Author: Ben Dickey, BSG&L Financial Services LLC
Disclosure: Long SDRL, CAT, TGP, BTU, CLF, FCX, LINE, KMP, UTX, EMR
After the huge amount of volatility for most of 2011, January and February have been much calmer. Volatility has been down substantially. The large up or down days in the market have not happened. The European debt crisis is still present, but the European Central Bank has kicked the can down the road giving their economies a chance to improve. However, investors are still hesitant to move back into the “risk” trade. This has driven down the yield on the ten year Treasury bond.
These factors have caused investors to ignore the good fundamentals that are in the equity markets. Inflation in the emerging markets has slowed so central banks in these markets have been able to loosen the purse strings again. The U.S. economy is plugging along at about a 3% annual clip so far this year. Investment returns for January and February have been fairly good, with the S&P 500 index up about 4.5%. The economy should continue to slog ahead in 2012, slowly but gaining slightly. Forecasts for the economy range from 2% to 3.5% growth in the first half of the year but slowing to a crawl in the second half.
This slowdown is due to rising taxes, increased business regulations and the new health care law that are all looming in the near future. Europe has pushed their problems further down the road, hoping their economies will improve and help their budget and debt problems. The emerging markets did manage to slow down their economies; however, they are still growing at a 6% to 8% rate. China’s manufacturing index was positive in January and February which helped industrial metals and the energy markets to improve.
I believe that Europe will slip into a mild recession, due in part to their austerity programs and also due to the massive amount of sovereign debt that must be rolled over in the next year or so. There is also a growing concern that all of the liquidity that the U.S. and other central banks are creating will cause inflation sooner or later. Currency and interest rate markets are looking uneasy.
Energy prices are continuing to rise. Gasoline prices are at their highest level for this time of year that we have ever seen. The economies of the emerging market countries should continue growing at their 6% to 8% clip. Europe, for all practical purposes, is currently in a recession. The emerging markets will continue their demand for large amounts of commodities, industrial machinery and parts. China sold twenty million automobiles in 2011. This growth will continue to put pressure on the oil markets. The Chinese government is investing billions of dollars in oil exporting countries to guarantee future supply.
For the first time, China now buys more oil from Saudi Arabia than the U.S. does. Many of the large US based companies that operate globally will be able to take advantage of this increased consumption demand and should grow their bottom line. However, I do not think that all of these positive factors around the world will have a large enough impact on our economy to improve it enough to reduce the large overhang of unemployed and under employed Americans. The U. S. economy will not have a robust recovery until business opportunities improve sufficiently for all companies which should lead to an increase in employment gains. Our economy is too large for manufacturing alone to jump start it.
There are a couple of positive factors in the U.S. economy. Major technological advances in the oil & gas industry have caused the U. S. to have an increase in oil production for the first time in over twenty years. The production of natural gas has increased to the point that prices have collapsed. This is lowering the cost to manufacturing companies. In addition, the increased production of natural gas liquids such as ethane, propane and butane has lowered the input costs for the chemical industry. As a result, chemical companies are moving production back to the U. S. from overseas. This also will reduce the balance of trade deficit and add jobs.
The Keystone pipeline project would have helped our oil supply. Canada producers more oil that they need domestically so they are in need of an ability to export oil. They really only have two choices. They can go west to the Pacific Ocean or south to the Gulf Coast. It is easier for them to ship oil downhill from Canada to the Gulf Coast than across the Canadian Rockies. This additional crude would have also allowed our refiners to make profits on the value added by refining the heavy crude and exporting gasoline.
These beliefs cause us to stay with an overweighting in our basic portfolio allocations to industrial, energy, and commodity companies. We like Caterpillar (CAT), Deere & Company (DE), Honeywell International (HON), United Technologies (UTX), Emerson Electric (EMR), and Cummins (CMI) in the industrial sector. We like Helmerich & Payne (HP), Cameron International (CAM), Halliburton (HAL), and Schlumberger (SLB) in the oil field services area. We also like Mitcham Industries (MIND) which is a seismic rental company.
Our holdings in commodities and energy have changed little. We continue to like Continental Resources (CLR), GeoResources (GEOI), Anadarko Petroleum (APC) and EOG Resources (EOG) in energy. In industrial commodities we like Peabody Energy (BTU), Freeport-McMoRan Copper & Gold (FCX), Cliffs Natural Resources (CLF), Vale S.A. (VALE), and Southern Copper (SCCO). To reduce overall portfolio volatility and generate income, we like Kinder Morgan Energy Partners (KMP), Linn Energy (LINE), Energy Transfer Partners (ETP) and SeaDrill Limited (SDRL). These companies have good dividend rates of between 5% and 9.5%.
We are light in the Technology sector, but like Amazon.com (AMZN), Apple (AAPL) and International Business Machines (IBM). We also only own one small regional bank, which is our exposure to the financial sector.
As I stated earlier, I believe the European debt problem has us most concerned about this year. I believe the election can also cause some turmoil due to the uncertain tax consequences. Hedging this volatility, in my opinion will be hard. Gold last year was as volatile as the markets. Several hedge funds lost huge sums of money betting on it. About the only way to reduce volatility is to add some consumer staples with good dividend streams. However, if you are a long term investor, the aforementioned sectors should allow an investor to outperform the markets with a somewhat reduced amount of volatility for the foreseeable future.
BSG&L is a Texas-based registered investment adviser. Our founding principals, Ben Dickey and Kevin Londergan, have more than 30 years experience in both accounting and financial services.
At BSG&L, we believe that greater and consistent returns can only be achieved by identifying long-term tendencies in the investment markets and understanding fundamental shifts in expected investment returns.