The Haymaker Hosts Chance Finucane
In The Ring - December 16th, 2022
Special Note
Dear Haymaker Readers:
Published here is our penultimate Video Haymaker entry for the year, as we will also be sharing Dave’s interview with StoneX’s Vincent Deluard as a Making May Monday edition in a few days’ time. That will effectively serve as our 2022 MHM sign-off, with one more Friday Haymaker* edition to come next week. As you might recall, Dave is planning a Year-in-Review post, which will effectively be a deep-dive analysis of the Haymaker’s best and worst calls — if there are any picks you’d like him to focus on in particular, please feel welcome to make mention of them in the comments section below.
As for this interview, in which Dave hosts Oxbow Advisors’ CIO Chance Finucane, be assured that it touches on nearly every major economic topic of the day. Dave and Chance discuss Oxbow’s background and current positioning, recession/bear market forecasting, corporate-profit trends, defiantly cheap energy, pricey “dependable-growth” stocks, and (a favorite non-favorite of Dave’s) the global housing crisis, among many more topics.
Also, this will be our first Haymaker as Host entry to include (drum roll) a transcript. We’re presently auditioning a software tool to help us out with this and hope to have this episode’s text accessible to our readers by Sunday. In the meantime, for those of you who have about 52 minutes to spare, the video is awaiting. Use the timestamp list below as your minute-to-minute guide.
In closing, we hope each and every one of you is finding ample holiday happiness this month. Here at Haymaker, we’re champing at the bit for 2023 to get underway, but we’re also finding time to be spent in enjoyment with family and with dear friends. Perhaps there are some important people in your lives whom you manage to see only sporadically, if at all, throughout the year. May you connect with them memorably and in good spirits (avoiding political bickering).
Our best to you all, from the Haymaker team.
*The inaugural 2023 Haymaker post will run on Friday, January 6th, with the year’s first Making Hay Monday following on the 9th.
Dave “The Haymaker” Hay: HAH #5 Introduction
Hello, Subscribers:
Those of you familiar with Oxbow Advisors, as I have been for years, might already know of their young CIO, Chance Finucane, a rising star in the finance world who I was happy to speak with last week. I was impressed by his verbal fluidity and obvious market savvy, particularly considering his relatively tender age (especially, relative to the Haymaker).
Chance and I found ourselves in agreement on most of the major issues we covered, devoting a lot of time to discussing Fed behavior, distinctions between economic recession and lengthy bear markets, how to situate your portfolio for equity exposure, and our respective takes on active (rather than passive) management in this economy.
This is a timely discussion I hope you will find useful for your own investment strategy needs. Please be sure to share your thoughts on the conversation. And please also share this content with others; we really appreciate it.
-Dave
To learn more about Evergreen Gavekal, where the Haymaker himself serves as Co-CIO, click below.
Timestamps
0:00 - 2:27 Introduction + Oxbow Background
2:28 - 3:18 The “Three Strategies”
3:19 - 6:55 Active Management Trends (and Evergreen/Oxbow similarities)
6:56 - 10:11 Recession or Enduring Bear Market? + Oxbow’s Base Case
10:12 - 13:18 Capitulation (Lack Thereof) and the Powell Pivot
13:19 - 18:01 Oxbow “Cautiously Positioned” & Bond Vulnerability
18:02 - 19:19 Inflation (Structurally Higher?)
19:20 - 19:59 Equities and Investment-Grade Bonds
20:00 - 22:42 Credit Spreads
22:43 - 23:40 Wilson, Cramer, and Competing Forecasts
23:41 - 25:18 Corporate Profits, Above Trend
25:19 - 27:24 Calls For a Mild Recession?
27:25 - 31:32 Fed Priorities, Powell’s Options & Double-Tightening
31:33 - 31:53 Money Supply (“Great Depression Flashback”)
31:54 - 35:08 Global Housing Bubble
35:09 - 37:07 China Reopening
37:08 - 40:21 Dependable Growth Stocks (When To Buy?) + The Case For Equity Exposure
40:22 - 45:05 Energy… So Cheap… What to Buy?
45:06 - 50:36 Oil Quantities/Demand (SPR Releases, Real vs Paper Market, Fuel Switching)
50:37 - Chance’s Closing Words and “Haymaking” a Pun
Transcript
David Hay:
This is David Hay and this is another edition of Haymaker as Host, and I'm privileged to have Chance Kin as our guest this week. This issue and Chance is at actually one of the kinda legendary firms in the investment business. Oxbow, which is based in Dallas, I believe. Right?
Chance Finucane:
Actually Austin, Texas. Austin, okay.
David Hay:
So, got the "Texas" part, right?
Chance Finucane:
Got that right. Our managing partner, Ted Oakley, started it in Corpus Christi and now we're in four cities across Texas, but Austin is our main headquarters at this time.
David Hay:
Well, I've got some good buddies down there who you might know. In fact, I think Ted attended a University of Texas game here recently with my good friend Danielle DiMartino Booth, and my other good friend Jim Edsel. I think they had a great time even though the wrong team won in that case. But yeah, so you brought up Ted and he is ... he's got a great reputation in our business. I've listened to him a number of times, read his work and it's gotta be a fun thing for you to work with him. And I think this, instead of doing the overview of Oxbow at the end, I thought we'd do it first. So can you give us a bit of background when the firm was founded, what your investment approach is when you joined the firm? And you are CIO, currently, correct?
Chance Finucane:
Yes, that's correct. Yeah, so Ted, it's been a joy to work with him the last five years since I joined at the end of 2017. Ted started, actually, a partnership in Corpus Christi with a couple other people he is working with. But Oxbow really came about in the last 10 or 20 years trying to have more of a formal RIA type operation. And what Ted's found over the course of his career was interacting with business owners after they sold their companies, he just saw a lot of examples of people who, after working so hard for decades, they'd sell their businesses and then they'd really be in a tough spot. And those couple years afterwards, and typically when you sell your business, it's made public and you get a lot of people coming after you with a lot of great ideas of things you can do with that money.
And if you haven't thought about next steps you want for your life and what you wanna do with your time as well as what you wanna do with this new wealth you can lead to some poor decisions and end up really cutting into what that nest egg was going to be for the remainder of your life, for your family. And so that's our focus is primarily working with business owners after they sell their companies. And we primarily focus on doing that by investing through three strategies. So we have a conservative income strategy that's meant to be very safe, mainly focused on short-term treasuries and high-grade municipal bonds. We have a high-income strategy which is intended to beat the bond market and generate a good amount of dividends and coupons for individuals to live off of while still protecting the principal value in those accounts. And then finally we have the long-term growth equity portfolio which is trying to invest in competitively advantaged businesses that are often growing at double-digit rates. And our intention there is to buy them when they're undervalued and trying to hold them for a handful of years at a time, not turn over the portfolio too quickly and just let those portfolios grow with the company growth over time.
David Hay:
Great, that's a good overview. And as I said your reputation precedes you. You are very highly regarded and it's fun to chat with you because you guys actually manage money and you pick individual securities. I mean you do deep research and that's actually very similar to what our firm does as well. And frankly, I mean we are both active managers. And the way the world has evolved, we've almost become endangered species. And I would imagine, given your business orientation, you believe that active management is going to have a comeback and is no longer going to continue to play second fiddle to passive. But I don't wanna put words in your mouth. Is that pretty close to what you believe? And, if so, how come?
Chance Finucane:
Yeah, we would agree with that. Especially, I think, what we've been noticing in research that we've been doing the last year or two is that this next decade we think is going to play out differently than what the 2010s looked like, where you basically could just invest in a lot of index funds and hold them for year after year, and you always seem to get 10, 12, 15% growth in your portfolio every year. Any dip in the market would only last for a few months, then you started going up again. And we think this is going to be a different environment for the next decade where active management and really having somebody being able to maneuver and adapt and be flexible in the portfolios is going to be more valuable. The best example if it plays out this way would be what we saw from the late 1960s to 1982 where you saw the market go up and down through three recessions but really not go much of anywhere and you lost purchasing power because of the high inflation during that stretch of time.
And so what we're noticing is right now we're in a period where we think there's more downside than upside, so we're conservatively positioned, but there are things happening that we think actually might make inflation more of a factor over the next decade because of just structural concerns with not enough supply being drilled out of, whether it's oil or other minerals and resources that are going to be needed around the world. And if you don't end up fixing that with more capital investment to increase supply that's available, anytime you see monetary stimulus or fiscal stimulus, we think that might lead to higher inflation and it's going to start messing with valuations and profit margins. So it's going to pay to just be able to have somebody managing your money or looking at your accounts that can maneuver from being offensive to defensive when you see those changes occur.
David Hay:
Well, I'm nodding repeatedly. I'm not trying to be a bobblehead doll here, but just well you're preaching to the pulpit. Everything you said is something that I absolutely agree with and we'll get into that more in a deeper in the interview. But I think that's a great summary of why this is likely to be a different decade. And in fact I would say that different from the last four decades, not just the last, not just since the financial crisis, but really since Paul Volcker crushed inflation in the early eighties, it's been kind of a no-brainer just to have a balanced portfolio if you're a conservative investor or a hundred percent equity index fund if you're an aggressive investor and there's no cash drag and it's very tax efficient. And so it's kind of no wonder that so much money has blocked that direction. But as we've seen with so many... the trends or the fads manias recently that when money comes charging in and really has gets to the saturated point you probably don't wanna be there. You probably wanna have a different approach. So that's good stuff. And so your podcast right before Thanksgiving, I looked at the title and it said that you're looking for a multi-year recessionary bear market, but then when I listened to your commentary it wasn't nearly that alarming. So what is your base case right now?
Chance Finucane:
Yeah, it's interesting when you see a headline generated, sometimes they'll pull something that is going to attract a lot of attention. I think the way we would view it, is that maybe a multi-year bear market, not necessarily a multi-year long recession, but I think what we've been looking at is that this seems similar to what we experienced from March, 2000 to March, 2003. Not that this has to last for three years, but you had excessive valuations that led to the start of that downturn in 2000. The actual recession didn't happen until 2001 and then you still had another year of decline in that three-year bear market before you finally saw a bottom. And you saw some opportunities in September and October, 2002 and then in March, 2003. So we think because it's been so long since we've had a bear market that's lasted longer than three months, much less 12 months or longer, everyone's kind of forgotten that this sort of drawn-out period just requires staying patient and monitoring things.
But it doesn't really work to your advantage to have this sense of urgency and always want to try and get ahead of the next move where you think the market's going to turn higher. So, I think, looking into next year our base case would be that we will go into a recession. We do see some data that suggests the first half of next year might be particularly difficult, especially if the consumer has drawn down the remaining excess savings they had from the fiscal stimulus that was handed to them in the previous two years. Once you get past the holidays, that might be a tough stretch. We've also seen, maybe it's later into 2023, typically; on average it's about six months after the fed pauses before recession would start. So somewhere in there I think we're just sort of monitoring things both from an economic level and then also waiting to see more of a capitulation from investors.
And maybe it's due to the fact that you haven't really seen a real significant negative revision in profit estimates for 2023, but we see numerous examples that state ... that ... or predict, rather, that you would expect earnings per share growth to turn negative and probably pretty significantly negative in 2023, whether Morgan Stanley has a model that predicts a 10 to 20% decline in earnings per share next year. We also have seen numbers that look at the CEO confidence surveys, and that tends to lead where earnings per share is going by a couple of quarters, and now it suggests that that's going negative. So things like that I think tell us that there's still more adjustments that people have to make to their expectations and that might lead to more selling and better valuations where we might become more interested. But as of now with where the market's trading, we'd say it's pretty averagely valued or even a little overvalued.
David Hay:
Well, I wanna come back to that earnings recession topic because I think it's such a critical one and also even Morgan Stanley, I'm glad you brought that up. But, getting back to the point that you made about capitulation, or really lack thereof, when you see the kinds of inflows that have occurred in a bear market year, it's pretty amazing. It's really the antithesis of capitulation, so that's another thing to be concerned about. I think it gets to your point that it's been so long since we've really seen a long-lasting grinding bear market. I'm old enough to remember the 1970s, and actually started in the business in the late 1970s, but was an investor in the early seventies and that was pretty much a lost decade. And you pointed out actually 1966, 1982, Dow basically traded from a thousand to, at the peak of 600 or so at the trough, and it lost a lot of ground to inflation in that period of time.
But that's so far in the distant past. Even the 2000-2003 one that you brought up, which, by the way, was a pretty mild recession, and yet it was, you know, S&P went down close to 50%, and the NASDAQ went down nearly 80%. So it does go to show that even with a mild recession you can have a very nasty market. So good points. And then if we look at recently, like last week, the stock market went into party mode, and we've had a very nice rally, but last week's was kind of the crescendo of that rally based upon Jay Powell's perceived dovish speech at Brookings. So do you think that the market perhaps is making a mistake and perhaps misread that by thinking that he's done some kind of dovish pivot?
Chance Finucane:
Yeah, we would think that they did misperceive his comments. And I watched a good portion of that interview and he did sound like his tone was softening, but all that matters is the numbers and whether you think they go above 5% or a little bit below 5% for where the peak rate is in the fed funds rate that they're going to get to next year, it really hasn't changed much, hasn't changed a great deal, despite maybe a little bit of a change in tone in the commentary. So, if they're still raising rates into February of next year, probably get somewhere between 4 1/2 and 5% in that peak rate. And then their intention is to stay there for essentially all of next year. I don't think people realize what that does to profit margins and your cost of capital, if we're going to stay at a nearly 5% rate on the short end, what that's going to do for anybody who's got to refinance debt or any M&A transactions that might continue to stall, you're not probably not going to see a lot in the way of IPOs.
And then if inflation stays higher, which we think it'll stay at least at a mid single-digit level through at least the first few quarters of next year, it's going to continue to be an issue on a profit margin side. The difference that we had in 2022 was that revenue growth was still very strong. I think you were about 10 or 11% revenue growth is what is probably going to be this year for the S&P 500, but that's going to slow dramatically next year, in addition to the continued margin deterioration, which we would expect leads to negative earnings going into 2023.
David Hay:
It all makes sense.
Chance Finucane:
Yeah.
David Hay:
So, it sounds like, I mean related to that, your firm is cautiously positioned and positioned currently. And even with bonds, you're preferring short-term versus long-term maturities. You get 4.7% right now on the one-year, you go out to 10 years and the yield is more like 340, 350. And, actually that's, that's been a massive rally in the 10-year keynote here of late, I mean it's gone, I think it peaked at about 421 and hit 340 yesterday. I mean that's a big move in a relatively short period of time. So, do you think that it's fair to say that longer-term bonds, much like stocks, are extended and vulnerable?
Chance Finucane:
Right now, we've got a small exposure to long-term treasuries but I think we still prefer the short-term treasuries. Typically, if this sort of recessionary type atmosphere plays out, you will see the long end of the treasury curve come down by about 150 basis points on average. So, if the peak early is in at about 4.2%, like you cited, then that means maybe we come down to as low as 2 1/2, or even a little bit lower into next year. So, there may be some more room for taking on more exposure in the long treasury bond. But, I think for right now, we're still happy with our exposure to everything sort of two years and less on the treasury side just, baking in that four, 4 1/2, 4.7% for clients with very little risk in terms of the fluctuation. So to answer your question, there might be a short-term reversion back a little bit higher in the long-term treasury yields, but if we are thinking there's going to be a recession, we would expect yields in the 10-year and the 30-year treasury to continue to come down a bit further into next year.
David Hay:
Well, supporting your recession argument, we've got a deeply inverted yield curve. And even Jay Powell's favorite one, which wasn't inverted until fairly recently, which is the three-month versus the 18-month has gone up pretty severely inverted as well. And when that happens, kind of to what you were just saying, you generally wanna extend duration and maybe it's a little late to do it after the move I just talked about, but why do you think this time is different? Cause you're kind of making the case that, hey, it makes sense to extend duration, but we're not doing that yet, even though we think a recession's going to happen. And you must have some reasons why you're not making more of a plan on longer duration.
Chance Finucane:
Yeah, I think the main reason for us just going through this 2022... basically, since 2007, the certain characteristics that you could kind of play in the long-term treasury bond market played out very consistently in terms of opportunities of when to add your exposure and then when to reduce. And this year caught us off guard. I think we increased our exposure to the long treasury bond at a point in time that, looking at 15 years worth of history, would've been the right time to add exposure. And I think people who had gotten used to that... we talked to Lacy Hunt and Van Hoisington, who have a excellent long-term track record in the long treasury bond, but everyone who had that sort of mentality got caught this year and we got caught a bit as well with a little bit too much exposure and rates went higher than they previously ever had during this sort of a cycle.
So, I think we're just trying to keep a little bit more of a moderate exposure in that we think this now has taken hold... what we thought was happening earlier in the year, we think that's now happening. So, to your point it is sort of a time that you'd wanna be taking a little bit more exposure to the long treasury bond, but we're trying to still have some humility just knowing that these factors are playing a little bit differently than what they have the last 15 years, and we wanna have a little bit more confidence in what variables are most important if this is going to be a little bit different environment for bonds going forward.
David Hay:
Well, it's a good point that I share your, I wouldn't say "confusion", but I guess maybe your ambiguity about the bond market right now, because, in the past, whenever we've had an inverted yield curve, portfolios that I run (bond related), we've extended maturity and duration But, this time, it's tough. It's been tough because you've had such a high inflation rate, and I think in listening to your recent podcast, that you believe the Fed is likely to have to throw in the towel at some point on their 2% inflation target and accept a normalized inflation rate that's more like three, four, five percent. And, if so, that means buying a ten-year treasury yielding 3 1/2 is not exactly a great longer-term investment. So, again, I don't wanna put words in your mouth. I mean, do you think that we're looking at a structurally higher inflation period for the next five years or so?
Chance Finucane:
Yeah, we would say that's possible. Hey, if you look at, you go back 20 or 30 years and the average inflation rate was more like 3%, then it fell to where it's been more like 2% the last 10 or 15 years. And we think it's definitely a possibility that you have to factor into your portfolios that we're headed back to that higher inflation level through a cycle. And to your point, that's going to play or wreak havoc on long-term bonds. And so even though there might be a short-term opportunity here over the next, say, six to 18 months in the long-term treasury bond, we would be very cognizant this time around of when we need to lighten that exposure or get out entirely because, if inflation is going to accelerate, let's say there's a scenario where the Fed and other central banks cut rates to try and boost the economy, we would expect inflation to take hold again and we would need to be out of the long bond. And that's a different environment than what we had from 1982 all the way up until 2020 or last year. So, I think that's where we're getting more tactical rather than relying on that secular trend that you had for nearly 40 years.
David Hay:
That makes total sense. And I think it applies to the equity side as well, that instead of just this buy-and-hold mentality that's been so effective since the early 80s, that it's time to be more, not trading oriented, but certainly more willing to take profits in these big run ups and then buy when you have another big decline, whether it's with the bond market or the stock market. So, given what's happened here lately to both stocks and bond(s), in fact, investment-grade bonds have rallied almost as much as the equity market. And that's an area where we actually were doing a lot of bonding buying here recently, but now we're seeing spreads tighten. I think that's something of a point that you made is that spreads have come down pretty substantially. Maybe that's a good thing to talk about, because, I believe, and I suspect you would agree, that credit spreads have a tremendous influence obviously on the bond market, but even the equity market. So, right now, high-yield spreads which have gotten up to about 600, 6% over, treasuries are now about 4 1/2 over 450 basis points. And in a true recession they go even higher than 600 basis points above, right?
Chance Finucane:
Yeah. The last three recessions that spread got to 1000 basis points. And, so, I think what you noticed the last couple times we had a bear market was when you saw the high-yield spreads get to around 700 basis points, that would be where you'd see the Fed capitulate and try to do something to assist the market, and then spreads would compress. But, this time around, if Powell really wants to try to be the next Volcker and keep rates high for an extended period, you could see, absolutely, a blowout where high-yield spreads go to that 1000-basis-point level. And the other thing that we noticed too was just in terms of default rates or what's expected... you recently just had a default rate, I believe of less than 2%, but you've got I think somewhere around eight or 9% of high-yield bonds trading at distress levels at that greater-than-1000-basis-point spread.
And normally when you see a distressed high-yield bond, that means it's likely to go... about a 50/50
chance it would go to default over the next 12 months, which would suggest that the default rate over the next 12 months is going to go from less than 2% to above 4%. And I'm not sure that people are really factoring that in given that spreads are as relatively tight as they are. The average high-yield spread over the last 25 years is somewhere around five to 5 1/2 percent. And, like you said, we're at about 440 right now. So, it's unusual considering all of the slowing numbers and deteriorating numbers you see in the economy. And yet we're at below-average spreads on the most junky sort of bonds out there.
David Hay:
So just for our less sophisticated listeners, the handful that are out there, most of our subscribers and followers are very knowledgeable, but when we throw out terms like "basis points", so 100 basis points is equal to 1%, when we're talking about spreads, we're talking about credit spreads, the difference between what a corporate bond pays and what the government pays, just to give a little tutorial there. But what you're really saying is that with these high-yield spreads, they could easily double from where they are right now.
Chance Finucane:
Absolutely.
David Hay:
Its even just kind of a garden-variety or maybe a little worse than a garden-variety recession. And that would be shocking, not only to the holders of higher-yield bonds, but also to equities, too, because it has a very nasty blowback effect on the stock market. So, it sounds like from what you said earlier, that you do expect a fairly serious earnings recession and you mentioned Morgan Stanley and Mike Wilson is, of course, their head strategist there, and I think he's one of the best on the street. He gets flack when the market's strong and he's saying, "Hey, let's, things are running ahead of themselves, you might wanna start to raise cash." He gets called a bear even though he get put out a really good bull recommendation back in... around the 10th or 11th of October, and really caught that rally precisely. So, also, perhaps this is going to increase your conviction about the earnings recession call, because CNBC's most famous talking head, I don't think I need to mention a name here, thinks Wilson is wrong. He was dissing him actually earlier this week. He thinks earnings will be fine outside of technology. He also thinks that there's not going to be a general recession. His forecasting record is, to say the least, not the greatest. So again, you may take some encouragement in that. But anyway, how far above-trend do you think corporate profits are currently?
Chance Finucane:
We actually saw this chart that stretches back 20 years. Artisan Focus Fund, the money manager for that mutual fund, posted a chart in his most recent quarterly letter just looking at the trend growth rate in the S&P 500. And I think now everyone's expecting $230 per share for next year for the S&P 500, but, that trend, which it's fluctuated around that growth rate, would actually say more like $200, be back more towards what the trend has been back to 2004 and everyone, I think people are assuming 250 for 2024 for earnings per share for the S&P 500. So, it just seems like everyone's kind of extrapolating out the growth rate that came out of the Pandemic and all the stimulus that we had and money being shipped off everywhere to buy all sorts of goods and then shifted over to services this past year as people were able to go out and travel and do more experiences. But, we think that getting back closer to that $200 number is probably more likely over the next 12 to 18 months.
David Hay:
That makes sense to me. Now, I do think earnings estimates have been, and continue to be, too high, and part of what's made it look better for the forecasters who are pretty optimistic coming into this year is the energy... Energy's had a tremendous contribution... I believe that if you back out energy the earnings have already gone negative, and it's going to be difficult for energy to continue to have the kind of numbers that they've had, especially with oil falling back. We'll get to energy because I think that's a pretty interesting setup that's going on there right now. But, does it concern you that the majority of economists... I mean first of all they are saying a slight majority is saying a recession will happen, which is pretty unusual. They typically miss it, but they do believe, and I think Wall Street, in general believes it's going to be a mild recession. Does that concern you? Do you think the likelihood is that they maybe have the recession call, right, but the severity wrong?
Chance Finucane:
Yeah, that could be. I think we share your sentiment that if all the economists agree with you, you probably need to double-check your thesis. But I think there's enough data and numbers to suggest that is the outcome. And it's just interesting, maybe because it's been so drawn out, people have had time to come to that conclusion. Yeah, it absolutely could end up being more severe than people expect. One thing that's interesting that we've been looking at is just, for instance, the unemployment rate, and labor has remained strong, but labor is sort of the last lagging indicator before it turns over into a recession. And, actually, those three recessions in the 1970s and early 1980s, it wasn't until several months into each recession, before the monthly non-farm payroll numbers actually turn negative. So, people think that, "Oh, look, the labor economy's good, everything's fine." But that's going to be the last thing that shifts.
And the thing that I don't think people realize, for instance, the Fed's numbers for next year, I think it's just a little bit naïve. They're saying, "Oh, well, right now, the unemployment rate's around 3 1/2 percent. We think it could go up to 4.4 or something like that." But if you look at every single recession going back to 1949, the lowest amount that the unemployment rate increased by was 2.2%, and the lowest peak unemployment rate coming out of a recession going back 70 years was 6%. So, if we're at 3 1/2 now, if we go into a recession, there's no way we're not getting to at least 5 1/2 or 6%, and the unemployment rate, which seems to be lower than what everybody is anticipating.
David Hay:
Yep. I'm right there with you. And you made a great point that, and this is one of the interesting things about the Fed currently, is they seem to be focused most of all on two things. The labor, the jobless market, I mean, they actually do wanna see the jobless rate go up, which is unusual for the Fed. But that's because of their second main focus, which is inflation, trying to get inflation down as close to 2% as they can. And so they're really in this with this Hobson's Choice of, do we take a serious recession on by trying to drive up unemployment enough to get inflation down, or do we accept, as you were talking about earlier, that structurally higher inflation rate. I believe that, eventually, Powell's going to have to relent, and do what he did back in 2018, but I think he's going to put up a tougher fight this time. But, it sounds like you, or looks like you agree with that, but he's going to be tighter for longer, but, then eventually, there's going to be an awful lot of pressure on him.
Chance Finucane:
Yeah, we agree. It's going to be interesting because I think he has every intention of trying to keep those rates high for as long as he can, and, I think there's an economic paper that Jason Furman cited in a Wall Street Journal that showed that you need to get unemployment rate up to 6% to get the inflation rate down to two. But that's going to be painful for the economy and for a lot of people, if Powell is willing to wait that long and see the unemployment rate increase to that level. And we agree that's about how high you need to get the unemployment rate to have inflation come down to their target. But if there's too much pressure from other parties, or he's just feeling pressure and needs to flip, that's where, back to our talk about active management of portfolios, it's going to be crucial to kind of know when that happens, all right, it's time to switch from conservative back to being more aggressive with our portfolio, and really thinking about what's going to benefit from accelerating inflation, the possibility of growth turning back around and accelerating. And it's just going to be that back and forth and monitoring really closely what he and other central bankers decide to do.
David Hay:
Well on that topic of Powell and tightening and how far he is going to go, one thing that I think is not getting enough attention is that this is only the second double tightening. And so that means, again, for the folks that aren't, don't watch this stuff real closely, that the Fed is not only raising interest rates, and has raised interest rates at a very rapid rate, one of the fastest rates on record in history, going back basically to the Volcker inflation attack, but it's also shrinking its balance sheet. So, it's doing the opposite of quantitative easing, where they were buying lots of treasuries with money that they just created from their magical money machine, and now they're actually going the other way. So they're draining liquidity out of the system. And by doing so, it's kind of a stealth tightening, but it's started out relatively slowly, but it's starting to, we get to maximum roughly 100 billion, a little under a 100 billion per month. So that could, from numbers I've seen, I'd be interested if you have a perspective on what that equates to, but I've seen that over the next year, that could be another 200 basis points of equivalent rate hikes. Looks like, somewhere in that... I know it's more art than science with that ... what is the true relationship?
Chance Finucane:
Yeah, I think we've seen different numbers, too. The most recent one we saw was that 95 billion per month that rolls off, and the quantitative tightening equates to about 20 basis points. If it was considered to be like an interest-rate hike, so, call it 240 basis points, if they kept that up through all at 2023. So, even if they do pause the rate hikes, you'd still have that, essentially, additional tightening. We had seen Felix Zulauf, I think pointed out that M2, or money supply growth, adjusted for inflation, is the most negative it's been since the 1930s, and that's just a very difficult environment for financial asset prices to sustainably move higher. So as long as you're going to see that tightening, both the stealth that you're talking about and still a couple more rate hikes, it's just going to be difficult to feel like, oh, we should really get aggressive and take on a lot more risk.
David Hay:
I'm smiling because I listened to Felix with my great friend Grant Williams at a podcast here, a week or two ago, and that's exactly the point he made that really caught my attention, that when you look at it in real terms, the money supply has already come down drastically and kind of alarmingly, but when you adjust it for the high level of inflation, it really is a Great Depression flashback, and that's a pretty staggering statistic. Another thing I think, which is not getting nearly enough attention, is the bursting of the global housing bubble. And I heard you make comments, which I agree with, that the U.S. banking system is in better shape to handle the bursting of this one, but, I mean, prices did get even higher, even if you adjust for inflation than they were in 2007 in the United States, than in a lot of countries around the world -- Canada, New Zealand, Australia... obviously China, their real estate market's a mess. Their bubble popped a while ago. But the Nordic countries where they had even negative interest rates where borrowers were paid to take out a mortgage in some countries, so prices got even more outrageous, and those prices are now coming down. So it does appear that we do have a bursting global housing bubble, and that's gotta have severely negative economic ramifications. But am I too worried about that?
Chance Finucane:
No, I wouldn't say that. Yeah, I wouldn't say that's the case at all. It's interesting... looking at other countries, the mortgages that are taken out in other countries, we're the only country that has a 30-year fixed-rate mortgage. That's the great benefit that the U.S. government provides people. In other countries, that might be very cheap healthcare, but then if you wanna buy a home in Canada or the UK or other countries like that, you're taking out a three- or five-year mortgage that then you have to, essentially, it's like refinancing it, whatever the new market rate is. And I really feel for people in other countries. For instance, in the UK, that market mortgage rate for a three-year mortgage was 1.6% in January, and right now it's 5.9. So, you can imagine if your three-year period is rolling off, and you have to take out a new one, but it's going to be double or triple the rate that what you had before, what that does to your monthly payments, can you afford it at the same time you're dealing with higher costs and your wages have probably not increased in line with that.
And that sort of reverse wealth effect is going to probably really take hold at the end of this year, and then into 2023. We had seen some data that suggested it was still a positive contributor to consumer spending and to GDP growth as recently as this summer, but now the rate of change has turned over and it's decelerating and will actually turn negative heading into '23. And we would expect that is an additional reason why you might see a reduction in spending. And it surprised me how abruptly it changed, but the luxury-goods spending turning to essentially flat year-over-year, and probably heading negative. We'd already seen that the bottom quintile of the income distribution was having a tougher and tougher time, but people were still spending on luxury items and that now has gone flat and is probably going negative. And that's usually the last area you see for weakness before consumer spending really starts to fall off.
David Hay:
All good points. And I think especially that, when you look at these overseas housing markets, that you have relatively short-term mortgage debt, and in some cases, in some countries, a very high level of variable-rate mortgage debt where the interest rate hikes are hitting almost instantaneously. So you're right, there's a tremendous squeeze going on in certain countries. And again, I don't think that gets the press and deserve, especially in the United States, where we tend to have an insular view of things. So the big news today is China's accelerated reopening, or attempt to, and you think that's going to alter your investment outlook in any way? Does it make you more bullish on certain areas that have been hurt by China's lockdown?
Chance Finucane:
It's possible. I think we had owned a little bit, we owned a couple of Chinese stocks in 2019, 2020, and then sold out of those in '21. And, I think...
David Hay:
Good move.
Chance Finucane:
Yeah, well we still took some of the hit as it rolled over, but we're able to get out intact. But I think, from our perspective, we really are not trying to make calls on Chinese stocks going forward, just given the ambiguity of the government oversight of a lot of the growth businesses or what businesses you might wanna invest in over there, as well as the regulatory framework with ADRs and what's going to happen there here in the U.S. But I think you can always look for other ways to get indirect exposure, whether that's owning a luxury goods company, we wouldn't buy one now, but things like that that have exposure to the Chinese consumer.
So we do own Nike and Starbucks. So that ends up being a boost if you start to see an increase in Chinese consumer spending. What's been interesting to us is that, as this news has come out about a reopening, you're starting to see an up-move today in Chinese stocks, but there hasn't been quite such a huge positive impact on the markets that I might have thought it would've been a month or two ago, when this narrative was building. So, maybe it's just as the sort of global recession or global slowdown takes hold, a Chinese reopening isn't enough on its own to improve things. So, it's something that we're monitoring, especially in relation to commodity prices, but you haven't really seen that affected in the oil price, which was a big part of the narrative for the oil price hanging on, and energy stocks staying higher. And right now that has continued to, sort of, move down on average, in recent weeks.
David Hay:
Very good point. I'd like to get that just a little bit. But you mentioned Starbucks, you mentioned Nike, I believe you also are bullish, or you own some dependable growth stocks like Visa, MasterCard, O'Reilly, but they're all great companies and they're in long-term up-trends, but they're not cheap. I mean, they're relatively pricey. So are you actually willing to buy them here? I mean, I know if you have a new account, that's one thing, but as far as... would, for existing accounts, are you committing new capital to those kinds of names or are you going to wait for a pullback?
Chance Finucane:
What we do, and the beauty of having separate accounts, rather than, say, a one mutual fund or ETF, is that we can be have good price discretion of when we buy in. So what we typically do is well, we've got our list of companies often that we've owned for years for our existing clients, and we try to hang onto those winners until you really see either fundamental or price trends breakdown. And then we have a consideration of whether we wanna liquidate the holding. So we'll keep the positions that we've owned for years and the names that you've mentioned, but when they're trading above our fair value, we're not going to jump in and buy for a new account that wants equity holdings. We're going to wait to take advantage of that volatility in the market and buy a half position or a full position as we get to prices that we think represent a discount to what we think the stock is worth.
And so that allows us over the course of several months or quarters to be able to build in that portfolio for a new client, but at a price that we think, all right, we're actually getting, we're not overpaying here, we're getting things at a good level that we think will generate a decent return that'll be able to grow over time. And it also saves some liquidity for if you have a real big selloff then we've got a lot available to really take advantage. And, for instance, in March, 2020, that was a really great time that we had some clients that we just had in the conservative strategy and maybe the high income strategy. But then when things started to really breakdown in mid-March of 2020, we could call them and say, "All right, now's the time we really want to get an equity portfolio going the way that we discussed and you're able to buy in at great prices."
David Hay:
Did some people actually say "Yes"? My experience is when things get really scary, the clients, they talk a big game before the price collapse happens and then they freeze. But it sounds like your clients went along with you, or you were very persuasive.
Chance Finucane:
It worked in this case back then because I think the decline happened so quickly and everyone was so concerned about their personal health and the health of their families with the uncertainty of Covid going around that, I think the concern that a citing about your financial health and watching your portfolios go down and maybe that making people more risk averse, I don't think that was as much of a factor last go around. We'll see if that ends up being a factor when we make that pitch to clients that have a little bit more equity exposure... whenever it happens next in the next year or two. But our whole focus is just trying to be very transparent and build trust in those relationships so that they believe us and they trust us when the time comes and [we say], "This is the time that we really think that stocks could double over the next five years and it'd be a great time to have some exposure."
David Hay:
Well, on the topic of, kind of the opposite of the higher-priced Steady Eddies, is ... energy, because that is about as cheap as any sector can be. When you look at things like PE and price to free cash flow, and, in many cases, dividend yields. It sounds like you guys prefer midstream, the energy infrastructure names. So, basically, the owners and operators of pipelines and storage facilities and fractionation plants and mostly pipelines. I mean, that's really where I think the bulk of the assets are. But are you comfortable mentioning any names, or, I'll give you one of mine if you gimme a one or two of yours, but what do you like there?
Chance Finucane:
Yeah, actually, I think we both own Enterprise Products at both of our firms. That's our top holding. It's just the, it's the best all around pipeline. They've got exposure to the Permian and the right places, and it's well managed pays a very high dividend and we've owned that one for clients in our high-income strategy for years and years. I think, what we've done is we try to have a core two or three different pipelines that we own, and then when we get really positive about the direction of the oil price and energy stocks, in general, we'll add a few more that have a little bit more volatility to their share price. But, just at smaller positions, they can really provide a great return over that period that you want to have a little bit more allocated to that area. So that might be, we don't own these right now, but that would be a Valero Energy or Devin or Pioneer, those types of companies that are going to fluctuate a lot more with sentiment around oil. And then we'll still have a little bit of exposure to some other sort of stalwart names like ... Chevron. We also, if we can find an oil royalty business that... we've owned Brigham Minerals for a number of years and that's one that will kind of adjust the position size based on our outlook for oil. But we typically have some exposure to that just because the business model for an oil royalty, or any sort of resources royalty business, is just outstanding.
David Hay:
Well, I'm a big fan of Bud Brigham, and he's the man behind that one and that's .... they're actually doing a merger right now, which looks like it might be a bit accretive to unit holders. But my name to give you, you probably have looked at it, but it sounds like perhaps you don't own it. It's a nine and nine, and by "nine and nine", I mean it's a 9% yield in nine times earnings, though actually even a little better than that. And it didn't cut its distributions through the two different oil busts that happened, one being really most recently to Covid and then the breakdown that happened back in two-thousand... 2014/15. But it's like most of these companies, a great thing that, unlike back then, when there was such an investment cycle going on, it's the same thing you were talking about earlier, where it's very hard, number one, to build a new pipeline, but they're also they're opting to pay down debt and to buy back units, which is just, we never thought that would happen in midstream. So this one is MPLX, which is basically the midstream entity for Marathon, and they just continue to perform very, very well, and it's just remarkably cheap. But, you're right, enterprise is the class act and it's actually not gone up that much this year on a really good year for midstream. I think it's only up to 14% or so.
Chance Finucane:
Mm-hmm.
David Hay:
Pretty good, actually.
Chance Finucane:
Yeah, actually we still think it's undervalued today. So that is one that we look to buy for new clients in the high-income strategy, and we've owned MPLX in the past. That's one of our preferred MLPs and it's probably one we would look to own again when our outlook turns more bullish on oil. I think, right now, it's just an interesting period. I remember you talking about it. I listened to your interview with Grant Williams, and it's just an interesting time because you know that structural deficit between supply and demand has not been improved because there's not enough capital spending in the industry to drive that supply higher to what we need it to be. And yet when you've got demand declining due to all of the monetary tightening around the world and potentially heading into a recession during an oil bear market, it typically takes over a year to play out and the average price decline is about 60%. And so we've kind of been monitoring both sides and I think that's why we took our exposure down in the first half of this year to oil in the high-income strategy. But we would be monitoring it so that we have an opportunity and make sure we take advantage to add back to that exposure in high-income and probably add some in the equity strategies, as well, when the time comes that we think the demand is going to turn and then that structural imbalance will start to become the prominent factor again.
David Hay:
Well, on the oil topic, it's a couple things that I don't think I've ever seen before. One is, which, that you're talking about, oil could go down 60%, it's down 40% already, and [that's] not abnormal with recession clouds building on the horizon. But what is abnormal is when you look at inventories, particularly if you adjust for the SPR, Strategic Petroleum Reserve releases, inventories are not just low, they are stunningly low, like dangerously low. So I've never seen oil prices come down like this with the kind of inventory situation we have. And, as you point out, the chronic underinvestment. So it seems like there's just quite a disconnect between the actual physical demand and supply for oil, versus what's happening in the paper market. And I'm sure you're aware of this, but I don't think many of our listeners are, that the paper market for oil is about 30 times what the actual physical market is.
In most commodities, it's more like three to four to five times. So what's happening in the derivative market, the futures market, primarily, overwhelms what's going on in the cash market, and you can get these real odd divergencies at times. But I have to say this is one of the strangest ones I've ever seen. But also one... the kind of 'Ripley's Believe It or Not!' category is the fact that you've got... like XLE has actually had a killer year, despite the fact that oil prices have are down and since early August the oil prices actually have fallen a fair amount and XLE has gone up, which is, sorry, the energy ETF that knows a lot of those names you were talking about. So what do you think the reason for that is? I mean this divergence between the equity performance and the actual commodity performance?
Chance Finucane:
The only thing I could think of would just be that people are seeing through the short-term cyclicality and looking at the structural concern and thinking that we're not going to fall for this. We know where the endgame's going to be and, therefore, we're going to stay owning these different oil stocks. And we had looked early in this year when oil was trading about at the price that it is now, XLE was trading between $16 and $70 a share. And so we were always thinking, okay, if it got back to that level, then we'd start looking to try and maybe pick off some names and increase our exposure. And what's ended up happening is, as you pointed out, it's still staying up in the 80sin per share levels for XLE, and has not followed the oil price back down. So, I think it's just sort of a tug and pull between which is going to win out. Is it going to be the economy, if there is a recession and demand comes down and that oil price continues to fall, or is everyone really just going to ignore that part in the short term and stick with owning all of these stocks?
And I guess, right now, we're sort of just kind of have a little bit of exposure to each side is really the only way, because we just don't know which way it's going to go. Historically you would say the oil price will win out, and the stocks will follow. That's what happened both in the Dotcom three-year bear market, as well as the 2007 to 2009 recession in bear market ... oil price stayed up into June of '08, and then finally rolled over and the stocks followed. So we'll see if that's the case this time. But right now the prices that are, the oil price that's being embedded for where these energy stocks are currently trading is significantly higher than what is actually on the market right now.
David Hay:
Yeah, I think if you look at ... you've mentioned '07-'09, so the Great Recession, and I believe for the year 2009, oil demand, or maybe during the worst of the recession, oil demand fell ... by an annual rate of about a million and a half barrels a day. But that's about what we've got OPEC saying they're going to cut, net. and China reopening probably will be another one and a half million barrels, because their demand is down at least that much due to all their Covid restrictions. Then you've got the fuel switching, which I think is still off the radar of a lot of people in Europe where, for the first time ever, they're going away from burning coal and gas to produce electricity and actually burning primarily diesel oil. So you add all these different things and you've got like 5 million barrels a day of ... plus Russia and the fact that Russia is probably going to lose some degree of output, although they're pretty clever about how they get around the sanctions. But nonetheless, it looks to me, to us, like you've got multiples of whatever the demand shrinkage might be due to a recession. But it is interesting, it's almost like oil itself is now a better buy than the equities, but they're both probably attractive.
Chance Finucane:
That could be. And if the scenario you're outlining, where all those different puts and takes lead to the oil price moving higher, that would just accentuate in our mind the final outcome for the economy, where that leaves inflation up for longer and really puts central banks in a tough spot in terms of having to leave rates higher for longer or you just let inflation go and it really stays higher for an extended period.
David Hay:
That's a good point. It seems to me that could be one of the big surprises of the first half of next year, is another spike up in energy. And I did hear that famous talking head from CNBC today say that you should sell oil into this little mini-rally we had today on the China reopening news. So if we did get triple-digit oil prices again next year, that would be tough on the economy and it would be, it'd be that stagflationary kinda scenario that that's always rough on non-commodity equities. So anything else you'd like to cover, Chance?
Chance Finucane:
No, I think we've hit just about everything. I think one other thing that we just saw that was interesting... I get asked a lot about financials, and one other space. I don't know your exposure to that, but, typically you've got two different types of financials. You've got you banks and your consumer finance names that move a lot more with the economy, very cyclical. And then you have your insurance businesses and insurance brokers. And we had read a report recently that just pointed out that this is probably the best past year for insurance and insurance brokers in a long time, because that's where everyone's hiding, along with other defensive sectors. But historically when that happens, you don't usually want to be in that space much longer. And those are businesses that, in our estimation ... are overvalued today. And at the same time we still think there's more deterioration to go for the banks and consumer finance names. So, usually when we get asked about financials, it is kind of just a stay away on all cards ,unless you're owning something like a Visa or MasterCard, which is a bit of its own business entirely. It's separate from those others.
David Hay:
A much stronger, more persistent business model. Okay. Well ... Chance... I've really appreciated the "chance" to chat with you and get to know you, and I've been impressed by listening to you and both today and when I heard your Thanksgiving, or right before Thanksgiving, podcast. So you've got a great way with words and a great handle on the financial market. So, I really appreciate you taking some of your precious time to be with me and with our viewers, and just wish you a very Merry Christmas and I hope you get some downtime during this time. I'm sure you deserve it and need it. I know I do.
Chance Finucane:
Yeah, definitely. It's been a long year, but yeah, very interesting year and thanks a lot for having me on the show.
David Hay:
Absolutely. We'll do it again.
Terrific interview. Thanks for all you do & Happy Holidays
I believe that oil stocks should start correcting during this temporary oil downturn. I sold all of my oil stocks the first week of December. I am concerned about China opening up. Everybody is celebrating that China has opened. This is great and needed, but I think what is under-estimated is the covid death count coming in January/February. I am currently getting an oil stock shopping list for February. I sold Laredo Pet. the day before a downgrade Dec 5; never been that lucky before! I think Laredo might be a great buy in February. Seems like management is making some good asset decisions (debt reductions, share buy backs, selling unmanaged oil acres). I can't believe how cheap Laredo is. I keep double-checking my numbers thinking my math is wrong. APA is performing well and I am hoping for a correction.