There's a significant sentiment shift occuring in the markets right now, and it is one that investors need to recognize sooner rather than later to avoid substantial losses. While the frenzy for growths stocks had been the predominant theme in recent years, investors are waking up to the fact that these stocks do not, in fact, have unlimited potential. At the same time, many of the established names that have fallen out of favor now present attractive value opportunities.
Equities.com had the opportunity to catch up with Monty Guild, Chief Investment Officer of Guild Investment Management to take a closer look at this market rotation, as well as attractive trends in the US and global markets.
EQ: U.S. stocks look to be on the track to recovery from the recent correction. One key theme that we keep hearing, however, is choppy markets and volatility. It’s been a while since we’ve been in that kind of environment for a prolonged period. How do you handle those kinds of market conditions?
Guild: We agree that the market is currently choppy and volatile, but that choppiness and volatility is actually covering a big sector rotation -- away from certain sectors that have been leading the market, to other sectors that are leading the market now. We view this as a sideways choppy to slightly higher market. We think we’re now in the season of the year when the market will continue to rally for the next few months, so we’re enthusiastic. We have been optimistic about stocks in general for the last few months, realizing that you’re going to have a pessimistic period in September and October. This year it moved forward to August as well. Often you have pessimistic periods in September and early October.
We expected that but what we've noticed, and the thing that is most encouraging to us, is that this market is rotating away from healthcare stocks and high-multiple stocks in general in the non-healthcare areas, and toward lower-priced, better-value companies. Specifically, they're rotating into some long out-of-favor sectors like energy, especially oil and other sectors possibly like gold. It’s definitely moving into the long out-of-favor, old-line tech stocks like the Cisco Systems, Inc. (CSCO), Hewlett-Packard Co. (HPQ), and so forth.
What’s happening, in our view, is you're moving from the higher-multiple, infinite PE stocks like the Netflixes (NFLX) and biotech stocks, toward more value-oriented stocks: Cisco, HP and the energy sector as well as some sectors that are doing a lot of retailing in China.
EQ: If a significant rotation is occurring in this market, how do you identify buying opportunities when you’re seeing these high-flying names coming down? How do you determine whether that is a buying opportunity or if it’s just an area that is falling out of favor?
Guild: We look at the tailwinds and headwinds that the sector is experiencing on a macro level. Then we look at the PE ratios on a micro level and the fundamental facts of the company’s growth and compare them to historical precedents. As an example, for a restaurant stock to sell at 18 times to 20 times earnings was very rare for many decades. Now many restaurant stocks are selling at 20 times, 24 times, even 25 times earnings. Eating out is a low-priced way to entertain yourself. Many people are using the savings from low gasoline prices at restaurants and to buy meals away from home. The reality is food prices have been low and that’s helped this group, but the PEs are high and restaurants’ stocks are no longer fairly valued. We would be a seller based on valuation even if the market isn’t rotating out of restaurant stocks yet.
We would be a buyer of retailers or restaurant companies that are doing well in China -- companies like Starbucks (SBUX), Apple (AAPL), or Nike (NKE) that can grow faster than other companies because of the 1.3 billion potential consumers in China. There are about 400 million to 500 million people in the middle class who can afford to buy Apple, Nike, or Starbucks products and they are buying them.
If oil prices start back up again, which we think they probably will over the next year or so, we would focus on retail and restaurant stocks that have business abroad as opposed to ones that have grown entirely in the US.
EQ: If you believe that oil prices are heading back up over the next year or so, does that mean Energy is another area to rotate into?
Guild: Yes, that’s another sector that we found an opportunity to rotate into a few weeks ago. We looked at the charts and we have noticed that Exxon Mobil Corp. (XOM), Chevron Corp. (CVX) and many of the big, stodgy, established, major integrated oil companies were showing good technical chart patterns after having gone down for a long period of time. Yields were between 3.5% and 5% and growing. Once the demand starts to pick up for energy again, the price of energy rises, and corporate profits of these companies could go up a lot. So we began to buy Chevron a few weeks ago, as well as Exxon, and more recently we've begun to buy some of the more aggressive ones like Continental Resources, Inc. (CLR), EOG Resources, Inc. (EOG), Whiting Petroleum Corp. (WLL) and so forth. The logic behind that is the price of oil probably is bottoming out in the low-to-mid $40s. It crept down into the $30s in August, but more recently it bottomed out in the mid-$40s even with all the bad news about oil.
So we look for good technical chart patterns along with bad news causing the stocks to fall. If bad news for a sector is coming in and the stocks aren’t falling, then they’re probably sold out. In many of these instances, there are probably more shorts out there, and the shorts will be interested in covering their positions. First the shorts will cover, and then the longs will get in.
EQ: If oil has indeed bottomed in the low-to-mid $40s, where do you see the ceiling at for this group over the next 12 to 18 months?
Guild: That's a hard one to answer and above my pay grade, actually. What I would say is clearly the Saudis and Russians wanted to produce a lot of oil to finance the wars that they're engaged in, and to finance their social spending within their own countries. It doesn’t do them any good at all to have oil stay down for a long time. They stated—especially the Saudis—that they wanted US oil shale producers to cut production and that is happening. US oil shale producers' rigs in operation are way down. Production has begun to fall and will continue to fall through mid-next year, according to senior officials in US shale oil companies. They kept drilling longer than people thought they would because even when the price of oil fell, the price of oil services fell also. So the profitability on some wells still continued at $50.
On the other hand, most oil shale producers cannot make money at $45 or $50 oil. A few can, so we anticipate that the price of oil will go back up to $55 or $60 and possibly $65. We don’t see it going anywhere near $95 in the near term because such a high price would just attract a whole lot of new drilling and spending in this sector, creating lower prices in the long run. The solution for low oil prices is low oil prices, because low oil prices stop production and therefore allows prices to rise. The problem with high oil prices is that they create more supply, and therefore eventually lower prices.
Given the behavior of the Saudis and their willingness to go to the mat to protect their market share—even when it hurt them, especially when Brent Crude got down well below $50—we anticipate that they would tolerate a $65 WTI price, which would mean about $68 or $69 Brent price without too much problem. I think they would be happy with that. I don’t think they would tolerate a $90 to $95 Brent price because they know that would increase production from the United States.
EQ: It seems that the market is shifting from a growth-oriented thesis to more of a value-oriented one. What advice do you have for investors in this kind of market, where they were originally looking for disruptive opportunities or opportunities that could outpace the rate of rising interest rates?
Guild: I’ve never understood the psychology of paying an infinite PE for disruptive technologies. I understand that disruptive technologies are useful and I understand that they create opportunity, but these aren’t the first disruptive technologies ever to come along, as prosaic as it sounds today. When McDonald's Corp. (MCD) first came out with fast food restaurants when more women started to enter the workforce, and more and more fast food began to be sold along with more and more frozen foods and packaged foods, society began to change in many ways. That was a disruptive technology of massive proportions. All we did was buy the stocks of the Kentucky Fried Chickens (YUM), McDonald's, and all the other players in the fast food sector. In recent years fast, healthy food has been a trend. This trend has created very high multiples for Chipotle (CMG) and other fast casual formats which are perceived to be healthy.
Our view has always been that you have to have growth, but you also have to have it at a reasonable price. When you get a company like Netflix, as an example, as great a company as it is, it’s selling at a very high PE ratio while growing substantially. But other people can enter that business and are entering that business. Their growth is slowing. Their top-line growth rate is probably going to be about 24% this year and maybe 24–25% next year. They’re now earning money and they're selling at roughly 200 times earnings. This kind of PE ratio is not something that we understand and we think the market is beginning to agree. For a company selling at that price, you have to be able to grow at a very rapid rate for a very long period into the future based on a discounted present value analysis. So our view is to stay away from the cult stocks and the stocks that sell at immense PEs. Those are going to come down as is happening with many of the biotechs.
EQ: So in a sense, these stocks are in for a reality check after a long period of free rein.
Guild: Well, you combine what’s going on with a bad political environment. A bad political environment can destroy disruptive technologies. If you look at the human genome project, many biotechnology companies have come forward with disruptive technologies that are curing diseases like Hepatitis C and others for which there was no cure for a very long time. In fact, a great number of cures for serious diseases have come forth because of the human genome knowledge over the last few years. But if the government does, as it is being widely advertised today, come down on the pricing of pharmaceuticals and biotech products on the whole industry because of the egregious behavior of certain parties in the industry, and cut off the pricing capabilities then new technologies will not be discovered. As a result, new products will not come to market and our pharma industry will be like the European pharma industry where they have tight price controls and no new product innovation to speak of. If we want new product innovation, we have to allow for pricing that will pay for that. So even though biotech may be a disruptive technology and they may be very useful in the long run, you also have to consider the political fallout.
As far as other technology areas like Twitter (TWTR), Google (GOOG), Facebook (FB), and others, my argument is these are all good but they have to be at a reasonable price. When they've been earning no money and selling for a market capitalization of $6 billion on $300 million in revenues (20 times revenues), that is overpriced. Once they start to earn money then they’ll have problems because all of a sudden they go from an infinite PE, where people can’t judge how pricey they are very easily, to a PE-based upon earning 20 cents a share and they're selling for $200. It’s a massive PE ratio and people start to sell them. We're very concerned that disruptive companies have moved from the theoretical growth stage that’s more focused on top-line numbers to the earnings stage because at that point in time people often start to realize how pricey these stocks are on an earnings basis. As a result, the stocks fall.
EQ: One area that we’ve never really discussed before is your thoughts on the small-cap sector. What are your thoughts on these stocks and where they stand in this market?
Guild: For many years, we were small-cap investors primarily. We moved toward big caps over the years because while we initially found that the information small cap companies can grow faster from a smaller base. Recently, the greater difficulty in financing of small enterprises have hurt and the costs of Sarbanes Oxley compliance have hurt.
Finally, today’s market tends to be focused on ETFs, which very seldom hold stock in small-cap companies. So the small-cap companies, by being left out of the ETFs, are increasingly being left out of the equation in recent years. I do think that we're coming to that stage of the cycle, the latter part of the blow off of a bull market, where small caps start to outperform, and I would not be surprised to see that happen in the next few months.
EQ: It has been a few weeks since the Fed’s decision not to raise rates in September. What has been the reaction that you’ve seen, both in the U.S. and globally?
Guild: Globally, this has done a great deal to benefit global markets as well as within the US. The obvious benefit within the US is that fear of higher interest rates has not shrunk PE ratios because PE ratios are inverse to basically what you can get on competing instruments and the growth rate. Higher interest rates means slower growth, which means lower PE ratios. For foreigners, the foreign markets have been pretty much hollowed out by the fact that everyone wanted to own US dollars. When the dollar is rising—and it will rise when you raise rates—then of course fewer investors want to own emerging market or even European stocks as much. People are going to focus more and more on US stocks because they want the tailwind of owning the US dollar.
Many investors all over the world invest in US stocks and all of them want the tailwind of the US dollar. When the US dollar is a headwind, they're much less likely to buy US stocks. It appears that when the US dollar is falling, foreign direct investment or foreign investments in US equities decreases. When the dollar is rising, foreign investment in US equities usually increases and the inverse is true for their local markets.
When people are sending their money abroad to buy US stocks, they're not buying as many stocks at home. When the dollar does not rise, and it looks the dollar may go sideways or even down slightly versus some of these other currencies, that’s a period when you can get a good rally in many of these emerging markets and foreign markets. It’s exactly what we've had in the last week or twol. It will continue if the dollar continues to go sideways or down. If the dollar starts to rally again, I would say you will see a rapid retreat in all of the foreign markets.
EQ: Looking at these foreign markets, we’re fairly familiar with your opinions on China. Are there any other markets that come on to your radar that we should know about?
Guild: We liked India, although they failed in much of their legislative agenda to create better infrastructure for the country. The opposition party is fighting against better infrastructure for the country and lowering taxes for businesses. Some of the states of India are held or dominated by parties that are actually communist or extreme socialist, and none of these states are pro-business. All of them want an advanced form of communism or socialism in their states.
Certain states in India are booming; the ones that have free market-oriented state governments. But certain states in India are also very backward; the ones where there's mainly subsistence farming and communist parties running the state.
Our argument would be that India can do well but the growth will be spotty. Interest rates are falling in India, which makes them attractive as well. They claimed to be having 6% growth and China claims to be having 7% growth. We believe both India and China are actually growing at about 5%, which is not bad when compared to the US or everywhere else in the world, but it’s not 6–7%.
For the long term, I think you can buy India on dips, but in the short run I would stay away from all foreign markets. Speculators might want to consider Brazil. It's definitely a speculation but could do well.
EQ: Lastly, what are your thoughts on gold going forward?
Guild: Gold is widely hated and ignored because people see no reason to own gold if there's no inflation. We agree there is no inflation to speak of and will be very little for the next couple of years. On the other hand, in the long term, gold has had a major correction. It’s been a great long-term investment over the last 40–50 years, and we think it will continue to be.
At some point in time, the US government is going to have to inflate away all their debt. They have three choices to deal with their debt. They can cut entitlements, which is a very unlikely alternative in our view. They can default on their debt at some stage, but I would argue that is also an extremely unlikely alternative. Or, they can do what the United States and every other country did after World War II. Many countries with huge debts and very little growth. The only way they could pay off that debt was to let their currency and the buying power of their currency decline. When they did, it made it easy to pay back all the savings bonds and government bonds sold to finance WWII in this country and abroad. We believe that’s what is going to happen.
When I was a boy, the equivalent of a new $30,000 car today sold for about $2000. That was 60 years or so ago. You can see that the value of the dollar has fallen about fifteen-fold in that period of time. A dollar in 1955 is probably worth about 6 or 7 cents today in terms of buying power. We anticipate another trend like that over the next 50 to 60 years where the dollar's buying power continues to depreciate.
Lowering the value of the currency is the only way that any government, especially one that is as pro-debt generating and so anti-paying back debt as ours, can ever pay back its debt. It won’t be us alone. It will be us and every other major country in the world. One way you take advantage of that for the long term is to own gold to try and ameliorate the decline.
EQ: So this is more of a longer-term play.
Guild: Very long term play.
EQ: It always makes sense to own a little gold in your portfolio.
Guild: That's our view. Usually 5% or 10% of your assets in gold just for the long-term insurance policy. Now that gold is down from $1900 to $1100/ounce, it’s probably a better time to buy it.
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