Does The Deflationary Dream Bail Us Out?

Maybe. Lemme take you back to 1986 when the Big Board was delivering zippy 30- and 40-point up and down days. Spot prices for oil had collapsed to a sawbuck per barrel and year-over-year had snuffed out any inflation left in the system. Bond rates broke to 7.5% while the central banks of West Germany, Japan and the U.S. synchronously lowered their discount rates.

The deflationary dream was coming true, then as now. Flattish auto sales becalmed the economy while IBM’s new computer line sold slowly. Corporate earnings were yet to bloom but the valuation of the market rose reciprocally as interest rates simmered down. The best recipe for any bull market is always the hope you are buying earnings on the come.

Decades ago, Texaco bought Getty Oil at the top of the oil market. Sounds familiar, like Occidental Petroleum leveraging itself to the hilt on its purchase of Anadarko Petroleum. There was the precedent of oil prices tripling in 1973 and then tripling again over the next several years. The market is the country, its fantasies and its reality intertwined with an enormous capacity for mutational exception.

The dividend discount model is an academic’s conceit. It only works in an orderly economy of trendline growth, not what we experience today – subpar GDP, minimal interest rates and inflation overlaid with probabilities of radical geopolitical eruptions.

The dividend discount boys understand all this. Their rationale is that industries sustain good and bad years. The pendulum of sentiment generally swings too far at both extremes in each cycle. If the country plunges into deep depression, like 2008-2009, 1973–1974 and 1982 all bets are off. Investment money is sucked down the drain pipes.

Very few money managers, analysts, economists or bank presidents are worth nine-figure money because of their investments or interest-rate forecast. Few, like me, leverage themselves in high-yield BB paper or like Warren Buffett, who placed 25% of stock market money in one property, namely Apple. I hardly approach such concentration with 10% positions in Alibaba, Facebook, Citigroup and Microsoft.

The investment dilemma can be stated another way. Most growth-stock players do get caught up in the periodic overvaluation and hysteria that bubbles up in each and every cycle. Then there are value players who step in when they see factories turning to rust. U.S. Steel is a good example, today, shuttering blast furnaces.

Unless you see a resurgence in worldwide GDP, industrials are goat meat. A few years ago, U.S. Steel spiked into the mid-forties on GDP optimism. Today U.S. Steel is slipping toward a single-digit piece of paper, capitalized at petty cash, under $3 billion.

I need to review my hits and misses for 2019. Fundamentally, I lacked the gumption to be optimistic, fully invested. My investment construct was a namby-pamby 60/40 ratio. My sense of financial markets’ history got in my way. I didn’t expect the price-earnings ratio to hang in at 18 times forward 12-month earnings.

I saw sloppy earnings, minimal interest rates, absent inflation and plenty of geopolitical turmoil. Trump was the loose cannon. All this came to pass, but the market is posting a 25% gain, a sometimes thing. I shoulda been 150% invested in growth stocks, selected financials like Charles Schwab, Citigroup and Bank of America. I avoided industrials, materials stocks and most healthcare properties.

Sector concentration did make up for a portion of my bad call on the market’s course. For me, nothing has changed. The S&P 500 Index carries at least 20% risk, corporate earnings go nowhere, inflation stays dead and the Federal Reserve Board is a toothless tiger in our setting of minimal interest rates.

Consider, the U.S., now is a net exporter of some one million barrels of oil. We used to import over one million barrels. OPEC won’t bite the bullet of a sizable cut in its production. Stocks like Schlumberger rest cut in half, yielding over 7%. Management should halve its dividend payout. What are they waiting for? They’ve never been on the money forecasting worldwide oil demand and futures prices.

Next year’s battle for investment survival must be fought out in the growth-stock sector. I see internet and e-commerce stocks outperforming because they can be modeled as to operating earnings and Ebitda multipliers. I except Amazon, concentrating on Alibaba. Agnostic on Apple but I missed the bus. If I’m wrong on tech, stocks like Facebook, Microsoft and Alphabet will drop 1.5 times any market decline. Adjusted for daily volume, the market is Nasdaq, not the Big Board.

If the country slips into recession soon, my 20% position in financials will drop like a stone. Loan losses, lessened financial market activity and slipping net interest margins will destroy my case for an upward valuation in bank price-earnings ratios.

Serious investors need to be right on several macro calls. Here are my two cents:

·      Is Trump reelected? Yes.

·      Does the country lapse into recession? No, because consumer spending holds up and no great excess is in bank lending emerge.

·      Pick a number on the S&P 500. Maybe, 10% lower because industrial earnings power has peaked with weakening worldwide demand. Earnings for financials flatten. Pharma is pricey and energy dead in the water. Technology, biggest market sector at 22%, is the toughest call, but I’m all in: Microsoft, Alibaba, Facebook and Alphabet. You can’t just look at price-earnings ratios. You’d never buy them. Properties like Facebook allocate more than 15% of revenues to R&D, bent on renewing themselves. These stocks are reasonably priced on metrics of Ebitda to enterprise value and to their multiple of operating cash flow.

If I’m right on half my calls, I’ll be happy. Don’t expect a rose garden blooming.

I’m going to give it away: The most reductive theme for years to come in the Western world is the need for low-interest rates to grow out of our economic stagnation.

Sosnoff and / or his managed accounts own: Alibaba, Facebook, Citigroup, Microsoft, Charles Schwab, Bank of America and Alphabet.

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