One year ago today, I wrote a post titled, Beware the Black Swan in Oil. A black swan is defined as, “a surprise, which has a major effect, and is often inappropriately rationalized after the fact with the benefit of hindsight.”
Oil turned out to be a black swan in 2015. Looking back it’s easy to rationalize how an oversupply of oil could cause a severe downside in prices. OPEC had already warned that they were going to go after the market share of U.S. energy companies. This black swan has caused capital destruction throughout the entire energy sector. The final phase of this black swan may result in consolidation or bankruptcies in the sector.
Moreover, the final phase is being marked by the dreaded dividend cuts. In past posts, I recommended that the time to buy the energy companies was when dividends were cut. This may no longer be prudent advice. This week, Kinder Morgan, which is one of the biggest MLP’s, cut its dividend. If oil remains near today’s price of $36 a barrel of oil, I expect more drastic dividend cuts throughout the industry.
To make matters worse, energy companies now have limited access to issue bonds to pay dividends. The game of financially engineering dividends through issuing debt is now over. The high yield bond markets are frozen. The lowest quality/junk bonds are now experiencing illiquidity not seen since the credit crisis. The falling value of these bonds could be setting up for a very interesting investment opportunity in 2016.
Throughout 2015, I recommended a zero allocation in energy companies and I still believe for now that it’s best to watch from the sidelines. We have experienced three market crashes in the last 15 years – in 2001 it was technology, in 2008 it was the Financial Sector, and now in 2015 it is the Energy’s turn to get crushed. The Technology and Banking sector both eventually recovered, which is why Energy investors are holding out. I expect energy prices to rebound sharply once supply/demand forces becomes more balanced. However, like all market predictions, it’s the timing that is usually wrong. Investors have been trying all year to call the bottom only to be early. Eventually, they will get the timing right.
The best piece of advice I have for you this holiday season is to avoid reading crystal ball predictions. Last year, Barron’s Magazine, reported that EVERY Wall Street strategist was bullish in 2015. Many analysts predicted 10% gains and a recovery in energy markets. Legendary investor Jeremy Grantham had the same advice this week, which is to watch out for Wall Street optimists.
My non-market related 2016 prediction is that active portfolio management will have another strong year. In my opinion, the growth of Exchange-Traded Funds (ETFs) has increased market instability and is creating many more investment opportunities for active managers. ETF’s should continue to gain in popularity along with robo-style investing. Robo-investing is low cost investing, but you get what you pay for. I believe these services just blindly buy ETF’s without regard to valuations. They construct asset allocations strictly using ETFs and take a blanket approach of buying major indices globally. This spreads the risk because they are global or so they say. In my opinion, nothing could be further from the truth. Investment risk to me, is a company’s ability to reinvest cash flows back to the company or return capital to shareholders. If there is no cash flow, it’s a risky investment. In contrast, if there is a strong growing cash flow, recurring revenue stream, expanding market opportunities, or above average dividends, it’s a lower risk investment. I believe that 2016 should be another good year for active managers.
If you would like to speak with me about building a diversified portfolio through customized portfolio management that aligns your risk tolerance with your financial goals, feel free to send an email to firstname.lastname@example.org.
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