By Nick Fisher, Portfolio Manager
As expected and discussed last quarter, we have seen the end of the Federal Reserve bond buying program known as Quantitative Easing (QE). To review, the easy money environment has encouraged risk-taking by investors. This has manifested itself in nearly every asset class over the last 3 years. We pointed out that confidence and complacency has crept into the market. This investor behavior, a direct result of (QE) will end with mal-investment and the loss of capital for less disciplined investors at some point in the future. In retrospect, it becomes so obvious, just as it was with the dotcom bubble, real estate bubble and will be with this market cycle.
One booming cycle coming to an end is in the energy markets. Nearly no one at the end of 2013 predicted much of a move in energy prices. Sure, a few prognosticators predicted that prices would be up or down at most 5-10%, but people forget that many asset classes including energy can be quite volatile. Consider that oil since mid 2012 had not moved much more than 10% in either direction. Consequently, no one vocally predicted an order-of-magnitude change in prices and yet that is exactly what has happened with Natural Gas and Oil prices. This is not out of the ordinary, oil prices have frequently had violent changes in price, yet investors have very short memories (we call this recency bias) and the recent past of 2012 and 2013 told them that prices were less volatile now in this “new normal.”
Due to advances in technology and cheap money (thank you QE), domestic drilling in the US absolutely took off.Remember the headlines of the last couple years describing the energy revolution and energy independence. With cheap money, risky energy companies had the ability to borrow $550 Billion in the high yield (junk bond) market over the last 3 1/2 years. In that time period, energy companies increased the number of drilling rigs from 1200 to 1800 (Baker Hughes). Of course with more rigs drilling and improved technology, the supply of oil available has ballooned and demand has stagnated due to the global slow-down.
As of this writing, oil and gas prices are down 53% and 44% respectively. Again this is not out of the ordinary. The tide of oil is definitely receding. As Warren Buffett has said, when the tide goes out, you find out who is swimming naked. I speculate there are a whole lot of small energy companies swimming naked. According to Deutsche Bank, about a third of energy companies with a bond rating of B or lower are at risk for bankruptcy. In the short-term, many of these energy companies have hedged their exposure to the fall in oil prices and this story will take some time to play out. In the meantime, investors have been selling energy companies, but they are not quite hated or feared yet. Only then will we know it has hit bottom.
What other assets have been impacted by QE? Where have analysts recently predicted incremental changes when an order of magnitude change would not be out of the ordinary at this point in the cycle? Time will tell. Ironically, once underway investors will avoid these assets like the plague, as they have energy companies recently. Just as this happens, we will find prices much more interesting. An investor must think contrary to the crowd in order to earn an above average return. Simply put, an investor should like things more when prices fall, sadly most don’t.
Volatility and the recency bias associated with volatility are largely responsible for investor greed and envy when markets are going up and fear when markets are declining. This makes for poor decision making, buying high and selling low. Consider that volatility has been much lower than is usual across most asset classes and we cannot expect below average volatility to go on indefinitely. Just as in the energy markets prior to their decline. For the average investor this can be a frightening proposition. Why not expect it, embrace it and look forward to the opportunities it creates?