January 31, 2016 Reverse Course

Risk/Reward Vol. 293

This will edition is truncated due to the birth of our eighth grandchild, Graham Michael McClement. Mother and son are doing well. Barb and I have had fun caring for his sisters while Amanda and Todd stay with Graham in the hospital. He comes home today.

With the surprise announcement on Friday that the Bank of Japan (Japan's central bank, like our Federal Reserve) is going to charge interest to Japan's money central banks for maintaining excess reserves, the US stock markets skyrocketed on Friday. The Dow Jones Industrial Average and the S&P 500 each rose over 2% salvaging what otherwise would have been a disappointing week. But even Friday's performance could not rescue January. US stock markets suffered their worst month since 2009.

So why did the BOJ announcement have such a whopping impact on US markets? Here is the answer. The move by the BOJ will encourage its large, money center banks to reduce the amount of funds held in reserve and to lend those reserve funds to customers at low rates. After all, charging any rate of interest is better than paying interest to keep money in reserve.. With the BOJ joining the European Central Bank and other central banks world wide in charging as opposed to paying interest on excess reserves (like the Federal Reserve does) pressure will mount on the Federal Reserve to reverse course and to either postpone its scheduled quarterly 25 basis point rate increases in 2016 or, even more drastically, to reverse the bump in rates that it implemented in December. If it does not reverse course, the Fed will be out of step with every other central bank. This would cause the value of the dollar to rise in relation to other currencies; hurting US exports and lessening even further the consumption of oil which is denominated worldwide in US dollars. If the Fed does reverse course, it will cheapen the cost of credit. Cheap credit encourages corporations to borrow money which they have used in recent times to fund stock buy backs. Stock buy backs buoy stock prices. The stock markets rose on Friday in anticipation of the Fed reversing course.

Adding to the stock market rise was news on Friday that the crude oil rig count in the US fell again last week. The number of rigs has fallen 68% since the high mark reported in October 2014. Fewer rigs means lower production, and lower production means higher prices. Thus, oil futures rose. As noted last week, recently, higher oil prices have equated to higher stock prices. In the past 20 trading days there has been a 95% correlation between the price of crude and S&P 500.

January 24. 2016 Fixin' A Hole

Risk/Reward Vol. 292

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

“He's a real nowhere man
Sitting in his nowhere land
Making all his nowhere plans for nobody”---lyrics from “Nowhere Man” sung by The Beatles

“I'm a girl watcher
I'm a girl watcher
Watchin' girls go by
My, my, my”---lyrics from “I’m a Girl Watcher” sung by The O’Kayshions

“She sells seashells by the seashore,
The shells she sells are seashells, I'm sure.
So if she sells seashells on the seashore,
Then I'm sure she sells seashore shells.”---lyrics from “She Sells Sea Shells” written by Terry Sullivan

If one looked only at where the stock market started and where it finished the week, one would see very little variance. One could conclude that Mr. Market was “a real nowhere man/Sitting in his nowhere land/Making all his nowhere plans/For nobody.” But that would belie what really happened. From trough to peak, the Dow Jones Industrial Average (DJIA) moved 821 points. At one time on Wednesday, the DJIA was down over 500 points from its Tuesday close. That same day, the VIX which measures volatility was over 30, its highest point since last August. This environment was not conducive to investing.

Why you ask? Could this all be a reaction to oil prices? Surely, not. Well, actually---maybe so. If you chart by the hour this week’s price of crude oil and compare it to the DJIA you will see an almost perfect correlation. If this correlation persists, I do not recommend initiating any new stock positions until the price of crude oil stabilizes. The nearly 20% swing from a $27/bbl low on Wednesday to a $32/bbl close on Friday is simply too much volatility. Add to this the fact that 1/3rd of the 155 oil companies covered by S&P now have junk credit ratings and the fact that Moody’s is initiating a credit review of every major oil company in the world, and you may decide, like I have, to take a pass on any stock purchases for the time being. Make like Popeye. When it comes to Miss Oil or those securities correlated to her, be “a girl watcher/a girl watcher/and just watch that girl go by/My, my, my.”

The above stated, I remain confident that sometime this year fortunes will be made in oil stocks. Among the ones upon which I remain focused is Royal Dutch Shell (RDS/A and RDS/B). With oil’s recovery on Friday, RDS rose nearly 6%, but still was down 3% for the week. It remains down 9% for the month, 24% for the quarter and 34% for the trailing twelve months. The above stock performance notwithstanding, Shell's CEO stated this week that RDS can sustain its $1.88 annual dividend (9% at current prices) through 2016 and beyond, a fact which should buoy its stock price once stability returns to the oil patch. If oil can hold above $30/bbl and if Shell secures approval of its merger with BG in next week’s shareholder vote, I may buy some. If I do and oil prices again plummet, I will “sell Shell at the seashore or elsewhere, I’m sure.”

As I review what has occurred over the past few months, I find comfort in knowing that my decisions to sell have preserved the overall profitability of my portfolio. The older I get, the more important preservation of principle becomes. Reward is less important than avoiding loss. My loss prevention rules remove much of the emotion associated with managing stocks. And let’s face it, my friends, investing involves a huge emotional component. Indeed, the entire money management industry is grounded in ascertaining, and investing consistent with, each client’s emotional tolerance for risk. My sell rules are like “fixin’ a hole where the rain gets in/They keep my mind from wanderin’/ There I will go /And it really doesn't matter if I'm wrong I'm right /Where I belong I'm right /Where I belong.”

January 17, 2016 Better Place

Risk/Reward Vol. 291

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

“We gotta get out of this place
Girl, there's a better life
For me and you”---lyrics from “We Gotta Get Out of This Place” sung by Eric Burdon and The Anim

“Falling in and out of love with you
Falling in and out of love with you
Don't know what I'm gonna do...I just keep
Falling in and out of love”---lyrics from “Falling In and Out of Love” sung by the Pure Prairie League

“This is my gimmick and I wanna win it
I'm selling out
I won't fight you no more”---lyrics from “The Sellout” sung by Macy Gray

Let’s review the news from the oil patch this week: on Tuesday it was reported that 30 oil companies have declared bankruptcy in the past few weeks and that many more are teetering on the verge of insolvency; several times this week the price of crude fell below $30/bbl closing on Friday at $29.65; despite a 51% cut in domestic capital expenditures, production continues to outpace demand; and on the international front, the sanctions against Iran are to be lifted in the next two weeks which will add another 1-2 million bbls/day to an already oversupplied market. Small wonder that I sold all of my oil positions on Monday. I barely broke even, the handsome gains about which I wrote just a few weeks ago having evaporated. I still like oil in the long run, but for now “We gotta get out of this place/Cash is a better life/For me and you.”

As for the rest of the market, Holy Pure Prairie League! Rarely have I seen such volatility; not only day to day but hour to hour. The VIX, which measures volatility, is at 28, its highest level since 2012. Check out this week’s charts. They tell a tale of “Falling in and out of love/Don’t know what to do/Falling in and out of love with you, Mr.Market.” By the end of the week however, it became clear that the falling was mostly “out.” Indeed, according to Tuesday's Wall Street Journal, pension funds are holding the highest percentage of cash since 2004. At the close on Friday, the Dow Jones Industrial Average was down 2.2% for the week and 8.25% year to date. The S&P 500 was down 2.2% and 8% for the same time periods. Panic caused a flight to safety. As a consequence, the yield on the US 10Year fell to 2.02% (remember, the greater the demand/price, the lower the yield) but not even that downward march immunized my beloved preferred shares and preferred share closed end funds from irrational selling. That said, my preferreds remain in the green. In fact, I used the stampede as an opportunity to add new positons in HPF and HPI.

What I found most compelling this week was the admonition by JP Morgan to use any rally in the stock market to sell equities. In effect, JP Morgan is “selling out/not willing to fight the bear anymore.” This is the first such advice in many years. Indeed, since 2010 JP Morgan and virtually every other investment house have advised the opposite; to wit, to use every dip as a buying opportunity. Sitting primarily in cash, I relish such advice. If followed by others, it will create great buying opportunities for me. Once again, remaining patient will be my greatest challenge. I don’t aspire to buy at the bottom---just somewhere near it. What is the bottom is anybody’s guess. I don’t need to know. I just need confirmation that it has been reached.

We may be facing a bear. So far, the stock market is on a pace to record its worst month since November, 2008. But with apologies to Eric Burdon, bear markets “Don’t Bring Me Down.” They end sometime. And when they do, profits can be made. Let’s face it folks, a bull market cannot run forever. Bulls and bears are the yin and yang of investing. “River Deep and Mountain High”, if you will. So “Don’t Let Me Be Misunderstood”. Bear markets may “Spill the wine”, but they allow smart investors to “take that pearl.”

January 10, 2016 Waterloo

Risk/Reward Vol. 290

ThIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

“Happy New Year
May we all have our hopes, our will to try
If we don't we might as well lay down and die
You and I”---lyrics from “Happy New Year” sung by Abba

“But you ran out of gas
Down the road a piece
Then the battery went dead
And now the cable won't reach”---lyrics from “Last Chance Texaco” sung by Ricky Lee Jones

“Welcome to my nightmare
Pressures on, blood pressure racing
I calculate my next step, pacin'
Don't know if I'll meet expectations”---lyrics from “Die Hard” sung by Dr. Dre

“Happy New Year/May we all have our hopes” and “the will to try” to prosper. Based upon 2016’s first week, that won’t be easy. I am not suggesting that “we might as well lay down and die”, but I am advising caution. And for good reason. In this past week, the Dow Jones Industrial Average (DJIA) and the S&P 500 (S&P) each dropped 6%. Political unrest in the Mideast, sinking oil prices worldwide and discouraging news from China (two days of precipitous stock market drops and a report that the Chinese economy will grow at only a 6% clip in 2016) combined to cause the S&P to notch its second worst kickoff week since 1929!

The continuing drop in oil prices is of particular concern to me. I remain confident that the price of crude will rebound above $50/bbl sometime this year. I don’t want us “running out of gas” or experiencing “batteries going dead”, but hopefully production will be cut by someone, soon. The current oil glut was the subject of a thoughtful piece written by Donald Lufkin in Friday’s Wall Street Journal. He characterized the current oversupply as a classic case of innovation (to wit, fracking) “creatively destroying” the Malthusian shibboleth that population will outstrip the supply of natural resources. Lufkin is optimistic that once the price of crude is rationalized we should be in for a sustained period of prosperity, freed from the yoke of Mideast petrocrats.

So do I view 2016 as “my nightmare, with pressure on, blood pressure racin’, pacin’ , not knowin’ if I’ll meet expectations?” Abba-solutely not! Why not? Because the majority of my holdings are preferred stocks, preferred stock closed end funds, REIT’s and other securities closely correlated to the yield on the US 10Year Treasury Note. (For an explanation of why I like this non diverse approach see Vol. 221 www.riskrewardblog.blogspot.com ) So far this year that yield has fallen which means the prices of the 10Year and those securities that are correlated thereto have risen. (Remember the lower the yield, the higher the price.) Indeed, I am even this week and would have been off to a banner start but for a few disappointments in the oil patch (OKE and VNRBP). With corporate profits expected to founder, I see my approach working well this year.

With apologies to Abba, I don’t see this first week as our “Waterloo.” Nor should we be sending an “SOS.” “Knowing Me, Knowing You” we should remain calm. This may not be a year where “The Winner Takes It All.” But with a principled approach aimed primarily at avoiding loss, one should see some profits. That is why I choose to “Take a Chance on Me”---or at least on my approach.