How QE, oil and U.S. stocks look from the other side of the Pacific

Regular columnist Ken Norquay CMT is currently on an extended vacation but he hasn’t forgotten his MoneyLetter readers. He writes from afar:

Late last year, I spent a few weeks in Hong Kong, financial capital of the Far East. What a magnificent modern city! Melbourne, Australia, was my home for the next few weeks. Travel gives us a chance to view our world through fresh eyes.

It’s the job of any financial writer to see through fresh eyes, to look for traps and false assumptions in the world of money. Investors who weathered the stormy bear markets of 2000 to 2003 and 2008 to 2009 know only too well what can happen to the unwary.

During both those periods the stock market averages dropped by about half—and most equity mutual funds did the same. Investors trapped in the old “buy-and-hold” mind-set lost half, then made it back, then lost it again, then made it back again. Perhaps a fresh look will help us avoid such financial fiascos this time around.

In recent articles, I have been discussing the financial seasons from the point of view of volatility. Markets change from long periods of stability to long periods of instability. Volatility refers to price change over time: high volatility means big price change over time—low volatility means small price change over time.

My concern has been that the Canadian and U.S. stock markets have gone up 190 per cent (the S&P/TSX composite index) and 276 per cent (the S&P 500 composite index), respectively, from the stock market lows in March 2009.

Changes in volatility often signal trend changes

After such a long strong uptrend, it would be normal to expect a reversal from up to down. Often a trend change is heralded by a change in volatility.

I recently noted two current examples of dramatic increases in financial volatility (crude oil prices and the U.S. dollar) and suggested this volatility might be warning us of an impending stock market reversal. Let’s look with fresh eyes at how these ideas appear from the other side of the Pacific.

The view from the other side of the Pacific

In the time that the price of crude oil dropped from $110 to under $50 a barrel (i.e., from June, 2014, to now), the Chinese stock market went up by 50 per cent—in six months! That rapid movement reminds me of the sort of roller-coaster ride the old Vancouver Stock Exchange used to feature. During this same time, the euro dropped 15 per cent and the Russian ruble dropped in half (versus the U.S. dollar.)

When I point to the inherent risk in the Canadian or U.S. stock markets, optimists ask: “What would cause such a decline in the stock market?” But investors from Hong Kong and Australia seem to know.

‘Quantitative easing’: a temporary fix

They see how the big upward surge in American stocks has been caused mainly by massive monetary stimulus by the U.S. Federal Reserve Board (via a series of rounds of bond buying known as quantitative easing or, in the jargon of economists, “QE1,” “QE2,” etc.).

Investors in Hong Kong and Australia see that this “QE” stimulus has expressed itself in a bounce up in the once depressed American housing market and in the U.S. stock market.

But, most of all, they wonder how long the monetary printing press can continue before the inevitable economic explosion will occur. They point out that other governments are considering the same “printing press” monetary policies in their own jurisdictions (mainly Europe and China). They see America’s “printing press” monetary policy as a temporary fix and feel its end is inevitable.

In the East and Down Under, the drop in oil prices was predictable . . .

What’s even more relevant for Canadians is how they see the massive drop in crude oil prices. Crude oil dropped to under $50 a barrel in January 2015. If prices simply stay where they are, the Canadian oil sands operations become unprofitable. It costs them $75 to $100 a barrel to convert raw oil sands (or bitumen) into oil, depending on the exact extraction method.

A similar fate awaits the American shale oil producers—it cost them about $42 to $50 to produce a barrel of oil.

The Hong Kong financial community is quick to point out how predictable the decline in oil prices was: with oil sands and shale oil assets producing so much crude now, U.S. demand for oil from the Organization of Petroleum Exporting Countries (or OPEC) producers had to fall. And, when demand falls, prices fall.

. . . So is a drop in high-cost output

However, now that prices have fallen so low, oil sands and shale oil will be unprofitable and production from those sources will drop off. Supply will shrink again. Then, price will rise again. Long-term stability turns into long-term volatility.

OPEC’s win = OPEC’s woe

To make things more complicated, we hear that if oil prices stay low, certain OPEC nations will run huge financial deficits. Their governments have ramped up their countries’ spending and debt levels. It’s similar to what happened in Greece a few years ago. These OPEC nations require oil prices well over $100 per barrel to balance their budgets. The Arab world is in financial trouble.

‘Blue chippy’ or ‘Casino Americana’?

Our friends on the west side of the Pacific seem more objective about the financial risks inherent in today’s economy. To them, the money world doesn’t seem at all “blue-chippy” and safe—it looks more like “Casino Americana.”

Where to find investment safety

However, what really counts is not the financial condition of the world. What really counts is the safety of your personal investment portfolio.

Yet that’s not quite true, either, is it? If you really think about it, the financial risk of your portfolio can be changed in a heartbeat. All you have to do is sell your risky investments and the risk disappears.

What really counts is the safety of your investor-mind. Do you think: “safety first”? Is your mind safety-oriented or profit-oriented? In the extremes, is your mind fearful or greedy?

You can’t repair the financial world; but you can repair your own investment account. Will you?

Looking out for #1

It depends on your point of view. In my investment book, Beyond the Bull, I point out that all ordinary investors see the financial world from the same point of view: their own well being. We care about what our investments are doing, and don’t really care about others. When we check the financial media for stock prices, we are most concerned about our own stocks, not the ones we don’t own. Looking out for “Number One” is human nature.

Be ready to act: Don’t just ‘buy and hold’

Logically, this means our investment plan should be sensitive to the risk inherent in the investments we own.

For example, many Canadian investors own energy stocks. If we notice the price of crude oil dropping, we need an action plan that will reduce the risk of our oil stocks. If “oil sands” stocks are dropping and banks are rising, we need to make a shift.

We need some objective economic indicator that will give us a signal as to when we should sell our oil stocks and a separate signal for when we should buy the banks. When the signal occurs, we sell or buy.

David vs. Goliath: Why the small investor has the advantage

Small investors (under $10 million) can buy and sell our positions quickly and easily. $100 million-plus portfolios can’t. Big investors think differently than we do. They have to ride out the crashes; we don’t. We can sell early in a downtrend. They can’t. Their collective selling creates the downtrend.

Even worse, imagine you are running Suncor Energy Inc. (TSX─SU) or Canadian Oil Sands Ltd. (TSX─COS). What can these firms do when oil prices drop in half? They’re trapped!

Or imagine you are managing a huge mutual fund or pension fund and investing hundreds of millions in Suncor or Canadian Oil Sands. These enormous funds are trapped too! When they do sell, their selling pushes those stocks lower.

You, by contrast, are not trapped. As a small investor, liquidity is your edge. You can sell or buy in a heartbeat. You’ll need an objective economic indicator that signals when you should buy or sell, and a good (discount) broker to execute your trade.

One sector to avoid and one to buy

Let’s look at some specifics.

Right now, Canadian oil stocks are still in a downtrend; it’s too early to buy. Most big institutional investors have not yet reduced their energy stock holdings sufficiently.

Gold mining stocks are much more promising. The stocks stopped going down in 2014 and have been showing strength recently as volatility increases in the currency markets.

For investors with a speculative bent, Canadian gold mining stocks are turning from downtrends to uptrends. These high volatility stocks provide good action for disciplined traders and speculators.

For more conservative investors, precious metals mutual funds and exchange-traded funds (or “ETFs”) would be good investments at this time.

Rising volatility: Two geographic markets to sell

Investors and speculators in Chinese and American stocks or mutual funds should be preparing to sell. Volatility is increasing and there are huge short-term gains on the table.

‘Double happiness’ for Canadian investors

Canadian investors have profits from two sources: the underlying stock markets have made big moves up and there has been a five per cent to 10 per cent move up in the U.S. and Chinese currencies versus the Canadian dollar.

 

The MoneyLetter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846