While stocks continue to move higher unimpeded with the exception of the occasional minor dip, there are a few major trends that could potentially drive the current bull market higher. Of course, investors have to keep an eye on headwinds as well.
In our latest interview with Monty Guild, Founder and Chief Investment Officer of Guild Investment Management, we discuss oil's fall and the impact on economic growth, as well as other tailwinds for the U.S. financial markets. Suffice it to say, Guild is optimistic on the prospects for bulls.
EQ: In a recent investment report from Guild Investment Management, you identified the depressed prices of oil as the biggest storyline in the market right now. Do you believe oil will stay at these prices for a prolonged period of time?
Guild: I don’t know how prolonged but at least for a few more weeks or months. I believe that oil will not move well above these areas above the $85 much of the time for the next several years.
EQ: There’s debate on whether oil can stay at these prices for too long because of how far it’s come down from its peak, but historically speaking, oil is still pretty high. Do you think that oil at this level is overpriced or are these prices right now reasonable?
Guild: I would say it's about fairly priced in the $75 range. I’m reminded of natural gas. In 2008, natural gas was almost $12 per thousand cubic feet. By 2012, it fell to about $4 and has stayed around that area since for most of the time. It started in the latter part of 2008 and continued to fall through 2009, 2010, 2011. It never got really much above $4.80 to $4.90. It went to $5 once or twice in that period, but most of the time it stayed around $4. I anticipate a similar situation with oil over the next several years. From now through 2020 for oil will resemble that 2008 to 2014 period for natural gas. I anticipate the price of oil will be trading in the $65 to $90 range, but more like between $75 to $85 range over that period on average.
The reason is because of the glut, which hit us in natural gas in 2008 as economics and new technologies allowed oil and natural gas to be produced much less expensively. It created a massive glut of natural gas in the United States. Natural gas is not very transportable or fungible, and therefore you had a price glut that has lasted.
I believe the same thing will happen with oil, which is transportable and fungible. But the problem is that demand for oil is growing at about 1.5% a year worldwide, and I think supply will grow faster than or equal to that. OPEC no longer has control over the pricing mechanism that it once had, especially Saudi Arabia, the kingpin of OPEC. Pricing is now a combination of supply and demand issues for many countries. The United States is doing a lot to keep the world's price of oil lower as are shale deposits in other parts of the world. We anticipate that oil prices aren’t going to do much in the next several years. The big run in oil, the big fun years for the last few years, in our view is over.
EQ: What kind of ramifications does that have on the oil and gas industry in the US? I know shale has been a big story in the U.S., but with depressed prices, do you foresee a major shakeout in these companies?
Guild: Yes I think the underfunded, undercapitalized companies will be shaken out. The big quality players with a lot of bank lines and cash won’t be shaken out. Shale is becoming more efficient every year but it's a relatively high capital cost to drill these wells. They’re very expensive and these wells deplete in a few years—about 30% in the first year, maybe another 25% to 30% in the second year. In the third year, the well is not producing anywhere near where it started at and you have to add a lot of new wells to keep the production higher.
That would be done from cash flow but a lot of these companies have been growing faster than their cash flow would argue for. They’ve been able to do this by being able to go to the banks and borrow based on the recent track record and the recent rise in the price of oil. We think the banks have gotten the message and we think these people are not able to borrow in that way and we expect to see all of the major domestic oil producers in the United States cutting their capital budgets and the number of new wells they're going to drill. That will eventually cause the amount of production growth to stop but I don’t think it's going to cause the amount of production to slow down. In other words, if production is 8.95 million barrels a day in the United States today, which it is or was a few weeks ago, Then I think it's going to stay about that level for the next few years or rise slowly.
Saudi Arabia only produces 9.15 million barrels a day, but the Saudis need the money. The Iranis need the money, the Libyans, Iraqis and everybody else who has produced, Valenzuela’s and others, they all need the money. While they may talk at the OPEC meeting about how they're going to work together and everyone is going to cut their production. What’s going to happen is a few people are going to cut their production, and everyone else is going to lie about it. When everyone else sees that, when the people who did cut their production see the others haven’t followed, then they'll go back to increasing it. For that reason I think any temporary rally in oil prices won’t last.
EQ: Do you foresee any ripple effects into other industries like equipment providers, industrials, maybe even alternative energies like solar?
Guild: It's really very bad for the equipment provider. It will produce some consolidation like this Halliburton Company (HAL) and Baker Hughes Inc. (BHI) situation, and others like it. That Halliburton and Baker Hughes situation was probably going on before this happened but there is a need and a demand by all of the big companies to get more efficient, have a broader cross section of services, and a broader offering. As a result of that, you're going to have real consolidation in the oil services industry.
EQ: Which industries should benefit most?
Guild:As far as the other industries that are going to benefit, the obvious and immediate beneficiary is transportation, especially airlines, but also other forms of transportation like shipping and rail. Trucking, of course will be greatly benefitted.
Another big beneficiary is consumer low-cost products. The higher price of oil the last few years has pinched the lower middle-income and lower-income consumer, and those people will be coming back into the consumption market to purchase more food away from home, more goods and so forth.
As far as manufacturing, that will benefit but over time because a good part of the manufacturing industry is oil service and oil transportation, like oil pipelines. Manufacturing will not be helped immediately by, this but over the longer period it will because lower energy costs makes it more efficient to manufacture, and especially to manufacture more in the United States. However, transportation costs will fall if you're manufacturing elsewhere too. But overall, it will help manufacturing eventually, just not right away.
EQ: What is the net effect on the economy's growth? Will this be more of a drag or serve as a tailwind?
Guild: Our model is there's four units of drag for every seven units of tailwind. So the net effect is positive. As an example, if we look at the energy companies in the S&P 500, it makes up 10% of the index. If you add in there the service companies and the transportation companies, maybe they make up 15% of the S&P 500. If they have their profits cut by an average of 15% to 20%, that equates to taking 3% off of corporate profits there for the entire index.
But when you look at the retailers, the transportation companies, the manufacturers and other importers who benefit from lower cost of transportation, it probably adds about 7% of corporate profits. The net effect is about a 4% increase in corporate profits for the S&P 500, but that won’t happen over one year. That will probably take maybe two to three years to happen.
My guess is it improves the GDP from about three-tenths to four-tenths of 1% per annum, and it will improve corporate profits by about 3% or 4% over the next two years, which would take corporate profit growth the next year from 5% to 7% and the following year about the same.
EQ: Another major trend right now on a global scale is the rising dollar in the face of aggressive stimulus from both Europe and Japan. The dollar has moved up pretty strong over the last couple of months. Do you see a near-term correction here? How drastic do you think this pullback would be?
Guild: The Dollar Index (DXY)—which is the euro, the pound and the yen against the dollar—has gone from late-June/early-July at about 79.7 to about 88.3 at the peak. So 79.7 to 88.3 is about 9%. I would expect the dollar to correct about one third to one half of that move up, which would be about 3% minimum, maybe about 4.5%. That would be somewhere between 85 and 86, which is a 3% or 4% correction in the Dollar Index from its high. I would think it would go to new highs again.
EQ: The strength of the dollar has been a huge catalyst, if not the biggest catalyst of the U.S. stock market because it is attracting a lot of international money as other currencies weaken. Do you see this as the largest catalyst that U.S. stocks have going for them or is there something else?
Guild: I think there are many catalysts, and I’ll name a few.
Lower oil prices are acting like a tax cut. The stock market continues to rise. The University of Michigan Consumer Sentiment Index is at 89.4 in the preliminary November print, which is up from 86.9 in October. It’s the highest since July 2007.
Unemployment has continued to fall and has reached a new six-year low of 5.8%. Job openings are at decade highs. The number of unfilled jobs is at a multi-year high as well. Inflation is under control. U.S. GDP and corporate profits are rising—GDP at 3.5% and corporate profits at 7%. Net foreign purchases of U.S. stocks are turning up and new money flows into mutual funds, stocks and ETFs are all rising.
Among U.S. stock market groups, we favor biotech and medical-related names, as well as transportation, high quality service providers, and we're also starting to look at retail and manufacturing stocks as they get benefit from these trends.
We also think gold is going to rise temporarily here as shorts cover their positions. Gold didn’t go up much when the fighting was happening in Ukraine. It didn’t go up much because there is no inflation but now it looks like gold is finally going up because the short sellers are covering their shorts and wanting to get long on something else. Meanwhile Russia is buying gold and Switzerland may put in an amendment, which will force the Swiss Central Bank to hold 20% of their assets in gold. Those would be big purchases. There are a lot of reasons the stock market is going up besides the hype of the strong dollar, although the strong dollar is part of it.
EQ: In October, we had a pullback that didn’t end up amounting to much, however, a lot of people at the time were thinking that it could potentially be the correction the market had been anticipating for quite some time. We didn’t get that official correction, which is defined as a decline of over 10%. Despite the resiliency of this bull market, do you see any headwinds facing the market right now that investors should be aware of?
Guild: Yes, the main headwind that I’m concerned about at this stage is Russia and their adventurism in Ukraine and other countries. Russia is a bankrupt country. It’s really having serious problems. The way President Reagan brought down the Berlin Wall and brought down the Soviet Union was by working with the Saudis to get them to lower the price of oil. This is according to a recent his son Michael gave. This forced Russia, which depended upon the oil revenues for their operations, to become almost broke and they couldn’t afford their big military expenses. That was probably not the only reason but it's certainly one big reason.
I think that this is going to be a weapon. The oil weapon is going to be a weapon wielded against the Iranians, wielded against others. Saudi Arabia wants to wield it against the Iranians. Other people want to wield it against other people. The United States wouldn’t mind the oil price to fall at all. I think President Obama never really supported the oil industry and he was very pro-environment.
Obama was very fortunate because the big boom in the oil industry and the big increases in production during his tenure in the office has allowed the U.S. to become much more energy independent, and has allowed the U.S. to hurt oppressive and unfriendly regimes that produce oil. Everything’s working with us. We still have luck in this country, even if we don’t do always do everything right.
EQ: Prior to the Alibaba IPO, you warned that when Alibaba (BABA) is introduced into the U.S. markets, it could potentially draw capital away from other established tech stocks. We saw that a little bit in Amazon (AMZN) . They were probably the one hit hardest. Is that trend still happening?
Guild: I think that big impact of Alibaba is over now. One thing that could wreck this market besides Russia is the massive amount of new issue offerings. The mass amount of new public offerings is sucking capital out of the market. If it continues, it's not going to be good.
When you get $2 billion to $4 billion of new money raised every week that money comes out of somewhere, people have to sell stocks or other assets to raise that money to invest in them. Or they take it out of money market funds or do something else. But as long as you're doing buybacks and as long as you're doing mergers and acquisitions, it adds back into market capital. But when you have companies coming public all the time, raising $2 billion here and $4 billion there every week that takes money out of market capital. That has to come from somewhere. Either it has to come from money market funds or from bonds or it has to come from existing stocks.
EQ: There's a huge proportion of capital still sitting in bonds despite the low yields. Would that be the first place you'd think it would come out of?
Guild: It would come from off the sidelines. A lot of people are still in cash and still haven’t participated. There was a report from Merrill Lynch that said so far this year $199 billion in foreign capital has gone into bonds in the United States and $116 billion has come into U.S. equities from abroad.
EQ: What is the thesis for bonds? Is it just a preservation of capital?
Guild: I think if you're a foreign investor, one reason why'd you want to own bonds is the dollar’s strength and preservation of capital. Frankly, I don’t think bonds are good at preserving capital at all. I remember the ‘70s, where bond yields quadrupled. That was pretty rugged. I would argue that it's mainly people wanting to be locked into the dollar.
EQ: In our previous interview, you discussed a few international opportunities. One was a China as a trading opportunity and the other was India as a multi-year play. How have they played over the past couple of months?
Guild: China has been an excellent trade. India has moved up but very slowly. I would say in the last couple of months India’s SENSEX is only up about 9%. China’s Shanghai Composite is up about 8% since mid-September. China has done a little less well, but then you have to take into consideration a decline in the Indian rupee. When you take into a consideration a decline in the rupee, because you can’t really hedge the rupee, it’s down 1.5% in two months.
If you bought an ETF that hedged the currency, you probably made about 7% to 8%. There are ETFs in China that hedge their currency. There aren’t any in India. They’ve both done fine, but we have a new favorite, if you want to know.
Guild: The U.S. is doing great. It’s number one. India is attractive, and China was attractive. Now it’s Japan. The Japanese yen has fallen substantially, making Japanese stocks and Japanese exports less expensive. We expect this to continue for at least a year. The new consumption tax, which was supposed to go into effect in October 2015, but when the first part of that was established in early 2014 it caused a recession in the last two quarters. They’ve learned their lesson and they're not going to do that. If Shinzo Abe calls a spot election in December, which we believe he will, and wins then that's going to give him four more years as Prime Minister. He’s been in for two years already. Instead of having one four-year term he'd have one six-year term. That is bullish. If he's re-elected, they will go pedal to the metal with QE and with the government purchasing stocks. They would do everything they can to get the country out of a deflationary mindset and to set things moving ahead.
In addition to India and China, which we still think is only a trade because the government has to come in and squeeze the shadow banking system every so often to calm it down. We believe Japan is good but the safe thing to do is to wait until after Mr. Abe is re-elected in the spot election in December. If you wanted to take more of a speculative approach you can buy Japan now but there will be some volatility especially if he is not re-elected. Right now the polls say he would be re-elected.
EQ: Are there any other takeaways that you’d like to share with our readers?
Guild: The only closing thought I have for your readers is that things are bullish. They’re extremely bullish in the U.S., extremely bullish in India, extremely bullish in Japan, and attractive for trading in China and Europe. Europe looks like it's going to get more together, and ECB Chief Mario Draghi said to the European Parliament that the governing council is unanimous in its commitment to unconventional measures, which could include changes in the size and composition of the Eurosystem balance sheet afforded to achieve price stability over the medium term.
That is central banker's speak for, “Hey, we're going to print more money. We’re going to buy government bonds.” The modest QE that is going on in Europe is going to turn on to full-blown QE. The full-blown QE continues in Japan. The full-blown QE continues in China. So regardless of whether or not the U.S. stopped their QE, we anticipate the world economy will continue to grow by about 4% plus next year and everything is going to be just fine.
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