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And This Too Shall Pass -- July 2008

Almost no one saw the credit crisis approaching, but now – a full year later – nearly everyone believes it will never end. The pessimism is certainly understandable: the world’s financial markets continue to reel from an increasingly toxic and self-reinforcing mix of rising credit losses and sharply higher energy prices. And while the U.S. economy recently demonstrated impressive resilience in the midst of unprecedented distress among banks and other financial institutions, it’s pretty clear that gas prices above $4 per gallon are starting to really hurt, leading to renewed fears that deeper problems lie ahead. As a result, it seems the daily American pastime is no longer taking SUV trips to the shopping mall but rather guessing which presidential candidate sounded the most pessimistic. Thus, consumer confidence has fallen to rock-bottom (1974) levels, and the chatter among the talking heads on the airwaves – and among the rest of us on public transit – tilts more negative each day. With the S&P 500 off about 20% since October, the market conveys not only its own surprise with the magnitude of the credit and energy crises, but also its resignation that a reversal and recovery from the current extremes – if it comes – is well beyond the visible horizon. Even the optimists now must admit that the “light at the end of the tunnel” might actually be an approaching locomotive. Well, let’s at least hope the train runs on coal…

Other than the energy and commodity-oriented areas, there have been few places to hide this year. Over 70% of the stocks in the S&P 500 fell in the first six months of the year, with nearly one-third of the index off more than 20%, indicating broad, deep weakness. And as unlikely as it might seem, the U.S. market has fared no worse than its international peers in 2008, and there have been some serious setbacks ( India and China are off 34% and 46%, respectively). Within the S&P 500, the energy sector has been on a tear – up 25% over just the past year, playing a growing role in the overall index’s performance. On the other hand, the financials sector is off 42% over the same period, reflecting the continuing pain of the credit crisis that began to unfold in full force one year ago. It has been a humbling period for many: the analysts, bankers and brokers who structured and sold many ill-advised credit deals; government regulators who were unable to comprehend the risks; CEOs who should have known better than to gamble with the survival of their own businesses, and finally investment managers who underestimated the severity and breadth of the capital crisis. A decline of such proportion provides plenty of regret, plenty of remorse.

The big issue today, of course, is the price of energy and other commodities. Investors are becoming increasingly mesmerized by the action, similar in some respects to the world’s obsession with internet and technology stocks a decade ago. While physical, necessary commodities differ markedly from sock puppet spokesmen, the anecdotes from the current levitation are beginning to sound a bit too reminiscent of that era (the $22.5 billion IPO valuation placed on OGX – a Brazilian oil company that’s never drilled a well – is a good place to start). The commodity issue is also a juicy target during the current political season, but even we would argue with those painting this episode as mainly speculation-driven. Underinvestment in exploration and development, a weak U.S. currency, relentless demand growth from developing nations as well as rising geopolitical risk have all played major roles (and have been thoroughly discussed by others). The “speculation story”, in our minds, is probably mischaracterized: rather than the image of millions of day traders or hedge funds attempting to manipulate a market, we see broad-based investment by institutions and individuals who now believe commodities merit a meaningful weighting in their portfolios. The rationale for such portfolio diversification into physical assets can certainly be rationalized, but the math doesn’t work so well. With total U.S. stock market capitalization about 13-times larger than the total contract value on all domestic commodity exchanges, even modest shifts into commodities can be understood as more of a physics problem than an economic one. To wit: trading volume in energy futures is up 30-fold since 1997. In any case, whether it’s called speculation or investment, the flows into commodity indices have been unprecedented and so far very profitable. Like a decade ago, the next question will be the more interesting: how long will the new money stick around when sentiment and prices (for whatever reason) reverse.

We believe prices will reverse. They already have in formerly hot commodities like lead, zinc, and nickel (off about 45% from recent peaks). As for oil, the record of cyclicality dates back more than a century-and-a-half: in 1985-86, oil prices dropped about 70% in five months (from $32 to below $10 per barrel), and more recently in 1998 the price dropped again to about $10 (65% off its year-earlier peak). Some readers may also recall a story from 1980, during the height of the Carter-era resource depletion scare, when economist Julian Simon bet conservationist Paul Ehrlich (The Population Bomb) that the real price of any group of natural resources of Ehrlich’s choice would be worth less a decade hence. Simon won the well-documented bet (and $1000) when the average price of five industrial minerals tumbled more than 40% on average, spurred by the hunt for new sources of supply, resource conservation by users and the development of substitutes (as always occurs with any commodity). For hundreds of years there have been regular scares regarding the imminent depletion of this or that resource based on current trends and known reserves. Yet every one of these pronouncements has ultimately been proven wrong as more efficient technologies are brought to bear by the free market.

In fact, the recent rise in oil prices – as in previous cycles – is already encouraging changes in investment and behavior that will ultimately reverse the current price trend. In addition to strong incentives to expand current oil and gas exploration and production, the hunt for petroleum-based alternatives is advancing quickly.Wind and solar power are rapidly gaining acceptance as they become more cost-competitive, and geothermal, nuclear and biofuels are likely to be part of the long-term solution as well. All of this will take time, of course. But importantly – and immediately – demand for energy is already exhibiting a meaningful decline, as the doubling in the price of oil over the past year works its way through the system. In the U.S., the latest monthly data show accelerating year-over-year declines in vehicle miles driven, the first meaningful drop since the 1980-82 recession. Greater demand for smaller hybrid and electric cars – and the shuttering of SUV manufacturing capacity – will also deliver a significant and long-lasting improvement in fuel efficiency (Note: average fuel economy improved nearly 30% in the mid-1980s following a price spike that started in 1979). Overseas, many developing countries (e.g. China, India, Indonesia) are removing government-supported subsidies that kept local energy prices for about one-half the world’s population well below market prices; the result is likely to be a real reduction in the rate of demand growth for these rapidly industrializing nations. In fact, while conventional wisdom cites rapid recent worldwide demand growth for oil, the actual data show a growth rate of just 0.8% in 2007. It would not be surprising to see an outright decline for 2008 when the final numbers are tallied.

We’re humble enough to admit that we can’t predict the exact path for energy prices in the coming months, but it’s pretty clear to us that the fundamental support for continued high prices is weakening at the same time investors appear to be allocating more funds to the energy/commodity asset classes. That’s a trade we increasingly view with caution, and we’re convinced the best opportunities lie elsewhere. But even if energy prices moderate soon, much damage has already been done to the economy’s health. Commodity inflation, currency weakness, rising foreclosures and a serious credit crisis dominate the headlines today. The gloom which hangs over the markets is not surprising, but it is precisely such an environment – near the bottom of a credit cycle – that makes it worthwhile to be a bargain-hunting value investor. While we cannot identify the catalyst to recovery, the aggressive response by the Fed to the credit crisis has helped eliminate many impediments. And the shakier demand fundamentals underneath the energy market lead us to imagine a likely price reversal given all of today’s circumstances. As we learned almost a decade ago, uncomfortable market trends can last a lot longer than imagined, but in the end, fundamentals win out. Today, we surely see the same economic threats as most investors, but more importantly, we also see our portfolios priced under 60% of our estimate of intrinsic value, a level we’ve not seen since early 2000. As many investors head for the exits, and as the “wall of worry” seems to grow ever-higher, we are struck by the value opportunities that grow daily. With experience and confidence, we believe the current anxiety and economic cycle shall pass. The journey should provide ample reward.

Edward S. Loeb
quarterlynews@harrisassoc.com