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December 04, 2014

December 04, 2014

Executive Summary

1.  How to profit from plummeting oil prices.  Conflict and geopolitical maneuvers among members of OPEC, and technological transformation in the U.S. oil sector, have converged to drive oil prices down dramatically.  Some nations, industries, and companies will benefit, and others will be hurt.  We see the U.S., most of Europe, Japan, China, India and most southeast Asian countries, and many Latin American countries as beneficiaries.  In U.S. stocks, we see transportation, retail and consumer, and pharmaceuticals being well-positioned to benefit (for a more complete list, see below).

2.  Goldilocks economic data will keep Fed support steady as economy grows.  October’s monthly data show a U.S. economy that’s steadily strengthening, but not so much that the Fed would feel pressure to raise rates soon.  U.S. growth is faster than its developed-world peers, and U.S. markets have the tailwinds of cheaper oil and a strengthening Dollar behind them.  

3.  Stanford scientists build a “window into space.”  Researchers at Stanford University have created a complex, layered micro-thin metallic film that could replace power-hungry air conditioning in many buildings.  It reflects almost all incoming light, and changes the frequency of outgoing infrared so that it will escape through the atmosphere into space — turning space into a usable “heat sink” for humans on earth.  Technological innovations will continue to reveal new resources where no one knew they were before.

4.  Don’t worry about Chinese growth.  Recent industrial production numbers from China led some to speculate that Chinese growth was weakening.  We expect Chinese growth to be healthy in 2015, supported by central government easing and especially by lower oil prices (China is the world’s largest importer of crude oil).  

5.  China “ghost city” waste wildly exaggerated.  Major news outlets reported a study by two Chinese economists claiming that from 2009 to present, $6.8 trillion of investment had been wasted or stolen in China.  However, a closer examination of their methods by The Economist revealed fatal flaws in their methodology.  There is theft and fraud in China — but as with many aspects of the Chinese economy, they can be exaggerated by sensationalism and misinformed journalists.  With China, we advise, “Let the reader beware” — and dig for the facts.

6.  Market summary: the bull is raging.  Global QE is ongoing.  The U.S. Dollar keeps getting stronger.  Oil keeps falling.  Real U.S. GDP is accelerating.  Stocks are fairly valued, and we’re in the strongest season for stocks.  With market stars aligned, we can say it simply: we’re bullish.

Oil Will Impact Every Investment Area — Where We Are Going, and How To Profit

Below, we offer a little history and a discussion of the current impact of lower oil prices on the world economies, as well as our thoughts on the industries and companies that will be benefitted by the new lower oil prices.

          History

Since 1973, the Organization of the Petroluem Exporting Countries (OPEC) has largely controlled the price of oil.  The members, including countries such as Nigeria, Saudi Arabia, Venezuela, and Iran, may not have liked each other, but they agreed to keep the price in line.  Since they were by far the world’s most prolific oil producers, such control was within their power.  Two big oil producers, Canada and Russia, do not belong to OPEC.

Even though the U.S. has been a big producer of oil, it consumes more than it produces.  Thus, the U.S. is and has been a major importer of foreign oil for decades.  However, U.S. imports have been falling fast for the last few years.
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Saudi Arabia, the world’s biggest producer, was also the most diplomatic, often taking pressure on their oil revenues to keep the cartel going.  They have recently decided to teach their fellow OPEC members and Russia a lesson by allowing the price to fall, so that oil will be unprofitable to produce except in the world’s lowest-cost fields.

          Saudi Arabia’s Current Goals

For public consumption, the Saudis must say that they want to stop U.S. shale oil producers from creating so much new production.  In reality, that goal is only a minor part of the Saudi agenda.  They have a much more important goal, which is to punish and politically enfeeble Iran and Russia.

Iran is their neighbor and their bitter enemy, and a country that has repeatedly stated that they want to destroy the Saudi regime.  Russia, for its part, has supported Middle Eastern regimes which want to destroy Saudi Arabia.

          Global Supply and Demand Balance

During the past decade and a half, demand from China, India, and other emerging nations has been strong, as these countries have become more wealthy.  Demand continued to be strong from the U.S., Japan, and Europe.

Since 2000, new oil supply has not been growing as rapidly as demand.  Globally, only a few moderate-sized conventional fields have been discovered.  In fact, Nigeria, Mexico, and Venezuela have seen oil production decline.

After 2010, the peak oil thesis argued that world oil production had peaked, and that prices had to rise a great deal to handle demand.  This theory has been rendered obsolete by technology.

Contrary To The Predictions of Peak Oil Theorists, U.S. Production Has Sharply Reversed its Decline

   


Our readers know that oil prices around $100 per barrel gave Canadian tar sands production a profitable opening, and that strong prices led to the ongoing shale oil production boom.  The technology which led to the shale revolution was horizontal drilling and fracturing (fracking), which we have explained in prior letters.  Of course, these technologies are not static, but are constantly being refined and improved.

As a result, U.S. oil production ramped up dramatically many years sooner than most analysts expected.  As the U.S. has grown nearer to self-sufficiency, OPEC sales to the U.S. have declined, and this has precipitated a price war within OPEC.

The overall oil market was dominated by strong demand from the emerging world until about mid-2014, when it became obvious to all alert market participants that world supply had exceeded world demand and that a glut had been formed, and that oil prices would subsequently fall.

Clearly, the last several months have proven that oil prices are not going to bottom at $80 or $70 per barrel as the hopeful had expected.

Prices are in a free fall, and we at GIM anticipate that U.S. domestic oil prices will reach $50 per barrel before it is all over.  At $60 per barrel, producers will start to cut back a lot of their production.  Prices will eventually rise and probably level off at about $60 to $80 per barrel over the longer run.

Today, oil prices are lower and more volatile than we have seen for years.  It is also very clear that OPEC is no longer able to control world oil prices.  Too many hatreds and too many differing goals for OPEC members make an accommodation and cooperation within the cartel look highly unlikely.
 
What Countries, Industries and Companies Are Benefitted By a Lower and More Volatile Oil Price?

Oil-importing countries are most benefitted.  Lower oil prices should act to decrease inflation and increase GDP growth in the countries below.

•  Most European nations;
•  The U. S.;
•  Japan, China, India, and most southeast Asian countries;
•  Most Latin American countries, with the exception of Brazil,  Mexico, Venezuela, and Bolivia.

All of these countries could experience consumer spending increases as oil prices fall for their citizens.

          What Countries Are Most At Risk?

The most damaged will be Russia, Iran, Venezuela, Saudi Arabia, Nigeria, Libya, Iraq, and other major oil-exporting nations.

          What Industries Will Be Benefitted?

1.  Transportation:
especially airlines and trucking.

2.  Consumers: lower gasoline prices cause consumers to have the equivalent of a tax cut and they will spend this on:
a.  Consumer goods (bullish for retailing and consumer product  manufacturers);
b.  Healthcare (bullish for hospitals, home healthcare, medical services, biotechnology and pharmaceuticals);
c.  Home improvement retail and manufacturers of appliances, and plumbing electrical and construction materials.

3.  Corporations will spend part of their energy saving on:
a.  Building new plant and equipment; and
b.  Hiring new employees to manufacture goods in their home countries.

4.  Exporters will benefit as the cost of transporting goods to foreign destinations will fall.

What companies will be most benefitted?  The prime beneficiaries will be companies which can grow rapidly and which have a moderate to large market capitalization.  This is because many foreign investors will buy U.S. stocks to benefit from the current strong U.S. Dollar, and the lower oil price will make the already moderately strong U.S. economy stronger still.

We at GIM currently own the following industries, among others, as a way to benefit from lower oil prices and a strong Dollar.  We believe many companies in the following sectors may be attractive.

Transportation:
Airlines, package delivery, trucking
Retailing:
U.S. and Chinese retailers
Consumer:
Healthcare services, insurance services, education, internet retailing
Pharmaceuticals:
Generic drugs, biotechnology
Technology: 
Internet, cloud services, technology equipment manufacturing, software, cyber-security
Financial:
Credit card servicers, regional banks

Investment implications:  When oil falls as it has now been falling for the past five months, the move is not likely to be short in duration.  Technological innovation, geopolitics, and economics are converging to increase supply and thus to drive the oil price down, and, we believe, to keep pressure on it for some time.  Many countries, industries, and companies will benefit, and others will be hurt.  We favor select transportation, consumer and retail, and pharmaceutical stocks in the U.S.  


“Goldilocks” Economic Data For the U.S. in October — Not Too Hot, Not Too Cold

A rundown of recent data shows the U.S. economy is not rocketing ahead, but is making steady progress.  The mix of stronger and weaker data suggests that the U.S. economy will continue to enjoy a supportive policy environment from the Federal Reserve, even while it is boosted by a rising Dollar and a falling oil price.

The timing of the Fed’s first rate increase is a subject of intense speculation, but for our part we’re persuaded by the analysts who see it later than most — perhaps in the first quarter of 2016.  Economic data that continue to be good, but not red-hot, will buttress that view.

          The U.S. Consumer

Probably the primary dial on Fed Chair Janet Yellen’s “dashboard” is the economic health of the American consumer and worker.  There may be other committee members with other pressing concerns, but this one still seems to be front and center.

Two weeks ago, we noted some positives for the U.S. consumer: a moderate uptick in take-home pay, falling oil prices, and an improving employment picture.  Relevant October data were good, but not stellar.  October’s wages and salaries were in trend with the year to date at a 4.4 percent nominal year-over-year growth rate.  Core inflation was slightly up at 1.6 percent — below the 2 percent target, but not alarming.  Sales of new single-family homes reached the highest level in a year, but the median price was up 16.5 percent from the prior month; under these conditions, continued recovery in sales volumes will be delayed.  Initial jobless claims ticked up slightly, but may have been distorted by the late Thanksgiving.

However, U.S. growth continues to impress.  The combined GDP growth rate in the second and third quarters was 4.25 percent annualized, which was the best six-month stretch since 2003.  The U.S. continues to run ahead of its peers — but not so fast that it would worry the Fed as it looks at inflation.  Core inflation was at 1.6 percent year-on-year in October — not too high, and not too low.

Investment implications: We see the situation for the American worker getting better, but still inspiring concern at the Fed.  U.S. GDP growth is steady and outpacing the U.S.’ peers in the developed world.  This broad picture reinforces our bullish outlook for the U.S. economy and U.S. stock markets — growth and friendly policy for awhile yet.


Stanford Scientists Cool Buildings With a “Window Into Space”

Stanford scientists have figured out how to make use of an unappreciated resource: the cold of space.  This is another example of technological innovation that solves problems people think are intractable — in this case, the expense and excessive energy consumption of air conditioning.

Essentially, air conditioning works by dumping the heat within a building into a heat sink — the outside.  It sends the heat outside the building by convection, the movement of air — and requires a lot of energy to do it.  About 15 percent of the energy used in U.S. buildings is devoted to air conditioning.

But there is a better heat sink than the atmosphere outside a building, a much larger and colder one — space.  And there is a much better way to transfer heat than convection, one that doesn’t require fans and compressors: infrared radiation.

Stanford professor Shanhui Fan and his research team designed a nanoreflector — a precisely layered and structured metallic film 1.8 microns thick that could wrap buildings.  It would produce what the team calls “photonic radiative cooling.”  

The film acts in two ways.  It’s an extremely effective mirror, reflecting 97 percent of the sunlight that strikes it.  And it’s also a radiator, tweaking the frequency of infrared radiation coming from the building so that it passes nearly unimpeded through the atmosphere.  It locks incoming heat out, and pushes the heat that’s already in the building through a “window into space.”

In tests they conducted, the film remained 10 degrees Fahrenheit cooler than the surrounding air, when placed in direct sunlight.

There are a lot of technical hurdles to pass before this product becomes commercially available.  We thought it was particularly interesting because it illustrates how technological advances make new resources available — in this case, the cold of space.  This is the fundamental response to the pessimists who think of human interaction with the environment as a zero-sum game.  Human ingenuity will always be discovering new resources, not simply using the ones that are already known.  

Investment implications:  We are observant for emerging technologies, even outside the venues where transformative and disruptive inventions are expected.  This technology could eventually cut energy costs for many buildings.


China 2015: A Key Part of the World Economy is Doing Well — and Lower Oil Prices Will Help a Lot

In 2015, China will grow at a respectable rate that will support world economic growth.  Some worried that China’s industrial production slowed a bit in November; that was because the government suspended many industrial activities in northern China around the APEC summit on November 5 to 11. China’s industrial production will pick up this month and continue strong throughout 2015.

China has taken many actions to stimulate economic growth:

•  Adding capital to state-owned banks.

•  Cutting bank deposit and lending rates.

•  Probable cutting of the reserve requirement ratio for all commercial banks — possibly as soon as mid December.

The government of China now seems to be introducing these easing measures such as the above, in order to stimulate stock market prices when they slide.  

Most important, China is the world’s largest oil importer.  They could benefit to the tune of over $100 billion in savings if prices stay at current levels through 2015.  This money could find many uses in China.  Almost all corporations would enjoy cost savings, consumers would have more money to spend, and infrastructure costs would fall.

All of these factors would increase economic growth while lower oil prices might moderate inflation.

Investment implications: Easing from the central government and the benefit of lower oil and other commodity prices could give Chinese growth a tailwind into 2015.


China’s “Ghost Cities” — Did They Really Waste $6.8 Trillion?  We Don’t Believe So, and Here’s Why

Two researchers at a Beijing think-tank published some startling research last week.  They claim that in the stimulus years since 2009, the Chinese government has wasted $6.8 trillion — either constructing ghost cities and excess capacity in heavy industry, or losing the money to outright theft and corruption.

We’re aware of the problem of theft and malinvestment in China, thanks especially to the work of Jonathan Anderson at Emerging Advisors Group, the China analyst we most respect.  But immediately on seeing the news about the study, we thought the number seemed excessive.
 
  Did China Really Dig a $6.8 Trillion Hole?
  Interesting Image

Although most newspapers are still reporting the $6.8 trillion number, The Economist provided a lone voice explaining why that number is a mirage, by delving into the methodology behind the report.

Essentially, the authors looked at the gradual decline of China’s investment efficiency (a ratio of investment dollars to resultant GDP growth).  They assumed that a 20 percent decline in that efficiency meant that 20 percent of the investment has been wasted.  In other words, if $1000 in investment produced a GDP gain of $500 in 2012, and only $400 in 2013, a 20 percent drop, then they assume 20 percent of the $1000 — or $200 — was wasted or stolen.

They also massaged data sets, taking average investment efficiency numbers from timeframes that would show a particularly dramatic decline (averaging numbers from 1979 to 1996, for example, rather than looking at a decade-by-decade breakdown).

We’re not academic economists, yet even we can tell how deeply flawed their reasoning is.  There are many, many reasons why investment efficiency might drop — most notably, simply the growth of an economy.  As an economy gets larger, it gets more difficult and more capital intensive to produce growth at old rates.  This is why a million dollars of capital investment in a small company can produce notable results in earnings growth — but wouldn’t have any effect at all on a giant company such as IBM (NYSE: IBM) or Exxon (NYSE: XON).

Criticism of the report’s claims will eventually spread beyond the pages of The Economist.  We simply note it as an example of an important principle: you can find reporting with questionable foundations even in the pages of prominent publications.  So we remain alert, listen to our intuition, and seek out deeper facts and contrary opinions.

Investment implications:  Investors have valid concerns about China, but many of them are exaggerated in the press, and prominent economic news about China is often misinformed.  We’ve noted many times our convictions that a banking crisis is not imminent in China.  We also note that although there has been fraud and misallocation of resources, the scale of that fraud may be misrepresented.  We always strive to dig deep for the facts.

 

Market Summary

 

The Bull Is Raging:  A Strong U.S. Dollar and Its Impact On Commodities, Stocks, and Currencies

          Commodities

Since most market participants think of commodities as being priced in Dollars, investors’ generally accepted tenet is that a strong Dollar causes weak prices for commodities.  The Dollar can certainly be a factor — but the specific supply and demand characteristics of individual commodities are much more important.

Today, most commodities are not falling in price like oil.  Precious metals, lumber, and some base metals have been falling in price, but many commodities are rising in price or moving sideways.

Grain and cattle prices have been rising modestly and slowly over the last few months.  Hogs, coffee, and sugar are moving sideways.

          A Triple Positive for Stocks

QE in the form of bond purchases, interest rate decreases, or both, from Japan, China, and Europe, is a strong indicator that demand for stocks in these regions will expand.

 A stronger U.S. Dollar has created better export prospects for countries that have seen their currencies fall.

Lower oil prices.

All three positives will work together to create a ratchet effect which could move stock prices higher in several markets.  We continue to believe that the U.S. market has the most potential upside, so our largest commitment is to U.S. stocks.

U.S. stocks are in a very strong position, as are Indian, Japanese, European, and Chinese stocks.  Among Chinese stocks, we believe investors should focus on consumer companies (retail and consumer products, healthcare, etc.).  If you buy Japanese stocks or European stocks, be sure to hedge the currencies, which will decline versus the U.S. Dollar.

          Currencies

A big part of the U.S. strategy for expanding economic growth worldwide is to allow the U.S. Dollar to float upward versus most world currencies, encouraging more exports from those nations and increasing inflation in those economies.  The reverse would then happen to the U.S. economy when the Dollar rises.  Inflation slows and exports decrease.  We believe that the Euro, Japanese Yen, British Pound, and many smaller currencies will continue to fall versus the U.S. Dollar.

          Summing Up Our View

We foresee strong economic growth in the U.S., with estimated Q4 real U.S. GDP growth up from 2.8 percent to 3.3 percent due to lower oil prices.

U.S. price-to-earnings and price-to-book ratios are only slightly above average; over 80 percent of the time, the market moves higher under these conditions.

The current season is the strongest time for stocks — mid October through mid April.

We at GIM are bullish for these reasons among others.

Thanks for listening; we welcome your calls and questions.