, the only other thing that really drives the return expectation is time. All else equal, an investor would demand a higher return for an investment that takes longer to mature; this is a fairly intuitive notion. But how much? If you are 100% (or at least 99%!) certain you will get your money back, how much return do you need to invest for, say 10 years? Well, at a minimum you would like to at least keep up with inflation, right?

If so, then investors in these high quality bonds implicitly form an opinion, or forecast, of inflation based on the return (in terms of yield or interest rate) they agree to at the time of purchase. So as we see bond yields fall to very low levels, even negative levels, that implies that investors are assuming little to no inflation, perhaps even deflation. Yields on Japanese government bonds turned negative around 2001, indicating that investors were assuming deflation in the future. As Japan has experienced more than a decade of deflation and stagnant economic growth, those investors were right!

It is easy to dismiss very low or negative bond yields as “crazy” or irrational, but more often than not the bond market is an excellent barometer of investor sentiment and forecasts. We utilize government bonds in our portfolios both as a core holding for KH Capital Preservation, and also as a tactical ‘hedge’ or insurance against market volatility in both KH CP and Global Growth.

Looking Forward (is hard to do)…
We don’t spend much time looking forward trying to forecast the future, but we like to think about whether we are well positioned, understand the opinions of our managers, and also look to exploit any obvious inefficiencies in the market. We continue to believe that as the markets have more than doubled from the 2009 bottom, it seems increasingly likely that returns going forward will not be as good as returns in the recent past, but it is hard to tell. In KHGG we are well positioned to capture continued advances in stock markets while remaining prudently hedged against volatility.  In KHCP we have a similar bias – we are predominantly informed by the overall lack of volatility in bonds and their usefulness as a core holding, but also maintain prudently sized diversified positions of capital preservation and low volatility.

Economic growth continues to look good, job growth and unemployment continue to improve and the Federal Reserve has indicated that they will likely begin to ease in later 2015. The changing political regime will likely cause some short-term perturbations, but those are easy to look through and ultimately are not terribly material to investment outcomes.

We appreciate the opportunity to invest our clients’ assets alongside our own as we manage our savings and investments the way we feel is most appropriate: with a constant tension between return and risk. That is the very great balance that is KilterHowling.