Dear Fellow Investors:
The “well known fact” with regards to oil over the last decade read like this: because of huge GDP growth in emerging markets like China, there were going to be 400 million new middle class citizens born of uninterrupted prosperity; they were going to want all the autos, consumer goods, $10,000 watches and food that Americans have. The demand for commodities was going to be endless because capitalism practiced under authoritarian control was going to be better than the “invisible hand” of the free market. No recessions or depressions required.
Now, with oil dropping from $95 per barrel to below $57 through the first half of December 2014, many pundits seem to focus on the over-supply of oil and falling demand in a slowing global economy. But we think they miss the long-term view.
As long-duration common stock investors, we don’t see oil dropping merely because OPEC and Bakken Shale have produced too much supply. Instead, we see oil’s demise as a symptom of something larger: the unwinding of a globally synchronized trade tied to the “well known fact” stated above.
Part of the job of the long-term contrarian investor is to identify a body of economic information which is not only known to all market participants, but has been acted upon by anyone in the marketplace who wishes to participate. We call this the “well known fact.” If we know where the vast majority of investors are, then we can contentiously go where they are not.
Nearly every major institutional and high-net-worth individual investor had to adjust their portfolio to this particular “fact” about China and the emerging markets over the last decade. The most successful money managers of the prior decade, who had successfully participated early in the “well known fact,” were validated and received adulation for promoting it (think BRIC-trade). As Warren Buffett likes to say, “What the wise man does at the beginning, fools do at the end.”
The boom created by a once-in-a-generation and massive capital re-allocation toward everything related to the globally-synchronized trade did what all booms do. It turned to bust. Few experts or pundits view it this way, but for many it’s often tough to see the forest through the trees.
We think it would be helpful at this point to review other psychologically-driven boom-bust cycles to analyze the depth of their declines and the duration of the bear market which followed. In this way, we might prosper from the disarray of investment managers and the largest institutional pools. They remained trapped chasing an over-capitalized belief in the 400 million new middle-class citizens on “a permanently higher plateau” in commodities.
Go-Go Mutual Fund Boom Peaked in 1968
- Well Known Fact: Technology sparked by the space race was limitless.
- Result: Small-Cap Stock Boom.
- Declines to 1974 Bear-Market Low 60-80%.
- Duration: 6 years.
Nifty-Fifty Large-Cap Stock Boom 1972
- Well Known Fact: 50 companies having limitless earnings growth and consistency.
- Result: Institutions had 74% of their portfolio in common stocks at the beginning of 1973.
- Declines of 50-80% and no ultimate bottom until 1982.
- Duration: 10 years.
Commodity Boom of the 1970s peaking in 1981
- Well Known Fact: Never ending double-digit inflation demanded investments which benefit from inflation (Oil, Gold, etc.).
- Result: stock, Gold stock and Commodity Boom.
- Declines of 70% in Oil and 60% in Gold ending in 1999.
- Duration: 18 years.
Tech Bubble 2000
- Well Known Fact: The Internet Will Change Our Lives.
- Result: Tech-Heavy NASDAQ Index fell 78% and isn’t back to even 15 years later.
- Duration 3 Years.
Residential Real Estate 2005
- Well Known Fact: Houses always go up in value and are geographically diverse.
- Result: Homes fell 50% in hottest markets and the leverage attached to them created the biggest financial meltdown since the 1930s, helping to cause a 50% decline in stock prices.
- Duration: 7 Years.
What can we as long-duration common stock investors glean from reviewing these past episodes of financial euphoria? First, it appears that stocks confess sins and cleanse faster than other asset classes. Second, the connection to leverage and the inter-connectedness of multiple asset classes seemed to cause longer-duration declines in the past. For example, tech stocks had very little debt and most investors weren’t using margin in 1999. Therefore, the grief didn’t spread to the real economy; however, owners of leveraged oil tax shelters and garden-style apartments in the Sun Belt in 1981 were illiquid and everything inflation-related was tied together.
Third, our observations suggest that asset quality affects decline duration. Exxon paid dividends from 1981-1999, while gold and commodity indexes didn’t. Investors had something to fall back on like earnings, free cash flow and dividends.
Lastly, how fast can money managers purge? Most institutions and high-net worth individual investors have the stamp of the well-known-fact all over their portfolios as evidenced by studies like the 2013 NACUBO study of endowments and foundations. It should take years to rearrange their commitment to all aspects of the globally-synchronized trade.
What do we look for among common stocks as we bargain hunt in sectors which get unwound by a vicious bear market following the unwinding of a “well known fact?” We will watch for the shaming of the globally-synchronized-trade apologists in the media and the closing or liquidation of sector mutual funds, ETFs, hedge fund and private equity vehicles tied to the globally-synchronized trade. This is historically what occurs near the bottom as capacity contracts severely. So far, nobody has even been criticized yet, let alone vilified. Wait for the time when few are mentioning the new 400-million middle class citizens and when the word “damn” gets put in front of the stocks, commodities and asset classes involved. Finally, we believe that you shouldn’t give too much weighting to any mid-December 2014 explanation which doesn’t include the psychology of a boom/bust cycle and the long-duration nature of the law of supply and demand.
The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.
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