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OPEC Deals Out Deflation

Monday, 27 April 2020 | 15:00

The market isn’t Matisse’s “The Goldfish Bowl,” a canvas of tranquil beauty. Rather, a bunch of geopolitically obtuse OPEC functionaries turned their backs on reality and created a setting of roiling deflation that could last a year or longer. The oil market cried out for a 20 million barrels a day reduction. Ten million barrels is a spit in the ocean.

Who thought we’d see oil quotes in the teens? Shabby blue chips like Schlumberger SLB finally cut its quarterly dividend to 12 1/2 cents. Reality has set in along with sharp cuts in capital spending.

For most of my years as a player, I contended with galloping inflation, high-interest rates and a Federal Reserve Board itching to take away the punch bowl. Paul Volcker pushed interest rates up to 15% and destroyed the market in 1982. Stocks sold at book value, yielding 5%.

OPEC has rung the bell on deflation. Coronavirus stats spell out slow recovery. For me, the leading indicator here is not the daily death toll, but the number of new hospitalizations. Until New York gets this number into low hundreds from present 2,000 daily admissions, it’s hard to project an early return to normalcy in the Northeast.

Andrew Cuomo should deal specifically with this leading indicator. As a money manager, I’m continually searching for potent leading indicators in the economy and financial markets. Dating back to the late fifties, the U.S. was practically a pure industrial economy. U.S. Steel, General Motors GM, Alcoa AA and DuPont comprised the starched-white shirted establishment. Tom Watson at IBM IBM decreed that all male employees don white shirts. Throw in Metropolitan Life Insurance, General Electric GE and Merrill Lynch, Pierce, Fenner & Smith.

My secret indicator then was the level of shellac consumption because shellac was poured over hot-grinding wheels, employed to shape metal. This tied it into industrial production rates of change. No technology sector then of much size. IBM basically was an electric typewriter leader. It took the discovery of the transistor by Bell Laboratories to launch tech, early sixties, as a contender for serious market size.

Currently, tech puts away all other market sectors. The trillion-dollar market caps are Apple AAPL, Amazon AMZN and Microsoft MSFT, not General Electric, Avon Products AVP and Eastman Kodak KODK, old leaders. Meanwhile, industrials, energy and materials are also-rans, dwindling to minimal single digit weightings.

Schlumberger, General Motors and Exxon Mobil XOM are suspects, even AT&T T. Their fundamentals are shaky. Consider prime bank stocks like JPMorgan Chase JPM and Bank of America BAC under a year ago buzzed like high flyers. Rising net interest margins and share buybacks would lead to mid-teens growth rates and rising price-earnings ratios. Today, such concepts are pie-in-the-sky. Bank stocks can rally, but they’re 40% below 12-month highs.

I love come-from-behind horses like Seabiscuit so I’ve probed Halliburton HAL, Freeport-McMoRan FCX, Teva Pharmaceutical and Enterprise Products Partners. Day-by-day they trade contrapuntally to the Amazon, Netflix NFLX and Apple universe. I don’t have courage for hardships like Ford Motor F, U.S. Steel and Alcoa.

I just probed Walt Disney DIS, but the market says I’m still too early. I like best-in-class operators, particularly after they’ve declined 40% from their highs. Too early for bank stock participation. After reading the March quarterlies of JPMorgan Chase, Citigroup C and Wells Fargo WFC the pattern of huge charge-offs on investments and loans is universal. Net interest margins have flattened, on their way lower.

The 52-week high on 10-year Treasuries was 2.6%, now 0.62%. Energy futures peaked at $64, ticking now barely over $20. If you believe as I do that deflation sticks around for a year or more, BB debentures yielding 5% are buys. Many high-dividend paying stocks should be avoided because of deteriorating fundamentals and yields barely covered by cash flow.

No Schlumberger, General Motors or Exxon Mobil. I’m not ready for the great franchise enterprises like American Express AXP and JPMorgan Chase. In a weak economy industrials remain suspect.

U.S. Steel may disappear while the sun is setting for Alcoa. It’s too early for Dow, Caterpillar CAT, Deere and DuPont de Nemours. Banks aren’t investable. The level of loan losses could run as a year-long event. Citigroup, JPMorgan Chase and Bank of America may decide they need equity infusions of $10 billion, each. Share buybacks and dividend hikes are history. Share dilution of 10% is possible in banks presently selling near tangible book value, at 10 times earnings.

Citigroup is the exception with tangible book value over $71 a share on a market price of $42, a 40% discount hard to rationalize as yet. But, I noted loan reserves at 2.9%, not exactly a reassuring ratio in these hard times on a loan base of $721 billion.

Pre-Black Monday the market capped its bull run selling near 20 times earnings, yielding 2.7% with interest rates for corporations ranging above 7%. Believe me, I felt it borrowing deal money at 7.5% with a 1% standby fee.

When speculation is in the air, the cost-of-carry for an asset determines its valuation. Higher the capital cost, the lower the price-earnings ratio valuation. But, this no longer holds in the deflationary setting today. Even BB bonds don’t yield more than 5%, while Treasury paper creeps closer ‘n’ closer to a zero rate of interest. In a deep-deflationary environment it’s impossible to model earnings power. Revenues decline, tenants withhold rent checks and individuals try to live off credit card maximums, then default on their seven-year car loans.

While the stock market can prolong years of stupidity, in terms of maintaining high price-earnings ratios the bond market acts wiser. For example, when long-term Treasury yields range between zero and 2%, the market can wind down to 11 to 14 times earnings, fearing deflation. We’re presently near zero on two-year Treasuries but the market wants to believe normalized earnings rest around the corner, certainly coming by yearend. So the S&P 500 Index, over 2,700, sells at 17 times perceived normalized earnings, around the corner.

Over 50 years as a player in junk, I’ve found the yield disparity metric useless as an economic indicator. When fear is in the air, I’m a buyer, assuming everything I collect is a hold to maturity because liquidity is a sometime thing and nobody is as dumb as me to hold such paper. There ain’t no dealer bids in size.

You can’t buy polite pieces of paper and file them away for a decade or longer. I feel like a lion tamer, my long whip cracking at the big cats’ heads who’d like to devour me.
Source: Forbes

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