Introduction
I have decided to dispense with the “Quarterly” Client Update Letter and replace it with a simpler new version that I can dispatch when I see fit and not when the calendar tells me I have too. I would rather write only when I have something worth writing about or soon after very important events transpire than be forced to write only every 3 months out of obligation when I may not have anything intelligent to write. This means my Update Letters may come more or less than 4 times per year but the exact number I do not know and that is the whole point.
Repentance is Good
Unfortunately, I wrote in early October that Santa Claus was not coming to Wall Street and made the following stupid statement that I wish I could go back and erase:
“The only thing that I am firmly convinced about right now is that the stock market has put in a top that will last for awhile and the strong 2019 upward bull trend is over.”
I am not too upset about this though because at some point in November—candidly about a week later than I wish I would have—I saw his sleigh coming hard and totally reversed course in your portfolios.
Four months ago the economic fundamentals were deteriorating and the stock market was feeling and looking like it was going to breakdown into an extended bear market. Yet, it turned around and moved aggressively higher. What happened, in reverse order of importance, was that (1) U.S. - China trade deal outlook improved, (2) global economic data generally started to pick back up a bit, and (3) the U.S. Federal Reserve began expanding liquidity into the financial system. To put it in the simplest terms that I can, overnight lending rates soared for a couple of days in September (in the news as the “Repo Crisis”) and the Fed stepped in to make sure the system was running smoothly and that short-term interest rates remained within their targeted area. What started with the Fed providing some support to the overnight lending market has now become quite significant with the Fed having added over $300 billion of reserves to the financial system so far.
There has been much discussion among investors as to what is really going on here. One issue is the huge U.S. Federal deficit which is currently $1 trillion and expected to average $1.2 annually over the next decade. The U.S. Treasury has been selling increasing amounts of short-term debt to fund the Federal budget. (We are now 10 years into an economic expansion and instead of improving the deficit continues to careen out of control.) The financial system is complex and I don’t have this all figured out—it’s not my daily focus—but when I ponder these forces I see that perhaps rising deficits are starting to pressure interest rates higher and the Fed is being forced to expand its balance sheet to keep things running smoothly. In other words, perhaps the lack of cash in the money market is due to the lack of a commensurate increase in investment demand for an abundance of short-term securities the U.S. Treasury keeps issuing to fund the deficit. This is something that bears watching closely. If this gets out of hand, then we will have a recipe for higher inflation and interest rates. For now, the stock market is interpreting this intervention by the Fed as a positive which has helped reinvigorate the bull.
In the following 2 charts I bring us up-to-date on what the stock market looks like now pictorially. First, we take a longer-term, historical view and then we zoom in on the last 2 years. These are both weekly, logarithmic charts (log charts use percentage of change) designed to better represent the longer-term trends.
S&P 500
since the beginning of the bull market
S&P 500
Over about the last 2 years
charts courtesy of barchart.com
I manually draw line channels on charts like these to help me identify where the momentum is taking a stock or a market and how to position within it. It is always good to be buying near the bottom of the channel and selling near the top. Right now we are at a level where it is not a good time to be buying. I do not make this statement in isolation. I also look at the valuation metrics for a bunch of stocks across industries. The vast majority of these are at least fairly valued and many are overvalued.
The stock market has now priced in loose Fed monetary policy and a global economic rebound. The following graphic from late 2019 shows that 68% of the stock market’s rise since March 2009 is attributable to company earnings growth and 32% is attributable to investors paying a higher price for stocks (P/E expansion). However, almost all of the rise in the U.S. stock market in 2019 (92% of it) is simply attributable to investors becoming more confident and paying more for stocks (or, put differently, paying more for the same amount of earnings).
Source: Bell Potter
This means there are a lot of expectations built into stock market valuations. A measure of disappointment on the monetary policy and/or economic fronts could be enough to take us down to the 3,000 to 3,100 level over the next few months which would imply a 5% to 10% decline. I think some measure of disappointment is likely in the near term and I have some spending money socked away in portfolios for such an event. There are some stocks I would like to buy, or buy more of, for you but not at the current price.
Okay, Let’s Talk Stocks
Honestly, I do not really care much if the stock market goes nowhere this year as I invest the stock allocation in your portfolios exclusively in only 15 stocks or what I like to call “The 15”. Several of The 15 went nowhere last year and I see them shaping up for potentially big years in 2020, regardless of what the broader market does (outside of some sort of major disruption).
One of these is Dropbox from which I am presently typing this letter (in Dropbox Paper). The message that has stood out to me recently concerning Dropbox is the impatience of investors. This company went public less than 2 years ago and disillusioned a bunch of investors who paid too much for it when it did. Ever since, the company has continued to grow users, average revenue per user, and build out and enhance their collaboration platform. There really has not been any setbacks in their growth or strategy. If anything, they have probably done better than many analysts expected. This is a classic case of investor impatience. It is just amazing to me how few investors can stop to consider the amount of time it actually takes to execute a serious long-term corporate strategy. One year is nothing. Anyway, I like the motto of the company to make work better and I think there is ample room for this. Are we really going to spend the next 2 decades with corporate communication revolving around Microsoft Outlook? I hope not.
Dropbox does consumer research and after recently receiving an invitation to do an in-depth video interview I jumped on the opportunity. I have several ideas of what the company can do to improve what they are doing and I talked the poor girl’s ear off for a half hour or so. One of these is to buy a company or, preferably, build in house the ability to save online articles into Dropbox for reading and listening too. Current examples of this are Instapaper and Mozilla’s Pocket that works with the Firefox browser. I capture articles with Pocket and Daniel reads them to me when I am on the go (Daniel is one of the robot voices). Anyone doing an extensive amount of internet research for their job knows how important it is to be able to save content for future reference. The problem now is that this content is separate from our files and separate from any collaborative platform we are using. I see an opportunity here for Dropbox to bridge the gap.
No one cares about Dropbox’s stock right now and that is exactly when you want to be owning it given that the company continues to execute well.
I recently initiated a big position in portfolios in Exxon Mobil. In the past I have done research on the oil & gas reserves of the oil Majors that are not state-owned and I know that Exxon and LUKOIL have the largest amount of proven and probable reserves. The following table provides the breakdown:
Exxon has roughly 17.4 years of proven reserves and LUKOIL has roughly 18.6 years worth. Having more reserves underground is obviously valuable but even more so in the current energy era when investors are starting to question the potential impacts of electrified transportation.
LUKOIL has generally been a long-term holding in portfolios. The share price has been in a strong bullish trend for years, all while paying a dividend yield in the 5% to 10% range, and has accelerated even higher in recent weeks, as shown here:
weekly, logarithmic chart courtesy of barchart.com
Because LUKOIL has an extensive amount of reserves the company has been able to be more selective when deploying capital for new projects. LUKOIL’s management has a minimum return on investment threshold of 15% for new projects assuming oil is at $50 per barrel. LUKOIL is generating strong free cash flow which is now going to share repurchases (a reduction in shares outstanding increases earnings per share for remaining shareholders) and underpinning its high dividend yield (e.g., 5% to 10%).
LUKOIL provides a model for what I see coming at Exxon. Shares of Exxon are hated right now which is a good thing because we want a lot of potential buyers ahead of us and not behind us. Shares of Exxon are now at a decade low.
weekly, logarithmic chart courtesy of barchart.com
Exxon’s extensive reserves, boosted even more in recent years by major discoveries offshore Cyprus and Guyana, will allow it to reduce future capital expenditures as less capital will be needed to maintain production levels. At the same time, the company is selling off some of its less attractive (economically speaking) assets which will provide even more cash. Management has explained that they are “high-grading” their portfolio. Having the ample reserve cushion will give Exxon the flexibility to adapt to a changing energy outlook. If electric transportation adoption accelerates they could even invest in things like lithium which would also seem to be a natural fit given the company’s extensive chemical businesses. Exxon is well positioned for the future and the time is now right. Exxon is my #1 pick for 2020. It is also paying a 5%+ dividend yield.
One more stock to talk about …
A couple of months ago I went shopping for another financial stock and hooked a fish in your portfolios with American Express (AMEX). By “hooked a fish” I mean I seemed to have bought it at just the right time and now the stock is running higher.
weekly, logarithmic chart courtesy of barchart.com
Part one of the recently signed phase one trade deal between the U.S. and China includes a provision that requires China to act quickly to open up its domestic market to U.S. bank cards and payment systems. The Wall Street Journal highlighted the Financial Services aspects of the deal as follows:
Financial Services: The deal removes barriers to help U.S. banking institutions, insurers and other financial-services companies expand in the Chinese market. That includes quickly reviewing license applications from credit-card companies and U.S.-owned credit-rating services. The deal sets a five-month deadline for China to allow branches of U.S. financial institutions to provide securities investment-fund custody services.
Perhaps as a signal of its willingness to uphold its end of the deal, China’s central bank quickly announced its acceptance of American Express’ application to operate a payments network in China. Mastercard and Visa are the global leaders in payment networks but they are not in China. This is big business with very high profit margins.
According to Reuters, China will soon be the largest card market in the world. AMEX is ahead of Mastercard and Visa when it comes to getting into China. AMEX’s management intends on going into China as a full payments network. There is a possibility here that AMEX will get up in running in China (with its joint venture partner LianLian Group) soon which could give it the opportunity to beat out Mastercard and Visa in the world’s largest market.
A few weeks ago I was listening to an interview with Warren Buffett and his sidekick Charlie Munger where they were talking about American Express (Buffett’s Berkshire Hathaway is a major shareholder). Munger mentioned the competitive threat of China’s WeChat in the payments market. At the time I didn’t realize the significance of his comment or why he even mentioned WeChat. Now I see AMEX’s strategy more clearly in that they are angling for the Chinese market where WeChat Pay is a leader in payments and probably have discussed this with Buffett and Munger.
I am not baking a sudden takeoff in China into my expectations for AMEX but it definitely bears watching because shares of Mastercard and Visa trade for more than twice the valuation of AMEX. To the extent that AMEX can take global market share over time in payments networks this could present a significant growth opportunity for the company.
The global payments market intrigues me and I plan on continuing to research and analyze the industry in the coming months.
A New Decade Dawns
I want to take some time to share my thoughts on the coming decade. I remember giving investment presentations in early 2011 and 2012 where I talked about what the U.S. deficit would look like in 2020 given the current trends at the time. Well, here we are and the deficit is probably even worse than what was anticipated a decade ago. The following chart shows how U.S. debt has risen by about 250% since 2010:
Source: Federal Reserve
If this was a stock chart, analysts would be screaming: “This stock is going higher!” The massive rise of government debt, not only in the U.S. but globally, has likely laid the foundation for a wild ride in the coming decade.
Excluding outright defaults, there is only one way for the U.S. and other highly-indebted developed economies to get out of this mess. Central banks will need to suppress interest rates and let inflation run hot. Over time, this allows income to grow faster than interest costs which reduces the size of the debt relative to the economy. The problem with this though is that things can spiral out of control. If bond investors wake up and realize that they are being fleeced they can rebel and demand higher interest rates.
I expect the Millennial generation will help provide the inflation this decade as they increasingly establish families, buy homes, etc. while the Baby Boomer generation will provide the bond investors willing to be fleeced for “safer” investments. A core doctrine of the financial advisory community requires that the older you get the more of your money gets put into bonds. Some investment services will happily automate this wealth destruction for you at a lower fee than what one would pay a human being to actually manage it.
The Rise of Baal
I remember as a young Christian reading the Old Testament and thinking how far off the idol worship of the ancient cultures seemed. “How ridiculous …” was the type of thought that ran through my mind and no doubt has run through the minds of many individuals reading this. It seemed so far fetched. Flash forward 20 years and now, as a seasoned disciple of Jesus Christ, what was ridiculous for ancient man is so blatantly obvious to me in our present world. Man has not changed one bit.
Today’s global warming / climate change movement is the modern-day worship of Baal, the ancient deity believed to control the weather, which was critical for the economic prospects of ancient agrarian-based economies. God used Elijah to demonstrate that He controls the weather. In many respects, the West has replaced the worship of God with the worship of Baal. Today’s Baal has its false prophets like Al Gore and many others. Nowadays, every time there is a hurricane or wildfire the problem is “climate change” and the solution is always de-industrialization and more taxes which are really just an oppressive judgement for worshiping other gods.
I am not saying that climates do not change. They do and historical analysis shows that these things move in cycles that are far beyond the control of man. Us Pennsylvanians know that it would not be that difficult for George Washington’s army to endure a Valley Forge winter nowadays. I am against the sensational abuse of weather to manipulate people for socialist agendas. I am not against electric transportation either—I drive a hybrid car—and I have made investments that will benefit from electric vehicle adoption because electric transportation is despearately needed in many cities, especially in Asia. Green theology only adds fuel to the fire of the investment case.
In the coming decade we could see the Greens become more militant or outright violent, at least maybe in Europe, but at the same time there we be a counter reaction from the crowd that sees through the nonsense. (It is interesting to note that earth worship was an aspect of the early Nazi movement in 1930’s Germany. I have an obscure book on the topic that I have only partially read that I intend to dust off and read completely this year.) The fact that climate change has become a religion that is constantly pushed on the population has become obvious to all people seeking the truth.
Believe it or not, I am not really off topic here because this climate theology could lead to enough persecution of the energy industry that translates into higher energy costs and thus higher inflation. Now we have Blackrock, one of the largest investment fund managers in the U.S., talking about eliminating coal producers from their holdings. Commentators on Bloomberg are now discussing how central banks and climate change would be a focus of Davos this year. If you are the European Central Bank and you need to create inflation why not get out your climate bible to justify printing money for green projects?
The volume of climate change discourse in the financial world is increasing with an intensity that is becoming inoculating. This is an important trend that I expect will have great relevance in this new decade. Its tentacles may ultimately have greater significance for the investment landscape.
Prepared For The Decade Ahead
In summary, the main driving forces I see in the decade ahead are higher interest rates, inflation, and a commodity boom, although it may be a few more years until the party really gets started. These trends are some of the reasons why I invested almost 2 years researching and analyzing the industrial & technology metals and mining industry and writing a dedicated newsletter on it. I wanted to have a deep expertise on it for what I see coming.
I am happy to have begun this decade with a lower fee structure for your portfolios. I got to where I wanted to be here and achieved the right balance to properly run this business while delivering more returns to my valued clients.
Thank you so much for your business.
Sincerely,
Joshua S. Hall, ChFC
Disclosure
The True Vine Letter is a publication of True Vine Investments, the investment advisory business of Joshua S. Hall, ChFC, and a Registered Investment Advisor in the U.S.A. The information presented is for educational purposes only and should not be regarded as specific financial or investment advice nor a recommendation to buy or sell securities or other investments. It does not have regard to the investment objectives, financial situation, and the particular needs of any person who may read this Letter. In no way should it be construed as personalized investment advice. True Vine Investments will not be held responsible for the independent financial or investment actions taken by readers. All data presented by the author is regarded as factual, however, its accuracy is not guaranteed. Investors are encouraged to conduct their own comprehensive evaluation of financial strategies or specific investments and consult a professional before making any decisions. Positive comments made regarding this Letter should not be construed by readers to be an endorsement of Joshua Hall’s abilities to act as an investment advisor.