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Is Now the Time to Buy Oil Stocks?

March 20, 2017, 2:11 pm

Oil and gas was one of the best performing sectors in the previous decade. Everything went right for the industry in terms of oil prices, which traded briefly above $100 in 2008. There was incremental demand from China as that economy grew rapidly. New supply was limited as companies were cautious about exploration after the industry was burned with oil falling below $20 in 1998. In addition, increased speculation from trading desks also caused the price to spike at times. Today, we’re looking at a very different picture. Hydraulic fracking and horizontal drilling in North America has increased supply and greatly diminished OPEC’s pricing power. The Chinese economy has also cooled. New financial regulation has caused many trading desks to shut down.

As a result, oil prices fell sharply in late 2014 when OPEC could not reach agreements on production cuts. Today, the Energy Select Sector SPDR ETF (XLE) is up just 22% excluding dividends since the end of 2009, which stands in stark comparison to the S&P’s 111% rise. In addition to declining oil prices, many companies have been guilty of poor capital allocation decisions. For example, Exxon Mobil (XOM) overpaid for natural gas producer XTO Energy in June 2010, issuing $25 billion in stock and assuming $16 billion in debt right before natural gas prices plunged. XOM also borrowed money to buy its own stock at much higher prices than what it currently trades for.

Most investors think of XOM, Royal Dutch Shell and Chevron (CVX) as the big oil players. They’re certainly well-known, financially strong and diversified, but there’s much more to this industry than those three. There are also exploration and production (E&P) companies, which explore for, develop and sell unrefined product; refiners, which take crude oil and turn it into finished products like gasoline, heating oil and jet fuel; and integrated companies, which are a mix of two. E&P and refiner companies tend to be more volatile given their unpredictable earnings.

Some E&P names include EOG Resources (EOG), Occidental Petroleum (OXY), Anadarko Petroleum (APC) and Devon Energy (DVN). The profitability of these companies is set to improve this year as oil prices are still generally higher than they were a year ago. Still, like most stocks in this group, they carry PEs at 40 or higher based on this year’s earnings estimates, which is very high for companies that will not produce a lot of organic unit growth in the current market conditions. Therefore, I feel these stocks are already discounting oil prices well above current levels and are vulnerable to further downside if this price rise (which doesn’t look likely at this time) fails to materialize.

The refining companies are enjoying good profitability right now, as the lower price in oil combined with stable demand for finished products has provided decent profit margins (also known as crack spreads, which measure the difference on how much it costs to process crude to final product and how much the refiner can sell it for). However, crack spreads are subject to rapid change should inventories of finished product build or the price of crude surge. Occasionally, these companies can go through quarters with limited profitability or even losses. Due to this earnings volatility, along with extreme capital intensity and limited unit growth, refiners have generally sold for low PE ratios. Currently the major refiners, Valero Energy (VLO) and Tesoro (TSO) sell for PEs of 12X and 13X this year’s earnings estimates, respectively.

The integrated companies benefit from being in both businesses; while declining oil prices will hurt their E&P operations, it will help their refining operations. As a result, these stocks generally trade somewhere in between the valuations of refiners and the E&P names. Valuations will be higher than refiners, since earnings tend to be more stable, but lower than E&P companies, as earnings don’t have the same potential upside with higher oil prices. For example, XOM and CVX trade at 20X and 22X this year’s EPS estimates, respectively. As is the case with E&P stocks, at this level of valuation the shares seem to be discounting higher commodity prices going forward.

In addition to discounting an increase in energy prices that seems elusive, these companies need to spend more to replace reserves than they had previously, and unit growth will be limited by greater fuel efficiencies, alternative sources of energy and even mandated limits on demand if governments take more aggressive steps to limit consumption due to future climate change. I believe XLE will continue to underperform until its valuation is more reasonable or oil looks ready to move higher, and I feel the same way about oil service stocks like Schlumberger (SLB) and Halliburton (HAL).

How to Keep Emotional Investing In Check

March 13, 2017, 2:38 pm

With all of the noise that’s been circulating the market since before the election, it’s become harder and harder to invest with a level head. Emotions end up running wild, causing investors to make quick, unjustified decisions that leave their portfolio worse off than it was in the first place.

The simple fact is that it is impossible, even with the best analysis and insight, to eliminate all risks when it comes to investing. But careful selection and proper diversification allow us to manage that risk and still produce above-average returns over the intermediate and long term. The key is a well-rounded approach, and I don’t recommend allocating more than 5% of your total investable dollars to any one position here in the Model or any other portfolio. This helps the losers, which are an inevitable part of investing, sting less.

Say a company you are invested in reports disappointing earnings and quickly leaves you with a 20% loss. With just 5% allocated to that stock, your portfolio takes a very manageable 1% hit for the year that your remaining stocks should easily be able to make up. If the 19 other positions have an average return of 12% and the market gains 10% overall, you’ll still outperform with 10.4% profits despite the 20% loser.

Of course, it’s still disappointing to be left with some red ink, so when you’re holding on to a stock that shows a double-digit loss how do you make a sound judgment based on business sense and not emotion? I like to remember Warren Buffet’s excellent dictum: In the short term the market is a popularity machine, and in the long run it’s a weighing machine. So I go back and review the long-term earnings power of a company, which is how most stocks are valued. If I see no reason to doubt my original assumptions and conclude that the stock is down either for a reason not clearly defined or because the industry is out of favor, there is no reason to panic. As long as I’m properly diversified I can weather the weakness.

However, if I find that the stock is down for a clear reason (such as an earnings disappointment) my earnings outlook would have to change. Even the slightest downward revision of future expectations can have a meaningful negative impact on value, especially for higher PE growth stocks. So let’s say a stock is down 10% following a weaker-than-expected report. My new calculations would likely show that the stock is expensive despite its decline. In this case, it would be important to stick to the knitting and sell, even though it may be painful to take the loss. Remember, staying disciplined with a risk management strategy is imperative to building wealth over the long term.

It all boils down to three key steps to controlling your emotions and making smart decisions when it comes to your portfolio:

  1. Diversify. When a position is not life or death to your portfolio, you are able to evaluate any potential problems more calmly and rationally.
  2. Accept the fact that some price movements are simply short-term randomness. If there are no headlines or unusual trading volume to suggest that a several-day pullback is meaningful, take a deep breath and keep a close eye on your position. Selling may still be warranted, but never pull the trigger as a panicked knee-jerk reaction.
  3. Realize that over time stocks will reflect the present value of their future earnings. If a stock is down sharply, reevaluate its earnings situation. If the new analysis suggests the stock still has more to fall, have the discipline to sell whether or not it’s painful – trust me, taking on a larger loss will be even more painful. On the other hand, if the company’s earnings potential has not been compromised, don’t be afraid to weather the storm and hang on for a rebound over the long term.

Investing should be treated as your business, not your baby. If you let the qualitative and quantitative facts act as your guide, over time you will achieve exceptional results.

Is There a Risk to Averaging Down?

March 6, 2017, 3:11 pm

We’ve all had that one stock that reverses and plummets 10%, 15% or more the day after you bought it. There are several strategies to manage that red ink, but two well-known ones are simply cutting your losses or averaging down (buying more shares in the company at a lower price than you initially purchased, which brings the average price you’ve paid on all your shares down).

Let’s say you bought 10 shares of XYZ stock trading at $100 (a total of $1,000). However, following a broader market pullback the stock drops 30% to $70 a share. You purchase 10 more shares of XYZ (or $700 worth), which brings the average purchase price to $85 a share ($1,000 + $700)/20 shares = $85 a share). You’ve lowered the original cost by $15.

Now averaging down is a bit of a double-edged sword. By lowering your initial cost, you stand to make a lot more money if the stock reverses to the upside. But if it continues falling, your loss will be greater since you own more shares. So the big question becomes: is it worth it?

My answer is that it depends. For longer-term investments, if you have a strong conviction that the market is declining and the weakness is not company-specific, it’s certainly something think about. However, you may want to consider only adding by a half or fourth position so you’re not overweight in that stock.

For options trades, I really don’t encourage it. You have to respect the action in the stock/option when you are dealing with a trade that has a certain expiration date. This is much different than when you are looking at a long-term investment where short-term movements in the stock might create buying opportunities. When you are dealing with a near-term expiration, time is the enemy and it is best to simply cut your losses. In some cases you can extend the time period by rolling the option, but it depends on if there are still enough near-term catalysts that would warrant the added time.

However, short-term stock trades are more of a gray area. There are several reasons why I don’t normally add to stocks that are down. When I’m holding a position for just a few months, I’d rather cut my losses and put the available cash into new trade set-ups. I also take risk management very seriously. If a stock gets down around 10%, I need high conviction it can turn around to stay with it. And if the reasons we got into a trade to begin with change – technical or fundamental – I will usually sell.

That said, when a stock is down for reasons that don’t change my thesis and look to be temporary, and when I have exceptionally high confidence that it will move higher, I may add a second position to lower my cost basis and make that money back faster. I don’t do this very often, though.

One of the challenges with these second positions – and your own dollar-cost averaging activity – is that conviction is a moving target. I have to have the same level or higher conviction in the stock than when I first opened the trade. Because I place a great deal of emphasis on the charts for stock trades, a move to the downside can weaken the technical situation or prolong recovery. It may improve the long-term fundamental opportunity, but that’s not my goal here.

At the end of the day, it really depends on your risk tolerance and what you’re comfortable with. If averaging down is something you’d like to try, just be aware of the benefits as well as the risks before you do it.

Should You Bet on the Bank Stocks?

February 27, 2017, 2:26 pm

Following all the media excitement about the “Trump Trades” and the sectors to be in (or stay away from) right now, I’ve gotten a lot of questions from investors on the street about them. Financials were one of most asked about, so I thought I’d spend some time talking about them today.

When you hear news about hope for earnings growth in financials, it’s referring to cyclical growth, increased lending as the economy advances and improvement in interest margins as interest rates rise. While loan growth has been on the upswing, a lot of changes that have been in company earnings have reflected cost controls.

In addition, gains in long-term interest rates remain elusive, and I believe investors looking forward to a steeper yield curve that brings higher net interest margins could be disappointed. Net interest margin for banks is actually a lot more complicated than the notion that Federal Reserve tightening will lead to higher profits; much will depend on how a bank positions its balance sheet for borrowing and lending.

Financials are quintessential value stocks versus growth stocks, accounting for 25% or even more of the Russell Value Indexes. They fit comfortably in the value style of investing, as they have historically sold for price-to-earnings and price-to-book ratios meaningfully lower than market averages. The low valuation reflects the lack of internal growth in the industry, and more importantly, the above-average risk in investing in financials.

This risk stems from the extensive use of financial leverage. While the days of holding $30 of assets for only $1 of equity are over, financials still require leverage to be profitable. For example, JPMorgan Chase (JPM), which is possibly the best capitalized large-cap bank, has $2.49 trillion in assets and $207 billion in tangible equity for a leverage ratio of 12:1. So if the value of JPM’s assets declined by 8%, either by loan losses or a decline in the value of securities held, the company’s tangible equity would be wiped out. This is an extreme example that would only occur in a depression, but I want to demonstrate how volatile balance sheets can be for financials and why they sell at low valuation ratios.

It’s also important to keep in mind that when banks prepare their financial statements, they make wide use of estimates, such as the amount of expected loan losses and in some cases, the value of securities held. Any error or underestimation of potential liabilities could have a significant impact on the final statements. This factor also tends to depress valuation ratios.

In addition, the earnings power companies like JPM or Bank of America (BAC) are expected to achieve is dependent on economic factors instead of secular growth, and the economic conditions needed to produce this kind of performance may not even occur. With the average bank stock with a market cap over $1 billion trading at 14.1X 2018 EPS estimates, a lot of the improvement has already been priced into the group.

Of course, this doesn’t mean that you should stay away from this sector right now. Financials can make for great longer-term holdings, especially with the Fed likely to raise interest rates three times this year. I just recommend waiting to grab them on pullbacks first.

Another Round of Records

February 21, 2017, 3:20 pm

It was another round of records for the broad market last week, with the S&P 500 flirting with new highs after Valentine’s Day and ending the week up 1.3%. And the party kept going today, with all three major indices hitting new highs again. Some of the gains have come on earnings season, which has been a good one. And even though another 870 companies are scheduled to report this week, the broad strokes have already been painted in.

Growth is tracking at a healthy 5% across the market as a whole, which would mark the first consecutive quarter of earnings growth since Q1 2015. At the start of the year, estimates were for Q4 earnings to increase 3.1%. This continued improvement in a wide range of sectors is just more confirmation of our belief that stocks will continue to move higher, because at the end of the day strength is based on underlying fundamentals – especially earnings. With the 2017 outlook improving each week, the future looks increasingly bullish.

Then there’s the Trump administration, which has talked about a big announcement on the horizon regarding tax cuts. There’s not a market in history that hasn’t welcomed tax cuts with open arms. And on top of that, economic numbers released last week show a solid economy as well as a pickup in inflation. All of these factors were viewed as bullish and acted as catalysts to send stocks higher.

I bring this up because improving economic readings combined with higher inflation could be the perfect storm for more interest rate hikes from the Federal Reserve. Chair Janet Yellen’s appearance in Washington last week sparked a boost in the odds we’ll get three 25-basis-point hikes sometime this year from 33% to 41% according to Fed Fund futures, and Goldman Sachs (GS) raised its odds of a rate hike at the next FOMC meeting in mid-March from 15% to 20%. While I don’t think a move in March is likely (unless something drastically changes in the next month), there’s still plenty of time for more rate hikes this year, so they are something we should be prepared for.

For more than a year the market fixated heavily on the Fed’s next move, but ever since the election ended and attention shifted to what’s going on in D.C. the central bank has taken a backseat. This can be good for easing market panic, but the Fed remains central to the future of stocks as interest rates will continue to play a role in performance through 2017.

My Top Three Valentine’s Day Stocks

February 14, 2017, 1:17 pm

There’s been a lot of love in the air on Wall Street these past couple of weeks, with the major indices hitting high after high on almost a daily basis—the S&P 500, Dow and NASDAQ all hit new intraday records just yesterday and the Dow reached another one today.

As a special Valentine’s Day gift to you, I’m sending you my latest video to share the top three stocks that are sure to feel the love today, too. Click below for all the details!

[ Click here to play message from Hilary Kramer ]

I hope everyone has a lovely Valentine’s Day!

Tuning Out the Noise to Keep the Profits Rolling

February 6, 2017, 1:26 pm

It was a little over a week ago when the Dow cracked its 20,000 milestone and the S&P 500 traded above 2,300 for the first time ever, but the strength was short lived as the indices were overdue for a bit of profit-taking.

But profit-taking wasn’t the only thing that sent the market lower. Another catalyst for the selling was President Trump’s executive order that blocked immigrants from seven foreign countries from entering the United States. While the order itself won’t have much (if any) impact on the economy and market over the longer term, the media ran with the story and found ways to connect them anyway. And given that the indices were already oversold in the short term, it led to some anxiety and a reason for some investors to ring the register on stocks that had rallied the last couple of months.

However, that selling needs to be put into perspective. Yes, the S&P 500 experienced a four-day losing streak January 26 through January 31, but the index was only down 0.85% from its all-time closing high. In addition, the Dow and NASDAQ ended last week at new highs with the S&P not far behind. That shows the resilience of the bulls, as not even a flurry of executive orders – which the media deemed as very negative – was able to significantly bring down stocks.

One reason the bulls and the market have been so resilient in the face of growing concern over what will happen under the new administration is the underlying fundamentals. You may not know it from reading the headlines, but we’re actually in the heart of the fourth-quarter earnings season. The financial media continues to focus its attention on D.C. rather than Wall Street, so it has failed to focus on the fact that the season has so far turned out better than expected. Companies are beating expectations, which in turn helps improve the valuation metrics used by analysts, and as I’ve talked about many times in the past, improving earnings will be the catalyst that drives stocks higher over the long term.

This just goes to show that it can be difficult to tune out the noise and focus on what’s really driving the market, especially when there’s a lot of unpredictability coming out of the White House. But there are ways for investors to manage the ups and downs.

First, it’s imperative that we don’t react to news bombs when they explode as this leads to emotional decision making and overreactions in stock prices. It is much better to let the smoke clear and see what appears in the aftermath. Odds are that there will be nothing new behind the smoke – once again, it was just the media and investors panicking. But if we let ourselves get caught up in the noise, we’ll find ourselves investing without a strategy or edge. Without those, we have very little chance of making money.

Instead, it’s best to use the market’s overreactions to our advantage by buying on the short-term dips and selling into strength. The S&P 500 has been trading in a narrow range recently and is currently at the same level it sat at in mid-December, but there’s no question that underlying stocks and sectors are on the move. That’s a great place to start when looking for your next buying opportunity.

What to Expect Following an Historic Week

January 30, 2017, 3:25 pm

Wall Street has been waiting on pins and needles lately, but last Wednesday the Dow finally reached (and then broke) its 20,000 threshold. It only took the index 42 days to rally the thousand points from 19,000. However, if you’re placing your order for Dow 40K hats, you may want to skip the expedited shipping. It took the index 17 years to double from 10,000 to 20,000.

As we’ve talked about, the Dow hitting this historic milestone isn’t necessarily bullish in technical terms, but it does have larger psychological implications. Most headlines had something to do with Dow 20K and social media was similarly abuzz.

This type of media exposure does two things. First, it gives those investors sitting on the sidelines the “sign” they’ve been waiting for to get back into the market. And even more important is that it nudges those who have sworn off the market over the last decade due to volatility and negative connotations regarding Wall Street. There’s a major case of FOMO (or the fear of missing out) going on around the country, and those who have sat on their cash all this time will finally begin to realize that they’ve missed out on a major market rally. They’ll fear that if they don’t get back in soon, they’ll also miss out on the next chance to make big money.

It’s difficult to argue with the turnaround in corporate earnings over the last two quarters. On top of beating expectations in the third quarter, S&P 500 companies also reported positive quarterly results for the first time in more than a year. Now we’re in the heart of the fourth-quarter reporting season and once again, the numbers look better than expected.

Approximately 70% of the S&P 500 companies that have already released their numbers have beat Wall Street’s estimates, and there are still a lot of heavy hitters left to report. From day to day, the market’s PE ratio is irrelevant because trading is actually being driven by news and emotions. However, the PE is still extremely meaningful over the longer term, so considering the “E” in that equation is earnings we still want to see results increase, as it will not only make the ratio more attractive, it will be a catalyst for the current rally to continue.

I don’t normally like to toot my own horn when I make accurate market predictions – I prefer to let our results speak for themselves – but this time is different than most. For months, I have maintained my positive outlook on the market even as Wall Street analysts have wavered between the bullish and bearish camps, causing panic for many investors out there. That conviction has paid off—and even with the slow start to this week, I see plenty more upside in the future.

The Dow’s breakout above 20,000 combined with the charts and solid fourth-quarter earnings season leads me to believe that the underlying uptrend will continue at least into the end of the first quarter. And it still isn’t too late to get in the game, with stocks looking even more attractive on the broader market’s current pullback this week.

Odds are good that the S&P 500 will finish 2017 up near historical averages, possibly in the 7%-9% area. Each and every bout of weakness will be scrutinized by the mass media as the “beginning of the correction,” but the smartest investors will simply ignore the noise and use those pullbacks as strong buying opportunities.

Buy the Election, Sell Inauguration?

January 25, 2017, 11:21 am

With the inauguration behind us, the focus now is on Trump’s first 100 days in office. Wall Street is most interested in what happens with regulations, taxes and infrastructure spending. I expect U.S. corporations will get an incentive to repatriate the roughly $2 trillion in cash they’re currently parking overseas. Even if that money is taxed at 10% as proposed, that’s a windfall of roughly two full years of profits for the S&P 500 coming out of the deep freeze and getting back to work.

A full-fledged corporate tax cut may take a little longer – and I don’t know how big the cut will end up being – but the impact could be huge. It would be a one-time growth accelerant for every profitable company on Wall Street, and nobody wants to be trapped on the sidelines when the “profit” side of the P/E calculation could jump 30% overnight.

There will be ups and downs along the way – which is fine because investors need both – but I continue to like the overall market environment. The good news is that earnings look constructive over the next few weeks. I’ve been tracking the trend every Friday, and the numbers keep getting better. We’re now on pace for 3.4% growth this season, which is nicely above what Wall Street was tentatively hoping to see. If the pattern holds up, this could be the best quarter in years. That’s great for trend trading and how the results impact the charts.

I’ve been asked a lot recently whether the election rally will reverse now that Trump has been sworn in and his administration is getting to work. I’ve also heard it talked about on the Street. Instead of “buy the rumor, sell the news” it has turned into “buy the election, sell the inauguration.” But everything I see indicates that it’s more talk than conviction at this point.

First, if big money was preparing to dump stocks once the transfer of power was complete, there would have been at least a few crucial “tells” – such as rising short interest and declining buy volume. After all, big money is complicated. It takes days if not weeks to shift massive portfolios, and during that time fund managers would be busy setting up new hedges and interim positions to make money if they really expected a downswing ahead. Those defensive positions have not materialized. Short interest on the S&P 500 as a whole has actually dropped 17% since the year started.

Granted, the big benchmarks have traded in a tight range the last few weeks, but some consolidation is natural after a 9%–10% surge. Even in this sideways cycle, the day-to-day action reveals that the sellers are actually at a disadvantage. So far this month, over 200 million more shares of the iShares SPDR (SPY) – one of the biggest exchange-traded funds on the planet, tracking the S&P 500 as a whole – have been bought than sold. Things may have quieted down after the initial post-election surge, but the bulls are still backing up their conviction with money and enthusiasm, increasing the odds of a fresh breakout to the upside.

I expect to see a lot of churn in the next few weeks, so stay on your toes if you expect to keep up as the market adapts to this new administration.

Ushering in a New Market Environment

January 20, 2017, 3:33 pm

It’s been a big week for Wall Street as key earnings reports rocked the market and Washington officially welcomed a new administration today. Donald Trump’s election victory sparked a major market rally that’s buoyed stocks to new highs, but there’s been increasing concern among investors as to what will happen in his first few months in office.

The bears are starting to bring up 1981, which is when Ronald Reagan moved into the White House. The S&P 500 rallied 9% from Election Day (November 1980) to Inauguration Day in January 1981. Over the next year and a half, the market lost approximately 30% of its value. Today’s naysayers are suggesting a similar pattern is about to unfold, but there’s no real comparison between 1981 and 2017. Interest rates were in the double digits and the economy was moving toward stagflation back then; today’s interest rate on a 10-year government bond is less than 2.4% and GDP should grow about 2.5% this year.

Another significant difference is that corporations are currently set to continue the earnings growth trend that began in the third quarter. The S&P 500’s EPS estimate in 2017 is $131, well above the $109 estimate for 2016. With the fourth-quarter reporting season underway, we’re starting to get a better picture of how 2016 wrapped up and some insight into how corporations are faring heading into 2017. If the numbers end up in line with estimates, it would result in 20% earnings growth in 2017 for the S&P 500.

While that’s a great number, the index’s recent run has already priced in a lot of that expected growth and could struggle to extend its gains unless the bottom line expands at a higher pace. At 18X 2017 expected estimates, the S&P 500 could meet its high around 2,358. However, I look for Trump’s policies of lower taxes, less regulation and an increase in infrastructure spending to help spur the economy, which in turn would create the higher earnings growth needed to keep the market moving upward.

Even if stocks don’t meet that full upside potential, I see no signs of a recession or major pullback. Let me repeat that: no signs of a recession. U.S. growth will likely increase this year and corporate expansion is almost a given. Plus, I continue to see underlying strength in stocks. The chart of the S&P 500 below illustrates this over the last few months.

After hitting support at the 200-day moving average (the blue line) the week of the November election, stocks have been on a major tear higher. Along the way, support has been established at the 50-day moving average and nothing indicates anything more than a healthy pullback ahead. A dip to the middle of the support zone (2,214-2,234) indicated above wouldn’t be surprising, but even a drop to the lower end would only bring the index down to well within the realm of normal considering the extent of the market’s rally since November.

If that does happen, savvy investors will meet any pullback to a major support level with open arms as an opportunity to add  quality stocks at a discount.