Published March 9, 2020
With market volatility so high, I’m publishing more of these unscheduled notes than scheduled reports these days. I also have a new article out on Seeking Alpha regarding current debt-laden economic conditions.
Today was one of the largest declines in the S&P 500 and Dow Jones history in percent terms, and is reminding investors everywhere that equity markets have real risk. It is times like this that I begin, carefully, putting capital to work.
Specifically, it’s the fourth-ever largest percent daily drop for the Dow in post-WWII history, and one of the top ten S&P 500 drops in that timeframe as well. And during the day, the S&P 500 triggered a stock market circuit breaker and was shut off for 15 minutes.
Treasuries and precious metals continue to hold up quite well as defense, while global equity markets are a mess. The S&P 500 is down almost 19% from its all time high, or a little more than 1% shy of entering arbitrary “bear market territory”, which is generally thought of as 20% down from all-time highs.
Here’s how this drawdown compares to other drawdowns since roughly WWII:
Futures are currently pointing towards a positive open tomorrow, but that can change overnight. After a day down this hard, it’s normal to have both volatile up and down days for a while.
The Oil War
And if you thought the stock move today was unusual, the oil price crash was truly historic. Oil fell over 20% today alone, is down about 50% from where it started the year, and is now deeply in unprofitable territory for the vast majority of worldwide producers.
Due to the coronavirus, and particularly China’s economic quarantine/shutdown during the past month, oil demand has diminished this year. Normally the group of oil-producing nations that collectively make up OPEC, along with their partnership with Russia, would cut oil production to preserve higher oil prices, to balance supply with demand.
However, U.S. shale oil has been growing and taking market share from them for the past decade. During the 2014-2016 period, Saudi Arabia purposely tried to oversupply the world with oil to bankrupt U.S. shale oil companies and take back market share, but it didn’t quite work and Saudi Arabia ended up relenting and cutting supply to raise prices, and thus forfeit market share.
During the past week, Russia and Saudi Arabia declined to reach a deal to cut oil production. Going a step further, both of them instead decided to increase oil supply. This is attempt #2 to take back market share, this time more coordinated. It is the perfect storm for the energy market, and a truly historic moment, because oil demand is weak and oil supply will now be maximized. This is a scorched-earth attempt to take market share back by bankrupting many higher-cost or indebted producers worldwide, and is particularly damaging to the weaker half of U.S. shale oil producers.
There are many different types of oil, with different cost structures. Investors often focus too much on the total cost of a barrel of oil to produce, rather than the more detailed cost breakdown. Some types of oil, such as Russian production, has big upfront costs but then rather low marginal costs after that, with big reserves. Other types of oil, like shale, have small upfront costs but then rather high marginal costs after that, with small reserves. And then companies all have different levels of balance sheet strength to get through hard times.
This low oil price environment is bad for all oil producers, but is a deathblow to that second type of group that has high ongoing production costs, because after the oil companies’ hedges wear off, it’s unprofitable to produce every new marginal barrel. They are the ones that will have a tough time surviving, and many will go bankrupt if this continues for a while. The first type of oil producer, the kind that already made a big upfront investment and now has low-cost operational production, can weather the storm better and come out the other side. For both groups, a strong balance sheet and the amount of hedging they had in place both help their survival odds.
Saudi Arabia vs Russia vs U.S. Shale: Who Blinks First?
Saudi Arabia, Russia, and the United States are the three biggest oil producers in the world.
Saudi Arabia has the world’s lowest ongoing production costs, but their social programs are almost entirely reliant on oil revenue, so their “real” break-even price is rather high. Russia has among the lowest ongoing costs (not quite as low as Saudi Arabia), but they have a somewhat more fortified financial condition and tax base to spread the impact out. Oil is a smaller part of the United States’ economy than either of those other two, but is critical for some states, and many of these are small shale oil producers that are free cash flow negative even at $50 oil. Oil prices this low is rather damaging to all three countries, in different ways.
Most likely, the weak half of U.S. shale is going to take the brunt of the impact. Russia can last for years like this if they have to. Many U.S. shale producers are small and already unprofitable, and their debts are being priced increasingly for bankruptcy already. Many shale stocks were down 40-50% or more today, which is way more than the integrated oil majors, or oil sands producers.
I would be very cautious buying into any of these U.S. shale oil sell-offs, and would instead focus contrarian “bullish oil recovery” plays on oil companies with strong balance sheets and low ongoing operational production costs.
Risk Assessment
During times like these, investors are faced with two major behavioral traps on either side of the conservative/aggressive spectrum.
One trap, and the more common one, is to get scared and sell everything, and then never get back in. Investors should always maintain appropriate diversification and risk management for their age and unique circumstances, but avoid the constant treadmill of buying at the top and selling at the bottom. My unscheduled notes on January 26 and February 25 gave a risk alert before and during the sell-off, to help remind readers to position appropriately for their risk tolerance.
The other trap is to blindly double-down on everything, thinking that just because something goes down, it must come back up. Individual stocks and sectors can be crushed for a long time. The broad Dow or S&P 500 indices have gone decades before reaching new highs. Recessions cause bankruptcies. Buying low is important, but it’s critical to make sure that anything you buy more of is solid enough to get through the rough patch and prosper on the other side. Be very careful with the use of leverage or any highly risky behavior.
Recent Portfolio Changes
It’s a good idea to do a portfolio audit, and check each stock, ETF, or mutual fund you hold and make sure that it’s something you’re truly willing to hold through a recession. Sometimes there are losing positions that are worthwhile to cut and replace with something else. Even if you’re down on a position, there’s an old saying that goes, “you don’t have to make your money back the way you lost it”. That’s what diversification and defensive hedges like treasuries and gold are for; they give us defense and flexibility.
I’m selling Oneok (OKE) and Carnival (CCL), which together represent 1.38% of the Newsletter portfolio and 1.35% of the Fortress Income portfolio. Oneok has been replaced in the Newsletter portfolio by Grupo Aeroportuario del Centro Norte (OMAB), a Mexican airport company (not airline, but airport, which is an important distinction) that focuses mainly on domestic flights within the country and is traded on the Nasdaq. Carnival will be replaced in both portfolios by American Express (AXP).
The problem with Oneok is that they have a lot of exposure to U.S. energy production, which is fundamentally at risk from the Saudi/Russia oil price war, and not necessarily just for the near term. The problem with Carnival is that the virus was not around during the initial analysis, and has continued to accelerate to the point where governments are directly saying not to take cruises. I will re-evaluate these two stocks in the future if a case for recovery comes into view. Both of them were hit by shocks that are outside of their control. Their current or upcoming portfolio replacements, OMAB and AXP have also been hit hard, but I have more confidence about their ability to weather the storm.
I am selling cash-secured put options on the VanEck Vectors Gold Miners ETF (GDX) in my larger accounts. The gold price is up year-to-date, the oil price is crushed year-to-date (which is one of the largest expenses for gold miners), and gold miners are down year-to-date (although not as much as the S&P 500). So, gold mining profits will likely be flat-to-up this year, while their stocks are still middling around, which makes for an interesting long-term accumulation point.
I’m making an asset allocation change to my retirement account, which is where I have the least equity exposure. My retirement account, which was previously 40% in treasuries and safe bonds, is being shifted to a slightly more aggressive position, down to 29% treasuries and safe bonds. This means I’m putting 11% from bonds into stocks.
Retirement account change:
- 33% treasuries to 21% treasuries
- 7% diverse bonds to 8% diverse bonds
- 30% large cap stocks to 35% large cap stocks
- 9% small cap stocks to 11% small cap stocks
- 21% international stocks to 25% international stocks
Potential Newsletter portfolio change:
Tomorrow I plan to exchange the 9% VGSH treasury ETF position with a 4% SHY treasury ETF position in the M1 Newsletter portfolio, and put the remaining 5% that is left over into stocks and commodities. If this occurs, it will be:
- 9% VGSH to 0% VGSH
- 0% SHY to 4% SHY
- 6% growth stocks to 8% growth stocks
- 14% commodities to 15% commodities
- 23% dividend stocks to 25% dividend stocks
That doesn’t mean I necessarily think “this is the bottom”; it just means that this is one of my potential rounds of bond-to-stock capital movement if the drawdown persists deeper.
Check the members area that has the Google Drive link to my portfolios, including my Newsletter portfolio, Fortress Income portfolio, and the Other Holdings tab which has my various investments including my options and retirement account ratios.
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All of the analysis in this research report is presented for informational purposes about investments in general, and does not constitute investment advice.
Individuals have unique circumstances, goals, and risk tolerance, so you should consult a certified investment professional and/or do you own due diligence before making investment decisions. Certified professionals can provide individualized investment advice tailored to your unique situation. This research report is for general investment information only, is not individualized, and as such does not constitute investment advice.
Every effort is made to ensure that the research content in this report is accurate, but accuracy cannot be guaranteed and all information is presented “as is”. Investors should consult multiple sources of information when analyzing investments.
Investments may lose value. Investors should use proper diversification and maintain appropriate position sizes when managing their investments.
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