“Always look for forced urgent selling.”
– Seth Klarman, Superstar Money Manager
– As our investment team at Evergreen GaveKal has been warning for the past couple of years, the US equity market is now in the throes of a well-overdue correction—if not in the early stages of a bear market. Fortunately, we are underweight this richly-valued asset class with a large allocation to US Treasuries, high-quality corporate bonds, and cash.
– On the less fortunate side, at least short-term, we have been selectively dollar-cost-averaging in to crashing midstream Master Limited Partnerships (MLPs) for several quarters. While most of Evergreen’s high-conviction energy infrastructure businesses continue to generate steady revenue growth and meet their distributions, despite a hostile environment, even the highest quality securities have been falling almost in lock-step with oil prices. As we last saw in the fall of 2008, we believe such indiscriminate selling is clearly due to forced liquidation, such as closed-end MLP funds receiving margin calls. Even though this experience has been painful, we believe it presents a tremendous opportunity for investors who are getting paid to wait patiently for a recovery.
– Looking at the broader US economy, it appears we are now on the edge of yet another deflationary bust where debt levels can no longer be sustained as a result of falling asset prices and declining cash flows. In 2007 and 2008, the deflationary bust came from the US housing market. Today, it appears to be coming from energy and other commodity markets, and what is happening in energy is not staying in energy. In the event that equities weaken further and corporate bond spreads* continue to blow out, we believe the coming quarters could give us just the opportunity we’ve been waiting for to put our cash reserves to work.
*Credit spreads represent the difference between yields on corporate and US government bonds.
The following commentary is from the Evergreen Investment Team:
No time for gloating. One of our investment committee members was recently approached by an EVA reader who asked, “Why aren’t you looking more excited?” When the reader received a confused look in return, he went onto to explain that because Evergreen has so often expressed its concerns about an unhappy ending to years and years of central bank incontinence, we should be feeling vindicated.
Certainly, we don’t feel as silly as we did a couple of years ago in warning that stocks were way over-priced and due for a sharp correction, if not an actual bear market. And, even though we were early, the reality is that the NYSE Composite, which includes 2000 issues, essentially topped out in the summer of 2014 (as did so many parts of the investment world). It is now down 11% from that time.
We also feel like we’ve given plenty of cautionary comments about the potential for a “deflationary bust”. For those who don’t fully grasp that concept, it can be summed up as a time when a wide range of asset prices begin falling, causing investors to panic and consumers to freeze up. The trigger for this nasty turn of events is often related to debt levels that can no longer be supported by the cash flow produced by the assets in question. The housing bust of eight years ago was a classic example of a deflationary bust. Reduced consumer spending due to plunging net worth (the negative wealth effect) causes profits to slide, making corporate debts harder to service. Layoffs soon follow, pressuring household debt servicing abilities. Thus, these forces feed on each other, often producing an even deeper dive in asset prices including, of course, the stock market.
This time around, it appears that ground zero for the deflationary bust is anything related to commodities, especially energy. There is little doubt the Federal Reserve’s zero-interest rate and QE policies fed (pun intended) the US oil and gas boom. Energy companies were able to access cheap equity and debt financing, due to rising stock prices and falling interest rates.
Fears of high inflation, when money printing went viral several years ago, initially drove up commodity prices, including oil. Consequently, the US energy industry ramped up its drilling and exploration activities. Historically high prices created frenetic investment as companies attempted to pump as much as they could as fast as they could. Aided by technology breakthrough such as hydraulic fracturing of rock formations, horizontal drilling, and 4-D imaging of subterranean oil deposits, American energy firms were able to double US crude output this decade.
Unfortunately for the US oil and gas industry, Saudi Arabia was not thrilled to see America quickly becoming less and less dependent on Middle East oil. To protect their market share, the Saudis began flooding the market with its low cost crude. So far, they have remained committed to this strategy, even though it’s starting to take a serious toll on their own economy. Many of the economic subsidies the Saudi royal family has offered its citizens are beginning to be scaled back, as it rapidly depletes its foreign currency reserves.
Despite the Saudis running production flat out, the amount of excess oil production only amounts to about 1% to 2% of global demand. Yet, the fact that this has been going on for over a year has created a massive overhang of oil in storage. In turn, this forced crude prices into the $20s earlier this week, down nearly $100 a barrel from their 2014 peak (and almost $120 per barrel from the all-time high in 2008).
And this is why Evergreen is definitely a no-gloating zone these days…
Not quite immaculate execution. We’d love to announce to the world that our clients’ portfolios are sitting serenely in cash and treasuries but that would only be partially true. The good news is that we do hold our highest level ever of cash, government bonds, and AAA-rated corporate bonds. Additionally, we’ve taken steps to make sure that the types of companies we own have durable businesses that can weather even tough economic climates. Further, Evergreen has its lowest stock exposure ever, with most clients at half of their normal equity targets. And we also have almost zero direct commodity exposure. Sounds great, right?
Well, as even casual EVA readers know, we also have been advocating—and implementing for clients–the gradual accumulation of master limited partnerships (MLPs) that operate mid-stream energy assets such as pipelines and storage facilities. As they have moved from a deep correction into a bear market and, more recently, into the most extreme plunge these typically steady-Eddie enterprises have ever experienced, Evergreen has been dollar-cost-averaging into the free-fall. (We would also point out that we have been putting our own skin in the game. The firm’s principals have been buying right along side of our clients. In case you’re wondering if there’s something in the office water tank, we aren’t alone. Other notable investors like Kyle Bass, Carl Icahn and David Einhorn have also pointed out energy’s relative attractiveness.) Click here for the Kyle Bass interview on Wall Streeet Week.
Despite yields that are often in double-digits—even from some of the safest names in the MLP world—the new year has brought another vicious decline in MLPs (and, of course, the entire energy complex with even the bluest chip oil and gas companies