Stocks are getting absolutely pummeled here, and given the fact that I have turned a lot more bullish on certain market sectors of late, I expect to have a lot of egg on my face in the coming days and weeks.
Now, I don’t think that the market as a whole is going to go up rapidly or that another bull market will soon be underway (In fact, I think we are in a secular bear market and the inflation-adjusted lows are even further down). However, I do expect a bear market rally during which new cyclical leaders may emerge. Two sectors I am watching are energy and consumer staples.
Here’s my thinking.
In July, I was very bearish on the market as a whole, especially on oil and gas. I wrote a bearish note on refiners saying:
I am on record for expecting a drop in oil prices in the very near future due to demand destruction. Regarding the super spike, I believe much of the end rally in oil prices had little to do with fundamentals and everything to do with commodity market liquidity.
Proof comes from refining margins. ‘ Big Oil’ has been sounding the alarm on downstream profits — refining margins have been depressed since at least the beginning of this year. Today, Valero Energy, the leading independent oil refiner in the United States, came out with its earnings for Q2 and they were very poor — down 67% from last year…..
If Valero can’t make money in this environment by refining heavy sour crude and is signalling that the peak driving season is a bust for the refiner’s, doesn’t that tell us something?
Demand destruction is in place, refining margins are down. It’s only a matter of time before oil prices give way.
–Refiners as a canary in the coalmine
Well prices sure have dropped and that play worked out pretty much as planned. However, I saw oil going down to $100 and as low as $70. We are easily beyond that now. In my estimation, we are seeing a typical overshoot to the downside and it could get worse because the economy is headed for a deep recession.
The contrarian in me says now is the time to start looking for value plays. In fact, I am looking to scan for companies I believe are fundamentally sound that are going through a cyclical and not a secular downturn.
For example, Yves Smith of Naked Capitalism has shared a bearish tone with me but continues to be skeptical of this market as prices continue to decline. She sent me an interesting analysis of the refining sector by Judy Alster.
Your jaw may drop when I tell you that six years ago this month major pure-play refiner Valero (VLO) was trading at 90 cents a share. Equally major refiner Tesoro (TSO) could be had for 93 cents. After that both stocks went straight northeast: In the summer of 2007 refining margins soared above $40 per barrel refined, taking Valero and Tesoro to historic highs above $77 and $64 respectively. Yesterday’s score: Valero $20.50, Tesoro a sad $11.31. October 2002 also saw Sunoco (SUN) at $15 before it rocketed above $91 a little over four years later, only to settle yesterday at $28.50. Even newcomer Western Refining (WNR) opened in 2006 at $17.65, flew to $64 in mid-2007 and yesterday was languishing at $6.55. What gives here, anyway. Tesoro and Valero are yielding a respectable 4%, Sunoco 4.8% and Western 3%; not one has cut its dividend. Are these stocks screaming values? Or is there another side to the story?
There’s another side. Refining industry fundamentals have changed drastically. Here and internationally, refining capacity has been growing for at least 10 years. We’re always hearing, “No new refineries have been built in the U.S. since the late 1970s.” True, but existing refineries have been increasing their capacity steadily. U.S. refineries have also increased their ability to process heavy, lower-quality, cheaper crudes and thereby produce higher-margin products. In the next few years, very large export-oriented refineries in the Middle East will come online, targeting Asian, European and American markets. India plans to start operating a new 580,000-barrel-a-day refinery by the end of this year and it won’t surprise you to find that the Chinese are set to expand as well.
With capacity and low-quality-crude capabilities growing, demand for refined products will need to keep up. That’s not happening right now. U.S. refined product demand dropped over 7% for the 12-month period through September; Europe and Japan are slowing down too. Eventually India and China will start buying automobiles by the dozens of millions but for the present, with the economy worldwide on life support, the trend is anyone’s guess. There’s no guarantee these stocks have bottomed, either; they could drop further, which would have the positive side effect of bumping up the yield. When demand starts rising, refiners’ profits and share prices should follow. For now these companies (none are in the 21st Century Investor Dividend Portfolio) offer stable dividends, but they’re profoundly speculative and submitted purely for your further due diligence and upon presentation of your Nerves of Steel Club ID card.
I agree with the overall tone of the message here, as refining stocks are cyclical. However, I believe that independent refiners like Valero and Tesoro (not Sunoco) are in a fundamental secular uptrend due to a lack of sour heavy refining capacity and this is the oil that is coming out of the ground. We have a dearth of light sweet crude and we still have a dearth of complex refining capacity to refine the heavy sour stuff. For me, the fundamental refining capacity constraints have not changed. (Note: I owned Valero for much of the last decade and sold in 2006). As I anticipated a massive selloff, I also expect a good return going forward.
On Tuesday commenting on potential value stocks falling through the floor I said:
There are many companies of that ilk. Take the oil and gas sector, pummeled by a 50% decline in oil prices. Valero Energy, the largest U.S. refiner, has a book value of $18.6 billion, but a market cap of $10.5 billion, having been reduced from over $75 a share to as low as $15. It now trades above $20. Why is that?
–Sprint: an example of stocks beaten down in the bear market
The answer is fear. And as a value investor, I know that now is the time to scan for bargains. I expect Valero Energy to have a terrible earnings report and to sell off even further actually. But if you are a value investor, you don’t mind if the market sells off because it just increases the number of value plays. Knowing whether something has declined because it is worthless or because of market fear is the hard part. It takes fundamental analysis. And in this market, no one is doing that.
If companies like Nestle, which released earnings today, can increase earnings in this environment, you know there are some fundamentally sound investments out there. Getting the right price is the second tricky part of analysis.
So I am still a buyer here — selectively.
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