To
get a better understanding of how investment managers select securities
and build portfolios, over the years, we’ve visited
a lot of managers in their own offices. It is useful to observe them
in their working environment, and from a practical standpoint, it
was often easier for us to visit them than vice-versa. We liked it
that way anyway — it meant they could spend more time on research
and managing portfolios, and less time on marketing!
It may seem trivial, but it is always interesting to see how firms
decorate their offices, especially their front lobby. We have observed
that a firm’s decor tends to be consistent with their investment
philosophy. For instance, value managers — those investment
managers that primarily emphasize getting a good deal on the price
of a company — often have relatively Spartan offices. Growth
managers meanwhile, who emphasize concepts, stories, and glamour
in their portfolios, tend to have a lot nicer-looking lobbies and
conference rooms. You can also guess who provides the fanciest sandwiches
for the working lunches.
Water
Regardless of their orientation, many investment firms feature
nice oil paintings of famous ships and other maritime scenes on their
office walls. The implied reference is that the investment firm is
the vessel that can navigate the rough waters of the financial markets.
The metaphor is apt as the markets can be choppy and quality professional
investment management can indeed help investors reach their financial
destinations.
When it comes to investing, the water metaphor works in many ways.
At Kobren Insight Management, we often talk about the market’s
cycles - and how they ebb and flow like the ocean’s tides.
We know that when prices are up, that they will be down again and
when prices are down, they will be up again. The tide comes in and
the tide goes out.
Oil
One market that has been doing a lot of flowing but not much
ebbing of late is crude oil. Just look at a price chart of the commodity.
Since the beginning of 2007, oil prices have steadily marched higher,
nary a significant retracement, and have gone nearly parabolic in
recent weeks. News flow has followed the price action (as it usually
does) and as a result we are getting lots of questions on oil and
commodities in general.
Can energy prices continue rising? Of course they can. The (near
unanimous) belief that the per capita increase in emerging market
demand, coupled with the long-term capital underinvestment in
the natural resource sector (with some geopolitical factors thrown
in for spice), will continue to push energy prices higher, strikes
us as a valid argument. However, that little phrase in parentheses
should at least serve as a red flag. As we have noted many times
before, when everyone in the market believes the same thing — things
are usually about to change! Let us be clear, we, too, share the
belief that the long-term secular trend of oil prices is bullish.
It’s just that we don’t necessarily expect prices
to remain at their current high levels in the near-term. In fact,
they could even reverse sharply; potentially eradicating any
year-to-date
gains in fairly short order.
Ambrose Edwards Pritchard of the London Daily Telegraph (among others)
laid out a compelling argument for why oil prices could decline,
perhaps even substantially, in the months ahead. The crux of his
argument is that right now, supply is rising while demand is likely
to contract, which should cause oil prices to begin to move lower.
When that happens, the potential exists that the non-traditional
commodity buyers who have recently entered the market — contributing
to the steepness of its ascent — could leave just as quickly
as they came, turning a modest decline into an outright plummet.
First, let’s look at supply. Nigeria, Iraq, Saudi Arabia,
Brazil, Azerbaijan and the Sudan have all boosted production of late,
or are expected to in the months ahead. By next year, the US itself
will be producing enough extra oil to reduce its import needs.
Demand is also likely to fall. The International Monetary Fund (IMF)
cut its forecast for world growth to under 4%, down almost a full
percent from the beginning of the year, and the United Nations (UN)
is predicting sub-2% growth. Given recent growth rates, these forecasts
do suggest a global economic slowdown. As a result, the major oil
forecasters have cut their estimates for crude demand in half.
It should also be noted that inflation is a real problem in many
emerging market countries where food and energy costs make up the
bulk of living expenses. China’s inflation is nearly 10%. Some
countries have much higher levels than that. Many of these nations
will likely actively look to slow economic growth in order to ease
inflationary pressures. The important point here is that these are
the very same countries who have accounted for most of the growth
in oil demand over the last couple of years. Add it all up, and it
doesn't seem likely that demand will accelerate in the near term.
According to a recently published report from Lehman Brothers titled, “Is
It A Bubble?,” in just the last two and one half years, assets
in commodity index funds have more than tripled, rising from $70
billon to $235 billion. Since energy dominates the indices these
funds track, this has meant a large flow of investment money into
oil, lifting crude oil prices. These are not dedicated commodity
investors, or firms hedging risks who have to maintain a position
in the asset class. Rather these investors only came to embrace the “diversification
benefits” of commodities recently (funny they didn’t
seem to care about such benefits when oil was at $20 a barrel). What
happens when this non-traditional asset class starts to underperform?
Will these new buyers stick around? It’s not likely.
Why Forecast?
We like to think that our success in managing money
is built upon our philosophy, process and people — not our forecasts. Nonetheless,
people want forecasts. The markets can also be emotional at times,
and random at others, yet investors want rational answers why prices
moved the way they did. Even though the markets are complex, most
investors (ourselves included) prefer simple answers. In reality
though, it’s just not that simple.
Given that we build diversified portfolios of mutual funds, managed
by portfolio managers with different mandates and mindsets, we hear
lots of smart men and women take, and argue passionately for, the
exact opposite positions on where a market will go next. Given that
both sides of the debate are populated by educated, experienced,
talented, and resourceful investment professionals — who are
often right — whose side do you take?
Long-time clients know our punch line — nobody really knows.
That’s why we build balanced, diversified portfolios. We have
our own informed opinions, too, and so build tilts into our portfolios
according to our relative return and risk expectations. But, we like
to think that diversified portfolios acknowledge the fact that we
know we can’t predict the future with absolute certainty. In
sum, balanced, diversified portfolios allow you to participate in
the global economy’s long-term growth, even if we miss the
mark on some specific market calls.
Our Forecast
Okay, with those caveats firmly in place, our current
market outlook calls for slower economic growth later this year.
Those economic
concerns remain centered on real estate and consumer debt which are
expected to negatively impact consumer spending. With that expectation,
we are staying the course with our current positioning in client
portfolios, emphasizing higher quality stocks and bonds.
We do acknowledge that relative valuation measures between some “low-quality” and “high-quality” asset
classes are starting to look more favorable for low-quality. In addition,
we do believe that the outlook for corporate earnings growth (as
opposed to GDP growth) a few quarters down the road is also improving.
Nonetheless, we are not looking to get more aggressive quite yet.
Short-term, we remain defensive on the market. Over the last fifty
years, June has been one of only two months of the year that has
actually averaged a negative return. It is also usually negative
more than half of the time (the only month to score worse on these
two counts is September). Match that with our aforementioned concerns
about the over-all economy, high valuations, and the uncertainty
associated with the upcoming election, and we think fresh buying
opportunities for riskier asset and sub-asset classes are still at
least weeks or months away.
Sincerely,
