The Island Investing Blog

  • An Economy in Recession

    From an email sent April 30, 2020:

    Good evening, IIM investors.

    This week’s GDP report formally confirmed what you probably already knew: the economy is either already in recession, or soon will be. That report was unique not only because it was rooted in a global pandemic, but because quarterly economic data won’t really tell us anything we don’t already know. We don’t need to wait until July to know that the second quarter GDP number will be Ugly with a capital u – or that next week’s April jobs report will be a particularly brutal one. What matters for long-term investors now, though, is what happens going forward. And that there is light at the end of the tunnel.

    The common definition of a recession is two consecutive quarters of negative GDP growth, although technically, the official dates are determined by the National Bureau of Economic Research (NBER) using a range of data, after the fact. This week’s GDP report showed that the economy shrank by -4.8% in the first quarter – when the economy was just beginning to shut down for COVID…the worst decline since the 2008 financial crisis. For some perspective about how abrupt this is, know that the first negative GDP quarter in 2008 was -2.3%, with five negative quarters in 2008 and 2009 overall, ranging from -0.6% to -8.2%. And that during the bursting of the tech bubble, the economy only shrank two non-consecutive quarters at -1.1% and -1.3% each.

    What’s more, the consensus estimate for GDP in the second quarter is -26%…which would easily be the worst in modern history. Initial jobless claims have now surpassed 30 million since mid-March, compared to the 23 million jobs created since the global financial crisis. A whole host of other data, from manufacturing output to retail spending, have plummeted. Other regions around the world are experiencing similar problems, with the Euro-area economy shrinking 3.8% in the first quarter. 
    Which is why the Fed is “using its full range of tools,” and D.C. has passed a variety of huge stimulus measures – alongside central banks and governments around the world.

    The fact that we know why this is happening, and that it will eventually pass, doesn’t make it any emotionally or psychologically easier to navigate, though.

     There are a few facts worth remembering as plans to reopen the economy are being put together. 

    First, the economy was fundamentally strong going into the crisis. This is not 2008, when the financial system ground to a halt due to its own excesses, or 2000, either, when valuations were exorbitant. This time around, the economy was still fundamentally healthy.

    Second, COVID-19 cases in the U.S. appear to be plateauing, there are initial signs of possible treatments, and other countries have been able to open up. This suggests that, depending on how we navigate the public health considerations, the U.S. economy can begin to strengthen over the next couple of months. The fact that many of those counted as unemployed are either furloughed or can be quickly recalled back to work is also a positive. Of course, timing matters…being recalled to work in mid-May is very different from July…and not all sectors will rebound quickly, or easily.

    Third, although many investors understandably want to see the stars align prior to even thinking about investing again, markets don’t wait for conditions to be perfect. The S&P 500 returned 13% in April and is up 32% since the March low. While we shouldn’t overstate the importance of a single month – and investors should continue to expect a high degree of uncertainty – the point is that markets are forward-looking…even when investors are not.

    So, while it’s challenging to do in the middle of a crisis, it is important to focus on longer time horizons. Recessions and bear markets are a natural and unavoidable part of investing. In many cases, they allow the economy to shake off excesses and re-allocate resources, paving the way for future growth. And once a crisis subsides, the subsequent economic expansions and bull markets can last significantly longer.

    Below are three charts that help to put recent economic data in perspective.

    1. The economy shrank in Q1 by the largest amount since the financial crisis

    rec1.png


    The economy shrank by 4.8% in the first quarter of the year, the worst drop since the 2008 financial crisis – and the early 1980’s before that. The economic shutdown that drove this number didn’t truly take effect until the second half of March. Thus, it’s widely expected that the Q2 numbers will be much worse.

    Since this is already well understood and expected, though, it’s important for investors to look ahead. If businesses can responsibly reopen in the coming months, then economic growth will begin to recover.


    2. The business cycle was already in its 11th year

    rec2.png

    The business cycle was in its 11th year before the coronavirus crisis, having begun in mid-2009. Not only was this last economic expansion the longest in history, but it grew at a steady pace. The fact that the economy was healthy entering the crisis increases the likelihood of a recovery.

    3. Recessions and bear markets are a natural part of long-term investing

    rec3.png

    Long-term investors will inevitably face many ups and downs over the course of their lives. It’s important to keep this in perspective and focus on what truly matters:

    Staying disciplined.

    While most investors would of course prefer for conditions to be perfect…the reality is that they don’t need to be in order to realize healthy returns.

    Please let me know if you have any questions.  

    Thank you and stay safe.

    – Cale

    ______________

    Cale Smith
    Managing Partner
    Islamorada Investment Management

    Posted by: Cale Smith , Commentary, For Investors
  • Negative Oil Prices?!?!

    From an email sent April 22, 2020:

    Good evening, IIM investors.

    The nationwide shutdown in response to the coronavirus has hit all corners of the economy, including the energy sector. The oil market made historic moves on Monday, as per those breathless headlines about the price of crude falling into negative territory for the first time.

    For those of you looking for more detailed discussions about oil, I’d encourage you to join Tarpon Folio investors already discussing much of this on the IIM Message Boards.

    For our other Spoke Fund and private account investors, however, I thought I’d attempt to explain in simplified terms what is happening in oil markets this week.

    Oil is a critical input into economic activity, with the International Energy Agency (IEA) estimating that global demand was roughly 100 million barrels per day prior to this economic crisis. With shutdowns across the U.S. and around the world, demand for oil has fallen sharply due to the coronavirus – by about a third, according to some projections. The fact that Americans aren’t commuting, airlines have cut flights and businesses have temporarily shuttered means that there’s reduced need for crude oil. While this decline in demand will be temporary, it also creates significant challenges for the industry, nonetheless – which filters over to many other parts of the economy, too.

    The oil market is also different from the stock and bond markets. While a share of stock is a purely financial asset, holding an oil futures contract means you are buying 1000 actual barrels of oil to be delivered at a later date. As with other commodities, companies that need physical oil on a future date can use these contracts to lock in prices today – and to hedge price movements, as well.

    However, not all buyers of oil futures contracts want physical oil to be delivered to them. In fact, there are approximately 30 times as many “speculators” than “physical market traders” in the oil market today.  In normal times, the speculators who trade oil contracts simply sell their contracts and close out their positions before the expiration date. In doing so, they can notch a financial gain (or loss) without dealing with the logistics of receiving, delivering or storing oil.

    There are even ETFs (Exchange Traded Funds) whose purpose is to do this for investors…and one of the most popular, with the ticker symbol “USO,” effectively blew up on Monday, too, prompting calls for further investigations.

    Alternatively, there may be situations where oil prices may be much higher at future contract dates (so the oil futures curve, or “strip.” slopes upward). In these cases, sophisticated investors and companies could buy futures contracts at the lower price today, then later take delivery of the oil and store it – either in a storage facility, or on a tanker ship. They can pre-sell this oil by buying longer-dated futures contracts at the higher price and lock in a gain today, after also taking into account the cost of storage between the two delivery dates. Later, they deliver the oil they stored to the buyer of the longer-dated contract, fulfilling their obligation.

    Those same dynamics broke down this week, though, for a number of factors.

    First, oil demand has declined dramatically, due to the economic shutdown caused by the coronavirus.

    Second, supply remained relatively high in spite of this demand drop due to disagreements between two large producers, Saudi Arabia and Russia.

    These countries only recently reached a deal with other OPEC countries to cut oil production by roughly 10 million barrels per day. They were joined in that effort to reduce supply by other countries in the G20, too, which contributed additional production cuts – voluntarily or due to production shut-ins. And though those supply cuts are insufficient to fully stabilize oil prices immediately, they do buy significant time, which will help bring the oil market back into balance as the year progresses.

    Third, this supply and demand imbalance has resulted in short-term oil inventory increases, which have to be stored.

     And over time, it becomes incrementally more difficult and costly to store each barrel of oil.

    Which is why the May WTI futures contract fell to negative levels on Monday – as it approached expiration on Tuesday.

     A negative price means that the holder (or seller) of a contract pays the buyer to take the contract (and physical delivery) off of the seller’s hands. 

    This happened Monday because 1) oil prices were very low to begin with, and 2) there was a “squeeze” in the market – very few buyers who wanted to take physical delivery and use or store those barrels. It’s important to note that contracts after May are priced low…but not in negative territory – and that the June contract closed at $22 a barrel on Monday – the same day the May contract hit -$38 a barrel. 

    So, there are both short-term and long-term impacts of what has happened in oil markets in recent weeks. The fact that oil prices fell into negative-price territory is an anomaly…a short-term phenomenon due to the mechanics of how oil trades among twitchy speculators. However, the fact that oil prices are low, and the fact that there are significant supply and demand imbalances, could persist for some time. As with everything else at the moment, this depends critically on if, when and how the economy reopens in the coming months.

    In general, cheaper energy prices are positive for U.S. consumers and the economy overall. Since lower energy prices reduce the cost of products and services both directly and indirectly, the emergence of the U.S. as a major energy player has been an unambiguous positive for U.S. consumers. For instance, as one of the charts below shows, gasoline prices were already well below average even before this crisis began. Additionally, the White House is planning to buy oil at these low levels to add 75 million barrels to the nation’s Strategic Petroleum Reserve. As taxpayers, we should all be happy with the timing of those buys.

    Below are a few charts that may help to put recent oil moves into perspective.

    1. Oil prices have plummeted, even falling into negative territory due to technical factors

    em1.png

    Oil prices have fallen due to the economic shutdowns that have resulted from the coronavirus pandemic. The drying-up of demand and temporary oversupply have pushed both WTI and Brent below levels last seen during the 2014-2016 period. In fact, WTI prices even fell below zero on Monday, due to a technical squeeze stemming from limited leased-storage availability.

    2. The U.S. is a leading global producer

    em2.png

    The U.S. energy renaissance of the past decade has seen U.S. energy production climb steadily. The U.S. produced about 13 million barrels per day prior to the coronavirus crisis.


    3. The energy sector’s earnings are tied to oil prices

    em3.png

    It’s no surprise that the health of the energy sector depends heavily on oil prices. Oversupply and plummeting demand are expected to significantly reduce the sector’s earnings over the next year. Since the last oil price peak in 2014, the sector’s estimated earnings-per-share have declined by about 87%…one reason the U.S. Administration appears to be moving to support this important sector during this COVID pandemic.

    4. In general, lower energy prices are good for the U.S. economy and consumers

    em4.png

    As an input into almost everything we buy and use, lower oil prices are generally positive for the U.S. economy as a whole. Gasoline prices, for instances, were already below average before the economic shutdowns hit. Cheaper energy prices effectively translate into more money in the pockets of all Americans – good news for when the economy eventually reopens.  
    Due to the size of the U.S. energy sector now, however, some economists also believe the drag on economic growth caused by a faltering energy sector will outweigh the positives associated with lower oil prices.  This, too, may explain the White House’s attempts to bolster the energy industry of late.

    What’s it all mean further out?

    Finally – as per a lot of discussion on the IIM Message Boards, what all this means for the price of oil once the economy recovers is of considerable interest to Tarpon investors.

    Because if the cliche that “the best cure for low oil price is low oil prices” is true…then in spite of many recent headlines, the energy sector could finally be an extremely attractive place to be for long-term investors. 

    Please let me know if you have any questions.  

    Thank you and stay safe.

    – Cale

    ______________

    Cale Smith
    Managing Partner
    Islamorada Investment Management

    Posted by: Cale Smith , Commentary, For Investors
  • IIM International Portfolios: Q1 2020

    “When We Are Absent One From the Other”

    In 2019, the equity market overcame trade disruptions, Brexit fears and slowing economic growth only to be impaired this year by a piece of RNA that jumped  from bats to humans, humans to humans, city to city and country to country. Travel restrictions were put in place, businesses were shuttered and earnings estimates for stocks dropped precipitously, as did equity markets;  The Morgan Stanley All Country World Index fell 21.37% for the first quarter of 2020.    As I write the number of deaths globally have surpassed 100,000. Our hearts and prayers go out to all of your during this humanitarian crisis, and we wish for you and yours safety and comfort.

    For the first quarter of 2020, our international ADR (American Deposit Receipt) Folio Frigate, that focuses on capital appreciation, fell on a net basis an estimated (all returns for benchmarks and Folios will be estimated) 21.4%. Economically sensitive stocks such as luxury goods provider Burberry and French bank BNP were the greater detractors of performance. On the other hand, pharmaceutical companies Novo Nordisk and Roche yielded a positive return. Relative to the S&P 500 ADR index, which fell 25.6%, Frigate benefitted from its cash position, which as with all of our international Folios, was the result of high valuations at the year beginning of the year.  Some of  this cash  was deployed into adding to some current positions and initiating or revisiting new positions in quality stocks finally trading at attractive levels; including L’Oreal and Adidas.  Since inception on July 1, 2013, Frigate has delivered a positive cumulative net return of approximately 10.3%.

    Over the same period, our international ADR Folio Treasure Harbor, which focuses on dividend yield, fell approximately 21.50%. Not surprising, energy related stocks Pembina Pipeline, Total and Royal Dutch Shell fell among investor concerns over their plans to conserve capital rather than returning it to shareholders. Performing relatively well were defensive positions such as Iberdrola, a Spanish utility company, and Nestle. China Construction Bank Corp also was an outperformer.  Treasure Harbor’s benchmark (85% SPDR S&P International Dividend, 15% SPDR S&P Emerging Markets Dividend ETF) was down approximately 24.2% during the 1st quarter. Although a modest cash buffer helped Treasure Harbor during the quarter, a below benchmark weighting to Emerging Markets and Financials also likely helped. There were no major changes in positions during the quarter; some of the excess cash was deployed in April. Since inception on  10/1/2013, Treasure Harbor has returned a negative cumulative return of approximately 11.7%.

    Yellowtail, our international Small/Mid- Cap Folio, was down approximately 22.1% the first quarter of 2020. Yellowtail’s benchmark VSS (Vanguard FTSE All-World ex-US Small-Cap Index ETF) was down an estimated 29.6%.  The major detractors aren’t a surprise, including:  travel retailer Dufry, pumping solutions provider Sulzer and market researcher Ipsos.  Defensive stocks, such as Japanese packaged-food company Nichirei, Swiss chocolatier Barry Callebaut and UK generic manufacturer HIkma were great buffers.  This was a great time to start deploying Yellowtail’s excess cash, some of which went to initiate two Swiss positions: Logitech, a manufacturer of computer peripherals and software, and Vetropack, a manufacturer of glass packaging. Since inception on 12/1/2014, Yellowtail has generated a positive cumulative net return of approximately 12.2%.

    In addition to managing our proprietary portfolios, we continue to reach out to clients and fine-tune their asset allocation.  In many cases we have been slowly deploying excess cash into ETFs giving exposure to asset classes such as:  Low Volatility, US Small Cap and Domestic and International Growth  Please let us know if you want us to revisit your asset allocation.

    Toward the end of March,  equity markets, anticipated the peaking of the crisis and noting various governmental supportive and economic stimulating actions, began to bounce off their lows. Trading is still volatile, but, colloquially, appears to be more rational with sector rotation and stock selection taking over from panic selling.  As investors monitor corporate announcements, viral containment efforts and economic progress, I expect the markets to remain volatile but ripe for opportunistic and strategic investments. I am mindful, and you should be too, that uncertainty is playing on many stages and it is time to invest carefully and wisely.

    In the meantime, I truly hope that the citizens of the world learn from this experience and:

    1. Vow to respect the Earth and all of its creatures

    2. Prioritize comprehensively addressing healthcare needs

    3. Put long-term safety and happiness above short-term greed

    4. Wash hands frequently– Seriously, go wash your hands!  I’ll be here when you get back.

    In this time of social distancing, I am remembering how we closed services at the Federal United Methodist Church in Oakdale Pennsylvania: “ The LORD watch between me and thee, when we are absent one from the other.” (King James Version,  Genesis 31:49).  Amen.

    – Lauretta “Retz” Ann Reeves, CFA AWMA

    Disclaimer: This post nor any of the material linked to herein in any way constitutes investment advice. Historical performance data above represents performance results as reported by the portfolio identified. Performance results are for illustration purposes only. Historical results are not indicative of future performance. Positive returns are not guaranteed. Individual results will vary depending on market conditions and timing of initial investment. Investing may cause capital loss. The publication of this performance data is in no way a solicitation or offer to sell securities or investment advisory services.

    Posted by: Retz Reeves , For Investors