Mid-Earnings Season Gut-check/ Black Gold About to Shine? / King Dollar No More?

Kaoboy Musings 10 – 10/29/2019

Mid-Earnings Season Gut-check

As of 10/29/19, a little over half of the S&P 500 have reported Q3 results.  I found it interesting that out of 10 major industry sectors represented, all 10 sectors had positive earnings surprises, 6 had positive sales surprises, and of the 4 that had sales disappointments, only 1 group (Utilities) had a negative surprise that exceeded 1%!  The second worst sales disappointment came from the Materials sector with a -0.90% sales surprise, but the earnings beat was a whopping 7.8%.  This seems to corroborate my thesis that the economy has strong bones despite the constant “wall of worry” that this economic expansion is “long in the tooth.”

In fact, the “wall of worry” is more than just nervous rhetoric; as I mentioned in some past Musings, this economy has seen a number of bursting mini-bubbles that, in my opinion, keep the overall market in check. 

Here are a couple of recent examples of carnage on my own “Bubblicious Watchlist”:

• WeWork, one of the private equity “unicorns,” appears to be really just a donkey – spectacularly crashing from a peak valuation of $47 bn to a “rescue” valuation of ~$7 bn.

• Beyond Meat (BYND), having hit a mid-year peak of ~$240/sh, lost 22% in one day to end at $81.99 on 10/29/19 as its lockup expired, proving that its valuation was “Beyond Believable.”

• GrubHub (GRUB) caused some hubbub also on 10/29/19 as it plunged 43% in one day to $33 – a far cry from the $149 peak reached a little over a year ago. 

In my view, despite the pain this has caused a relatively narrow slice of market participants (like Softbank), these bursting “bubblets” remove a lot of speculative froth in the market and greatly reduce the chances of a market-wide rout a la 1999-2000.  As a “value” guy, I am optimistic that this may herald a shift out of the high-multiple/high-growth “go-go” names and into the low-multiple, “boring” names that have been left by the wayside. 

Black Gold About to Shine?

Speaking of sectors left by the wayside, there is no bigger dog than the Oil & Gas sector (represented by the XOP in red), as evidenced by the chart below, which shows 11 different sector-specific ETFs alongside the SPY (S&P 500) in white, all normalized to a starting value of 100 at the beginning of 2019. 

Truth be told,  this underperformance has held true over the last 5 years ever since crude oil collapsed from ~$115/bbl at the end of 2014.  In short, a combination of cheap money plus a huge wave of technological innovation in hydraulic fracturing has created a surfeit of cheap oil, which has allowed the U.S. to surpass Saudi Arabia in oil production for the first time in decades. 

I feel like a broken clock when I say this, but I believe the U.S. “shale miracle” will not last forever and that we will see a return to significantly higher oil prices in the not-so-distant future – even without Elizabeth Warren’s frac-ban coming to fruition. 

My thesis goes something like this:

Capital discipline, which was lacking, has returned to the U.S. shale space.  From 2015 to now, the U.S. shale space has seen dozens of bankruptcies and consolidations.  Given the abysmal performance of this sector, the capital markets have all been shut except to the lowest-cost operators in this space.  Even the lowest-cost operators have “found religion” and become rational players in terms of focusing on living within free cash flow – this is a huge departure from the “outspend at any cost” attitude that pervaded the industry just 3-5 years ago.  As a result of this newfound capital discipline, rig counts are at multi-year lows (see below), where the blue line denotes 2019. 

Meanwhile, Saudi Arabia desperately needs to get oil prices higher.  Despite the oil bromance between Saudi Arabia and Russia, OPEC+ has been unable to lift oil prices out of the doldrums due to the confluence of U.S. overproduction over the last several years along with global growth concerns due to the trade war. 

In 2018, oil creeped back into the mid-$70’s as the production cuts seemed to be working at the same time Trump’s sanctions hit Iranian production.  That all changed when Saudi Crown Prince bin Salman was implicated in the murder of the journalist Khashoggi, and Trump leveraged this against Saudi by insisting that they open the floodgates to make up for the lost Iranian production.  Then, just as these Saudi barrels were en route, Trump gave waivers to several countries (after he had threatened no waivers) – this is what caused the December of 2018 rout in crude oil from $75 to $45. 

Since then, crude oil has rebounded to the mid-$50’s.  Why is this a problem for Saudi Arabia?  Aren’t they the lowest cost producer in the world?  Yes, but the issue is that the social programs the Saudi government put in place since the Arab Spring require $85-$90 oil for fiscal breakeven, and they have been hemorrhaging for years.  Little wonder that the much-anticipated Saudi Aramco IPO has been postponed multiple times already.  Perhaps the third time is the charm, and this time they will really go public this year.  But then that begs the question: why would Saudi want to sell even part of their crown jewel, unless 1) they really need the money, or 2) maybe they know something we don’t about the longevity of their oil fields? Incidentally, their primary Ghawar field has been producing since 1951.

Finally, I should mention that crude oil has historically exhibited an inverse correlation with the USD, because it is the most important, USD-denominated commodity in the world.  See below (white is a USD index called the DXY, and orange is crude oil):

In addition to all the aforementioned fundamental reasons why I think oil is about to move higher, this relationship adds another technical reason – I believe that the USD is about to weaken, and that weakening will add more fuel to a potential oil rally (pun intended).

The chart below shows what happened to our yield curve once our Fed Chair turned dovish.  What a difference a month (and a couple “Non-QE” QE Fed moves) makes.  This chart shows the yield curve on 10/29/19 (green) and 9/27/19 (yellow) – the recession indicator (inverted yield curve) that has successfully forecast 10 out of the last 3 recessions seems to have sputtered away. 

King Dollar No More?

While a slightly lower Fed Funds rate by itself won’t do a whole lot to stimulate the economy, what I think is far more significant is that it prevents the USD from becoming too strong and importing economic weakness from abroad.  Remember that ~20 central banks around the world are easing despite the world being awash in $17 trillion of negative-yielding sovereign debt.  Referencing  Kaoboy Musings 7, I believe this has more to do with long-term, structural/demographic headwinds that afflict other countries much more so than the U.S.  Yet in a globally interconnected economy, the lodestone of super-low interest rates around the world will manifest in an inexorably strengthening USD, which would make our exports relatively less attractive and thus “import” economic weakness from abroad – unless we too join in the easing cycle, at least enough to arrest this spiral. 

My last chart below zooms in on the DXY (previously shown to be inversely correlated with oil), which is basically an index of the USD against a basket of major world currencies;  note that the recent swoon coincides almost exactly with Jerome Powell’s metamorphosis from “hawk” to “dove.”

Here’s the bottom-line of all this:

1. I think the market may be shifting out of “bubblicious” names and into “value.”

2. There is no “value” sector that’s as beaten up as the oil and gas space.

3. There are several fundamental reasons why oil (and oil stocks) may be poised to move higher.

That, coupled with the Fed’s dovish stance, may add USD weakness as further fuel for an oil rally.

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About

Kaoboy Musings is a private distribution list/blog that I created to encourage dialogue regarding the economy & markets, geopolitics, investment ideas, and life in general. I have a passion for the markets and investing, and even though I no longer accept investor capital, I try to keep current on global events and opportunities and remain active in the markets.  I’ve always found that writing my ideas down, sharing them with smart people, and encouraging two-way discourse and devil’s advocacy is often the best way to validate or invalidate a thesis and stay mentally flexible.

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