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The Quarterly Report

  • The Quarterly Report
  • Fourth Quarter 2014
  • Chuck Osborne

Dem Bones

We live in a connected world. I’m sure you know what I mean. You may be on a trip somewhere and you run into a neighbor, or you might meet someone for the first time and find out you grew up down the street from one another. This past fall my wife and I enrolled our son in a newly established charter school, and the wife of one of the founding board members was one of my Wake Forest classmates. I once boarded an airplane and sat down next to an old high school friend I had not seen in twenty years. When I was a young single professional I went out with a colleague in my office, and we were going to be joined by an old friend of his named Richard. I commented that I went to high school with a Rich who had the same last name, but my friend told me it couldn’t be the same person because his friend hated it when people called him Rich. A few minutes later Rich and Richard ended up being the same person after all. In the immortal words of come- dian Steven Wright, “It is a small world, but I wouldn’t want to have to paint it.”

I don’t know what is more amazing, how many times the world reminds us how connected everything is, or how many times we seem to forget. We seem to want to silo everything. We do it in our budgeting. I cannot tell you how many times I have spoken to people with spending problems and had a conversation that goes like this:

Me: You are spending more than you make, that must stop if you wish to get ahead.

Client: Well the problem is the price of gas went way up and I drive so far to work every day that it really has caused a big deficit in my budget for commuting.

Me: But what about this big vacation you took?

Client: Oh that is not a problem. I stayed within my vacation budget.

Clients like this fall into the trap of using complicated budgeting software that breaks everything down and completely forget that it is the whole that matters. The various budget categories are all connected. If one’s personal budget has ten categories and he runs a deficit in one of them then he must make up for that somewhere else. Otherwise he ends up spending more than he actually has. If day-to-day expenses increase, then he may not be able to spend as much as he otherwise would on vacation.

This siloed way of thinking impacts people’s investments as well as their budgets. Clients come to us all the time with portfolios that make no sense simply because they are all parts and no whole: They have an account for college funding for each child; his and her 401(k) accounts; old job retirement accounts; and that one stock Aunt Betsy left them. Each account has a different strategy, sometimes even different risk tolerances. Some folks have conservative money and risky money.

There are lots of reasons for this hodge podge approach to financial and investment planning. Some of it is simply the pace at which we live these days – everyone is moving so fast that nothing gets done correctly. We know things are not correct, but we just never seem to get around to fixing them. Some of it is that people really do silo these things in their minds. “The money Aunt Betsy left us is sacred because she was my favorite Aunt, so whatever you do, don’t lose a dime.” “The college fund for Sally? Well let’s face it, she is the youngest so we won’t be contributing a lot. Let’s roll the dice and see if we can’t win the lottery. If that doesn’t work out she can just live with her older brother, we sent him to Harvard.” Of course this is not logical when we stop and think about it, but when do we ever do that?

Most people conduct most of their financial dealings with their emotions, not their logic. They loved Aunt Betsy. They really want to go on that vacation. They love their kids and deep down just know that their kids will all get scholarships. This is where we come in.

I once heard a speech about the Declaration of Independence. How it starts with the line, “We hold these truths to be self-evident.” What does that mean, self-evident? The speaker said it meant that when one thinks about it for just a second she sits back and says, “Well duh.” The trick is that one has to take that second to actually think about it. Many simply never do that. They see a headline in a newspaper and never take a second to say does this actually make sense? In fact, to the extent most people do think, they tend to do it in reverse; they draw their conclusions and then search out evidence for those conclusions, ignoring all other evidence.

A few years ago in the heat of the financial crisis I got into a discussion with a friend about government deficits. I suggested that one should wait until the crisis had passed before worrying too much about the deficit. He sent me a paper written by an economist he had heard speak and highlighted a line about the long-term problems with deficit spending (with which I agreed, by the way). He failed to highlight the very next sentence which said that the middle of a big recession is not the time to deal with deficits. But that sentence did not fit his already drawn conclusion. I’m not even sure it ever registered with him.

That economist understood that the world is connected. Deficit spending is not a good thing, especially when done chronically year after year. There are, however, other issues. Spending more than one makes to take a fancy vaca- tion is one thing, but spending more than one makes because of an illness is an entirely different issue. Nothing can be intelligently analyzed in a silo.

Today there is nothing that fits this description more than the price of oil. Oil has dropped in price by more than fifty percent and the explanations for this are incredible. According to the pundits and Wall Street apologists, this is a logical reaction to the plummeting demand for oil and the oversupply caused by America’s energy boom. This is when one should start to question the headline.

The drop in the price of oil has been taking place since June, and there have been no significant changes in supply or demand for oil since June. That does not stop those who have already drawn a conclusion from seeking out data to support that conclusion. Speculators are lining up to be quoted about the plummeting demand for oil. The only problem is that out in the real world, according to government organizations that track such things, there is no drop in demand.

The U.S. Energy Information Agency (EIA) projects global demand for oil growing in 2015 by nine hundred thousand barrels a day…yes, growing. This number corresponds to the estimate given by the International Energy Agency (IEA). It is true that their projections for next year were higher a few months ago, so if one assumes these organizations are actually correct in their forecasts – granted that is a huge leap of faith – then one could say the growth in demand is slowing, but demand is not shrinking in the least and it certainly isn’t plummeting.

Much has also been written about the “glut” in oil supplies. Currently the world is producing more oil every day than we consume, but that is not unusual. According to the EIA the world produced 91.96 million barrels a day in 2014 while we consumed 91.44 million barrels a day – a difference of 520,000 barrels a day. In 2012 the world produced 89.76 million barrels a day and we consumed 89.14 million barrels a day – a difference of 620,000 barrels a day. Of course 620,000 is more than 520,000 and there was no crash in the oil price in 2012. In 2013 the world consumed more than it produced as demand increased more than supply, and my bet is that happens once more.

People who live in New York and never drive anywhere may not under- stand this, but everyone else will use more oil if the price is cheaper. Consumer Reports recently named the new car models with the lowest consumer satisfaction. Guess what, they were all tiny, super fuel-efficient cars. Gas is a lot cheaper than it was when those disgruntled consumers settled for those models. The toe bone is connected the foot bone and the foot bone is connected to the heel bone. Don’t be surprised if consumers start going back to larger, less efficient cars.

Many of the pundits who go on and on about the plummeting demand for oil claim that it is because the global economy is evidently collapsing. A day later the very same pundits will talk about third quarter GDP for the U.S. coming in at 5 percent growth. The U.S. is the largest economy on the planet. We are the largest consumer of oil. We love our big cars and hate the tiny things high-priced oil made us buy. Yes, Europe has issues and China is growing up and no longer having pubescent growth spurts, but the heel bone is connected to the ankle bone and the ankle bone is connected to the shin bone. The U.S. economy has positive momentum and now the U.S. consumer has just been given a huge budget saving price cut at the pump.

Here is one of those self-evident moments: The economy of the United States cannot grow at five percent, or anywhere close to that, and the demand for oil drop. One of those big market- moving stories must be incorrect. After all the shin bone is connected to the knee bone. Everything we consume in the U.S. requires energy in order to be produced and transported. GDP (gross domestic product) is a measure of everything we produce and consume. The knee bone is connected to the thigh bone and the thigh bone is connected to the hip bone.

So what is really causing the price of oil to drop? In my opinion that is the wrong question. The question should be the same question we started asking in 2008: Why in the world did oil’s price go so high in the first place? In 2008 I wrote about the roaring price of oil. Once again, back then supply and demand were blamed. Of course it was true that demand from emerging markets had an impact, just as greater production from the U.S. is having one now, but then as now, the price jump happened rapidly while the supposed excuse had been around for years. The best research we could find in 2008 suggested that the supply and demand alone would justify a price in the $60 to $70 range. Nothing has happened since then which would substantially change that estimate. EIA data suggest that global supply and demand have grown slowly and largely together since 2008.

What has changed is institutional investors. I mentioned in 2008 that pension plans, endowments and other institutions were piling into oil. Stocks looked bad in their rearview mirror and commodities had been rising so they started selling stocks and adding commodities to their portfolios. Oil was trading at $140 per barrel when I wrote that. Those investors were a large part of the reason, because if everyone buys the same investment at the same time the price goes way up. You see, the hip bone connected to the back bone and the back bone is connected to the shoulder bone.

Fast forward six years and those stocks all those institutional investors got out of have come all the way back and then some. But those institutional investors and their retail financial adviser copy cats have been going into commodities. Oil was already down almost $40 per barrel over that time period. Once again with eyes glued to the rearview mirror these same institutions are now questioning their collective wisdom. Many have begun to exit such “alternative” strategies. The shoulder bone is connected to the neck bone and the neck bone is connected to the head bone. This ride in oil is far more about Wall Street than it is about Main Street’s demand for oil.

The problem with investing in commodities such as oil is that they are not really investments. As Benjamin Graham taught us, “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” A commodity is simply worth what someone is willing to pay and that is a speculative operation. When one takes a moment to think it becomes self-evident: speculation is driving the price of oil.

The pundits don’t want you to see the connections. Wall Street makes money from trading – to them it makes no difference in which direction the price is going. Emotions drive trading, and in the case of oil, the emotion is fear. Those emotions are more easily manipulated when issues can be siloed. But, Dem Bones are connected. Whether it is budgeting or managing one’s investments or anything else, the more one understands that Dem Bones are connected, the more self-evident the prudent path becomes.




Charles E. Osborne, CFA, Managing Director

Review of Economy

Isn’t this a gas? Oil prices are dropping and the economy is growing. Things are looking better out there. GDP grew at 5% in the third quarter and while not expected to be quite as good in the 4th quarter, most signs point to continued growth.

The official unemployment rate dropped to 5.6% and jobs appear to be making a slow but steady comeback. Workforce participation remains histor- ically low but hopefully the jobs growth will encourage people to get back into the labor market.

Quantitative easing is now a memory, so the question has become when will they raise the rates? My guess is no time soon. Things are looking better, but inflation is non-existent and the Fed is not likely to act unless there are signs of inflation.

Review of Market

Volatility continued this quarter. The S&P 500 was down 0.25%. Much of the rest of the world looked worse. Headlines in 2014 keyed on the success of name brand benchmarks like the S&P 500 and the Dow Jones. But smaller company stocks finished the year up less than 5% and down for the last six months.

Bonds were flat with the Barclays Capital U.S. Aggregate Index up 0.09%. High yield bonds sold off during the quarter with the Merrill Lynch High Yield Master Index down 1.48%, which makes high yield bonds now more attractive going forward.

International markets were down again this quarter. The MSCI EAFE index fin- ished down 3.44% and down 4.48% for the year. Emerging markets were also down this year with the MSCI Emerging Market index down 1.82% in 2014.

Market Forecast

We continue to be cautious about the near term as this market seems to be in a glass half empty mood. However, we are still confident in the longer term. Valuations on equities remain reasonable. Volatility has returned over the last several months. This should continue to wash out some traders and create opportunities for investors.

U.S. large cap stocks are still attractive. International stocks look better from a valuation per- spective but European economies have issues. Emerging markets remain the most attractive on a valuation basis and held up rather well compared to their developed neighbors. Small company stocks remain overvalued, even after leading the negativity for the last six months.

Bonds remain our biggest concern over the long term, but they are still a shelter in the storm when the market does go down.