A. Gary Shilling’s INSIGHT Economic Research and Investment Strategy
In This Issue 1 $10 to $20 Oil Still Likely The recent failure of OPEC to freeze oil output and plans by Saudi Arabia to diversify from petroleum confirm that the OPEC cartel is fading fast. W ith global production continuing to exceed demand, inventories are building toward capacity, and then unwanted oil will depress prices. So will intensifying financial strains on energy producers. The oil short-covering rally of recent months is probably over, and prices are headed toward our long-held target of $10 to $20 per barrel. That's the marginal cost that rules in a price war. Later recovery to $40 per barrel average costs is still far below the $100 per barrel that many earlier energy investments anticipated. 13 How To Make Big Money There are a number of strategies for making big money. Many, but not all, involve leverage of some sort—technical and financial leverage, economies of scale, etc. Others are driven by taking a small piece of a very large pie. 1. Government Subsidies 2. Inheritance 3. Little Equity, Lots of Debt 4. Financial Engineering 5. Other Leverage 6. Great Ideas, But Not Necessarily The First Implementers 7. Small Slices of Very Big Pies 8. Cartels and Monopolies 9. Sell the Sizzle, Not the Steak 10. Take Advantage of Addictions and Vanity 11. Picks and Shovels 12. Get Paid W ith Money That Isn’t The Payer’s, Especially If They’re Desperate
Volume XXXII, Number 5
May 2016
$10 to $20 Per Barrel Oil Is Still Likely* We’ve discussed at length in past reports that OPEC is fading fast as an effective cartel, and American frackers have replaced OPEC as the world’s swing producers (see “After OPEC,” Feb. 2016 Insight, and “Oil Prices: Look Out Below!,” April 2016 Insight). Now, even the cartel’s kingpin, Saudi Arabia—led by the powerful 30-year-old Deputy Crown Prince Mohammed bin Salman (MBS)—is facing up to this reality. Retreat He personally trashed a potential output freeze at the meeting of major oil producers in Doha, Qatar last month after Iran refused to go along. He also recently revealed plans to reduce the Saudi Kingdom’s dependence on oil by selling on the public market 5% of state-owned and crown jewel Aramco, which would bring in $100 to $150 billion, given the Prince’s estimate of Aramco’s value at $2 trillion to $3 trillion. Until it was nationalized four decades ago, “Aramco” stood for Arabian American Oil Co., with major ownership by large U.S. energy companies. The Saudis have been very secretive about Aramco’s accounts ever since, and the necessity of revealing key numbers as a public company reveals the pressure on that oil-dependent economy to report revenue ands and profits as well as the nation’s proven oil reserve, of around 260 billion barrels. Still, MBS said, “Aramco’s listing has many benefits, the most important and before everything is transparency.” Note, however, that this likely sale of Aramco shares out of desperation would about cover the kingdom’s budget deficit for only 2015. The plan will also create the world’s largest sovereign-wealth fund to finance nonoil investments abroad by transferring Aramco ownership to it. In addition, MBS hopes to increase non-oil revenue from activities such as tourism and mining and make spending more efficient. Saudi allies in the Persian Gulf—the United Arab Emirates, Qatar and Kuwait—have presented similar plans, but implementation has been slow.
28 Investment Themes 29 Summing Up 40 Commentary: Aristotle Lives!
* Based on a speech by A. Gary Shilling, PhD to Oil Price Outlook Conference, sponsored by the Japan Society, New York, N.Y., on April 28, 2016.
INSIGHT (ISSN 0899-6393) is published monthly by A. Gary Shilling & Co., Inc., 500 Morris Avenue, Springfield NJ 07081. President: A. Gary Shilling Telephone: 973-467-0070. Fax: 973-467-1943. E-mail:
[email protected]. Web: www.agaryshilling.com. Twitter: @agaryshilling Editor and Publisher: Fred T. Rossi. Economic Research Associates: Chris Skyba and Callie Renner. © 2016 All rights reserved. No part of this publication may be reproduced or redistributed without the written permission of A. Gary Shilling & Co. Material contained in this report is based upon information we consider reliable. The accuracy or completeness is not guaranteed and should not be relied upon as such. This is not a solicitation of any order to buy or sell. A. Gary Shilling & Co., Inc., its affiliates or its directors and employees may from time to time have a long or short position in any security, option or futures contract of the issue(s) mentioned in this report.
May 2016
A. Gary Shilling's INSIGHT
1
[email protected]
"Saudi Vision 2030" Ditto for the Saudis, and the Prince has dubbed his plan “Saudi Vision 2030,” which also calls for privatization of areas such as health care and education. Last year, oil provided 73% of state revenues, and the collapse in oil prices (Chart 1) forced the kingdom to dig into its foreign-currency reserves to the tune of 16%, or $116 billion, over the course of 2015. That reduced the total to $616 billion at year’s end and $587 billion as of March 2016 (Chart 2). The Saudis also borrowed $10 billion from international banks, with a five-year maturity—the first loans in 25 years. This loan is expected to pave the way for additional money by tapping international bond markets. Qatar and Oman already borrowed in recent months while Abu Dhabi is considering an international bond offering. With two-thirds of the population under 30 years of age and an unemployment rate over 11%, Saudi Arabia has major challenges, especially with a budget that requires $96 oil prices to balance it (Chart 3). Furthermore, the royal family essentially buys the allegiance of its subjects with no-show jobs while the physical work is done by Indians, Pakistanis and other foreigners. In addition, the Sunni royal family has to placate the opposing Shiites that dominate the northeast oil-producing section of the country. A significant example of the pressure on the Saudi economy is the recent decision by Saudi Binladen Group, the Persian Gulf’s largest construction company, to slash 50,000 people from its 200,000 workforce. Those laid off, mostly construction workers from Asia, have been paid their outstanding compensation, but the firm has already defaulted on a number of debt repayments and hasn’t paid subcontractors and suppliers, mainly because of the Saudi government’s failure to pay for completed or ongoing construction work.
@agaryshilling
www.agaryshilling.com
CHART 1 Brent and WTI Crude Oil Prices
$ per barrel; nearest futures contracts Last Points 5/4/16: Brent $44.62; WTI $43.78 120
120
110
110
100
100
90
90
80
80
70
70
60
60
50
50
40
40
30
30
20 Dec-13
20 May-14
Oct-14
Mar-15
Jul-15
Dec-15
Brent Crude Oil WTI Crude Oil
Source: Thomson Reuters
CHART 2 Saudi Arabia Foreign-Exchange Reserves US$ billion
Last Point 3/16: $587.1 800
800
700
700
600
600
500
500
400
400
300
300
200
200
100
100
0 2001
2002
2004
2006
2007
2009
2011
2012
0 2016
2014
Source: Bloomberg and International Monetary Fund
CHART 3 Oil Breakeven Price for Major Petrostates $ per barrel
$250
$250 $208
$200
$200
$150
$150
$100
$76
$70
$68
$98
$96
$93
$89
$100
$105
$58
$52 $50
$50 Current Brent Crude, $/barrel: $45.83
Current Brent crude price: $44.62 per barrel
$0
$0 t ai
uw
K
.
ar
.E
Q
at
.A
Ir
an
aq
Ir
U
ez
en
V
ia
a
l ue
r ge
l
A
di
an
a
A
r
i ab
m
O
a
n
ah
i ra
y ib
L
B
u Sa
Source: Bloomberg and The Wall Street Journal
2
A. Gary Shilling's INSIGHT
May 2016
[email protected]
@agaryshilling
www.agaryshilling.com
CHART 4 Other oil producers’ budgets are strained by the nosedive in prices (Chart 3). The Total Oil Output for Non-OPEC and OPEC Countries millions of barrels per day International Monetary Fund estimates Last Points 3Q 2015: non-OPEC 58.68; OPEC 37.71 that Middle East oil-dependent 60 60 economies had $390 billion in lower 55 55 revenues last year and expects another 50 50 shortfall of $150 billion this year. Angola, an OPEC member, is seeking financial 45 45 aid from the IMF as is Azerbaijan, 40 40 which relies on oil and gas exports for 35 35 75% of government revenues. Iraq, Nigeria, Ecuador and Venezuela, among 30 30 other oil producers, are seeking 25 25 1994 1996 1999 2001 2004 2006 2009 2011 2014 international aid to offset falling oil Non-OPEC revenues. In Kazakhstan, where the OPEC government relies on oil for half its Source: Energy Information Administration revenue, the IMF forecasts GDP growth of just 0.1% this year compared to 6% Arabia, $76 in Iraq, $70 in Iran and down to $52 per barrel in 2013. Russian officials have been hoping for higher oil in Kuwait (Chart 3). Many of these producers thought prices to lift the country out of recession. earlier that high oil prices would last indefinitely and pushed up their spending and budget needs when prices exceeded Chicken $100 a barrel. Furthermore, the Saudis and their Persian Gulf allies continue to play their desperate game of chicken with other Furthermore, the prices at which some major producer major oil producers. As we’ve discussed repeatedly in chickens out isn’t the “full cycle” or average cost of Insights since December 2014, cartels exist to keep prices production. That includes drilling costs, overhead, pipelines, above equilibrium, which encourages cheating as cartel etc. and now run $40 to $50 per barrel for new U.S. shale members exceed their allotted output and other producers oil production. take advantage of inflated prices. So the role of the cartel leader, in this case the Saudis, is to cut their own output to In a price war, the chicken-out point is the price that equals accommodate the cheaters in order to keep prices from the marginal cost of producing oil from an established well. falling. But the Saudis have seen their past cutbacks result It’s the price at which free cash flow vanishes. This game in market share losses as other OPEC and non-OPEC of chicken is similar to a gasoline price war among service producers increase their output. They most certainly hate stations on all four corners of an intersection. One cuts Chart 4, which reveals that OPEC output in the last decade prices to gain market share and the others follow to avoid has been essentially flat while all the growth has been losing sales. The final and bottom price isn’t the full cost enjoyed by others such as Russia, American frackers and per gallon of running the station, including labor costs, rent, Canadian oil sands producers. equipment depreciation, etc. It’s the cost of gasoline coming off the tank truck, plus taxes, the marginal cost. So the Saudis and the other Persian Gulf producers with sizable financial resources embarked on a game of chicken Marginal Costs—$10 to $20 Per Barrel with other OPEC members, with Russia, American frackers, Once fracking operations are set up and staffed, leases paid etc. They thought they could stand lower prices longer than for, drilling is completed and pipelines laid, the marginal their competitors who will have to back out first. In August cost of shale oil for efficient producers in Texas’ Permian 2014, the Saudis had $745 billion in foreign-currency Basin is about $10 to $20 per barrel. Unlike some other reserves, and despite drawing them down subsequently to drilling locations, producers there can tap numerous layers fund budget deficits and pay for imports, they still had $587 of oil-bearing rock from a single location, hyping efficiency. billion in March, as noted earlier (Chart 2). Also, decades of drilling in the Permian Basin have spawned plenty of support businesses that keep drilling costs low. Bottom Price And with new pipelines to carry the crude to trading hubs, We first discussed over a year ago that the price at which bottlenecks there have been eliminated. So Permian Basin major producers chicken out and slash production isn’t oil now sells at a premium at the well head, reversing the determined by the prices needed to balance oil producer earlier discount to oil extracted elsewhere. budgets, which are $208 per barrel in Libya, $96 in Saudi May 2016
A. Gary Shilling's INSIGHT
3
[email protected]
Furthermore, fracking costs continue to fall as productivity leaps. The number of drilling rigs that are working in the U.S. continues to drop (Chart 5). But the rigs taken off line are mostly the old vertical drillers that drill only one hole per platform while the horizontal rigs, which drill many wells per platform like the spokes of a wheel, increasingly dominate. So the output per working rig is accelerating (Chart 5).
@agaryshilling
www.agaryshilling.com
CHART 5 Crude Oil Rotary Rig Count and Average Oil Production Per Rig Last Points 4/16: rigs 372; oil production 475 1600
500 450
1400
400 1200 350 1000
300
800
250 200
600
150 400 100 200
50
In addition, many oil companies keep 0 0 2008 2009 2010 2011 2012 2013 2015 producing even with losses based on Rig Count - left axis sunk and overhead costs as long as Average Oil Production Per Rig (barrels/day) - right axis prices exceed marginal costs, and the Source: Bloomberg and Baker Hughes resulting cash flow is available to service debt. Also, Wall Street has treated in danger of default. And in Europe, reserve-based bank energy shares as growth stocks, so many oil and gas lending to energy producers has mushroomed in recent company CEOs’ bonuses are based on increasing output as years. These loans, backed by the borrowers’ petroleum well as growth in their energy reserves. This encourages reserves and future production, have totaled over $12 investment for increasing output, not profits. Furthermore, billion to Europe’s 10 largest non-government-owned oil companies use yet-to-be extracted oil and gas as collateral companies, and are vulnerable to falling petroleum prices. for bank loans. Recently, Houston-based Goodrich Petroleum filed for Chapter 11 bankruptcy and converted $400 million in debt to equity with a swap with investors who bought bonds the company issued last year. Goodrich is not alone, and debtfor-equity swaps slash interest expenses and allow troubled energy producers to divert the money to drilling budgets, resulting in increased output. Still Investing It’s also true that investors have been willing to buy new shares issued by beaten-up exploration and production companies this year, apparently convinced that oil prices won’t drop, but rather rise. This, too, allows problematic outfits to cushion their balance sheet against lower energy prices and potential bankruptcies while encouraging them to keep producing. Nevertheless, over 50% of energy loans at U.S. banks are
Recently, the Financial Accounting Standards Board, which sets accounting rules for U.S. companies, moved to require banks to record all losses they project over the lifetime of loans as soon as they’re made. Previously, they could wait until losses actually occurred. This will eliminate their current approach to troubled energy loans, which is to “extend and pretend” they will revive, “delay and pray” for higher oil and natural gas prices to bail them out, or—our favorite—assume that “a rolling loan gathers no loss.” The Comptroller of the Currency estimated that for 2013, this provision would have boosted loan-loss provisions by 30% to 50% for banks industrywide, and obviously much more with the subsequent drop in energy prices (Chart 1). This rule won’t be effective until 2020, but banks may well move earlier, adding further pressure to energy companies and encourage them to produce oil as long as free cash flow is positive.
Want to stay up to date on Gary Shilling's media appearances and his thoughts on the economy? Be sure to follow him on Twitter @agaryshilling 4
A. Gary Shilling's INSIGHT
May 2016
[email protected]
@agaryshilling
www.agaryshilling.com
Meanwhile, U.S. banks are in the spring redetermination season when they must reassess the value of borrowers’ collateral. This pressures them to not only write down or call troubled loans, but also to refuse to renew untapped credit lines, commitments to make future loans to specific borrowers.
troubled country like Russia that desperately needs the revenue from oil exports to service foreign debts and pay for imports might well produce and export oil at prices below marginal costs. So these marginal costs of oil production were the basis of our forecast in early 2015 that prices could well drop to $10 to $20 per barrel.
Even The Energy Giants Even huge international energy companies are feeling the heat. In 2015, the seven largest publicly-traded Western energy companies, including Exxon Mobil and Royal Dutch Shell, replaced only 75% of the oil and gas they produced with new proven reserves. And recently, Exxon Mobil lost its perfect triple-A credit rating it held since 1930 as Standard & Poor’s downgraded it to double-A-plus, leaving only Microsoft and Johnson & Johnson at the top. Exxon’s decision to sell $12 billion in new bonds earlier this year and use the money to fund capital spending and keep paying out dividends, even in the face of the oil price collapse, has wounded its balance sheet. Its total debt, $39 billion at the end of last year, has tripled since 2012.
Chicken Out Price As we discussed at length in our February 2016 Insight, which traced cartels going back to ancient Greek times, the oil cartel earlier had all the elements needed to be successful (Chart 6). Oil is a commodity that otherwise can be left in the ground, avoiding production and inventory costs until it’s produced. Earlier, oil was so much in demand that users were relatively insensitive to price, and it had few substitutes. OPEC included most of the low-cost suppliers with few effective non-OPEC competitors. There were few OPEC members, which promoted cooperation and discipline in constraining output to support prices. In all cases, the OPEC members were supported by governments and, indeed, were the governments themselves. Earlier, robust economic growth supplied robust demand for crude oil. And there were few technological improvements in energy production to spawn non-OPEC competition.
Until recently, Exxon and other integrated oil companies as well as stand-alone refiners have benefited from cheap U.S. shale oil—landlocked due to the ban on exports— which they could refine and then export as gasoline and diesel at high mark-ups. But permission to export U.S. crude has narrowed the difference between domestic and foreign crude prices (Chart 1), and excess inventories abroad of oil products are depressing prices. So the refiners’ profit margin has shrunk from $10.30 per barrel on average last year to $6.75 in the first quarter. This shift is severely depressing the profits of oil-refining businesses. Marginal costs of production are also $10 to $20 per barrel or lower in the Persian Gulf. Furthermore, a financially-
In part because of its very actions to restrict and control oil production, OPEC now faces a very unfavorable climate and it’s probably finished as an effective cartel (Chart 7). Today, alternatives to oil, especially liquefied natural gas, are growing as well as government-sponsored renewable energy such as solar and wind. Non-OPEC oil suppliers have leaped, notably from Russia and Canadian oil sands, but especially American frackers. Infighting among OPEC members has destroyed cooperation and discipline, with the Saudis and Iranians fighting proxy wars in Syria and Yemen while financially-weak OPEC members such as
CHART 6
CHART 7
A Successful Cartel
Unfavorable Climate for OPEC
1. Involves a commodity that can otherwise be left in the ground, avoiding production and inventory costs until it’s needed. 2. Its product is so much in demand that buyers are relatively insensitive to price. 3. The commodity has few if any close substitutes. 4. It includes most of the low-cost suppliers and has few meaningful non-cartel competitors. 5. It involves relatively few cartel members, thereby promoting discipline. 6. It's sponsored by governments and even religious authorities that benefit from the cartel and protect it. 7. It operates in a period of strong economic growth and robust demand for the product. 8. It faces few technological improvements in the industry.
1. Alternatives to oil, especially natural gas but also government-subsidized renewables, are growing. 2. Non-OPEC supplies are leaping, notably from Russia and especially American frackers. 3. Infighting among OPEC members has destroyed discipline. 4. Global economic growth is weak, and the ongoing shift from goods production to services in China and elsewhere is curbing oil demand. 5. Conservation is limiting oil demand. 6. Rapid technological advances in fracking, horizontal drilling, deep-water and Arctic drilling, etc. are mushrooming non-OPEC supplies at low and declining costs.
May 2016
A. Gary Shilling's INSIGHT
5
[email protected]
@agaryshilling
CHART 8
Nigeria and Venezuela resist any talk of production cuts—at least not by them. Global economic growth and therefore demand for oil is weak. Meanwhile, the normal course of economic growth favors services over goods consumption (Chart 8). Furthermore, China, that giant consumer of oil and other commodities, is shifting from manufacturing and infrastructure spending to consumption outlays and services (Chart 9). Energy conservation measures in the West, initiated by the 1973 Arab oil embargo, are limiting oil demand. And rapid technological advances in fracking, horizontal drilling, deep-water and Arctic drilling, etc. are mushrooming non-OPEC supplies at low and declining costs. Non-OPEC output is estimated to rise from 58.1 million barrels per day in 2015 to 58.6 million this year. Disintegration Of Discipline The disintegration of OPEC’s discipline over its members’ oil output over the last several years is stark. Earlier, individual members had specific quotas, but the lack of adherence resulted in an OPEC total limit of 30 million barrels per day until late 2014. Then, when the cartel decided not to reduce output in late November of that year, all limits on output were abandoned in the hope that flooding the market with crude would force major non-OPEC producers to chicken out and slash their output. Subsequently, OPEC output climbed to 33.2 million barrels per day in April, its highest level in recent history (Chart 10), and the cartel still has 3.1 million barrels per day in excess capacity. Saudi output climbed from 9.5 million barrels a day in December 2014, right after the Nov. 27 OPEC decision, to 10.3 million barrels a day last month, and the kingdom still has 1.2 million barrels a day in excess capacity (Chart 11, opposite page).
www.agaryshilling.com
Personal Consumption of Goods and Services
as a % of personal consumption expenditures (PCE) Last Points 1Q 2016: goods 31.7%; services 68.3% 70%
70%
65%
65%
60%
60%
55%
55%
50%
50%
45%
45%
40%
40%
35%
35%
30% 1947-I
30% 1959-III
1972-I
1984-III
1997-I
2009-III
Goods Services
Source: Bureau of Economic Analysis
CHART 9 Chinese Value-Added by Industry as a % of nominal GDP
Last Points 3Q 2015: primary 9.0%; secondary 40.3%; teriary 50.9% 55%
55%
50%
50%
45%
45%
40%
40%
35%
35%
30%
30%
25%
25%
20%
20%
15%
15%
10%
10%
5% 1992
5% 1994
1997
1999
Primary
2002
2004
2007
Secondary
2009
2012
2014
Tertiary
Primary: Agriculture, forestry and fishery; Secondary: manufacturing, energy, construction and mining; Tertiary: Services Source: Chinese National Bureau of Statistics
CHART 10 OPEC Crude Oil Production millions of barrels per day
Last Point 4/16: 33.22 35
35
30
30
25
25
20
20
15
15
10
No Freeze In another important development early this year, Saudi Arabia tried to get other 6
A. Gary Shilling's INSIGHT
10 1970
1984
1991
1995
1998
2002
2005
2009
2012
Source: Bloomberg
May 2016
[email protected]
OPEC members as well as Russia to freeze output at January’s levels. This was an obvious sign of cartel weakness because it would have left OPEC with the same basic problem that led it to start playing chicken back in November 2014—flat OPEC output while the growth in global demand and market share would go to others, especially American frackers (Chart 4). The freeze plan, of course, failed after Prince MBS overruled the Saudi oil minister, Ali al-Naimi, and scotched the deal since Iran refused to participate. Besides, nobody involved trusts anyone else. The Russians continued to pump flat out to support their recessionary economy as the collapse in oil prices devastated government revenues and export earnings of that energy-dominated economy. In April, Russian output at 10.8 million barrels a day was close to her post-Soviet era record (Chart 12). Back in 2001 and 2008, Russia promised to curb output but instead increased it while the Saudis cut back.
@agaryshilling
CHART 11 Saudi Arabia Oil Production and Estimated Production Capacity millions of barrels per day
Last Points 4/16: oil production 10.3; capacity 11.5 13.0
13.0
12.0
12.0
11.0
11.0
10.0
10.0
9.0
9.0
8.0
8.0
7.0
7.0
6.0
6.0
5.0
5.0
4.0
May 2016
4.0 2000 2001 2002 2004 2005 2006 2008 2009 2010 2012 2013 2014 Oil Production Estimated Production Capacity
Source: Bloomberg
CHART 12 Russian Oil Production
millions of barrels per day Last Point 4/16: 10.8 12
12
11
11
10
10
Meanwhile, in war-torn Libya, the government that controls the eastern half of the country reported last month that its oil company loaded its first cargo of 650,000 barrels of crude. This was over the objections of the Tripoli-based unity government that dominates western Libya, but adds significantly to Libya’s recent limited output (Chart 13). Iran Libya did not agree to a production freeze, hoping to recover from the disruptions of civil war. Similarly, Iran refused and insisted to regaining its oil export level that was devastated by Western sanctions because of that nation’s nuclear program. With sanctions lifted, Iran’s output has already jumped by 700,000 barrels a day, from 2.8 million barrels a day in January to 3.5 million barrels daily in April (Chart 14, page 8), and she plans to boost output to 6 million barrels a day in 2020. That would make Iran the second-largest OPEC producer behind Saudi Arabia
www.agaryshilling.com
9
9
8
8
7
7
6
6 2005
2006
2007
2008
2009
2010
2012
2013
2014
Source: Bloomberg
CHART 13 OPEC Oil Output by Country millions of barrels per day
Last Point: 4/16 12
12 10.3
10
10
8
8
6
6 4.3 3.5
4
3.0
4 2.9 2.4 1.8
2
1.7 1.1
2 0.7
0.7
0.6
0.3
0
0 a
i ab
r
di
u Sa
A
aq
Ir
.
an
Ir
U
t a a ia ia ai ia ol el er er es uw zu ng lg ig e on K A N A n d e In V
.E
.A
ar ya or ib ad Q L cu E at
Source: Thomson Reuters
A. Gary Shilling's INSIGHT
7
[email protected]
@agaryshilling
CHART 14
(Chart 13). Note that in 1978, Iran produced 5.8 million barrels a day. Earlier, many doubted that Iran would increase output so quickly because of deterioration of oil production facilities during the sanctions, and would need immense infusions of Western technology and equipment to recover. Nevertheless, not only has the 700,000 barrels per day surge this year exceeded the original 400,000 barrels estimates, but output in February topped capacity by 200,000 barrels a day and 300,000 barrels a day in March. Note that capacity has leaped from 2.9 million barrels a day since then to 4.0 million barrels a day. With oil revenues covering 25% of her government budget, Iran is zealously undercutting Saudi and Russian prices to sell oil in Europe and Asia. Ironically, that is inducing producers ranging from Angola, Albania and the U.K. to Saudi Arabia to export more crude oil to the U.S. Countries such as Venezuela and Iraq are also selling oil at discounts just to keep pumping.
www.agaryshilling.com
Iranian Oil Production and Estimated Production Capacity millions of barrels per day
Last Points 4/16: oil production 3.5; capacity 4.0 4.5
4.5
4.0
4.0
3.5
3.5
3.0
3.0
2.5
2.5
2.0
2.0 2000 2001 2002 2004 2005 2006 2008 2009 2010 2012 2013 2014 Oil Production Estimated Production Capacity
Source: Bloomberg
CHART 15 World Crude Oil Supply and Demand millions of barrels per day Last Points 4Q 2015: excess supply 2.3; demand 94.8; supply 97.1 2.5
100
2.0 95
1.5 1.0
90 0.5 0.0 85 -0.5
Excess Supply Earlier, the International Energy Agency predicted that even if U.S. frackers cut production 600,000 barrels a day this year and a further 200,000 barrels per day in 2017, and the now-dead freeze on output worked, excess supply will run at 1.5 million barrels a day until 2017. That’s a continuation of the recent 1 to 2 million barrels a day excess (Chart 15). At the same time, energy demand in the OECD developed countries has been essentially flat in recent years (Chart 16) due to weak economic growth, conservation and the tendency of consumers to save and not spend their windfalls from lower energy costs (Chart 17, opposite page). So the growth in demand in the last decade has come from developing countries, but that is tapering off as economic gains in China and other emerging countries drop due to slow demand for their exports from North America and Europe and declining 8
A. Gary Shilling's INSIGHT
-1.0
80
-1.5 -2.0
75 2001 2002 2003 2004 2006 2007 2008 2009 2011 2012 2013 2014 Excess Supply - left axis Demand - right axis Supply - right axis
Source: Bloomberg and International Energy Agency
CHART 16 Annual Average Oil Demand for OECD and Non-OECD Countries millions of barrels per day
Last Points 2015: OECD 46.39; non-OECD 48.28 60
60
50
50
40
40
30
30
20
20
10
10
0
0 2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
OECD Non-OECD
Source: The Wall Street Journal and Bloomberg
May 2016
[email protected]
volumes and prices for the commodity exports on which many of them depend. Those lands now account for over half of total global demand (Chart 16). Inventories In past Insights, we’ve drawn attention to the crucial role of inventories in determining future oil prices. After all, with global output exceeding demand by one-to-two million barrels per day (Chart 15) and that surplus likely to persist, the extra oil must go into storage (Chart 18). And when the storage facilities are full, the surplus will be dumped on the market to the detriment of prices.
@agaryshilling
www.agaryshilling.com
CHART 17 Cumulative Actual Savings vs. Fixed Saving Rate and Gasoline Windfall since December 2014; US$ billion
Last Points 3/16: addit. saving $96.9; gas windfall $124.1 140
140
120
120
100
100
80
80
60
60
40
40
20
20
0
0 5 5 5 6 5 5 6 5 5 15 14 15 -15 -1 15 -1 15 -1 16 -1 -1 -1 y-1 -1 -1 tl gnar ar n- eb n- eb a pr ec ov ep Oc u Ju Au Ja A Ja F M J F M S N D M
ec
D
Cumulative Actual Consumer Savings vs. Fixed 4.6% Saving Rate Cumulative Savings from Declining Gas Prices
Source: Energy Information Administration and Bureau of Economic Analysis
Cushing, Oklahoma, which is essentially one huge tank farm, is the delivery point for determining the price of West Texas Intermediate, the U.S. benchmark. At present, 90.5% of working capacity there is utilized and the rate is jumping (Chart 19). In the week ending April 29, Cushing inventories jumped by 821,969 barrels. U.S. total inventories—the highest in 80 years—are three times bigger than in 1978 while consumption has risen only 3%. In Europe, the Amsterdam-RotterdamAntwerp region, basically the mouth of the Rhine and, therefore, the water entrance to the Continent, is the key oil storage area. There, too, petroleum inventories are leaping and are within 10% of full capacity (Chart 20, page 10). At 62 million barrels, inventories are at the highest level since data started in February 2013 and up 29% since then. As of early March, oil storage facilities were 70% full, close to the 71% record last June. Globally, crude oil inventories have jumped to record levels with a leap of 370 million barrels since January 2014. China is running out of capacity for her commercial and strategic reserves. Last year, oil imports hit a record high of 6.7 million barrels per day, running ahead of consumption and adding 260 million barrels to stockpiles. This year, another 230 million barrels are expected to be May 2016
CHART 18 Commercial Crude Oil Inventory weekly U.S. ending stocks
Last Points 4/29/16: inventory 543.4; yr./yr. 10.9% 30%
550
25%
500 450
20%
400
15%
350
10%
300
5%
250
0%
200
-5% Jan-14
Apr-14
Aug-14
Dec-14
Mar-15
Jul-15
Nov-15
Crude Oil Inventory (million barrels) - left axis Year/Year Percent Change - right axis
Source: Energy Information Administration
CHART 19 Crude Oil Storage Capacity Utilization Cushing, Oklahoma
Last Points 4/29/16: shell 75.6%; working 90.8% 90%
90%
80%
80%
70%
70%
60%
60%
50%
50%
40%
40%
30%
30%
20% Mar-11 Oct-11 May-12Dec-12 Jul-13 Feb-14 Sep-14 Apr-15 Nov-15
20%
Tank Net Available Shell Storage Capacity Utilization Tank Working Storage Capacity Utilization
Source: Energy Information Administration
A. Gary Shilling's INSIGHT
9
[email protected]
added to reserves, leaving only about 100 million barrels in space storage capacity in China. With oil storage facilities abroad reaching full capacity, oil is being imported into the U.S., where about two-thirds of capacity are filled, leaving room for another 100 million barrels. Flotation And Rolling Storage Surplus oil is also being stored in ships— ”floating storage”—even though it costs $1.13 per barrel per month compared to 40 cents in Cushing and 25 cents per month in underground salt caverns, like those used for the U.S. Strategic Petroleum Reserve. Furthermore, as low oil prices have made shipping it by train unprofitable, rail tank cars—”rolling storage”—are being utilized. Their cost is about 50 cents per barrel per month. An additional driver of oil storage is the attractiveness of buying oil now and putting it in storage while selling futures contracts against that physical oil. Then that oil will be delivered later to fulfill those contracts. The futures market calls for prices to be much higher in later months and years than now, anticipating that current prices are temporarily low (Chart 21). This is called a contango and this rising price curve allows speculators to lock in attractive profits, after storage and financing costs.
@agaryshilling
CHART 20 Total Crude Oil Stock in Amsterdam-Rotterdam-Antwerp Region millions of barrels
Last Point 4/29/16: 59.4 65
65
60
60
55
55
50
50
45
45
40 Feb-13
40 Jun-13
Feb-14
Jun-14
Oct-14
Jan-15
May-15
Sep-15
Jan-16
CHART 21 WTI Crude Oil Futures Curve
May 2, 2016 close prices; $ per barrel 56
56
54
54
52
52
50
50
48
48
46
46
44
44
42 Jun-16
There’s also lots of oil stored in the ground in drilled but untapped wells (DUCs) that can easily be brought into production if financially-stressed energy companies are desperate for revenue. They, joining speculators, can also sell oil from DUCs in the futures market and then produce and deliver it later. Futures prices for 2017 and 2018 above $45 per barrel have encouraged producers to lock in prices and drill more wells. There are about 1.8 million DUCs in U.S. shale oil fields, and estimates are that putting 660 of them on stream in Texas alone would increase output by 300,000 barrels a day. A. Gary Shilling's INSIGHT
Oct-13
Source: Bloomberg
So, this process adds to demand for oil storage now but will increase oil on the market when that oil is delivered out of storage later. Indeed, the recent rise in oil prices (Chart 1) has made it attractive to close out some futures positions established earlier by delivering physical oil to the contract buyers.
10
www.agaryshilling.com
Feb-18
Oct-19
Jun-21
Feb-23
42 Oct-24
Source: Bloomberg
Wary Producers Furthermore, after the rise and then collapse of oil prices a year ago (Chart 1), a number of wary oil producers are using futures markets to hedge their later production at prices they thought were far too low only several months ago. Many shale oil producers have no choice, given the effects of the earlier nosedive in crude prices on their budgets and prospects for bankruptcy. The example of Continental Resources, one of the biggest shale drillers, is vivid. It famously closed out most of its oil hedges in late 2014 when oil first dropped below $80 per barrel, figuring that prices would revive quickly. Instead, they collapsed to a low of $26 per barrel in January and have only recovered to $43 per barrel. Still, for 2016, only about 36% of U.S. producers have hedged their expected output compared with half of production in earlier years. May 2016
[email protected]
Furthermore, any further oil price rise could be capped by oil in DUCs becoming attractive to produce. Also, China, among the world’s five largest oil producers at 4.3 million barrels a day last year, has been relying more on imported oil while cutting more expensive domestic production. China’s significant underground oil would no doubt be exploited if prices rise. The margin cost of even China’s most expensive oil fields, about $40 per barrel, is lower than the current Brent reference price of $46 per barrel (Chart 1).
@agaryshilling
www.agaryshilling.com
CHART 22 NYME Crude Oil Futures Positions and WTI Crude Oil Price Last Points 4/26/16: positions 334.3; WTI price $43.73 350
65 60
300 55 50
250
45 200
40 35
150 30 100
25 Jan-15
Mar-15 Apr-15 Jun-15 Aug-15 Oct-15 Dec-15 Feb-16
Crude Oil Net Non-Commercial Futures Positions (thousands) - left axis
Short-Covering Rally? On balance, we still believe that oil prices are headed for much lower levels, probably to our long-held forecast target of $10 to $20 per barrel. In this context, the recent rise in prices has been a shortcovering rally, very much like what occurred early last year (Chart 1), but with much more speculation. Since January, net long futures positions of WTI by speculators have risen from 163,000 contracts to 334,000, or by 105% (Chart 22). Interestingly, speculators in oil futures contracts have not been especially clairvoyant in predicting prices. Using weekly data since January 2015, the higher correlation between WTI prices and the number of speculative futures contracts was for coincident weeks (Chart 23). In other words, speculators were the most bullish at price highs and the most bearish at lows. Nevertheless, the correlations do rise as the lags between futures and spot prices shorten. This suggests some correct anticipation of actual crude prices by speculators. In early 2015, many forecasters and investors believed that relatively shortcycle fracked oil would soon be exhausted, slashing supply and hyping prices. So investors poured a record $18 billion into energy share offerings last year. But frackers proved very efficient and U.S. oil production fell only modestly after being propelled to record highs by frackers (Chart 24). So, as of late May 2016
WTI Crude Oil Price ($/barrel) - right axis
Source: Bloomberg and Commodity Futures Trading Commission
CHART 23 Correlation Coefficient for WTI Crude Oil Price and Net Non-Commercial Futures Positions 90% R2
90%
80%
80%
70%
70%
60%
60%
50%
50%
40%
40%
30%
30%
20%
20%
10%
10%
0%
R2
0%
-10%
-10% -10 -9 -8 -7 -6 -5 -4 -3 -2 -1
1
2
3
4
Lags (-)
5
6
7
8
9 10
Leads (+)
Note: WTI crude oil price as a function it leads or lags crude oil net non-commercial futures positions, measured weekly Source: Bloomberg and A. Gary Shilling & Co.
CHART 24 U.S. Crude Oil Production
millions of barrels per day Last Point 4/29/16: 8.83 10
10
9
9
8
8
7
7
6
6
5
5
4
4
3
3
2
2
1
1
0
0 2000 2001 2002 2004 2005 2006 2008 2009 2010 2012 2013 2014
Source: Energy Information Administration
A. Gary Shilling's INSIGHT
11
[email protected]
@agaryshilling
February, those 2015 offerings were down an average of more than 20% from their original prices. How To Lie With Statistics The recent rally pushed oil prices from their January low of $26 per barrel to the high of $46 in late April, a jump of 77% before the more recent retreat to $43. But that 77% climb followed the 76% drop from the June 2014 top of $107 per barrel (Chart 1). Sounds like a complete recovery? Not so since only 25% of the swoon has been retraced to date. Consequently, it still feels horrible to those who invested in oil when it was over $100 per barrel. So much for this short course on How to Lie with Statistics! The oil price recovery, which now may well be over, also was driven by hopes, not based on any fundamental change in the excess of petroleum supply over demand, the primary cause of the price collapse. So another big leg down in oil prices seems likely, triggered by several probable developments that will reinforce each other. First is the filling of oil storage facilities that will then force ongoing excess production to be dumped on the market, thereby depressing prices. Second, pressure from lenders, backed by bank examiners, on financially-weak borrowers that will force them to produce as much oil and gas as possible to gain the revenue to service their debts. Finally, the likely continuing rise in the safe-haven dollar against the currencies of weak developing economies will hype their cost of imported oil—which is universally priced in U.S. dollars— and thereby curb demand. Recession Prospects If prices drop to our $10 to $20 per barrel target, the financial disruption to the highly-leveraged oil industry will continue to outweigh the benefits to energy consumers and precipitate a global recession. That's no doubt why falling oil prices depressed stocks earlier this year and vice versa. Already, the earlier slump in oil prices is resulting in financial strains among consumers in oil-producing areas. Laid-off energy workers are stressed and so too are people
12
A. Gary Shilling's INSIGHT
www.agaryshilling.com
employed in the bars, restaurants, hotels and stores they earlier frequented. Since September 2014, 119,600 oil and gas jobs nationwide have been eliminated, 22% of the total. Schlumberger, the largest oil-field servicer in the world, laid off another 2,000 employees in the first quarter. That brings the cuts since November 2014 to 36,000, or 28% of its workforce. Auto loan and credit card delinquencies are jumping on oildependent Oklahoma, Texas, Wyoming, Louisiana, North Dakota and other states. Furthermore, tax revenues are also affected, with 70% of Wyoming’s state revenues coming from oil, natural gas and minerals. The last thing most families want to risk is their abodes, but house mortgage payment delinquencies are also rising. An oil price drop to the $10 to $20 per barrel range would be a shock reminiscent of the dot com collapse in the late 1990s that precipitated the 2001 recession, and the subprime mortgage debacle in the mid-2000s that touched off the 2007-2009 Great Recession, the deepest since the 1930s. Later Price Rebound Oil prices would not stay in the $10 to $20 barrel range indefinitely, however. In the aftermath of a global recession and after excess energy production was squeezed out— painfully, no doubt—price rises would be expected. In the longer run, petroleum prices would likely increase to the average cost of new production— not just marginal costs but also including overhead cost and reasonable profit margins. Still, with the strong possibility of chronic deflation being initiated by a worldwide downturn and the depressing effects on labor and other costs, the equilibrium prices of oil might be surprisingly low, in the $40 per barrel range. That would be far below what is needed to justify much of the squeezed-out supply that was initiated when prices were closer to $100 per barrel. Writedowns of uneconomic energy investments and bankruptcies could be widespread.
May 2016
[email protected]
@agaryshilling
www.agaryshilling.com
How To Make Big Money: 12 Time-Tested Strategies The prime driver of the political populism that is now rampant in North America and Europe is the lack of real income growth for over a decade (Chart 1). As we discussed at length in our March 2015 report, “The Next Big Thing,” and in subsequent Insights, voters no longer believe mainstream politicians can deliver acceptable purchasing power growth, so they’ve turned to the fringes. CHART 1
Fringe Politicians Witness the far-right National Front in France, led by Marine Le Pen, which wants to cut off immigration and enact protectionist measures. Extreme right and left parties have significant followings in Spain, Italy and even normally-staid Germany. Leftist Jeremy Corbyn now leads the U.K. Labor Party that earlier wasn’t that far from Margaret Thatcher’s Conservatives.
Real Weekly Wages and Household Incomes year/year % change
Last Points 2014: income -1.5%; wages 1.0%
In Austria’s recent first round of the presidential election, a populist and antiimmigration candidate emerged as the frontrunner, the Greens Party leader was second and the mainstream candidates, whose parties have ruled the country since World War II, didn’t even make it into the runoff.
4%
4%
3%
3%
2%
2%
1%
1%
0%
0%
-1%
-1%
-2%
-2%
-3%
-3%
-4%
-4%
-5%
-5%
-6% 1980
-6% 1985
1990
1995
2000
2005
2010
Avg. Real Weekly Wages of Production and Supervisory Employees Real Median Household Income
Source: Bureau of Labor Statistics and Census Bureau
CHART 2 Share of Aggregate Income by income quintile
Last Points: 2014
Highest Quintile
52%
50%
48%
46%
44%
Many of these populists promote the protectionist belief that foreigners are stealing jobs from the natives—Turks, North Africans and Syrian from Europeans, Mexicans from Americans and Chinese workers from the West in general.
42%
Lowest and Second Quintile
54%
12%
26%
10%
24%
8%
22%
6%
20%
4%
18%
2%
16%
0% 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011
14%
1st Quintile (lowest)
4th Quintile
2nd Quintile
5th Quintile (highest)
Third and Fourth Quintile
In Canada last year, left-leaning Justin Trudeau replaced Conservative Stephen Harper as Prime Minister. And in the U.S., Bernie Sanders on the far left has a significant following in the Democratic primaries while populist Donald Trump looks to be the Republican presidential candidate.
3rd Quintile
Source: Census Bureau
They also promote the concept that the rich are robbing the poor. Now, it’s clear that the top 20% of households have been gaining income share in the U.S. while the other four quintiles’ shares have declined since the government data started in 1966 (Chart 2). Nevertheless, losing income share was acceptable to many Americans in earlier years because their purchasing power was rising at the same time. But declining income share and real incomes has put people in the mood of Howard Beale in the old movie, “Network,” when he rises from his anchorman’s chair, walks to the window, opens it and yells, “I’m mad as hell, and I’m not going to take it anymore!” May 2016
A. Gary Shilling's INSIGHT
13
[email protected]
Other Spending Sources Furthermore, in the 1980s and 1990s, many were less concerned about their income growth because they believed that ever-rising stock prices (Chart 3) would fund their kids’ education, their own early retirement and a few ‘roundthe-world trips in between. Ditto for the rising value of houses (Chart 4), a much more significant part of net worth for most Americans than equities, which are primarily owned by high-income households. Households also increased their spending about a half-percentage point per year faster than their after-tax incomes from the early 1980s until 2005, a move that reduced their saving rate from 12% to 2% (Chart 5). The flip side was the increase in total household debt in relation to after-tax income from its 65% norm to a peak of 130% before the more recent decline (Chart 5). But faith in equity portfolios was devastated by the collapse in the late 1990s when the dot com bubble broke and again during the 2007-2009 Great Recession (Chart 3). Those were two of only five stock market declines of over 40% since 1900 (Chart 6, opposite page). Similarly, the subprime mortgage collapse and housing debacle (Chart 4) in 20072009 destroyed the belief of many that they could make a fortune speculating in housing without even putting a nickel down. Meanwhile, the pressure to save, especially by the spendthrift postwar babies now facing retirement, is pushing the saving rate up as spending and debt rates fall (Chart 5).
@agaryshilling
www.agaryshilling.com
CHART 3 S&P 500 Index Last Point 5/5/16: 2,050 2500
2500
2000
2000
1500
1500
1000
1000
500
0 Jan-80
500
0 Jul-89
Mar-99
Jun-07
Jun-09
Jun-11
Jun-13
Jun-15
Source: Yahoo Finance
CHART 4 Case-Shiller 10-City House Price Index seasonally-adjusted
Last Point 2/16: 200.96 240
240
220
220
200
200
180
180
160
160
140
140
120
120
100
100
80 60 Jan-87
80 60 Mar-91
May-95
Jul-99
Sep-03
Nov-07
Jan-12
Source: Standard & Poor's
CHART 5 U.S. Personal Saving Rate and Household Debt (consumer + mortgage) as a % of disposable personal income
Last Points 4Q 2015: saving rate 5.4%; household debt 104.7%
Populist Plans So, many Americans are now susceptible to populist plans to transfer massive amounts of income and assets from those who they regard as the crooks at the top to their supposedly hard-working but depressed constituents. Bernie Sanders wants free health care and college tuition for all, with the costs of more than $18 trillion over 10 years covered by $19.6 trillion in tax increases (Chart 7, opposite page).
16%
140% 130%
14%
120% 12% 110% 10%
100% 90%
8%
80% 6% 70% 4%
60%
2% Jan-59 Jan-65 Jan-71 Jan-77 Jan-83 Jan-89 Jan-95 Jan-01 Jan-07 Jan-13
50%
Saving Rate (SAAR) - left axis Household Debt as a % of Disposable Personal Income - right axis
Source: Bureau of Economic Analysis and Federal Reserve
14
A. Gary Shilling's INSIGHT
May 2016
[email protected]
@agaryshilling
www.agaryshilling.com
CHART 6 Hillary Clinton’s tax and S&P 500 Declines Over 40% spending plans are less exuberant but still substantial. Trough Date Trough Level % Decline Peak Date Peak Level She would raise $1 trillion in June 1932 4.77 September 1929 31.30 84.8% higher taxes over the next April 1942 7.84 February 1937 18.11 56.7% decade, with the top 1% October 3, 1974 62.28 January 11, 1973 120.24 48.2% earners paying 77% of the October 9, 2002 776.76 March 24, 2000 1,527.46 49.1% total, or $78,284 more in taxes March 9, 2009 676.53 October 9, 2007 1,565.15 56.8% on average in 2017, according to an analysis by the Tax Policy Center. The top 0.1%, with in 2136 after 127 years for good behavior. Don't hold your incomes over $3.8 million, would pay over half of the tab. breath! She proposes to cap deductions for high-income households, More recently, the powerful former Speaker of the New raise taxes on private equity managers’ carried interest and York State Assembly, Sheldon Silver, was sentenced to 12 increase capital gains tax rates on assets held between one years behind bars, ordered to pay a fine of $1.75 million and and six years. The minimum tax rate on incomes over $2 told to forfeit $5.3 million he gained from criminal schemes. million would be 30% with a 4% surcharge on incomes He received millions of dollars in kickbacks and bribes exceeding $5 million. She also wants an increase in the from outsiders he aided in obtaining state contracts, according estate tax rate from 40% to 45%. She’d use the money to to prosecutors who labeled his schemes “multifaceted and benefit lower-income households with spending on nefarious.” education, energy and family leave.
Crooks To be sure, some of those with massive incomes and assets are full-fledged crooks such as Bernie Madoff. He ran the world’s largest Ponzi scheme that sucked in about $65 billion from investors who truly believed he could produce double-digit returns year after year with virtually no volatility or risks. The government estimates their net losses at $13 billion, and since Madoff never invested a dime and therefore had no losses, his business and personal expenses were grandiose, to say the least. In 2009, Madoff, age 71, was sentenced to 150 years in the slammer but could get out
Nevertheless, there are a number of strategies for making big money that are entirely legitimate. We’ve assembled a list of 12 that have stood the test of time. Many, but not all, involve leverage of some sort—technical and financial leverage, economies of scale, etc. Others are driven by taking a small piece of a very large pie. Before examining each, however, we must point out that luck is often paramount, regardless of how sound or flawed the game plan. Being in the right place at the right time has made fortunes for idiots. Think of the dot com speculator
CHART 7 Sanders' Spending And Tax Proposals
New Federal Spending Medicare for all $15 trillion Social Security $1.2 trillion Infrastructure $1.0 trillion College affordability $750 billion Create paid-leave fund $319 billion Bolster private pension funds $29 billion Youth jobs initiative $55 billion Child care/Pre-K not available
Federal Tax Increases Business healthcare premium tax $6.3 trillion Ending tax-free status for employer health insur. $3.1 trillion Wall Street speculation tax $3 trillion Individual healthcare premium tax $2.1 trillion Social Security tax hike $1.2 trillion Raising marginal income-tax rates $1.1 trillion Corporate offshore income tax $1 trillion Capital gains tax hike $920 billion Payroll tax hike $319 billion Death tax hike $243 billion Ending tax deductions $150 billion Energy tax $135 billion Carried interest tax $15.6 billion
TOTAL: $18.3 trillion+
TOTAL: $19.6 trillion Source: The Wall Street Journal
May 2016
A. Gary Shilling's INSIGHT
15
[email protected]
who only sold out in late 1999 because he was buying a McMansion for his new wife, and that house then doubled in value over the next five years. Conversely, “the best laid schemes o’ Mice an’ Men, Gang aft agley, An’ lea’e us nought but grief an’ pain, For promis’d joy!” as Robert Burns put it. Bad luck can turn a surefire strategy into a disaster. Elisha Gray had the misfortune to arrive at the U.S. Patent Office to patent the telephone a mere hour after Alexander Graham Bell.
@agaryshilling
www.agaryshilling.com
CHART 8 Miles of Railroad in Operation in the U.S. 1850-1950; thousands of miles
300
300
250
250
200
200
150
150
100
100
50
0 1. Government Subsidies 1850 Perhaps the most time-honored and surest way to make big money is the old fashioned way—skill, brains, luck, clairvoyance, hard work—and so much government support you can’t miss! Records show that contractors who supplied food to Roman soldiers made fortunes, even when they provided full fare and not short rations. Recall that in the movie, “Schindler’s List,” Schindler’s successful business of manufacturing pots and pans for the German Army made it possible for him to rescue many Jews from the Nazis. Similarly, American defense contractors today prosper when the Pentagon weapons budget rises.
Benefiting directly from government spending is obvious. What’s more subtle and therefore more interesting are the vast government cash and tax subsidies. Again, this is nothing new. The Homestead Act in 1862 gave free Western land to homesteaders both to relieve crowded Eastern cities and to populate the Continent before European powers encroached on the U.S. The building of the transcontinental railroads in the late 1800s was subsidized by free land in one square mile pieces on alternate sides of the right of way in checkerboard fashion (Chart 8). More later on the tycoons involved.
50
1875
1900
1925
0 1950
Source: Historical Statistics of the United States
And states add more. New Jersey rebates 50% of the cost of a system and for every 1,000 kilowatts generated, the homeowner gets a mandated $2,400 from his electric utility to help fulfill its requirement to produce renewable-source power. Ethanol is subsidized with a $0.45 per gallon tax credit. Agriculture and Real Estate U.S. agriculture has been heavily subsidized since the 1930s, and even more so in Europe. In this country, the prices of grains, wheat, corn, cotton, tobacco and even honey are supported one way or another and provide 23% of farm income. Import quotas on sugar do double duty by keeping domestic prices well above world levels to the benefit of producers in Louisiana, Hawaii and elsewhere while favoring foreign producers the federal government likes—a list that obviously doesn’t include Cuba, but may CHART 9 U.S. Corn Production billions of bushels
Last Point 2016*: 13.65
Energy Petroleum remains heavily subsidized by tax measures such as the depletion allowance, accelerated depreciation and expensing of intangibles—and they've made fortunes for oil tycoons for decades. Windmill farms would not exist without heavy government subsidies of 2.2 cents per kilowatt hour currently. Ditto for solar energy, which accounts for only 0.6% of U.S.-produced electricity. Homeowners get a federal tax credit of 30% of the cost of a solar power system. 16
A. Gary Shilling's INSIGHT
16
16
14
14
12
12
10
10
8
8
6
6
4
4
* 00 001 002 003 004 005 006 007 008 009 010 011 012 013 014 015 16 20 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 20
* Projected
Source: Bloomberg and U.S. Department of Agriculture
May 2016
[email protected]
@agaryshilling
www.agaryshilling.com
CHART 10
soon now that the U.S. has re-established diplomatic relations with the island nation.
Agricultural Employment as a Share of Total Employment Last Point 2014: 1.0%
U.S. corn production has been high with good weather in recent years (Chart 9, opposite page) and as Midwest farmers expanded to satisfy biofuel demand and exports to growing developing economies. But the world followed suit with Brazil, the No. 2 grower behind the U.S., and Argentina producing huge crops that they’re selling at discounts in the U.S., aided by the strong dollar in recent years. The collapse in ocean shipping rates is also reducing corn import costs. Don’t be surprised if Congress again comes to the rescue of American farmers with more corn subsidies. Despite the tiny and dwindling percentage of the nation’s workers in agriculture (Chart 10), sizable farm subsidies will persist as long as there are two Senators from every state.
5.0%
5.0%
4.5%
4.5%
4.0%
4.0%
3.5%
3.5%
3.0%
3.0%
2.5%
2.5%
2.0%
2.0%
1.5%
1.5%
1.0%
1.0%
0.5% 1948
0.5% 1958
1968
1978
1988
1998
2008
Source: Bureau of Economic Analysis
CHART 11 Steel Price
US$ per short ton Last Point 5/5/16: $560.0 900
900
800
800
Real Estate Real estate is another large beneficiary 700 700 of government largess. Commercial real 600 600 estate investors enjoy tax-free exchanges that allow them to defer taxes by promptly 500 500 buying a second property after selling a 400 400 similar appreciated holding. Full-time real estate professionals, who spend more 300 300 than half their working hours and more Oct-08 Jul-09 May-10Feb-11Nov-11Aug-12May-13Mar-14Dec-14Sep-15 than 750 hours a year on that business, can deduct depreciation, interest costs Source: Bloomberg and property taxes from their income. Individuals can deduct mortgage interest for federal income tax purposes, and realize up to $500,000 and whole financial institutions that the Resolution Trust of appreciation per married couple on their primary Corp. was almost giving away. Full disclosure: We were residence every two years. among them. The earlier real estate bubble (Chart 4) was significantly fueled by cheap mortgage money and low lending standards by government-controlled Fannie Mae, Freddie Mac and the Federal Housing Administration. Also instrumental was the widespread conviction in Congress and successive Administrations that everyone deserved to own their own house. And when real estate gets into trouble, taxpayers foot the bill, as was seen by the federal bailout of the banks and other big mortgage lenders in 2008. Earlier, the collapse of the S&Ls in the late 1980s, due to unsound real estate loans, resulted in a $130 billion federal bailout. Many savvy investors profited handsomely by taking over loans May 2016
The U.S. steel industry is, in effect, perennially subsidized by anti-dumping and other tariffs on imports, especially from China as U.S. prices fell by a third last year (Chart 11). Chinese steel shipments to the EU have doubled in the last two years as prices collapse. U.K. crude steel production is down 18% in the last decade. Tata Steel, an Indian conglomerate that is Europe’s second-largest steel producer and owner of a majority of U.K. steel factories, has decided to sell its British plants due to “deteriorating finance performance.” This puts tremendous pressure on the U.S. government for aid to the industry.
A. Gary Shilling's INSIGHT
17
[email protected]
Health Care The government, of course, hugely subsidizes the mushrooming health care bill (Chart 12) and currently pays 45% of the total through Medicare, Medicaid and other programs (Chart 13). That share is forecast to reach 50% in 10 years—to the immense profitability of many. Look around your community. We bet that many of the newer, bigger buildings are health care-related as are the high-paid professionals working in them. Nevertheless, Obamacare, by violating the basic insurance principle of higher premiums for the biggest risks, has forced major health insurer United Health Group, after deepening losses, to withdraw from almost all the 34 states in which it offered exchange plans. Humana is losing money and most health insurers seek huge rate increases from regulators.
@agaryshilling
CHART 12 National Health Spending as a % of GDP
Last Point 2014*: 19.6% 20%
20%
18%
18%
16%
16%
14%
14%
12%
12%
10%
10%
8%
8%
6%
6%
4% 1960
We’re not aware of any significant attempts to expand the number of medical schools and MDs trained—despite the fact that a growing number of physicians, including residents in teaching hospitals, are trained in India or other countries. Then there are those medical schools in the Caribbean for Americans for whom there is no room in U.S. institutions. Feet In The Trough Over decades, we’ve examined the breadth and depth of government involvement in the economy to determine the percentage of the population that depends on government in a major way— enough so that they’d squawk if their 18
A. Gary Shilling's INSIGHT
4% 1970
1980
1990
2000
2010
2021
Actual Projected
* Projected
Source: Centers for Medicare and Medicaid Services
CHART 13 Government Health Care Expenditures
as a % of total national health care expenditures Last Point 2014: 43.5% 45%
45% 1966
40%
With the aging of the postwar babies (Chart 14), government support for health care will mushroom (Chart 12). It’s curious that despite the leaping health care costs, government doesn’t seem much interested in increasing supply and then letting competition control prices. In fact, some local governments limit the expansion of hospitals in local areas for fear that overcapacity will encourage overuse, increase costs per bed and require more government subsidy.
www.agaryshilling.com
40%
Medicare Coverage Starts
35%
35%
30%
30%
25%
25%
20%
20%
15%
15%
10%
10%
5% 0% 1960
5% 0% 1970
1980
1990
2000
2010
Source: Office of Management and Budget
CHART 14 U.S. Population Age 65 and Over as a % of total population
Last Point 2015: 14.9% 22%
22%
20%
20%
18%
18%
16%
16%
14%
14%
12%
12%
10%
10%
8% 6% 1945
8% 6% 1970
1995
2020
2045 Actual Projected
Source: Census Bureau
May 2016
[email protected]
@agaryshilling
www.agaryshilling.com
CHART 15 Government Beneficiaries and Non-Beneficiaries % of total population
1950 10.4 5.0 1.0 1.3 0.7 2.0 5.4
1960 14.6 6.0 1.4 1.3 0.8 2.5 8.6
1970 18.4 7.7 1.5 1.4 1.3 3.5 10.7
1980 17.7 8.1 0.9 1.3 1.6 4.3 9.6
1990 15.3 8.2 0.8 1.3 1.7 4.4 7.1
2000 14.8 7.9 0.5 1.0 1.7 4.7 6.9
2004 14.5 7.8 0.5 0.9 1.7 4.7 6.7
2007 14.4 7.8 0.5 0.9 1.7 4.8 6.6
with additional dependents without additional dependents Fed Gov. Retirement State & Local Gov. retirement Veterans’ Pension & Comp Welfare, etc. Unemployment Insurance Social Security, OAI (retirees) Social Security, SI (survivors) Social Security, DI (disability)
8.2 7.2 0.1 0.3 2.0 1.4 1.0 1.7 0.6 0.0
15.4 13.9 0.3 0.5 2.2 1.7 1.1 5.7 2.0 0.4
22.6 21.3 0.5 0.6 2.3 4.1 0.9 8.3 3.2 1.3
27.6 25.8 0.7 1.1 2.0 4.7 1.5 10.3 3.3 2.1
26.4 25.6 0.9 1.6 1.4 4.7 1.0 11.4 2.9 1.7
23.9 23.2 0.8 2.2 1.1 2.1 0.7 11.3 2.5 2.4
24.0 23.1 0.8 2.3 1.2 1.6 1.0 11.2 2.3 2.7
23.8 23.1 0.8 2.4 1.2 1.4 0.8 11.3 2.2 2.9
Additional Dependents
1.1
1.5
1.3
1.8
0.9
0.7
0.8
0.7
0.0 0.0
0.0 0.0
0.4 0.4
5.6 5.6
4.4 4.4
6.9 6.2
9.5 8.9
10.6 9.8
Food Stamps minus welfare Low-Rent Housing Supplemental Education Grants
0.0 0.0 0.0
0.0 0.0 0.0
0.0 0.0 0.4
4.6 0.0 1.0
3.3 0.0 1.1
4.0 0.7 1.5
6.5 0.8 1.6
7.4 0.9 1.6
Additional Dependents
0.0
0.0
0.0
0.0
0.0
0.7
0.7
0.7
10.0 4.8
12.5 5.1
11.0 4.6
10.4 4.8
9.5 5.1
8.2 4.3
8.5 4.6
9.4 5.1
Due to Government Spending Due to Agricultural Programs Due to Regulation and Protection
3.8 1.6 0.1
4.0 0.9 0.2
3.8 0.5 0.2
4.0 0.4 0.4
4.5 0.3 0.2
3.9 0.2 0.2
4.2 0.2 0.2
4.6 0.3 0.2
Dependents
5.2
7.3
6.4
5.6
4.4
3.8
3.9
4.3
71.3
57.5
47.6
38.8
44.4
46.3
43.5
41.8
34.2 37.1
23.7 33.8
19.8 27.8
17.8 21.0
23.8 20.6
24.6 21.7
23.5 20.0
22.7 19.1
Direct Gov. Beneficiaries Private Workers Total
17.0 34.2 51.1
25.1 23.7 48.8
33.9 19.8 53.8
44.3 17.8 62.1
43.3 23.8 67.1
41.6 24.6 66.3
44.4 23.5 67.9
45.9 22.7 68.5
Dependents of Direct Gov. Beneficiaries Dependents of Private Workers Total
11.7 37.1 48.9
17.4 33.8 51.2
18.4 27.8 46.2
16.9 21.0 37.9
12.3 20.6 32.9
12.1 21.7 33.7
12.1 20.0 32.1
12.3 19.1 31.5
Total Gov. Beneficiaries Total Non-Beneficiaries
28.7 71.3
42.5 57.5
52.4 47.6
61.2 38.8
55.6 44.4
53.7 46.3
56.5 43.5
58.2 41.8
Total Population
152.3
180.7
205.1
227.2
249.5
281.4
293.7
301.3
Government Employees with dependents without dependents Federal Military Civilian State & Local State Local Dependents Transfers & Pensions
Other Recipients of Gov. Benefits
Private Employment due to Government
with addit. dependents without addit. dependents
with dependents without dependents
Non-Beneficiaries Private Employment not due to Government Dependents
May 2016
A. Gary Shilling's INSIGHT
19
[email protected]
government goodies were removed. We ignored minor items like lunch subsidies for school children. But when we added up government employees and their dependents, suppliers of government purchases and their dependents, recipients of Social Security, welfare, Medicare, Medicaid, student loans, farm subsidies, etc., we found that the percentage of the American population involved climbed from 28.7% in 1950 to 61.2% in 1980 (Chart 15, page 19).
@agaryshilling
CHART 16 Social Security, Medicare and Medicaid as a % of GDP
22%
22%
20%
20%
18%
18%
16%
16%
14%
14%
12%
12%
10%
10%
8%
8%
6%
6%
4%
4%
2% 1970
That figure then receded to 53.7% in 2000 due to strength in the private sector while anti-government sentiment slashed the number of welfare recipients. But the percentage climbed back to 56.5% in 2004 and 58.2% in 2007, and is headed for 60% in the decades ahead as the postwar babies tap Social Security, Medicare and Medicaid (Chart 16). Since over half of Americans have their feet firmly planted in the government feeding trough, it’s highly unlikely that government subsidies will disappear or even be cut substantially. In fact, the amazing reality is that the percentage hasn’t risen more than it has since with over half of Americans already receiving substantial financial support from government, they could simply vote for more. As noted earlier, Bernie Sanders and Hillary Clinton both want to move in this direction.
2% 1990
2030
2050
2070
Medicare Medicaid + CHIP + Exchange Subsidies
Source: Congressional Budget Office and Social Security Administration
CHART 17 Labor Force Participation Rate for Ages 65+ Last Point 4/16: 19.6% 30%
30%
25%
25%
20%
20%
15%
15%
10% Jan-48
10% Jan-57
2. Inheritance You can always make big money by picking rich parents who die young after you encourage them to save the money for you. Then there are wealthy and feeble uncles with no other heirs. Another approach is to knock off all your relatives who stand between you and the money, as shown in the wonderful old Alec Guinness comedy movie, “Kind Hearths and Coronets.” The daughter of a 19th century English A. Gary Shilling's INSIGHT
2010
Social Security
Government subsidies, then, are often a great way to make big money. But there are drawbacks because he who pays the piper calls the tune. Because of soaring medical costs, the federal government is more and more controlling the fees it pays to hospitals and other medical service providers. This is clear from the fee structures imposed by Obamacare.
20
www.agaryshilling.com
Jan-66
Jan-75
Jan-84
Jan-93
Jan-02
Jan-11
Source: Bureau of Labor Statistics
duke takes off with an Italian tenor. When she dies, her son wants to honor her request to be buried at the family estate, but the present duke regards the late mother and son as despicable foreigners. So the son systematically kills off about 10 men and women who stand between him and the dukedom, all played by Alec Guinness. They include a suffragette shot in a hot air balloon while celebrating her release from prison, an aging Anglican rector, an incompetent admiral, a stuffy general, a closet alcoholic and, finally, the duke himself. The son’s goal, however, wasn’t money as much as revenge and the prestige of being an English duke. For most, however, inheritance is not the route to riches, as we’ve reported in past Insights. In 1993, two academicians estimated that the postwar babies, who have saved little for their retirement, would inherit more than $10 trillion in 1990 dollars from their parents ($19 trillion in today’s May 2016
[email protected]
money). Not to be outdone, other researchers in 1999 concluded that at least $41 trillion would be passed on over the following 60 years. Wow! If you're a typical postwar baby, quit your day job and get ready for a life of leisure! Reality Sets In But those same researchers concluded that the boomers would get a mere $7 trillion after estate taxes. Subsequent work by AARP slashed the total for inheritances of all people then alive to $12 trillion in 2005 dollars. Most of it, $9.2 trillion, would go to pre-boomers born before 1946, only $2.1 trillion to the postwar babies born between 1946 and 1964, and a mere $0.7 trillion to the post-boomers.
@agaryshilling
CHART 18 Real Quality-Adjusted House Price Index index 1890=100
Last Point 2015: 155.60 200
200
180
180
160
160
140
140
120
120
100
100
80 60 1890
80 60 1910
The reality, however, is that parents are living longer and incurring more medical expenses before they die. A 65year-old man can expect to reach 84 and a similarly-aged woman is likely to live to 87. That’s almost two decades beyond normal retirement, and by then, high and soaring health care costs may well dissipate wealth substantially. About 40% of those 65 and older will probably spend some time in a nursing home, and costs there can run over $100,000 per year. Also, many well-to-do older Americans are selling their big money-pit houses in suburbs and moving into retirement communities, some of which shift them from independent living facilities to assisted care and finally to nursing quarters as they age. We refer to them as “happy acres” and some of their names about as euphemistic. In many of these, however, the new residents pay sizable up-front fees, enough to buy a comfortable house, but they don’t actually own anything. So there’s no inheritance for their offspring when they die as ownership is retained by the developer. The Rich Get Richer The AARP survey also found that families with high net worth receive bigger inheritances than those with less. Well, what would you expect? Rich kids often have wealthy parents. So, most of the money is not going to those with few assets but to those who are already well off. All this evidence is borne out by the current zeal of the postwar babies to save aggressively for what they earlier hoped would be carefree retirements, as noted earlier (Chart 5). They’re also working longer, as shown by the rising labor participation rate for those over 65 (Chart 17, opposite page). Sure, many are still in good health and want May 2016
www.agaryshilling.com
1930
1950
1970
1990
2010
Source: Robert Shiller
to stay active, but many have so few assets, including inheritance, that they’ll need to work until they die or enter nursing homes. You can’t pick your parents, but you can pick your spouse, and marrying for money is an age-old strategy for acquiring major assets. Nevertheless, our great and unfortunately late friend, Robert M. Dunn Jr.—our colleague at Stanford’s PhD program and then a professor at George Washington University in Washington, D.C.—loved to quote his mother as saying, “Son, if you marry for money, you’ll earn every nickel of it!” 3. Little Equity, Lots of Debt You can make lots of money by investing with little equity and huge borrowing—as long as you’re right on the investment’s price direction! Real estate is obviously in this arena. Earlier, 20% downpayments on houses were the norm, but during the late 1990s-early 2000s housing bubble (Chart 4), they shrank to zero or even negative numbers with “piggyback” loans, second mortgages on top of the usual 80% first mortgages, which took the total loan to more than 100% of a house’s value. Those loans were especially attractive to subprime borrowers with little demonstrable income or assets, and lenders were only too happy to accommodate them. Many thought that house prices would leap indefinitely and were totally unaware that, adjusted for inflation and size, house prices historically have been constant—and despite the 20062009 collapse, still remain well above that norm (Chart 18). Let’s look at a simple example of why this was so attractive. If a house buyer puts down 20% and the price rises 10%, he makes 50% on his investment—excluding, of course, A. Gary Shilling's INSIGHT
21
[email protected]
brokerage commissions and other closing costs, taxes, maintenance, utilities, mortgage interest, interest foregone on his downpayment, etc. But with 3% down and the same 10% appreciation, the gain on his investment is 333%, and with zero down, the gain is infinite percent. Then, of course, there is the matter of size. A house that costs twice as much promises twice the dollars of profit. So, many bought the most expensive houses they can finance, using second mortgages to secure bigger properties with the same equity, and then relying on interestonly and option adjustable-rate mortgages with low initial teaser interest rates to hold down their monthly payments. But this math works both ways. Those with little or nothing down were highly susceptible to delinquencies and defaults when falling prices pushed their home equity in negative territory. This became painfully clear when house prices collapsed in 2006-2009 (Chart 4). Leverage is very much used in both commercial and residential real estate. Hedge Funds and Private Equity Hedge funds, of course, employ tremendous borrowing, which is needed to achieve the superior returns needed to justify high fees for investors, often 2% annual management fees plus 20% of the gains. With declining and low interest rates in recent years (Chart 19), pension funds and other institutional investors as well as individuals have poured money into hedge funds and related products, pushing their assets from $1.5 trillion in 2008 to almost $3 trillion last year (Chart 20). Nevertheless, hedge funds in recent years have vastly underperformed the stock market and investors are retreating. Industry leader California Public Employees Retirement System, with $279 billion in total assets, decided in September 2014 to eliminate entirely its $4 billion hedge fund portfolio. Others followed and in the first quarter of this year, the net withdrawals were over $14 billion. 22
A. Gary Shilling's INSIGHT
@agaryshilling
www.agaryshilling.com
CHART 19 10- and 30-Year Treasury Yields Last Points 5/5/16: 10-yr. 1.75%; 30-yr. 2.60% 5.5%
5.5%
5.0%
5.0%
4.5%
4.5%
4.0%
4.0%
3.5%
3.5%
3.0%
3.0%
2.5%
2.5%
2.0%
2.0%
1.5%
1.5%
1.0% Jan-07
1.0% Dec-08
Dec-10
Dec-12
Dec-14
10-Year Treasury Note Yield 30-Year Treasury Bond Yield
Source: Federal Reserve
CHART 20 Global Hedge Funds: Assets Under Management US$ billion
Last Point 2015: $2,796 3000
3000
2500
2500
2000
2000
1500
1500
1000
1000
500
500
0
0 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15
Source: BarclayHedge
CHART 21 Apollo Global Management and KKR & Co. Stock Prices Last Points 5/5/16: Apollo $16.64; KKR $13 40
40
35
35
30
30
25
25
20
20
15
15
10 Jan-14
May-14
Oct-14
Feb-15
Jul-15
Dec-15
10 Apr-16
Apollo Global Management KKR & Co.
Source: Bloomberg
May 2016
[email protected]
Private Equity Private equity funds, another earlier Wall Street darling, also use heavy borrowing. Typically, they load the corporations they take private with heavy debt and use the proceeds to pay dividends to their investors. This can reduce their net investment to very low levels, giving them tremendous financial leverage. Then the private equity outfits attempt to cut costs and otherwise improve cash flow to justify those huge interest expenses, and eventually take the cleanedup companies public. But shaky security markets in recent years have dampened this bailout strategy and depressed the stocks of private equity firms. So major player Apollo, whose stock was down 53% from its January 2014 peak, plans to buy back up to $250 million of its shares. Similarly, industry veteran KKR, with its stock off 49% in the past year, will buy $500 million of its equity (Chart 21, opposite page). Futures contracts don’t exactly involve borrowed money, but it amounts to the same thing. To buy or sell a futures contract on $164,000 of 30-year Treasury bonds requires a speculator to have $3,650 with his commodities broker. If bond prices rise 1%, he makes $1,640, or 22%, on his money, excluding commissions. But, of course, futures work both ways. A 1% price decline would cut his capital in half.
@agaryshilling
CHART 22 ABX BBB-
06-1 tranche 110
110
100
100
90 80
90 80
02/01/2007
70
70
60
60
50
50
40
40
30
30
20
20
10
10
0 Jan-06
0 Nov-06
Aug-07
Jun-08
Mar-09
Jan-10
Source: Markit
CHART 23 Citigroup Stock Price Last Point 5/4/16: $44.66 600
600 05/9/2011 1 for 10 Reverse Stock Split
500
500
400
400
300
300
200
200
100
100
0 Jan-06
Bank Capital Banks typically borrow 10 times their capital or more through deposits and other means, which gives them immense financial leverage. Much of this borrowing is used to finance long-term and relatively safe business and consumer loans, but investments in subprime mortgages proved to be lethal in 2008 when their value collapsed (Chart 22). Also, the reliance on short-term funds sank Lehman in 2008 when scared lenders refused to renew those overnight loans. Many lenders, especially the big banks, earlier emphasized highly profitable proprietary trading, private equity investments and all manner of derivatives activity. Given the small size of the banks’ equity relative to the assets they May 2016
www.agaryshilling.com
0 Dec-07
Dec-09
Dec-11
Dec-13
Dec-15
Source: Yahoo Finance and Bloomberg
controlled, the profits on these activities were tremendous when their bets worked out—but so were the losses when housing collapsed. Our favorite example is Citigroup, whose equity price collapse of 98% from a peak of $564 per share in December 2006 was so embarrassing that the bank resorted to a 10-for-1 reverse stock split. That raised it from what would have been $4.40 per share today to the current $44 price (Chart 23) After Washington and international lenders bailed out virtually all of the major banks worldwide in 2008, they were pressured to enhance their capital tremendously (Chart 24, page 24). Also, the big banks have been bereaved of proprietary trading and other highly profitable activities and pushed back toward traditional commercial banking— taking deposits and then lending them out—as well as asset management. A. Gary Shilling's INSIGHT
23
[email protected]
4. Financial Engineering A recent subset of financial leverage is financial engineering. This involves deliberate measures to produce big profits and high income through asset purchases, taking advantage of price leaps to sell more stock, multiple layers of companies, careful tax planning, etc. Note that the average S&P 500 company hasn’t used debt increases to fund share buybacks (Chart 25) aimed at increasing profits per share. The biggest 1,500 nonfinancial companies increased their net debt by $409 billion in the year ending March and used almost all of it, $388 billion, to repurchase their own shares, net of new issues. The debt and equity of the median U.S. nonfinancial company is 11 times operating cash flow, higher than in 2007 and at the peak of the late 1990s dot com bubble. Obviously, those funds are not being used for capital investments that will produce future profits.
@agaryshilling
www.agaryshilling.com
CHART 24 Tier 1 Risk-Based Bank Capital Ratio
measured as core equity capital to total risk-weighted assets Last Point 4Q 2015: 12.4% 13.0%
13.0%
12.5%
12.5%
12.0%
12.0%
11.5%
11.5%
11.0%
11.0%
10.5%
10.5%
10.0%
10.0%
9.5%
9.5%
9.0%
9.0%
8.5%
8.5%
8.0% Mar-00
8.0% Sep-02
Mar-05
Sep-07
Mar-10
Sep-12
Mar-15
Source: Bloomberg and Federal Deposit Insurance Corp.
CHART 25 S&P 500 Stock Buybacks and Net Debt US$ billion
Last Points 1Q 2016: net debt $402.5; 4Q 2015 buybacks $145.9 180
450
160 400 140 120
350
Still, this financial engineering has been 100 300 carried to extremes by companies like 80 Valeant and SunEdison. Valeant doesn’t 60 250 develop new drugs but rather buys 40 200 companies with already-approved 20 pharmaceuticals and then hypes their 0 150 2008 2009 2010 2011 2012 2013 2014 2015 prices. Last year, the firm skyrocketed Stock Buybacks - left axis the prices on two cardiac drugs by 525% Net Debt - right axis and 212%. The company maintains that Source: Standard & Poor's it’s just brining their prices up to competitive levels. Valeant earlier used cheap financing provided by its high-priced stock and is based, ended the party. Its stock has lost 86% of its value bonds to make ever-bigger acquisitions in the classic “roll from the August 2015 peak to present (Chart 26, opposite up” strategy. In effect, its growth was through accounting page), or $78 billion. and valuation multiples rather than economies of scale or new products. In a similar vein, solar-power company SunEdison filed for bankruptcy in late April after its market capitalization Ponzi Scheme? plunged 99% from its $10 billion value last summer (Chart A number of major hedge funds owned Valeant stock, but 26). SunEdison spent over $18 billion on acquisitions and this Ponzi-like scheme worked only a long as the company raised $24 billion in debt and equity between 2013 and this kept doing new deals. But investigations into Valeant’s year. It grew through deal-making and tax planning, and practices by the SEC, the U.S. Attorney’s Offices in bought up renewable power projects around the world Massachusetts and New York, the State of Texas, the before the market soured last summer. Its subsidiaries, North Carolina Department of Justice, the U.S. Senate’s known as yieldcos, raised cash from investors and then Special Committee on Aging and the House Committee on bought operating projects from SunEdison. They then paid Oversight and Reform as well as requests for documents out the cash flow in the form of high dividends to their from regulators in New York and Canada, where Valeant shareholders, tax-free. 24
A. Gary Shilling's INSIGHT
May 2016
[email protected]
Income-starved investors jumped in as did investors seeking green companies. But then came changes in state tax breaks for those projects and the collapse in oil and natural gas prices. And the SEC and Justice Department are investigating the company’s possible overstatements of its financial condition, concerns also expressed by senior SunEdison executives who fretted over a vast overstatement of the firm’s cash flow and profits. Like Valeant, SunEdison looks like a Ponzi scheme that requires a constant inflow of new money to keep from collapsing. Maybe they both studied Bernie Madoff's technique!
@agaryshilling
www.agaryshilling.com
CHART 26 Valeant Pharmaceuticals and SunEdison Stock Prices Last Points 5/5/16: Valeant $34.49; SunEdison $0.20 300
35
30
250
25 200 20 150 15 100 10 50
5
0 Jan-15
0 Mar-15
May-15
Jul-15
Oct-15
Dec-15
Feb-16
Valeant Pharm. - left axis SunEdison - right axis
Source: Bloomberg
5. Other Leverage Our third strategy, little equity with lots of debt, of course, amounts to huge financial leverage. But leverage as a way to make big money extends well beyond the use of debt to other forms of finance. Think about movies vs. stage productions. A play can only reach an audience of several hundred and must be repeated night after night by the same actors to generate much revenue. Many of them tire of the repetition and leave the cast before the end of the successful run of a play or musical. Sure, road companies of popular musicals are the norm and provide some leverage for owners of the show. And popular musicians perform in huge football stadiums, complete with giant video screens, to reach much larger audiences. But none of these enhancements rival the leverage of movies, which are presented to unlimited audiences worldwide and, if they have legs, for decades to come (Chart 27). The same leverage and opportunity for big money exists for entertainment transmitted via CDs, DVDs, radio, TV and the Internet. Obviously, the big squabble over pirating CDs and DVDs involves originators who want to receive the full financial 12000 benefit of that leverage. At the same time, mass distribution of entertainment does have its drawbacks. In the old days of vaudeville, an entertainment group would perfect an act in New York City, then shuffle off to Buffalo—that's where the term originated—and on to Cleveland, Detroit and points West and South. After hitting all the major, and many minor, cities in the country, they’d return to New York two or three years later to develop May 2016
another act. While on the road, however, they never needed to change the script, except to put the name of the town in which they were playing in their jokes. But today when a comedian tells a joke on national TV, they need a huge team of writers to come up with new material for the next show. Athletics Leverage is the lifeblood for professional and, to a certain extent, college athletics. Decades ago, professional athletes weren’t especially highly paid except for a few superstars. But then came TV broadcasts of games. Today, negotiations over $20 to $25 million contracts for professional football and baseball players are simple decisions on how the TV revenues will be split up (Chart 28, page 26). Then there are the fees for endorsements by stars, equipment and sportswear lines, etc. Years ago, I met Billie Ray Smith, then a securities salesman CHART 27 U.S. Movie Box-Office Gross US$ million
Last Point 2015: $11,127.6 12000
10000
10000
8000
8000
6000
6000
4000
4000
2000
2000
0
0 1985
1988
1991
1994
1997
2000
2003
2006
2009
2012
Source: Motion Picture Association of America and Box Office Mojo
A. Gary Shilling's INSIGHT
25
[email protected]
in Dallas for White, Weld, where I was Chief Economist. We became great hunting and fishing buddies. He had a wonderful personality and was wellknown in his earlier career as an allAmerican football player, so much so that he regularly entertained American troops in Vietnam during that war. Through Billie Ray, I learned about hero worship. One day when we were walking down the street in Dallas, he said, “Gary, I want to go into this tobacco store to get me some cee-gars (cigars).” While he was picking out his stogies in the walk-in humidor that resembled a bank vault, a young man behind the counter engaged me in conversation. I knew that he too was a football player because his physique had a straight drop from his ears to his gigantic shoulders, with no neck indentations. He asked me, “Is that Billie Ray Smith? I saw his Super Bowl ring.” Actually, Billie Ray Smith had two Super Bowl rings from his playing days with the Baltimore Colts, but I earlier assumed that he’d gotten that huge ring with a horseshoe on top from a gumball machine. When Billie Ray returned with his cigars, the young man vigorously shook his hand, said what a privilege it was to meet him and how his Daddy had met him on the football field.
@agaryshilling
www.agaryshilling.com
CHART 28 NFL Salaries and Television Revenues Last Points: 2014 8000
2500
7000 2000 6000 5000
1500
4000 1000
3000 2000
500 1000 0
0 1970
1976
1982
1988
1991
1994
1997
2000
2003
2006
2009
2012
NFL TV Revenues; million USD - left axis Average NFL Salary; thousand USD - right axis
Source: NFL Players Association and SB Nation
CHART 29 S&P 500 Publishing and Printing Index Last Point 5/5/16: 270.02 400
400
350
350
300
300
250
250
200
200
150
150
100
100
50 1990
50 1993
1997
2001
2005
2009
2012
Source: Bloomberg
Billie Ray was a national sports hero, but his playing days ended before nationwide TV broadcasts of pro football games propelled player incomes. He told me his highest annual income was $35,000, even though he had a longer-than-normal playing career, stretching into his 30s. Sports TV revenues, of course, are provided by advertisers who hope their messages will be effectively and profitably leveraged many, many times to viewers. Ditto for radio, newspapers and magazines as well as the Internet ads that are CHART 30 increasingly replacing those in print media. Advertising by Medium 2015; US$ billion
We say “hope” because it’s difficult in most cases to measure the effect of advertising on sales. And even though online ads have many more viewers than those in print, the net revenues are much lower. Note the miserable failure of major newspapers to replace hard copy ads with electronic versions. The result is poor profits, ongoing consolidation and lousy stock performance (Chart 29) for the industry as a whole. Note that newspapers and magazines combined now account for only 13% of total media advertising (Chart 30). 26
A. Gary Shilling's INSIGHT
Television (national and local) $63.3 Internet $59.1 Mobile $19.8 Radio $14.5 Newspapers $14.4 Magazines $9.6 Total $180.8
35.0% 32.7% 11.0% 8.0% 8.0% 5.3%
Source: Bloomberg and Magnaglobal
May 2016
[email protected]
@agaryshilling
Lawyers And Mass Production The nonfinancial leverage we’re thinking about also applies to lawyers. Large law firms don’t make their big money from billing partners’ time, even at $1,000 per hour. It’s the time of all those associates who may be paid $150,000 per year or $75 per hour, but are billed out at $350 per hour. That’s why legal bills that involve three hours in partner time but also 20 associate hours aren’t uncommon. Then there are all those mass-produced items. Producing the first one of a new car model costs billions of dollars, but mass production drops the unit cost drastically—and pumps profits. The same is true for Apple. The cost of developing a new smart phone is high, but cheap per unit when millions are being manufactured by low-cost labor in the Far East. Building cars still requires lots of steel and other materials. To the extent that a mass-produced product contains fewer raw materials and more intellectual content, the leverage is greater. Consider Microsoft. Once a new software program is developed, it costs next to nothing to transmit it via the Internet to a customer. Years ago, our Insights were all in hard copy form, which entailed considerable printing and mailing costs. Now, with most readers preferring online versions, those costs are largely eliminated—but we hope the content still makes our monthly reports a bargain! 6. Great Ideas, But Not Necessarily The First Implementers Ralph Waldo Emerson supposedly said, “If a man can write a better book, preach a better sermon, or make a better mousetrap than his neighbor, though he builds his house in the woods the world will make a beaten path to his door.” Recall that Emerson holed up in a cabin on Walden Pond, but his wife did bring him a hot lunch every day. History doesn’t record a beaten path to Emerson’s cabin door, but what he said has been true in some instances. As we noted in our 1998 book, Deflation: Why it’s coming, whether it’s good or bad, and how it will affect your investments, business and personal affairs, Henry Ford virtually created the massproduced automobile industry. His application of interchangeable parts and introduction of the moving assembly line increased the production of cars by the whole industry from 65,000 in 1908 to 1 million in 1915. Between 1913 and 1914, the labor time required to put together a Model T chassis dropped from 2 hours and 38 minutes (down from an original 12 hours and 28 minutes) to 1 hour and 33 minutes. Consequently, the price of the Model T runabout dropped from $500 on August 1, 1913 to $260 on December 2, 1924. Henry Ford paid his workers an unprecedented $5 per day. He reasoned that if May 2016
www.agaryshilling.com
they couldn’t afford to buy the cars they were assembling, he wouldn’t sell many. At $5 per day, 300 days a year (they worked Saturdays back then), the assembler made $1,500 and paid few taxes. A Model T at $260 was definitely affordable! With the auto industry now mature and on the ropes during the 2007-2009 Great Recession, it’s easy to forget how powerful Henry Ford became. He went into steel, shipping and many other industries related to his auto empire. His influence was immense. Charles Stewart Rolls and Sir Frederick Henry Royce worried about competition from Ford even though they were in England producing luxury cars at the other end of the price spectrum from Model Ts. The leaders in Brave New World, Aldous Huxley’s nightmarish utopia written in 1932, were addressed as “Your Fordship.” Wait In many cases, however, entrepreneurs were better off preaching sermons while waiting to build the second or third version of the better mousetrap. Alexander Pope said, “Be not the first by whom the new are tried, nor yet the last to lay the old aside.” He was talking about literary criticism, but his words also apply to entrepreneurs. Ever hear of Seattle Computer Works? That firm developed a computer operating system in the 1970s that Bill Gates bought in 1980. IBM was late in realizing the potential of PCs after Apple led the way, and knew that its engineers were too tradition-bound to develop an operating system quickly. So Gates paid $50,000 for Seattle Computer Works and licensed MSDOS to IBM for use in every one of its PCs, making a fortune as a result. More recently, buying dot com stocks at their IPO prices in 1999 was not a good deal even with the enormous first day price jumps on a number of them. Investors were throwing money at them, begging these startups to burn through the money as quickly as possible in order to build their reputations and market shares. Those start-ups didn’t need many physical facilities to generate revenues and the expected zillions of website visits were supposed to produce huge earnings and stock prices. But they were easy-entry businesses. So, big advertising was considered necessary to develop brand loyalty and prevent the next entrepreneurs from stealing business with slightly lower prices. Lots Of Ads In early 2000, we counted the editorial and ad space in several leading print publications. In five consecutive issues of The Wall Street Journal, total pages averaged 84, with 51% of the space in ads and of that 62% were Internet-related. (continued on page 30) A. Gary Shilling's INSIGHT
27
[email protected]
@agaryshilling
www.agaryshilling.com
INVESTMENT THEMES Our Investment Themes section reflects the positions that are in or being considered for our managed portfolios. We may add or delete portfolio positions in the course of the month, but those changes will not be show in Insight until the following report.
In January, many saw the world headed for recession, with the Fed’s plans to raise interest rates this year adding to the gloom. Markets told this story with commodities, especially oil, falling, Chinese economic growth slowing, investors stampeding out of emerging markets and stocks falling while safe-haven Treasurys and the dollar rallied. Then in February, euphoria replaced despair as the Fed, as usual, backed off and oil producers discussed an output squeeze. So most markets reversed their January patterns. Still, we don’t believe the fundamental reality has changed much in the last four months. Commodities continue to be in substantial excess supply—especially oil, which is still likely to fall to our $10 to $20 per barrel target. Export-dependent developing economies’ financial woes persist. The dollar is still favored as a safe haven in a sea of global trouble and as almost every other country tries to devalue against it. Looming deflation and safe-haven status continue to favor Treasury bonds. So we’re sticking with the investment themes that have been serving us so well for over two years:
1. 2. 3. 4. 5. 6. 7.
28
Short commodities Short crude oil and related securities Long the dollar vs. euro and yen, commodity currencies and developing economy currencies Short emerging-market stocks and bonds Short junk bonds Long 30-year Treasurys Short U.S. stocks
A. Gary Shilling's INSIGHT
May 2016
[email protected]
@agaryshilling
Summing Up Stock indices, except for Asia, were up through most of April as investors digested corporate earnings reports that were not as bad as feared—even though U.S. corporate profits declined for a third straight quarter—and saw the Federal Reserve as being in no great rush to raise interest rates. Higher oil prices also helped energy stocks and financial companies. The Dow Jones Industrials closed above the 18,000 mark on April 18 for the first time since last July while the S&P 500 topped the 2,100 mark a day later for the first time since December 1. But markets then reacted negatively to weakness in tech stocks as well as to the Bank of Japan’s late-month decision to not ease further in an effort to spur the economy. The yen surged against the dollar after the central bank’s move. The greenback was pretty much flat vs. the euro while yields on 10-year Treasury notes edged up slightly. Fed policymakers after their late April meeting said again that they’ll raise short-term interest rates at a “gradual” pace—but that doesn’t mean another quarter-point hike will be happening any time soon. After bumping up its fed funds rate by 25 basis points in December, the Fed held its fire at its January and March meetings, and again last month, and we think the Fed will continue to hold off while economic conditions remain uncertain. “Labor market conditions have improved further even as growth in economic activity appears to have slowed,” policymakers said in a statement. While cautious about the U.S. economy, the Fed sees some improvement in global economic and financial markets, which it promised to “closely monitor,” quite different verbiage from earlier statements saying that “global economic and financial developments continue to pose risks.”
www.agaryshilling.com
February and 0.9% over the prior 12 months. Core CPI increased 0.1% while the 12-month core rate rose 2.2%. Producer prices fell 0.1% in March vs. February and were down 0.1% year-over-year. Stripping out energy and food prices, core PPI dropped 0.1% in February and 1.0% on a year-over-year basis. Despite the failure of major oil producers to agree on a production freeze, crude oil prices edged up steadily in April, topping the $45 per barrel mark for the first time since November. Retail sales continue to be weak, falling 0.3% in March after remaining unchanged in February and falling 0.4% in January. Year-over-year, sales rose 1.7%. March’s weak number was due mainly to a 2.1% decline in sales of vehicles and parts; ex autos, retail sales were up 0.2% in March. Sales at gas stations rose 0.9%, due to higher fuel prices. Nonfarm payrolls rose by 215,000 in March while February’s gain was revised slightly upward and January’s increase was revised slightly downward. The unemployment rate ticked up to 5.0% from 4.9% while the labor participation rate inched up again, from 62.9% to 63.0%— its highest in two years. Average hourly earnings were up 2.3% from a year earlier. But, with productivity declining in the fourth and first quarters, it takes more employees to produce the same output while rising unit labor costs depress profits. Housing starts fell 8.8% in March from February but were 14.2% higher than a year earlier. Building permit issuance fell 7.7%. New home sales fell 1.5% in March due to pronounced weakness in the West. The median price of $288,000 was 1.8% lower than a year earlier. Existing home sales rose 5.1% in March from February, led by an 11.1% jump in the Northeast and a 9.8% rise in the Midwest. The median price of $222,700 was up 5.7% from a year earlier.
Continuing the uneven trend of economic growth since Led by gains in Portland, Seattle and Denver, the S&P/ 2009, the initial estimate of first quarter GDP came in at Case-Shiller index of home values in 20 cities rose 5.4% in +0.5%—well below the fourth quarter’s +1.4% and the February from a year earlier, but third quarter’s +2.0%—but in line the pace of gains has been slowing. with weak first quarter results in THE NUMBERS The National Association of 2011, 2014 and 2015. Despite April 2016 Year-to-Date Home Builders’ confidence index % Change* % Change lower gasoline prices and low remained at 58 in April. Dow Jones Industrials +0.5% +2.0% interest rates and the warm winter, S&P 500 +1.1% +0.3% consumer spending declined in the Nasdaq Composite -4.6% -1.9% The Conference Board’s first quarter as did business spending Nikkei Average -14.2% -2.6% consumer confidence index fell to due to weak overseas demand and STOXX Europe 600 +1.2% -7.1% 94.2 in April from 96.1 in March. restrained consumer spending in Shanghai Composite -17.0% -2.2% The University of Michigan’s FTSE 100 n/c +1.1% the U.S. consumer sentiment index fell to 3/31/16 4/29/16 89 in April from 91 in March. 10-yr. Treasury note 1.83% 1.78% Desperately seeking inflation: Despite a rebound in gasoline prices, consumer prices barely budged in March, up 0.1% vs. May 2016
$=¥ €=$ West Texas Inter.
106.43 1.15 $45.94
*through April 29
112.55 1.14 $38.16
Fred T. Rossi Editor A. Gary Shilling's INSIGHT
29
[email protected]
@agaryshilling
www.agaryshilling.com
How To Make Big Money (continued from page 27) In contrast, in the late 1980s-early 1990s, tech ads were only 20% to 30% of the total and 4% in the late 1960s-early 1970s. In our early 2000 survey, a company called Freedom3 ran a full-page ad with two kids jumping for joy and a brief pitch for the Corel Linux OS. Venture capital firm EarlyBirdCapital.com used a full-page to inform the world that it can “See What Others Can’t.” VA Linux had a 698% first day gain, but it was a whole lot cheaper in 2001 after that stock bubble collapsed (Chart 31). Ditto for TheGlobe.com, which jumped from its IPO price of $9 per share to $63.50 the first day of trading, a 606% leap. TheStreet.com was a terrific buy at its IPO price of $19 per share, followed by a first day catapult of 216%. But the patient investor who waited until October 2001 to buy the stock at $0.98 per share enjoyed a 1,038% rise through February 2007.
CHART 31 VA Linux Stock Price Last Point 2/28/07: $4.31 250
250
1st Day Gain: 698%
200
200
150
150
100
100
50
0
50
0
Dec-99 Oct-00 Jul-01 May-02 Mar-03 Dec-03 Oct-04 Jul-05 May-06 Feb-07 Dumont Some of us are old enough to remember Source: Yahoo Finance Dumont’s lead in selling TV sets when they were new gadgets, but the company lost out to latecomers like RCA and Motorola. Chux was the leading disposable diaper but succumbed to Procter & Gamble’s Pampers. Ampex had a commanding position in video recorders and tapes for two decades but then Sony took over. But Sony had its own setbacks. Recall that its Beta format for videotapes was technically superior to the VHS format, but how many Beta video players exist today outside museums? Then videotape players disappeared in favor of DVDs and Blue Rays, which now are giving way to video streaming.
Rheingold Brewery brought out Gablinger’s low-calorie beer in 1967, a cool summer with weak beer sales. So Rheingold lost interest and Miller Lite later mastered the field. Until the early 1960s, AT&T had a nationwide monopoly on long distance telephone service. Then Tom Carter invented the Carterphone, a device that allowed owners to rest the telephone receiver earpiece over a microphone and the mouthpiece over a speaker. That way, the telephone was acoustically coupled to an amateur radio transmitter or a mobile radio network. Only 4,000 Carterphones were ever installed, but AT&T saw it as a threat to its long distance monopoly and its ownership of all telephone instruments. Can you remember when every telephone was owned by the phone company and manufactured by its Western Electric division? Back then, we bought some telephones in Hong Kong, smuggled them home and (illegally) hooked them up as telephone extensions in our residence. AT&T claimed that any equipment but its own might cause catastrophic damage to the system. Carterphone and AT&T went to court in 1966, and in 1968 the Supreme Court ruled in favor of Carter Electronics. So the FCC ordered the nation’s phone companies to connect their lines to non-Bell devices, as long as they were technically compatible with the phone network. Little Carter broke the huge AT&T monopoly, but did that give it a commanding lead in supplying telephone instruments and related gear? Heard much about the firm lately? It voluntarily dissolved in 1969. Great Inventions Great inventions are seldom the route to riches without the control of the resulting production leverage as they become widely used. Europeans made the initial discoveries in electromagnetics, but it was the Americans who turned that knowledge into practical money-making uses. Thomas A. Edison, of course, was the champ, with his development of electric lights, the phonograph and the movie camera. And he made sure he had plenty of patent protection to benefit from his labors.
30
A. Gary Shilling's INSIGHT
May 2016
[email protected]
@agaryshilling
His original movie studio is still on display at the Edison National Historic Park at Llewellyn Park in West Orange, N.J., but the movie industry soon moved to Los Angeles for two reasons. The sunlight was better in the days of very slow film. But more interestingly, his rivals wanted to be far away from “Edison men.” Those were thugs Edison hired to enforce his patents on the movie camera by literally breaking up violators’ equipment with sledge hammers. Strong message to follow! 7. Small Slices of Very Big Pies Fortunes can be made by taking small slices of very big pies, especially if those ultimately granting the slices are making money. Fees of, say, 1% of the transaction’s price don’t sound big, but they add up to big numbers. This is especially true if a merger or IPO or leveraged buyout involves tens of billions. And note that large acquisitions often don’t require much more work than smaller ones. Even a 1% fee on Aramco’s likely IPO of $100 billion to $150 billion would be $1 billion to $1.5 billion, enough to make many investment bankers happy. The term “leveraged buyout” got a bad connotation with the discrediting of Michael Milken and the collapse of his firm, Drexel Burnham in 1990. So they’re now called “private equity deals.” Nevertheless, those involved still treat themselves to huge fees in dollar terms, but still minor percentages of the deal size. Furthermore, buyout outfits often charge the investors in their funds 1.5% annually. Again, the percentage may sound small, but the funds are huge, tens of billions of dollars. Banks, of course, traditionally profit from the spread between the interest rates they pay on deposits and the higher rates they charge on loans. As noted earlier, these spreads of a few percentage points are greatly magnified as a return on bank capital by the relatively small ratio of capital-to-assets,. In effect, banks combine our third strategy, invest with huge financial leverage, with our seventh, small pieces (interest rate spreads) of big pies. Still, the recentlyrequired increases in bank capital are reducing the leverage (Chart 24).
www.agaryshilling.com
CEO Pay There’s much handwringing over current high and leaping CEO pay levels. But here, too, corporate leaders’ compensation is often tiny compared to profits and much smaller as a share of revenues. That’s one reason why shareholders have shown little effective concern—as long as stock prices are rising. Sure, there are other reasons for outlandish CEO pay. Directors are reluctant to challenge CEO desires for fear of breaking boardroom camaraderie and disrupting the congeniality needed to get corporate business done, as discussed in “Little Room At The Top,” April 2016 Insight Commentary). Directors who object to huge compensation awards find themselves marginalized and merely tolerated when executive pay and other matters are discussed. Many board members take the attitude that it’s not my money, so why not pay up and buy peace? Their linkage to shareholders, whose money it in fact is, is often vague and remote. Compensation Consultants Compensation consultants are increasingly hired by corporate boards and not top officers, but often with CEO recommendations. So they want to please senior management by pushing for higher pay levels. We’ve never seen or even heard of a case in which compensation consultants say the CEO in question was overpaid. And almost every corporate leader wants more money. Some think they need it to compensate for the probability that their tenure may be short. Many reflect the reality that today, the way corporate brass keeps score is by the size of their pay. Regulations for public companies now allow for stockholder “say on pay,” non-binding votes on senior officers’ compensation. And in an increasing number of cases, shareholders are voting “no” to board compensation committee recommendations. Last month, 59% of shares were voted against BP’s executive compensation for 2015, including a 20% increase for CEO Bob Dudley, after the oil giant lost $5.2 billion last year. About a third of
Want to stay up to date on Gary Shilling's media appearances and his thoughts on the economy? Be sure to follow him on Twitter @agaryshilling May 2016
A. Gary Shilling's INSIGHT
31
[email protected]
Citigroup’s shareholders also voted against the pay plan for top executives last month. About 64% were in favor, but down from 84% last year. Furthermore, 39 companies in the Russell 300 index have lost “say on pay” votes at least twice between 2011 and last month. Oracle shareholders have said “no” four times. Companies seldom back down immediately after losing “say on pay” votes. But they probably are less aggressive on executive pay in future years. Once a company gets into the penalty box over “say on pay” votes, it’s hard to get out.
@agaryshilling
CHART 32 S&P 500 Operating Profit Margin quarterly operating profits/sales
Last Point 1Q 2016: 9.02% 12%
12%
10%
10%
8%
8%
6%
6%
4%
4%
2%
2%
0%
0%
-2% 2000
-2% 2002
The small slice of a big pie route to riches isn’t confined to finance and CEO pay. Fast food franchises make pennies per hamburger and nickels on a soft drink, but it adds up as they sell millions of dollars’ worth. The same is true of many other businesses where profits per dollar of revenue are small but volumes are huge. Polls consistently show that most Americans believe that profits represent a much, much higher portion of sales than they actually do (Chart 32). 8. Cartels and Monopolies Cartels and oligarchies are great ways to make big money— as long as they last. In 1975, we did an exhaustive study on cartels and noted that they are definitely not new. In The Wealth of Nations (1776), Adam Smith made his oft-quoted statement, “People of the same trade seldom meet together, even for merriment or diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” Cartels are formed to promote profits by keeping prices above equilibrium through restricting demand. Of course, a cartel only works when demand is so insensitive to price that higher prices will actually increase the seller’s total revenue, as was earlier the case with OPEC (see Chart 6, page 5). Aristotle discusses one of the earliest cases on record involving a philosopher, Thales of Miletus, who was ridiculed for being smart but still poor. To prove the value of his vast knowledge, he used his astronomical observations to ascertain that there would be a bumper olive crop in a certain year. Long before the harvest, he rented all the olive presses in the area, which were so cheap in the off season that even his meager funds were sufficient. The huge crop 32
A. Gary Shilling's INSIGHT
www.agaryshilling.com
2005
2007
2010
2012
2015
Source: Standard & Poor's
arrived on schedule, and the demand for olive presses skyrocketed. Needless to say, Thales made a killing in subletting them and proved that a philosopher, when he likes, can easily become rich—but his “ambition is of another sort,” said Aristotle. Our February report, “Lessons of History for OPEC,” covered our earlier detailed history of cartels, why they were formed and why they failed. As discussed in our frontpage report, and outlined in Chart 7 on page 5, the favorable conditions for OPEC are over and the oil cartel is fading fast. Steel The American steel industry had a powerful cartel that lasted for over half a century after the founding of US Steel in 1901. Back then, no one could compete with Andrew Carnegie, so J.P. Morgan organized the buyout of his Federal Steel Co., which was then combined with other producers. In Europe after World War II, the European Coal and Steel Community, the ancestor of the EU, was formed by governments to limit output and competition. But foreign competition killed the U.S. steel cartel and its pricing power late in the last century, despite repeated government attempts to provide protection. Almost all American producers except US Steel went bankrupt under the weight of noncompetitive labor costs. Wilbur Ross bought and combined bankrupts such as Bethlehem Steel sans excess labor costs to form International Steel Group. The Mittal family that controls Arcelor Mittal went on a global steel producer-buying spree and bought ISG. was the firm trying to create a new global cartel before the onslaught of Chinese steel floods the world? Earlier, we noted that Mittal is seeking help from the British government to avoid closing English steel mills. May 2016
[email protected]
@agaryshilling
www.agaryshilling.com
CHART 33 Utilities Electric, gas, water and telephone utilities Real Airline Passenger Revenue per Passenger Mile CPI-deflated; 1982-84=100 used to be treated as natural monopolies Last Point 2015: 4.66 and, therefore, regulated. They made 16 16 good, steady returns but weren’t fabulously wealthy since regulators 14 14 usually allowed a set return on 12 12 investment, which encouraged them to spend on plant and equipment whether 10 10 they needed it or not. Serious deregulation started in 1984 when AT&T 8 8 was forced by a federal antitrust suit to spin off the 22 local companies into 6 6 seven “Baby Bells.” Deregulation of natural gas pipelines and electric utilities 4 4 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 followed and free competition was hailed Source: BTS and Haver Analytics as the consumer’s friend. But with the collapse of Enron in 2001 and the Fares between specific destinations like New York to skyrocketing of electrical prices in California that Enron’s Chicago were identical on all airlines for both first-class as energy traders aided and abetted, to say nothing of the well as coach. One airline would file a fare change with the troubles at electric utilities that decided to become dot CAB and the rest would follow quickly. Still, competition coms, the deregulation trend came to a grinding halt. existed, at least on routes served by multiple carriers. One big TV winter-time ad campaign featured an entertainment Some electric utilities were essentially re-regulated. The celebrity sitting by a swimming pool in the bright Florida seven Baby Bells have shrunk to three that include wireless, sunshine. The ad ended with him beckoning at the viewer cell phone and other telecom modes—AT&T, the and proclaiming, “Come on down, the weather’s great!”— combination of AT&T, Ameritech, Southwestern Bell, on his airline, of course! Pacific Telesis and BellSouth; Verizon, which includes the
former Bell Atlantic and Nynex; and Qwest, formerly US West. Now the industry is dominated by AT&T and Verizon. Still, competition in telecom remains fierce and consolidation reflected it more than it heralds a new golden age of oligarchy profits. Airlines Until 1978, airlines were controlled by the Civil Aeronautics Board. The CAB controlled airline routes, with specific airlines pretty much dominating specific geographic areas. Delta was strong in the Southeast, United owned Chicago, Eastern flew up and down the East Coast and to the Caribbean. International routes were confined to only two carriers, TWA flew domestically and abroad, but PanAm only flew from U.S. cities to foreign destinations. Fares were also controlled by the CAB, which essentially rubber-stamped whatever airlines wanted. Since passengers paid through the nose, the industry thrived even though costs were high (Chart 33). Airline personnel were wellpaid, and pilots were truly the princes of labor. Senior pilots made over $200,000 per year—a king’s ransom in the 1970s—for working less than 40 hours per month. This allowed many of them to live in, say Montana, and commute at company expense to their flight bases in New York and other major cities. May 2016
Bizarre Competition Competition also took some bizarre forms. At one point on the lunch-time New York to Chicago flight, the CAB approved regulations that allowed only sandwiches to be served. So the competitive juices flowed, and airlines vied with each other to see what can be put between two pieces of bread. We recall that the top of the tree was reached when one carrier stuffed a whole filet mignon between two slices of rye while other airlines only had a chicken or a pheasant. Another weird example by one airline was the ripping out of seats and their replacement with piano bars, complete with bartenders and piano players. Needless to say, the huge revenues and lack of fare competition meant that airlines did indeed concentrate on passenger service with unlimited drinks and decent eats. This was all before competition ranked airline food with military intelligence, congressional ethics, tax simplification, vegetarian vampires and postal service on the list of great oxymora. Predictable Problems Upon airline deregulation in 1978, we foresaw big trouble for the industry because of its economic structure. Fixed costs are high in the short run and marginal costs are very A. Gary Shilling's INSIGHT
33
[email protected]
@agaryshilling
low. An airline that’s scheduled to fly from Atlanta to Los Angeles has incurred all the overhead costs of management, airplanes, reservations personnel and systems, airport gate costs, etc. Furthermore, it is locked in to the costs of pilots, flight attendants, ramp workers and gate agents for that flight. So, the cost of flying an extra passenger is trivial— that passenger’s meal or snack and several gallons of jet fuel. In addition, it soon became clear after deregulation that the industry is an easy entry business. Sure, planes are expensive but lenders are eager to finance them—if the airline goes belly up, the lender can easily fly away the collateral. As we all know from Economics 101, in this environment, the airline makes money in the marginal short run as long as the passenger who fills an empty seat pays more than those tiny marginal costs. So when there’s free fare competition and excess capacity, fares—at least for the last passengers—will be driven almost to zero. We recall in the early deregulation days being in Chicago and getting a lastminute fare on start-up People Express back to Newark, N.J. for $50 while old line carriers charged over $300. Territory Invasions Not only were fares but also routes deregulated in 1978. Consequently, airlines invaded each other’s territories with gay abandon. In one instance, we were in LaGuardia Airport waiting for an American flight to Dallas. We happened to be standing slightly in back of the gate counter and saw a message flashing on the computer screen that said, “Convert Braniff Revenues! Convert Braniff Revenues!” We asked the clerk what that meant and she explained that she’d get bonus points if she could convince Braniff-ticketed passengers to switch to American. American was invading the Dallas market that was critical to Braniff, and had no qualms about pushing Braniff to the ropes. Indeed, that airline filed for bankruptcy shortly thereafter, in May 1982—for the first time. Old-line carriers have fought deregulation with frequent flyer programs designed to create customer loyalty. They also keep challenging deregulated fares with sophisticated computerized pricing models that separated price insensitive business flyers from cost-conscious leisure flyers. The over-the-weekend stays required to get the low-ball prices are only one example. Couldn’t Buck The Jet Stream These competition-deflecting strategies by high-cost airlines had some success in the 1980s and exuberant 1990s, but by the end of the last decade, the legacy carriers were no longer able to buck the jet stream of competition. With the stock market collapse in 2000-2002, the huge gap between 34
A. Gary Shilling's INSIGHT
www.agaryshilling.com
business and tourist airfares induced many businesspeople to fly steerage. Mushrooming Internet websites made it easy for passengers to overcome the airlines’ deliberately confusing array of fares and nail down the lowest ticket costs. Meanwhile, leaping jet fuel costs could not be offset with higher fares. Furthermore, the previously successful hub and spoke air route system proved too expensive to compete with the point-to-point systems of upstarts, specifically Southwest. As the low-cost air carriers more and more dominate, the legacy airlines, with high labor costs, inflated fuel costs and pressure on fares, suffered huge losses. Also, legacy carrier management and labor have been totally unwilling, until very recently, to face the reality of deregulation and the resulting competition. This attitude, unfortunately, is common in other businesses. Real, or inflation-adjusted, airline revenues per passenger-mile flown have been on a steady drop since the late 1970s deregulation (Chart 33). In past Insights, we noted that old line companies in industries like steel, autos and airlines that were shielded from competition by regulation, cartel-like structure, protectionism, etc. almost never adapt successfully when those shields are removed. Apparently, management and labor are so comfortable with the earlier easy life that they can’t bring themselves to change. Only the startups, with fresh attitudes and structures, are successful in the new environment. A Fresh Start A very important deterrent to consolidation in the airline industry is the cost-cutting opportunities of bankruptcy. This makes it possible to cancel labor contracts, if the bankruptcy judge agrees, and even the threat of filing for bankruptcy can wring concessions from unions. Bankruptcy also allows airlines to drastically reduce or even eliminate debt to say nothing of essentially wiping out stockholders, as was the case with United’s parent, UAL, Northwest, Delta and US Airways. Another big advantage of bankruptcy is the opportunity to dump defined benefit pension fund obligations on the federal government’s Pension Benefit Guaranty Corp. The bankrupt simply has to convince the judge that it can’t restructure without getting out from under that albatross. The PBGC benefits are lower than those promised by airlines to pilots and other high-paid airline employees. So, threatening bankruptcy is another way of pressing unions for concessions. A pilot could see his pension cut in half if his employer enters bankruptcy and then bails out of its pension plan. With all these advantages, it’s no wonder that U.S. airlines have entered bankruptcy 279 times since 1978. May 2016
[email protected]
9. Sell the Sizzle, Not the Steak An age-old route to riches is to promote hopes and dreams, regardless of how far they may be from reality. Of course, government regulation has curtailed the wild health claims for snake oil and many other patent medicines, hair restorers, potency formulas and fountains of youth, but opportunities still abound.
@agaryshilling
CHART 34 "Get Rich Quick" Books
“How to Get Filthy, Stinking Rich and Still Have Time for Great Sex! An Entrepreneur’s Guide to Wealth and Happiness” “Get Rich Quick” “Trump: How to Get Rich” “Do This. Get Rich!” “How to Get Rich on The Internet” “How to Get Rich With A 1-800 Number” “How to Get Rich in Real Estate” “How to Get Rich Selling Insurance and Annuities to Women” “How to Get Rich Selling Cars and Trucks to Women” “How to Get Rich While You Sleep” “How to Get Rich Buying Bankrupt Companies” “The Automatic Millionaire” “The Millionaire Next Door: The Surprising Secrets of America's Wealthy”
Years ago, we met a couple with a thriving business selling pills, lotions, salves, soaps and even toothpaste that contained royal jelly. That substance is secreted from glands in worker honeybees’ heads and is fed to larva that will become worker bees. But when the worker bees sense that there is no queen in the hive, they feed extra doses to a number of larva and they become queens (hence the name royal jelly), which are able to produce female worker bees and male drones. Of course, the first queen to emerge from the cocoon stage (we beekeepers call it sealed brood) immediately stings to death those other yet-to-emerge queens. There’s going to be only one queen per hive! The wife of this couple had suffered a near death from cancer, but recovered completely when a friend recommended royal jelly. So she became a true believer, and they imported the stuff from China and combined it with other substances to make their products. The couple explained to me carefully that in their marketing literature, they were not permitted by the FDA to make any health claims they could not substantiate with scientific tests—and they had none. But they could print statements of satisfied customers who testified to miraculous cures from royal jelly products. That’s protected by the First Constitutional Amendment guaranteeing free speech. As beekeepers, we're well aware of other medical claims involving bees and honey. Some believe that if they eat local honey, they won't get allergies, but there's no scientific evidence of that. Others think that getting stung by honey bees prevents arthritis, and there is a cottage industry of beekeepers who incite their bees to sting people on a regular basis—and for nice fees, of course. Bee stings do produce reactions that temporarily combat the pain of arthritis, but again, there's no scientific evidence of permanent help. And if you don't believe me, just look at my hands. I get stung 400 to 500 times a year, but my twisted but still functioning fingers look like those of my mother and some other blood relatives. May 2016
www.agaryshilling.com
Garlic and Penny Stocks In a similar vein, garlic growers have benefited from the belief that garlic protects against heart attacks. Health food entrepreneurs have accommodated those who don’t like the taste or digestive effects with garlic pills, widely advertised on TV and elsewhere. But a scientific study, complete with double blind tests and placebos, found absolutely no effect in reducing cholesterol. Garlic producers, of course, responded that the tests weren’t meaningful. Even more recently, researchers found that high doses of antioxidant supplements like beta carotene, vitamin A and vitamin E actually raise death rates. Those who made money from vitamin pills are not amused. Penny stocks of dubious, even nonexistent Canadian gold mining companies were long the staple of the Vancouver Stock Exchange and appeal to sizzle lovers. So, too, do getrich-quick schemes. We recall getting a call at home at dinner time, before the do-not-call-rules, from “Ol’ Earl down here in the oil patch.” We listened to his pitch long enough to be sure that the oil investment he offered was too good to be true, and it probably was. When he said the magic words, “You can’t miss,” we hung up. Then there are all the get-rich-quick and related self-help books (Chart 34), DVDs, lectures and online courses. The purveyors can make good livings and then some selling their strategies as they prey on hopes and dreams. But do many buyers stop to ask, if this guy really knows how to do it, why would he share that priceless knowledge with the rest of the world? Why wouldn’t he keep it to himself, build a big fortune and retire at age 29 with his trophy wife on his own private Caribbean island? But, as P.T. Barnum said, “there’s a sucker born every minute.” Amend that to read, every second. A. Gary Shilling's INSIGHT
35
[email protected]
@agaryshilling
10. Take Advantage of Addictions and Vanity Catering to addictions and vanity has always been a big money-maker, even more so when they are outlawed. Think of sex and prostitution, the world’s oldest profession. Concubines have always been a trapping of political and economic success. The courtesans of Washington, D.C. who frequently embarrass politicians, Congress and Administration officials are no different from those in Louis XIV’s court. They’re just less socially acceptable in America.
www.agaryshilling.com
CHART 35 Caffeine Content of Soft Drinks Starbucks Coffee (16 oz.)
Red Bull Energy (8.3 oz.)
Monster Energy (8.3 oz.)
Mountain Dew (12 oz.)
Pepsi (12 oz.)
Coca-Cola (12 oz.)
Smoking is on the decline as health awareness and high prices, promoted in part by high taxes, curtail demand. California just increased the age for cigarette buyers from 18 to 21. That follows Hawaii last year, and other states may follow while a number of cities including New York City and Boston have 21 age requirements. Since 90% of smokers start by age 18, the hope is that higher age limits will keep people from smoking altogether. Tobacco exports to England drove the thriving Virginia colony in its early days, but the business could be hazardous. Sir Walter Raleigh, who is credited with introducing tobacco to Britain, reportedly enjoyed two pipesful before his beheading, for unrelated reasons, under Queen Elizabeth I's orders. But those still hooked on tobacco will pay almost anything to satisfy their nicotine addictions. That’s why the tobacco industry accepted the huge $206 billion settlement with state attorneys general in 1998. They simply jacked up prices to offset their fines, and with the full approval of health officials who hoped leaping prices would discourage smoking. The average price of cigarettes today is $5.96 per pack in California. And don’t forget the growing industry of nicotine patches and gums, smoking-cessation clinics, hypnotists and other devices that benefit from smokers’
0
50
100
150
200
250
Milligrams
Source: Mayo Clinic and American Beverage Association
attempts to kick the habit, despite limited success. Caffeine And Soda Then there is caffeine addiction, which has created vast fortunes in coffee and tea. It had a lot to do with originally attracting the British to the Far East. And don’t believe soft drink makers when they say they put caffeine in their products to improve the flavor and pep you up (Chart 35). It’s mainly to make them habit-forming. With the recent surge in obesity and the related diabetes, a number of civic leaders and even countries have declared war on sugar in soft drinks. India, South Africa and the Philippines, among others, are debating special taxes on sugar-laced soda. The World Health Organization in January recommended taxes on sugar-added beverages to reduce childhood obesity. Former New York City Mayor Michael Bloomberg tried but failed to limit the size of sugary soda servings to 16 ounces. U.S. soft drink sales have been falling for the last four years straight, and the switch to other liquids is expected to continue. Can you recall when it was humanly possible to get through the day without sipping continually from a bottle of spring water?
Make Sure You're Getting Your Monthly INSIGHTs If you receive INSIGHT via e-mail and haven't received your report by the 10th day of the month, there are several possible reasons why: 1. Your e-mail's in-box is unable to accept a message with a large file. 2. Our INSIGHT e-mail to you was deposited directly into your junk mail or spam folder. 3. You changed your e-mail address and forgot to let us know. 4. Our INSIGHT email mysteriously vanished into the atmosphere, as happens once in a rare while. If you have not received your monthly INSIGHT, check your junk box and spam folders first before calling us to report a delivery problem. Also, if your e-mail address changes, please let us know. And if you receive INSIGHT via regular mail, please let us know of any address changes as soon as possible. We can be reached at 1-888-346-7444 or 973-467-0070 between 9:00 am and 5:00 pm Eastern Time. 36
A. Gary Shilling's INSIGHT
May 2016
[email protected]
But the public is not solidly behind this health measure, even though global soda sales volume rose only 0.1% last year. Two years ago, Mexico, with a major obesity problem, put a one-peso per liter, or 10%, tax on sodas. The tax raised over $2 billion since January 2014, a third more than the government expected, and sales of carbonated soft drinks dropped (Chart 36). Mexico’s National Institute of Public Health estimates that per capita consumption of sugar-sweetened beverages was 8% lower in 2015 than the pre-tax 20072013 years, adjusted for population growth and economic activity. But Mexico’s daily caloric intake only fell by six or seven calories, or 0.2%. And carbonated soft drink sales revived last year (Chart 36). In the first quarter of 2016, Coca-Cola’s Mexican soda sales rose 5.5% from a year earlier for its largest bottler and 11% for the second largest. And last year, the market shares of full-calorie Coca-Cola and Pepsi-Cola rose slightly to 48% and 11%, respectively, from 2014.
@agaryshilling
www.agaryshilling.com
CHART 36 Volume of Carbonated Soft Drinks Sold in Mexico year/year % change
Last Point 2015*: 0.5% 5%
5%
4%
4%
3%
3%
2%
2%
1%
1%
0%
0%
-1%
-1%
-2%
-2%
-3%
-3% 2009
2010
2011
2012
2013
2014
2015
Source: The Wall Street Journal and Canadean
CHART 37 Auto and Apparel Personal Consumption Expenditures year/year % change; 3-year moving average
Last Points 1Q 2016: auto 3.5%; apparel 1.3% 16%
16%
14%
14%
12%
12%
10%
10%
8%
8%
6%
6%
4%
4%
2%
2%
0% Illegal Drugs -2% -2% Illegal booze, of course, was the lifeblood -4% -4% of the Mafia during Prohibition, and a 1951 1961 1971 1981 1991 2001 2011 high but bloody life it was. Now, illegal Motor Vehicles - left axis Apparel, lagged 1 year - right axis drugs are huge money makers. So much so that a major demand for U.S. currency Source: Bureau of Economic Analysis is for $100 bills used in the illegal drug Vanity and Small Luxuries trade. Its practitioners have major problems in laundering Appealing to vanity is another lucrative business, and the money that is far too much to be employed profitably always has been. In the bazaars of Cairo you can still buy in their business and must be recycled into legitimate Cleopatra’s secret formula lotion. And think of all the activities. The European Central bank just announced that money spent on face creams, hair coloring, botox injections, it will no longer issue €500 bills worth $570 each to reduce body slimming gyms, etc. Then there are all the gorgeous the ease of transporting suitcases full of illegal and laundered clothes to fit on those magnificent bodies. What’s your money. guess as to how much was spent by women as well as men on looking good at the recent Academy Awards ceremony? The war-torn economy of Afghanistan has revived due to The devil, and his vanity-feeding acolytes, really does wear the poppy industry, under the careful protection of local Prada. warlords. Several years ago, we met the head of a dock and bulkhead construction firm. He told us his previous Small luxuries is a category we discovered decades ago occupation was in the Caribbean, welding steel plates over when we noticed that auto and apparel sales are often drug-filled secret compartments in ships headed for the mirror images. When people can’t afford new vehicles, they U.S. He was paid $10,000 per day for his work, but he didn’t buy new clothes as consolation prizes a year or so later need it to pay hotel bills at his next residence, Attica State (Chart 37). We also learned that in South Africa, before the Prison in New York State. end of apartheid, socially ambitious blacks carried the fine, 0%
May 2016
A. Gary Shilling's INSIGHT
37
[email protected]
@agaryshilling
slim and expensive umbrellas found among London’s investment bankers. They couldn’t afford much, certainly not cars or even taxi rides. But they wanted the best of what they could. Hallmark operates on the same principle. Greeting cards aren’t big expenditures, and for just a buck or two more than the run-of-the-mill supermarket offering, you can tell the recipient that you care enough to send the very best. Starbucks operates on the same small luxuries strategy that makes people happy to pay over $4.50 for a latte served in a cool atmosphere. Then there is the light blue box from Tiffany's that may only contain a pair of cuff links, but reeks of prestige. 11. Picks and Shovels Supplying goods and services to a risky but potentially very profitable venture is a time-honored way to clean up. The old story is that few gold miners in the 1849 California gold rush got rich, but those selling them picks and shovels—and Levi pants—did. I was a graduate student at Stanford in the early 1960s, and on a recent return visit I toured the Stanford Museum and the room devoted to the Stanford family. Leland Stanford was one of the Four Horsemen who promoted the transcontinental railroads in the late 1800s, along with Charles Crocker, Collis Huntington and Mark Hopkins. None of the railroads made much money and all ended up being reorganized, despite all the free federal land they were granted, as noted earlier.
Ditto for investment advisors and mutual fund advisors. Nevertheless, with choppy security markets and low interest returns in recent years, fees for investment advisors have been declining. Some money market firms with trivial investment returns slashed their fees to zero or close to it. Hedge fund fees are under pressure with 2% management fees plus 20% of the profits becoming less standard. Mutual funds are reducing their fees and some are eliminating their front and back end “load” charges. At the same time, investors are increasingly wondering whether many conventional asset managers are adding enough value and returns to justify their fees. The acceleration in assets under management of ultra-low fee and index fund champion
The Vanguard Group
assets under management; US$ trillion Last Point 2015: $3.1 3.5
3.5
3.0
3.0
2.5
2.5
2.0
2.0
1.5
1.5
1.0
1.0
0.5
0.5
0.0
0.0 1975
1979
Recent Cases Fast forward to today, and businesses that prosper as suppliers to those who hope to make gigantic profits are legion. In stock bull markets and especially bubbles, investors have dreams of fabulous riches and will pay heavily to those who serve their needs, aspirations and whims. This includes stockbrokers, as shown by the close correlation between A. Gary Shilling's INSIGHT
stock prices and brokerage commissions.
CHART 38
But the promoters became immensely wealthy, enough so that Stanford and his wife, Jane, after he died, were able to finance an entire university. The museum exhibit pointed out that the Four Horsemen’s technique was to establish railroad companies that sold stock to the public. Then they set up separate businesses to supply those companies with rails, timbers and other goods at huge profits. They effectively transferred the railroad investors’ money to their own pockets—and to those of Stanford students for generations to come. Thanks, Senator Stanford!
38
www.agaryshilling.com
1983
1987
1991
1995
1999
2003
2007
2011
Source: AdvisoryHQ
Vanguard is clear evidence (Chart 38). Fiduciary Responsibility This trend will no doubt be enhanced by new regulations that require brokers not just to recommend investments that are suitable for their client but those that are in their best interest. This will force brokers to justify and expense fees above rock bottom. This is the expansion to brokers of fiduciary responsibility that already applies to registered investment advisors. Those that provide back office, custodian and other services to stockholders like State Street Boston and Bank of New York Mellon are also in the picks and shovels business. And note that almost all areas on Wall Street depend on stock price action. When stocks are rising, mergers and acquisitions, private equity, investment management and IPOs are all vibrant. So, houses involved in all these activities prosper. May 2016
[email protected]
@agaryshilling
Stock market radio and TV shows also get big shares of the goodies. Enthusiastic viewers remain glued to the tube in exuberant markets, and advertisers are only too happy to pay heavily for air time. Don’t think that the joy of their shows’ anchors over ever-rising stocks is artificial. They know who butters their bread. Of course, when the gold vein plays out, the miners disappear and picks and shovels sales plummet. And the few that are sold fetch lower prices. The earlier residential real estate bubble (Chart 4) fed armies of brokers, mortgage lenders, builders, appraisers, construction material suppliers and Wall Street houses that generated all those subprime residential mortgage-backed securities and collateralized debt obligations. Mortgage lenders promoted loans to patently unqualified subprime borrowers because of their lucrative fees. The U.S. Justice Department has for years challenged the anticompetitive fixing of commission rates by real estate brokers, but homebuyers don’t do much negotiating as long as prices are rising. 12. Get Paid With Money That Isn’t The Payer’s, Especially If They’re Desperate Small pieces of big pies get bigger and easier to obtain when the buyer of the pie wants it badly and considers the service in question essential to get the deal done. We saw this in our own firm years ago when an industrial consulting client was making a major acquisition. We were told of it at the last minute and asked to do a quick study of the fit between the client and the company to be purchased. The investment banking, legal and accounting fees, all necessary for the deal to close, totaled about $1 million, a lot of money at the time. The CEO definitely wanted the acquisition and considered our input as no more than a blessing of his decision. So he offered us a mere $5,000 for the study. We did it even though several of our economists spent a weekend on it and missed our company outing that year, a deep sea fishing trip. We’ve often thought about who got paid what on that deal as a reflection of their relative importance in the CEO’s eyes! Well, on the bright side, our colleagues who labored in the office didn’t get seasick as did most of the rest of us on that rough-seas day. A Walk Down The Hall This strategy has wide applicability. CEOs are often quite free with corporate money in paying bonuses to consultants who may help save their companies, even when those outside experts tell the corporate chiefs what they already know. A CEO friend talks about high-priced consultants he hired who took what he called “a walk down the hall.” They interviewed all of his senior staff on the issue in question and then simply regurgitated that information to him—for a sizable fee, of course!
www.agaryshilling.com
conclude that the senior brass is undercompensated. But those consultants are paid well because they’re considered necessary to substantiate pay scales. Corporate directors approve lavish CEO compensation and severance packages in part because it isn’t their personal money and they want to keep the leader happy. Business-oriented law firms are particularly good at this strategy, especially when their clients face significant class action suits, other substantial legal difficulties or potentially debilitating regulatory problems. Corporate officials will spend almost any amount of their firm’s money to stay out of trouble, and lawyers know it. And when their lawyers sympathize with them over how bad the class action lawyers are who oppose them, corporate leaders should remember that without those class action suits, their own lawyers would not have billable hours. And billable hours they can run up so fast you can’t even see the meter spin. We know of one case where the defense attorney had to work nine hours a day, seven days a week for two months straight to justify the time he billed. Of course, the class action lawyers are also getting paid with other than their clients’ money since they almost always work on contingency bases. It’s the defendant who, in effect, pays them when the usual settlement is reached. The last thing the plaintiffs’ lawyers want is a time-consuming trial they might lose. Soft Dollars Mutual funds and other managers of others’ money used to pay for securities trading, outside research, quote machines and even furniture with brokerage commissions. This was the vast “soft dollar” business, which they preferred to hard dollars, cash payments that came out of their hides while soft dollars were paid from their clients’ assets. The result was that some services paid in soft dollars, including lavish entertainment, clearly did not benefit the money manager’s clients. Abuses led the SEC to restrict soft dollars to outside research and other services that clearly benefit the owners of the managed funds. In an era of market-determined commission rates, anything an institution pays above barebones execution of a few pennies a share for a stock trade has to be justified as a client-benefiting expense. The fun has definitely gone out of the soft dollar business! What Do You Think? This list of 12 strategies for making big money is probably not exhaustive. Perhaps this number could be expanded. Still, we hope our list gets you thinking. Maybe some of our strategies may suggest highly profitable opportunities to you. On the other hand, do you have other approaches we haven’t thought of? Please give us your thoughts.
Compensation studies by outside consultants almost always May 2016
A. Gary Shilling's INSIGHT
39
[email protected]
@agaryshilling
Commentary
spending, Obamacare, etc. have failed to arrest the polarization of income that has been underway at least since the 1960s. Yet rather than concentrate on enlarging the economic pie, so everyone gets a bigger slice, the strategy of Bernie Sanders and Hillary Clinton is higher taxes on the rich to be transferred downward.
Aristotle Lives! Aristotle, Plato and other ancient philosophers first decided how the world was ordered, based on intuitive principles, and then looked for supporting evidence. Hence their conviction that the universe revolved around the earth. But careful observations by Copernicus and Kepler as well as Galileo’s telescope made the geocentric concept increasingly untenable, and Newton’s law of gravitation confirmed the heliocentric theory. Those years saw the birth of the scientific method—looking first and the letting the evidence dictate the conclusions. But over 300 years later, the Aristotelian model of first deciding how the world works and then selecting the data to support those preconceived notions still persists. Even in the scientific community. Several years ago, investigators of global warming threw out data that did not verify their belief that it’s the result of fossil fuels. As a physics major at Amherst College, I learned that true scientists never, never, never discard data, whether it supports their hypotheses or not. The outliers may prove to be the most important observations. Aristotelian thinking also pervades government regulation. If specific measures fail to produce the desired results, the reaction is not to reappraise the theory but to intensify the actions. Government job training programs have generally failed to prepare people for productive employment, but the standard response to more of the same. Government attempts to redistribute income from higher to lower income groups through tax increases, welfare 40
A. Gary Shilling's INSIGHT
Conservatives can be just as doctrinaire as liberals. Years ago, I spent an afternoon, one on one, with Milton Friedman, who told me there was no such thing as shortages or surpluses because prices would always match supply and demand. But crude oil supply continues to exceed demand by one to two million barrels per day. He also said labor rates around the world would equalize to stem the U.S. inflow of cheap manufactured products but was oblivious to outcries by American workers after the resulting declines in their real incomes. This Aristotelian mindset is reinforced as government programs build strong constituencies. Charter schools in which instructors are free to concentrate on educating students have proved superior to public schools where teacher unions’ interests often come first. But union strength has held back this expansion. Ironically, businesses that fight increased government regulation often support it after they’ve incurred the time and expense of adapting. Reverting back to lower carbon emission standards would be very difficult and costly for the electricitygenerating industry. The Sarbanes-Oxley law, enacted in 2002 in response to questionable accounting at Enron, Worldcom and elsewhere, added huge corporate audit and compliance expenses, and addressed an era that is long past. But the resulting need for substantial
www.agaryshilling.com
outside auditing services spawned a substantial constituency. Similarly, the 2010 Dodd-Frank law, the response to the financial crisis, is so massive and complicated that some aspects are yet to be worked out. That includes the Volcker rule that eliminates proprietary trading by banks. Yet the financial excesses that this after-the-fact legislation addresses are unlikely to be repeated, at least not until the current generation of embarrassed bankers are gone. Due to the Aristotelian mindset and robust constituencies, government regulations are seldom reversed entirely. Almost alone was the elimination in the late 1970s of the Civil Aviation Board, which set airline routes and fares. Galileo was formally condemned by the Pope in 1633 for his heliocentric theory, but that action was only revoked 332 years later in 1965. The Fed and other major central banks have been thoroughly Aristotelian in recent years. They persist in “forward guidance,” advising markets on future monetary policy even though their decisions are datadriven and they have consistently overstated economic growth, inflation and interest rates. Our analysis revealed that stock and bond volatility was less before than after the advent of forward guidance. Still, there may be some hope that Aristotle will be returned to ancient Greece. Several key Fed and Treasury Department officials recently suggested that their new regulations may have increased market volatility by reducing liquidity.
May 2016
