December 19, 2014

December 19, 2014

Executive Summary

1.  Corrections are normal — watch the fundamentals.  The pullback over the past week and half was prompted by a number of fears — mostly related to the effects of oil’s sharp decline on U.S. and global credit markets.  We believe those fears are overdone.  We do not see global systemic risk from oil-rich governments liquidating holdings from their sovereign wealth funds; we think fears of Russia’s collapse are exaggerated; we think fears of systemic stress derived from energy-related high-yield debt in the U.S. are overdone.  The bullish fundamentals that we identified in last week’s 2015 outlook are still in place.

2.  Data encryption goes mainstream.  Responding to consumers’ desires for privacy and security (privacy from state surveillance, and security from hackers), more and more consumer-facing and internet infrastructure companies are implementing default encryption.  Apple’s Tim Cook boasts that Apple couldn’t hand over iMessage data even if they received a subpoena.  We view this trend as positive.  Intelligence agencies will still be able to crack the communications they really need to read, and consumers will be more secure from hackers.  After a few years of prominent stories about security breaches, the defenders of privacy are visibly pushing back.

Practical Investing:  Eyes on the Fundamentals in a Correction
The focus of this letter is to provide practical information and analysis for successful investing.
We manage money based not on theory, but on the closest analysis of the available information.  We avoid the theoretical and focus on the practical.  Last week, in giving our 2015 outlook, we were bullish on U.S. stocks.  We continue to be just as bullish.
The fears that have caused the U.S. market to sell off in the last week and a half include:
1.  Fear that lower oil prices somehow represent a very slow world economy, or even the risk of a world-wide recession.  Perhaps this would be sparked by a credit market collapse — after all, 15 percent of all high-yield debt is energy-related (about which, see below).  However, for there to be a problem in the credit and equity market that was more than just a short-term phenomenon, economic data would need to be weak and decelerating.  We don’t see weak and decelerating economic data for the U.S.; we see strong and accelerating economic data (and after Wednesday’s press conference with Federal Reserve chair Janet Yellen, we note that the Fed agrees with this assessment).  We also see commentators misinterpreting good economic data, and scaring themselves into believing that they’re not good.  This is unrealistic.  It ignores the fact that oil price declines benefit the global economy much more than lower oil prices hurt — although, as we’ve discussed, some economies and sectors within those economies will benefit more than others.  Lower oil prices create economic and consumer well-being in the great majority of world economies, and the overall positive effects in the U.S. will far outweigh the negative effects on specific sectors and industries.  We anticipate that global economic growth will accelerate, not decelerate, in 2015.
2.  Fear that lower oil prices will lead to a collapse of Russia, or that distressed sovereign wealth funds will sell assets and depress global stock prices.
As far as Russia is concerned, we don’t believe this is a problem for the U.S.  Let Russia’s strength be sapped — it serves the political needs of the West, and it also reduces Russia’s ability to finance foreign military activity.  A collapse may increase their belligerent attitude, but Putin won’t get far if Russian belligerence results in even more constraints on Russia’s economy.  Germany’s ties to Russia, especially in energy dependence, have become uncomfortably close; Germany — and the rest of Europe — will need to distance themselves economically and financially from Russia.  Most significantly, they will need to reduce their reliance on Russian energy.
Further, we believe that the risk of a Russian collapse is overstated anyway.  Certainly, sanctions and falling oil prices will drive a deep recession in Russia during the coming year.
Two factors lead us to moderate our worry.  First, Russia’s financial system is in a position of relative strength — the country is a net creditor with little external debt.  We note that Russia’s macro situation is radically different than it was during the ruble’s collapse and Russian default in 1998:
Russian Debt-to-GDP — Far Healthier Than During the 1998 Crisis
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Source:  International Monetary Fund

Secondly, the Russian people’s stoicism in the face of economic adversity should not be under-estimated.  For ordinary Russians, patient endurance of economic turmoil is written too deeply in their cultural DNA to have been weakened by the last ten years of prosperity.  We believe that even in the face of recession, internal Russian opposition to Vladimir Putin’s rule will be more subdued and peripheral than many foreign analysts fear it will be.

Don’t mistake our calm for a lack of concern about Russia’s long-term problems, and the long-term problems Europe will face as a result of Russia’s intransigence.  We are simply arguing that market fear of a contagious Russian meltdown is overblown.

3.  Fear that bank debt tied to oil will collapse bringing the world or U.S. banking system down.  In our view, fear of this risk is not reasonable.  The proportion of oil-related lending is much too small in terms of total loans outstanding.  The highest-risk energy-related high-yield bonds represent less than 0.3 percent of the total U.S. corporate bond market.  Doubtless, more high-yield energy-related debt will be downgraded as the effects of oil’s fall are evaluated.  Even so, this is a matter of some investors taking a hit — not the kind of spark that would be needed to ignite a systemic credit event.


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Data Source:  Securities Industry and Financial Markets Association, Bloomberg


4.  Fear of sale of securities by the sovereign wealth funds of countries whose wealth is generated by the sales of petroleum.  This will happen, but will not be a major negative.  It will create some overhead supply for the stocks of the big-capitalization companies that are held by the major sovereign wealth funds.


Our research suggests that distressed selling of assets from oil-related sovereign wealth funds will not be a significant issue for the global financial system.  The largest oil-related sovereign wealth funds — those worth $100 billion or more — have total assets of about $4.3 trillion.  Even if we assumed that all were distressed (which they aren’t) and would sell a significant portion of their equity holdings (which they won’t), those sales would amount to a very small portion of the total market capitalization of developed-world stocks, and would be spread out over a considerable period as they made sales to meet fiscal needs.




We’re bullish on world economic growth in 2015, and we’re bullish on U.S. economic growth in 2015.  We are not panicked by the normal stock market correction which is currently taking place.  As we often say, the U.S. market can correct 5 to 10 percent at any time, for a variety of transitory reasons.  This is one such correction.


Investment implications:  Our bullish thesis for our favored markets in 2015 has not been derailed by the current correction, which we regard as a normal and healthy event in an ongoing bull market where stocks are, on the whole, fairly valued.  We think that the credit risk posed by oil’s fall to distressed sovereigns or distressed oil producers is not the systemic threat some observers are anxious about.  

Encryption Goes Mainstream

In spite of the past few years’ news stream about government surveillance, hacking, and data breaches, consumers’ data is getting more secure than ever — at least when it comes to web browsing, social media, messaging, and email communications.  Consumer-facing companies like Facebook (NASDAQ: FB), Apple (NASDAQ: AAPL), and Google (NASDAQ: GOOG), as well as IT infrastructure companies like Cisco (NASDAQ: CSCO) and Akamai (NASDAQ: AKAM), are leading a trend to encrypt communications by default.  

While encryption of web activity used to be the domain of geeks, encryption by default, with simple configuration, is becoming the norm.  Apple’s Tim Cook told Charlie Rose in September: “Our view is, when we design a new service, we try not to collect data.  So we’re not reading your email.  We’re not reading your iMessage.  If the government laid a subpoena to get iMessages, we can’t provide it.  It’s encrypted and we don’t have a key.”


More Communication Is Now Encrypted By Default

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Facebook has gone as far as to ease access to its site by users of Tor, an encrypted web access system.  Tor is useful to Chinese and Iranian dissidents, since they can use it to get around their countries’ firewalls, and this is doubtless the reason behind Facebook’s effort.  (Tor is also the only way to access contraband sites such as the late Silk Road and its successors, where a lot of illicit commerce occurs.)
The bottom line is that the default use of easy encryption will make surveillance and interception of communications more difficult for intelligence agencies around the world.  They still have the means to crack communications, but will need to be much more focused and determined to do so.  And the vast majority of law-abiding consumers who just want to feel that their communications are hidden from prying eyes will have some more piece of mind — especially since cyber-criminals are not likely to have the robust encryption-cracking resources that the likes of the NSA will be using.

Investment implications:  Despite the increasingly robust default encryption of consumers’ communications.  We think that intelligence agencies will still be able to get the data they need, albeit with more difficulty; and we think it is one more step towards consumers being safe from hackers.  All the high-profile hacks of the past two years are beginning to bear fruit in a new security orientation of consumers and businesses.  Technology companies will continue to innovate and invest in new security and privacy solutions.

This week’s letter is shorter than usual.  We are keeping a close eye on the markets.  As markets head into the final trading days of the year, we are watching current volatility closely.  We encourage our readers to call or email with questions or concerns, and wish you a joyful holiday season.