Short-term Deflationary Pressures Mean More Downside for Gold Prices

We became bearish on gold prices in late 2012, and first articulated our $1,100-$1,300 price target in our January 25, 2013 global macroeconomic issue–when gold traded at $1,660 an ounce. Over the last 14 months, we have reiterated our bearish views on both gold prices and gold miners; in our July 7, 2013 commentary (“A Technological Revolution in the Making – The U.S. Giant Awakens“), we further lowered our price forecast to $1,000-$1,200 an ounce, and asserted that the price of gold will hit bottom by the end of the 1st half of 2014.

At the time of our July 7, 2013 commentary–when gold traded at $1,220 an ounce–we asserted that the two most reliable indicators for at least a tradeable bottom were absent. Quoting our July 7, 2013 commentary:

The two most reliable psychological indicators for a tradeable bottom in any asset class are: 1) Panic, or 2) Indifference. The best time to invest in any asset class is after years of investors’ indifference. That–along with other screaming buy indicators–was the reason why I invested in physical gold and unhedged gold miners at under $275 an ounce in late 2000.

In this commentary, we reiterate our $1,000-$1,200 price target, but are pushing our forecast to 2Q-3Q this year. In addition, we are revising down our absolute bottom from $900 to $850 an ounce, as the marginal cost (both all-in-sustaining and pure extraction costs) of production has come down substantially over the last 18 months (the price of gold traded at the marginal cost of extraction various times during the 1990s bear market). Here are our reasons:

After nine more months of trading, gold investors have neither panicked nor capitulated. While gold ETF holdings have declined from a peak of nearly 85 million troy ounces in late 2012 to just 56 million troy ounces today, COMEX gold net speculative long positions remain elevated at more than 15 million troy ounces (see Figure 1 below, source: Goldman Sachs).

Figure 1: COMEX Gold Net Speculative Position (Left, million toz) vs. 10-year TIPS Yield (right, inverted)

COMEXGOLDSPECSWe believe the trend for gold prices thus remains down. This is further compounded by short-term, but significant global deflationary forces, some of which we have previously discussed.

Those that are Gold Miners Specific

All extremes eventually become their opposites.” – Plato, and later Carl Jung

A bull market inevitably builds excess, and nowhere is this more evident than in the evolving marginal cost curve of gold miners. At the bottom in 2002, the marginal cost of extraction was approximately $300 a troy ounce. Despite technology improvements, the marginal cost of extraction steadily rose to nearly $1,000 an ounce by 2011 as gold miners exploited lower-grade mines and as mine workers enjoyed higher wages. Since the peak in 2011, the marginal cost of extraction has come back down to $850 an ounce (see Figure 2 below, courtesy Goldman Sachs). Deflation has set in within the gold mining industry–and given that it is a commodity industry, it is a race to the bottom. Ironically, some gold miners are producing even more gold in an attempt to stem cash flow problems–thus increasing supply and depressing gold prices even as demand remains anemic. So far, there have been no major mine closures; nor major bankruptcies in the industry. We believe that neither the price of gold nor gold mining stocks will bottom until the industry experiences a couple of major mine closures and/or bankruptcies. The gold mining ETFs, GDX ($24.26) and GDXJ ($36.66), could easily decline another 25-30% from current levels.

Figure 2: Real Gold Prices vs. Marginal All-in-Sustaining Cost of Production vs. Marginal Cost of Extractionrealgoldprices

Those that are U.S.-centric

As we discussed in our March 30, 2014 commentary (“An Imminent Correction in Risk Assets“), the outlook for U.S. monetary policy is not conducive to higher prices for risk assets, including gold–at least not in the short-run. While the price of gold continued to rally for three more months after the end of QE2 (peaking in September 2011)–gold has failed to rally despite the implementation of QE3 (which resulted in $1.5 trillion of agency MBS and Treasury purchases). As QE3 is scheduled to end by the October 28-29 FOMC meeting, it is likely that the price of gold will be pressured even further, unless: 1) U.S. commercial banks overcome their regulatory burdens and start lending more freely, or 2) the Euro Zone threatens to fall apart and the ECB is forced to monetize a substantial amount of peripheral debt and/or Euro ABS securities. Note the chances of either of these scenarios occurring are next to none (Spanish 10-year yield is trading at just 3.18%, or 50 bps above the 10-year Treasury).

With regards to the U.S. short-term inflationary outlook, the two following indicators (one leading and one coincident) come to mind:

1) The highly respected ECRI’s monthly U.S. Future Inflation Gauge (a leading indicator) remains depressed. For example, the rise in U.S. home prices (owners’ equivalent rent makes up approximately 25% of the U.S. CPI) has recently stalled due to anemic growth in U.S. wages and the rise in U.S. interest and mortgage rates. Unless U.S. wages experience a structural uptrend (not likely anytime soon), CPI inflation will likely remain low. Note that one of the best predictors for future CPI readings is actually today’s CPI reading, as the CPI reading is fed into variables that could cause future inflation, such as Social Security cost-of-living adjustments, union wage adjustments, and some private defined benefits pension plan cost-of-living adjustments.

2) The Cleveland Fed’s expected inflation yield curve as imputed from TIPS yields is still low, despite the Fed’s purchases of $4 trillion of agency debt, agency MBS, and Treasury securities over the last five years (see below chart). As of March 2014, the ten-year expected inflation rate is 1.74%. With the Fed beginning to shift to a tightening mode, we expect the Fed to begin raising the Fed Funds rate by the middle of next year, and for U.S. real interest rates to be definitively positive by the end of 2015.

While we are bullish on gold prices over the next 5-10 years (due to what we believe will be heightened political will to inflate out of our future pension/healthcare and student debt obligations), the next 6-12 months remain a very bearish period for gold prices.


Those that are Global in Nature

1) The annual growth rate of foreign reserves on the Fed’s balance sheet–an important global liquidity indicator–turned negative earlier this year–the first time since early 2012. Global deflationary events beginning in the 1980s (1994 Tequila Crisis, 1997 Asian Crisis, 1998 Russian/Brazilian/LTCM crises, etc.) have always been preceded by a year-over-year decline in the amount of foreign reserves on the Fed’s balance sheet. This is not surprising, as the vast majority of global trade is still settled in the US$. As the U.S. current account deficit shrinks (due to higher domestic oil production, “on-shoring” of U.S. manufacturing, etc.) global US$ liquidity will continue to decline–putting further pressure on the balance sheets of countries that are dependent on exports to the U.S. Since many of these countries are net purchases of gold, we believe declining foreign reserves will act as a deflationary force for gold prices over the next 6 months;

2) On April 1, Japan raised its sales tax from 5% to 8%. This act–which is felt instantaneously–is deflationary for the Japanese economy. The Bank of Japan is now expected to ramp up its quantitative easing policy (which will take several quarters). Domestically, this will counteract the deflationary effects of the sales tax increase by exporting deflation around the world. This deflationary shock will be felt mostly by Japan’s trading partners, as well as its trade competitors (South Korea, China, etc.). Since China is traditionally the second largest net buyer of gold, we expect Chinese demand for gold (whether as an investment or inflation hedge) to subsequently decline. In addition, while the Japanese economy will experience some inflation due to the Bank of Japan’s actions, this will have little effect on gold as Japanese demand for gold is effectively zero (most likely, the Japanese will purchase domestic equities/real estate as an inflation hedge).

3) India’s official gold imports hit a peak of 162 tonnes in May 2013. Indian gold imports made up 28% of the world’s demand in 2012–ahead of Chinese gold imports at 26% of the world’s demand. At the peak, gold imports were the biggest contributor to the Indian current account deficit. Since the Indian government took more proactive steps to curb gold demand in summer 2013, official gold imports have dropped substantially (see Figure 3 below, courtesy Goldman Sachs). Official Indian gold imports (which excludes imports via smuggling channels) are expected to be only 550 tonnes or lower in 2014–down from as high as 863 tonnes in 2012. The raising of gold import tariffs has resulted in a two-thirds reduction of the Indian trade deficit since May 2013! We do not believe the Indian government will reduce the import tariff substantially over the next 6 months. As such, Indian public policy suggests an ongoing deflationary pressure on both Indian gold demand and gold prices in general.

Figure 3: India’s Gold Imports have Collapsed Due to Higher Import Tariffs



An Imminent Correction in Risk Assets

In our 2014 U.S. stock market outlook (published on December 22, 2013), we asserted that U.S. stocks will only return in the single-digits in 2014, due to: 1) a tightening Fed, 2) the reluctance of the ECB to adopt quantitative easing policies, 3) higher-than-average valuations, as well as 4) increasingly high levels of investor speculation (e.g. record high levels in margin debt outstanding). We stand by our 2014 S&P 500 year-end target level of 1,900 to 2,000.

Conversations with our clients suggest one overarching investment concern/theme. Investors are concerned with the unprecedented global monetary experiments, while most of Asia is concerned about runaway Chinese credit growth and the country’s shadow banking system. The shift from a unipolar investment environment (one dominated by U.S. policy and institutions) into a multipolar one–beginning with the fall of the Berlin Wall in 1989 and accelerating with China’s entry into the WTO in 2001–means an understanding of global macro is essential to understanding the main drivers of future asset prices (hint: it is not classical indicators such as P/B, P/E ratios, etc.). Going forward, monitoring the actions of the People’s Bank of China and Chinese credit growth will be just as important as monitoring the actions of the Federal Reserve.

We believe 2014 represents a transition year as the Federal Reserve definitively halts its QE policies/asset purchases and as Chinese policymakers adopt financial reforms (e.g. allowing companies to go bankrupt to prevent future moral hazard problems) in an attempt to alleviate investors’ long-term concerns. In many ways, these recent moves–including Fed Chair Janet Yellen’s surprisingly hawkish comments at the March 18-19 FOMC meeting–are reminiscent to the events of 1994, when the Greenspan-led Fed unexpectedly began hiking the Fed Funds rate in February 1994. The Fed Funds rate rose from 3.0% to 5.5% by the end of the year, while the two-year Treasury yield surged from 4.0% to more than 7.5%. The S&P 500 experienced significant volatility and finished down the year by 1.5%.

We do not believe the Fed will hike the Fed Funds rate anytime soon; however, we anticipate the Fed to halt its QE/asset purchase policies by the end of this year; and to begin hiking rates in the 1st half of 2015. That is, global liquidity will get tighter as the year progresses–further compounded by overbearing U.S. financial regulations, a hike in the Japanese sales tax this week from 5% to 8%, and the ECB’s reluctance to adopt a similar QE policy. The action in the S&P 500 in the 1st quarter of this year has so far proved out our thesis. The S&P 500 ended 2013 at 1,848.36 and as of last Friday, sits at just 1,857.62 for a meager 0.5% gain. We reiterate our year-end target of 1,900 to 2,000. In the meantime, we believe the S&P 500 is heading into a significant correction, i.e. 10-15% correction over the next 3-6 months–for the following 3 reasons.

1) Hot Money Action is Getting More Risk-Averse

Since the global financial crisis ended in early 2009, EM fund flows from DM countries have been highly positive. Fund flows to EM countries turned negative during the summer of 2013. Many EM countries never implemented much-needed reforms during the last boom (Russia leadership just proved it is still stuck in the 19th century), nor made much-needed infrastructure and educational investments (with the major exception of China). Investors have forgotten that EM growth (actual and potential) rates no longer justify such investment fund flows–and have continued to dial back risk-taking in general. Most recently–the stock prices of two of the hottest industries, i.e. Big Data and Biotech–have taken a significant hit in recent trading. We believe momentum investors are now leaving the stock market; and that there is a good chance this will turn into a market rout (i.e. S&P decline of 10-15%) over the next 3-6 months.

2) The Federal Reserve’s Monetary Policy Tightening

Once the Federal Reserve wrapped up its “QE2″ policy of purchasing $600 billion in Treasuries at the end of June 2011, the S&P 500 subsequently corrected by 14% over the next three months. The S&P 500 had already declined by 3% during May/June 2011, as the Fed did not provide a clear indication of further easing (i.e. QE3) until later in 2012. Prior to the end of QE2, the Fed purchased an average of $17.5 billion of Treasuries on a weekly basis. At the peak of QE3 (i.e. before the recent tapering), the Fed was purchasing an average of $20.0 billion of Treasuries and agency-backed mortgage securities on a weekly basis. The current tapering process is already having an effect on global liquidity, as foreign reserves held by global central banks have been declining over the last couple of months. Based on the current tapering schedule, the Fed will halt its QE policies at the October 28-29, 2014 FOMC meeting. The Fed’s balance sheet of $4 trillion of securities will take a decade to unwind (if ever). Unless the ECB chooses to adopt similar QE policies, we believe global central bank tightening (EM central banks are projected to tighten further over the next six months) will act as a significant headwind to equities and other risk assets for the rest of 2014.

Feds Balance Sheet

 3) A Record High in U.S. Margin Debt Outstanding

Our studies and real-time experience indicate significant correlation between U.S. margin debt outstanding and other leverage indicators, as well as major peaks and troughs in the U.S. stock market. We first discussed this indicator in our January 29, 2014 commentary (“Record Rise in Margin Debt Outstanding = Single-Digit U.S. Stock Returns in 2014“). We asserted that the record rise in margin debt outstanding (a 12-month rise not seen since July 2007–during the last major peak in stock prices) is indicative of significant speculation in U.S. equities. Since our January 29 commentary, U.S. margin debt outstanding has risen another $23.6 billion to a record high $502 billion. Meanwhile, the 6-month rise in margin debt outstanding hit $88 billion–again, a high not seen since July 2007 (when it hit $105 billion). More important, it is clear to us–based on the action in Big Data and biotech stocks over the last couple of weeks–that the willingness to speculate is declining. All of these indicators suggest to us that the S&P 500 will experience a major 10-15% correction over the next 3-6 months. We also assert that Emerging Market stocks will experience a significant decline, along with gold prices. We expect gold prices to bottom at the $1,000 to $1,200 an ounce level over the next 3-6 months. We will look for a buying opportunity in both gold and North American gold-mining stocks sometime in the next two quarters.

Building a Specialty Brand in the 21st Century

Here at CB Capital, we are a firm believer in working with strong consumer brands. Our investors like them, and understand how to analyze, cultivate, and assist brands in staying at the forefront of various consumer and societal trends.

For our brand clients, we understand that your consumer brand wants loyal, sophisticated, and high-margin consumers. These sophisticated consumers must have purpose, and your brand must fit their purpose or what they stand for, whether it is a lifestyle option (Whole Foods, Nike, Starbucks, etc.), part of an overall movement/statement (Tesla, Apple, etc.), part of a niche culture (Lululemon, Urban Outfitters, Burton, Active Ride Shop, etc.) or recognized as the best in class (Amazon, Google, Goldman Sachs, etc.). Once your brand becomes part of your consumers’ lives, it is sticky. Your brand will ride the waves of their successes. Marketing becomes word-of-mouth, and your products will sell at a premium.

On the other hand, you do not want fickle or gullible consumers. Most of these folks have no solid belief systems and cannot be trusted to be long-term, loyal consumers. These consumers are not only fickle, but will only dilute your brand. Sophisticated, generous, and loyal consumers would not be wearing or consuming the same brand as these folks. Many of these folks also do not play fair—returning items to stores they have worn for a night, etc. True, sophisticated and responsible consumers/citizens do not engage in this type of practices.

As an aside, there are certain sub-industries and industries where there still exist numerous brand-building opportunities. The fast casual, healthy and organic restaurant industry in the U.S. comes to mind, as well as lifestyle brands that serve various niche consumers–we believe that brands catering to anti-establishment, individualistic but responsible ideas will continue to garner a premium in the 21st century. For other industries, it is mostly a race to the bottom. These include traditional/mass retailing, the PC/server industry, as well as traditional full-service and casual dining chains.

To create and manage a brand successfully, we must understand that a brand name is part reputation, part familiarity, part psychology, and we must also understand the unquantifiable thrills or sense of belonging that a consumer feels when he or she purchases something that bears his or her favorite brand name. The concept of a brand name first arose with the advent of advertising and mass media in the 1930s—further compounded by the adoption of the 40-hour workweek, allowing consumers more time to enjoy the things that they bought. It is not a coincidence that Disney’s success took off during the 1930s, as for the first time, the middle class had idle time to watch films. To this end, Interbrand’s ten factors of creating and managing a brand are timeless. The information in the below figure are taken verbatim from Interbrand.

Figure 1: Interbrand’s Ten Timeless Factors for Managing/Valuing Brands

Internal Factors

External Factors

Clarity: Clarify internally about what the brand stands for in terms of its values, positioning and proposition. Clarity too about target audiences, customer insights and drivers. Because much hinges on this, it is vital that these are articulated internally and shared across the organization. Authenticity: The brand is soundly based on an internal truth and capability. It has a defined heritage and a well-grounded value set. It can deliver against the (high) expectations that customers have of it.
Commitment: Internal commitment to brand, and a belief internally in the importance of brand. The extent to which the brand receives support in terms of time, influence, and investment. Relevance: The fit with customer/consumer needs, desires, and decision criteria across all relevant demographics and geographies.
Protection: How secure the brand is across a number of dimensions: legal protection, propriety ingredients or design, scale or geographical spread. Differentiation: The degree to which customers/consumers perceive the brand to have a differentiated positioning distinctive from the competition.
Responsiveness: The ability to respond to market changes, challenges and opportunities. The brand should have a sense of leadership internally and a desire and ability to constantly evolve and renew itself. Consistency: The degree to which a brand is experienced without fail across all touchpoints or formats.
  Presence: The degree to which a brand feels omnipresent and is talked about positively by consumers, customers and opinion formers in both traditional and social media.
  Understanding: The brand is not only recognized by customers, but there is also an in-depth knowledge and understanding of its distinctive qualities and characteristics. (Where relevant, this will extend to consumer understanding of the company that owns the brand).

Building a Strong, Trustworthy Brand in an Age of Low Corporate Trust

London Business School Professor Daniel Goldstein remarked in a March 2007 (pre- financial crisis) Harvard Business Review article that “Research shows that customers may prefer a recognized brand even if it has clear shortcomings—even if, in certain circumstances, it’s dangerous. Consumers in a recent study believed that airlines whose names they recognized were safer than unrecognized carries. On the whole, this belief persisted even after participants learned that the known airlines had poor reputations, poor safety records, and were based in undeveloped countries. In other words, a lack of recognition was more powerful than three simultaneous risk factors.That was the pre-financial crisis point of view—when trust in corporate brands, corporate leaders, and mainstream advertising was still high.

Although already declining, consumers’ trust (especially the sophisticated and potentially loyal consumers that every specialty brand wants) took a nosedive as the financial crisis accelerated in 2008. Americans suddenly realized there was a dearth in global leadership, in all levels of society. Your financial adviser failed you. Professors did not predict the downturn. American consumers no longer trusted mainstream brands and traditional marketing/advertising campaigns. Americans initially cut back on spending; then became more selective as the U.S. economy recovered (many industries, such as the casual dining industry, are having a difficult time responding to this). Brands responded to the economic crisis by running for cover (the weaker brands went out of business), by first attacking its supply chain (i.e. cutting costs) and laying off workers. While this helped profit margins in the short-term, this is the wrong strategy in the long term. During recessionary times—and with Americans becoming more selective in their spending—the competition for sophisticated and loyal consumers becomes even more intense. Combined with the growing distrust in mainstream brands and advertising, Brands will need to find better ways to engage and respond to its consumers’ ever-more selective needs and high standards.

How do you build brand value in an age of low corporate trust, and among an unprecedented increase in marketing channels?  As early as 2010, Eric Schmidt remarked that every two days, the world created as much information as we did from the dawn of civilization up until 2003. Naturally, traditional (TV, newspaper, etc.) advertising is dead, especially among sophisticated, younger consumers who are also selective in their consumption of media. It is not surprising that Forrester Research sees 1) social media, and 2) mobile marketing, as the two most promising marketing spend categories  over the next several years:

Figure 2: U.S. Interactive Marketing Spend Forecast (source: Forrester Research, Inc.)

forrester interactive marketing

The rise of social media not only changes how we communicate; but how Brands could communicate to their consumers. The most effective manner for Brands to engage their consumers—and to build brand value—is no longer B2C (i.e. Business-to-Consumer, or one-to-many). Most of our clients no longer believe in this marketing model. Rather, our research have found that social media is—for the first time—empowering many “influential” consumers who could be strong advocates for their favorite brands. For the first time, the rise of Big Data and easy-to-use collaborative tools allow consumers to engage in more dynamic, one-on-one interactions. The key for Brands is to gather and then harness the power of their most influential consumers to promote awareness and help close sales.

In other words, Brands first transmit their message to their most influential and dynamic consumers, who also provide active feedback to their most-loved brands. From hereon, the Brand begins to lose control of the messaging, as much of that process is now dependent on its influencers.

Figure 3: Key to Brand Building in the 21st Century (Source: CB Capital Partners, Inc.)

21st century marketing

For certain Brands, losing some or all control of its messaging is a scary thought, especially in today’s age of “viral” campaigns and consumer activism. But it is precisely because of this latent power in consumer (influencers’) activism, aided by social media technologies, that injects such power into today’s market campaigns—all at very little cost. An extreme sample is what we have labeled as the “Veronica Mars Model,” where through the power of modern social media marketing and fund-raising, the ROC of a project could literally hit infinity (covered in a recent blog post). This new way of marketing is all the more effective because it keeps Brands actively engaged with their influencers and thus keep them on their toes.

Building a Strong, Trustworthy Brand in a Globalized, Self-Actualizing World

Segmentation, especially for specialty brands, is an important and delicate exercise. Done correctly, your Brand will thrive. Done incorrectly, it is a waste of marketing dollars at best. We learned in Marketing 101 that segmentation based on demographics (income, education levels, etc.) no longer works (the major exceptions are certain film genres and the video gaming industry). Demographics data is easy to gather, and in the by-gone “Mad Men” era, high-income/education, nuclear families may have aspired to similar material brands, but this is no longer the case. We like to describe the evolution of consumers’ needs—on a global basis—using a modified version of Maslow’s Hierarchy of Needs, overlaid with a time line showing the impact of globalization on consumer trends since the end of WWII.

evolution of consumer decision making

We can be forgiven for citing Maslow’s Hierarchy of Needs, since we live and work in southern California. With the evolution of the consumer decision-making process, it no longer makes sense for a Brand to segment and target its market using demographics when its potential market is global, and when individuals no longer identify with their fellow citizens. For example, I teach an upper-division public policy class at UCLA. My U.S. students are very culturally aware and most of them identify themselves more closely with other global, young, and well-educated citizens—not with their fellow Americans. Repeatedly, CB Capital’s experience with our clients and our research show that:

1) Traditional segmentation and marketing methods no longer work. Clients who adopt social media and community outreach efforts wisely have been very successful, while keeping marketing costs low. For years, one of our clients has developed residential communities through feedback from focus groups and local surveys, versus traditional demographic methods. Through unique designs catering to the needs/tastes gathered from this feedback, our client is able to sell his homes for a premium, while keeping construction costs relatively low. His communities are integrated into nature, and are aesthetically pleasant. On a recent visit, we met a young family, older and younger couples, and large social groups. Clients who do not understand this evolution still embrace traditional advertising, which has no feedback loop, while outcomes cannot be measured.

2) Consumer spending in the 20th century was driven mostly by material needs. Aspirational spending meant paying for “expensive” brands which provided a sense of belonging to the Bourgeoisie. Such consumer mentality still exists in China and India  today (where a Starbucks coffee, an iPhone, or a VW means you have “arrived”) but are slowly becoming passe. Today–as the above figure reminds us–premium consumer brands are based on the concepts of self-identification, self-actualization, along with a sense of belonging within a group of like-minded, distinct individuals with similar life philosophies.

The successful 21st century brand will need to understand and adopt the marketing concepts and consumer trends as enunciated by points 1) and 2) above. Otherwise, it is simply a race to the bottom, as many 20th century “brands” and concepts are fast becoming commoditized.  In the latter case, “brand building” will be a waste of money. We are mindful of these facts and strive to only work with clients with strong, defensible, 21st century brands.

The Robot Revolution Invades U.S. Casual Dining

In my July 15, 2007 commentary, we foresaw the potential for a dislocation in the U.S. casual dining industry through technological innovation and adoption. At the time, the iPad did not yet exist; but technologies such as touchscreen, high-speed WiFi, and the necessary software systems for automation were beginning to form. At the time, we believe the appearance of Microsoft’s “Surface” technology will herald a trend of full-blown automation in the casual dining industry. Quoting our July 15, 2007 commentary:

For a “dislocation” technology in the restaurant industry, look no further than the Microsoft “Surface” technology – which is simply an amazing piece of technology.  At first glance, kids will simply think of this as a cool technology to view photos or transfer videos, but give it a couple of years and many restaurants will start utilizing this technology as part of their food/drink ordering and clean-up system.  Besides having the ability to order food or drinks, the “Surface” will know what you are drinking and will ask you if you need a refill when your cup is half-empty.  Once all your plates are empty or nearly empty, the “Surface” will also alert the busboy so he can come and remove your dishes.  At the same time, you will be able to start ordering desserts as well, or of course, pay for your meal (either through your credit card or through Paypal).  In five years, the number of waiters needed in the restaurant industry will be halved, and 15% tips will no longer be needed (assuming a reasonable 40% decline in cost each year, these US$10,000 machines/surfaces will only cost US$750 by the end of 2012).  What outsourcing or off-shoring cannot do (i.e. displace workers whose jobs tend to be localized), technology will.

We were a little early as we assumed adoption would begin by 2009-10. At the time, we did not foresee the severity of the 2008-09 financial crisis. With the over-expansion of many casual dining chains during 2004-06–and with liquidity, borrowing, and consumer spending suffering a major breakdown during the 2008-08 financial crisis–many casual diners simply stopped investing in new stores and technologies. Now that U.S. consumer discretionary spending is back to a 6-year high (and with stock prices of many casual diners, such as EAT, DIN, and CAKE, near all-time highs), investing in new technologies to streamline the ordering and payment process suddenly makes sense again.

For many casual dining chains, there are little points of differentiation among their brands. e.g. Olive Garden, T.G.I. Friday’s, Ruby Tuesday, etc. As we discussed in our May 26, 2013 commentary (“The Generational Divide in Casual Dining Trends“), many traditional, casual dining chains also suffer from three major strikes–at least among the Gen-Ys: 1) A perception of a lack of quality service, 2) A perception of serving cheap-quality food, and 3) An outdated décor. These three strikes are especially glaring when compared to the newer, healthier, and more convenient choices such as Panera Bread, Corner Bakery, or at the higher end of the scale, Cheesecake Factory, RockSugar, and of course, independent operators–especially those with high-end brand names or those serving more exotic (e.g. sushi) and adventurous cuisines. Simply put, what the Gen-Ys settled for when they were kids would not work today.

Seen in this context, there is not much many casual dining chains could do to differentiate their products to increase profit margins–major strategic or product offering shifts notwithstanding. The only option is cost-cutting through technology–in this case, automation technology that streamlines the ordering and payment processes.

Most appropriately, Austen Mulinder, CEO of Ziosk and a former Microsoft executive, is now implementing the idea of tabletop tablets to the casual dining industry. Ziosk’s goal is to “revolutionize the experience and economics of Casual Dining,” and claims that over 100 million guests have already been served under its system. Most notably, Ziosk recently won a national contract to provide tabletop tablets to Chili’s, which will likely accelerate adoption by other national chains.

Exhibit 1: Ziosk Tablet – Order, Pay, and Play Loyalty-Related Games at the Table

Ziosk tablet

Out of the current installation base of over 1,200 locations, Ziosk claims that 80% of customers interact with the device in one way or another. The most frequent use is for direct credit card payment, the 2nd for survey questionnaires, and the 3rd for ordering of drinks, desserts, and appetizers. Ziosk claims that dessert sales are 20% to 30% higher for those who use the device, with quicker table turns and increases in chain loyalty if guests opt for email signup. All in all, restaurants that choose to utilize this device tend to experience 3% higher core food and drink sales on average.

One of Ziosk’s major pitches for this device is that the cost is “less than free,” as the cost of these devices could be subsidized by gaming revenue generated on these devices. A final area of benefit is reduced labor intensity, assuming more customers choose to order and pay through these devices. While restaurants deny that these devices will replace waiters, we believe this is where the casual dining industry is heading. e.g. Some Tokyo restaurants are already doing away with waiters. Make no mistake: The robot revolution has now spread to the casual dining industry.

Exhibit 2: California, Texas and Florida are the Focus Expansion Areas in 2014

Ziosk locations

Declining U.S. Dollar Liquidity Coming Home to Roost for Emerging Markets

Emerging Markets’ finance ministers today surely feel the pain of their European counterparts in the early 1970s. Shortly after President Nixon removed all U.S. dollar convertibility to gold, European finance ministers complained of the global inflationary pressures of such a move, driven by Nixon’s “guns and butter” policy and a deteriorating current account deficit. In just a generation, the United States transformed from the world’s largest creditor to the largest debtor country. Nonetheless, the superiority of the U.S. Dollar as the world’s reserve currency was never really challenged. Surely, Charles de Gaulle–who tried to tip our hand by trading France’s dollar reserves for gold in 1963–must have been spinning in his grave.

Responding to his European counterparts, U.S. Treasury Secretary John Connally famously said “The dollar is our currency, but your problem.” All of which is true. Sure, I lived in Texas for 12 years. Many of the buildings at my alma mater, Rice University, were funded by the wealth of the oil barons–including that of Sid Richardson, whose ventures helped Connally become a successful businessman in the 1950s. This is typical Texan culture–John Connally was merely being blunt–this has been the official if unspoken policy of the United States since Alexander Hamilton helped establish the First Bank of the United States in 1791.

The QE policies created by outgoing Fed Chairman Ben Bernanke simply continues this tradition of “America first; the rest of the world second.” Even the misguided Fed policies of the early 1930s was no exception. As all former and future Federal Reserve Chairs recognize, Fed policy must be targeted for the good of the U.S. economy and U.S. labor–not fine-tuned to satisfy the whims of finance ministers of foreign countries.  Making policy for the good of the U.S. economy–and the U.S. economy only–is the only way to ensure the superiority of the U.S. Dollar as the world’s reserve currency.

Seen in this light, the current plight of EM countries (e.g. Turkey, South Africa, Brazil, and Russia) is not really a problem for U.S. policymakers, even though U.S. “hot money inflows” have overly inflated EM currencies and assets in recent years. But make no mistake: U.S. Fed tapering, as well as a shrinking U.S. current account deficit  (an expanding U.S. current account deficit acts as a global liquidity provider, as most of world trade is still denominated in US$), will continue to be a drag on EM countries for much of 2014. The fact that recent rate hikes by Turkey, South Africa, Brazil, and Russia failed to stem fund outflows is highly problematic (in Russia’s case, it is especially troubling as Brent Crude is still over $100 a barrel). Cumulative EM net fund flows since January 2013 turned negative last August (below chart courtesy the Bank of England), and we believe fund outflows from EM countries will accelerate as the Fed continues to taper. Other global liquidity providers that are strong enough to arrest this decline–i.e. China and the U.S. consumer–will simply not come to the aid of EM countries. The only possible candidate is ECB easing, but we do not anticipate the ECB to ease aggressively enough to stem the decline in global liquidity.

Chart 1: 2013 Cumulative Net Fund Flows into EM Countries Turned Negative Earlier Last Summer


More important, the state of EM finances has been declining precipitously over the last several years. Studies from the BIS and the Bank of England show that over the last several years, large foreign inflows into EM countries have enabled EM credit levels to rise sharply. As such, credit-to-GDP gaps in most EM economies have risen to levels not seen since the 1997 Asian Crisis, as shown below. With EM outflows now accelerating–and with the Chinese and other EM economies experiencing dramatic slowdowns–I expect EM assets to underperform for at least the next several months. Furthermore, recent corruption scandals in Turkey are reminding investors that political risks in these countries is still quite high. There may be a buying opportunity in EM equities during Q2 or Q3 2014, but for now, stay away.

Chart 2: Credit-to-GDP Gap in EM Economies – Higher than that During the 1997 Asian Crisis


Record Rise in Margin Debt Outstanding = Single-Digit U.S. Stock Returns in 2014

In a May 24, 2007 commentary titled “Leverage, Leverage, and more Leverage” (four months before the peak of the last bull market), I emphatically stated: “Despite what the mainstream media says, there are now signs that liquidity conditions are deteriorating … Make no mistake: This “pillar” of liquidity [subprime lending] of the U.S. housing market has fallen and will have a depressing effect on the U.S. housing market and on U.S. households’ liquidity for many years to come.

By early October 2007, I was discussing why I was short the U.S. stock market and why investors should be trimming their equity long positions.

We believe there are 3 distinct pillars to superior investment performance: 1) Investing in non-correlated strategies (e.g. Japanese stocks in the 1960s and 1970s), 2) the ability to find inefficiencies in selected markets (e.g. private real estate or the ability to influence markets, such as that of PIMCO), and 3) recognizing shifts in investment regimes ahead of the curve, and adjusting one’s asset allocation or investments accordingly.

If an investor or adviser has no ability to engage in 1), 2), or 3), then he or she should leave the industry and do something else. This certainly applies to most advisers and investment managers I have met.

But I digress. Back in May 2007, we recognize that there existed unprecedented leverage in the global financial system–and more important, the availability and ability to pile leverage on leverage was drying up. The desire to speculate using immense leverage was not limited to the subprime or LBO markets. Consider that Japanese households were actively engaged in the Yen carry trade, with margin currency trading increasing by 41% to US$896 billion in the Japanese retail market during 1Q 2007 alone. In fact, Japanese individuals were responsible for as much as 30% of all FOREX trading in the Tokyo time zone by early 2007.

Another leverage indicator was U.S. margin debt outstanding. We like to use this age-old, proven benchmark to measure the amount of speculation in the U.S. stock market. While we recognize that both institutions and high net worth individuals can gain access to leverage through futures or OTC swaps, the amount of U.S. margin debt outstanding is much more transparent and is reported monthly. More important, the rate of change in U.S. margin debt outstanding has had significant correlation to other leverage indicators, as well as major peaks and troughs in the U.S. stock market.

For example, in the same May 24, 2007 commentary, we mentioned that the six-month increase in margin debt ($74 billion) had risen to its highest level since March 2000, while the 12-month increase ($77 billion) rose to its highest level since September 2000. We also mentioned that the 12-month increase in margin debt for month-end May 2007 would rise again. In fact, margin debt outstanding rose by $40.2 billion for the month of May 2007 alone. The 12-month increase in margin debt outstanding would eventually surge to a record high of $160 billion by the end of July 2007. At the time, we believed–at the very least–a significant correction was at hand.

Fast forward to today. Many of our stock market indicators are overbought (see our January 10, 2014 commentary “The Message of the CB Capital Global Overbought-Oversold Model“). In our December 22, 2013 commentary (“CB Capital’s 2014 U.S. Stock Market Outlook: Cautious and Moderately Bullish“), we asserted that U.S. stocks in 2014 will return in the single-digits, i.e. 5% to 10%. Furthermore, the latest margin debt numbers (as of December 31, 2013) also suggest of a highly overbought U.S. stock market, as evident in the below chart. In fact, the 12-month increase in margin debt has risen to $123 billion–the highest level since July 2007, and certainly the highest level since the current bull market began in March 2009. Seen in this context, even a single-digit return outlook in U.S. equities in 2014 could be construed as being too optimistic.


The Message of the CB Capital Global Overbought-Oversold Model

I hope all our clients are off to a great start this year. If we could summarize our long-term global outlook in one word, it’d be “transformation.” e.g. Most U.S. college students are being forced to re-evaluate their life options, as 1) a university degree is no longer a ticket to sure-and-life-time employment, and 2) rising tuition costs mean opportunity costs of attending college (versus entering a trade) have become cost-prohibitive for many Middle Class Americans. A constant debate at CB Capital has been whether the rise of the American Middle Class in the mid-20th century was an anomaly–or if, more likely (in my opinion)–we are seeing the rise in the Global Middle Class, and that the American Middle Class is meeting them half-way.

Another structural force that is putting pressure on the wages of the Global Middle Class is the rise of “Smart Machines.” A decade ago, it was still too expensive to automate most tasks–even repetitive tasks with the exception of auto manufacturing and semiconductor production. In many ways, increasing automation over the last decade was simply an extension of a trend in place since the dawn of the Industrial Revolution in the late 1700s, i.e. automate simple, repetitive tasks through more capital intensive processes. The rise of Smart Machines is now altering the fundamental fabric of working labor, especially among Emerging Market Countries. In the past, upstart EM countries were able to industrialize (e.g. China in the 1980s to 2000s) by taking advantage of their low-cost labor and a significant export market. The rise of lower-cost, Smart Machines will put an end to this, as we will discuss in our 2014 inaugural global macro issue.

“Transformation” and structural trends notwithstanding, we are also big believers in “reversion-to-the-mean” trades. At the same time, we believe in the increasing evolution of the global human condition, so we (for the most part) don’t believe in shorting overvalued markets as measured by traditional benchmarks such as P/E or P/B ratios. We do, however, like to go long in distressed or oversold opportunities, as long as the long-term economics make sense.

Our global macro commentaries have always been more tactical and granular. We have discussed individual commodities, as well as certain conditions in specific countries, such as China and India. For most of our clients, we realize it is very difficult to keep track of all country-specific market indices and new international ETF products. To that end, we have constructed a simple model designed to keep track of the overbought/oversold conditions in all Developed and EM investable countries and regions as tracked by the MSCI indices.

The inner workings of the CB Capital Global Overbought-Oversold Model are rather simplistic. For each country or region, we first compute the month-end percentage deviation from its 3-, 6-, 12-, 24-, and 36-month averages. Each of these percentage deviations are then ranked (on a percentile basis) against all their monthly deviations stretching back to December 1997 (May 2005 for the MSCI Frontier Market Index). This way, we are comparing apples to apples and can control for country- or region-specific volatility. Following is our Global Overbought-Oversold Model readings for the major indices and Developed Markets as of December 31, 2013.

Global Overbought Oversold Model Dec 2013 1

All the percentile rankings highlighted in red or green represent rankings: 1) in or below the 10th percentile, and 2) in or above the 90th percentile, respectively. That is, relative to the historical percentage deviations of the same country or region, a ranking highlighted in red is more oversold than 90% of its readings going back to December 1997; while a ranking highlighted in green is more overbought than 90% of its readings. For example, the world’s developed markets (MSCI World) is highly overbought on a two-year time frame, as its current price level’s deviation from the two-year average is higher than 94.2% of all historical deviations going back to December 1997. Similarly, the U.S. stock market is now highly overbought on a two- and three-year time frame. This is one reason why–as discussed in our 2014 U.S. Stock Market Outlook–we are more cautious on U.S. stocks this year, even though we do not foresee a peak in U.S. equity prices anytime soon.

Note that Emerging Markets is only mildly oversold on all time frames. Such readings do not guarantee above-average returns this year, especially with challenging fundamentals such as social conflicts and deteriorating trade deficits (e.g. India, Indonesia and Brazil). Following is our Global Overbought-Oversold Model readings for Emerging Markets as of December 31, 2013.

Global Overbought Oversold Model December 2013 2

Despite the recent selling in Thailand and Turkey, none of the readings for EM countries are sufficiently oversold to warrant even a speculative trade on the long side. When it comes to reversion-to-the-mean trades, investors better make sure the underlying story has not changed–or else, an oversold condition could turn into a market crash (e.g. purchasing Japanese stocks during WWII, Asian bank stocks in 1997, or money-losing U.S. tech stocks in 2001). At this point, Thailand is only oversold on a 3-month time frame; its longer term readings are not attractive enough to warrant a long position, given the country’s current societal conflicts and political uncertainty. A much better trade would have been going long on the MSCI Germany (could be readily purchased through the MSCI German ETF) in December 2011, when the index was highly oversold on both a 3- and 12-month time frame. A long position taken on the MSCI German ETF at the end of December 2011 would have returned 32.1% in the next 12 months–far outpacing a long position in Developed Markets (MSCI World: +16.5%) and the U.S. (MSCI U.S.: +16.1%).

Again, note that the above model is a price-only model and therefore doesn’t take into account valuations. As has been emphasized, it also does not work well for countries that are experiencing secular changes, or for timing peaks in the stock market (the quickest way to lose money is shorting a market or a stock that has high positive momentum and/or high valuations). One thing that comes in very handy, however, is the model’s ability to evaluate oversold countries/regions and to provide initial ideas on the long side. Going forward, we will update this as appropriate for our clients.

CB Capital’s 2014 U.S. Stock Market Outlook: Cautious and Moderately Bullish

At 12:01 pm, on Thursday, September 20, 1920, a bomb exploded outside 23 Wall Street, the worldwide HQ of J.P. Morgan & Co. The massive dome on “The Corner“–the pride of J.P. Morgan–shattered. Dwight Morrow, Morgan partner, college friend of Calvin Coolidge, and later ambassador to Mexico, was hit and suffered cuts and bruises. 38 people died and 143 were hurt. The “Wall Street bombing” took more lives than the 1910 bombing of the Los Angeles Times building–the deadliest act of domestic terrorism up to that time.

All of the ticker machines inside the offices of J.P. Morgan & Co. were destroyed–save one. The clacking noise of Clarence Barron’s Dow Jones ticker machine could still be heard–printing out news of the bombing, speculation on the consequences, and news that the NYSE will reopen the next day. The clacking on the Dow Jones ticker machine sent a clear message to the terrorists, anarchists and socialists: U.S. commerce–and the U.S. entrepreneurial spirit –will not be stopped.

Indeed, the 1920s would come to be known as the “Roaring Twenties”–one of the most prosperous times in U.S. history.

A review of 2013 shows something extraordinary: The S&P returned 30% YTD, while the Russell 2000 of U.S. small cap stocks returned 34%. The performance of U.S. stocks in 2013 ranks as the 8th best performing year going back a century. In our 2013 outlook last year, I gave Developed Markets (which includes Canada, Western Europe, Japan, Australia, Singapore, and Hong Kong) a return rating of “7,” suggesting an above-median return. I was also relatively bullish on U.S. stocks versus other developed markets. I (Henry) expected U.S. stocks to return in the mid- to high-teens. An inherent optimist, even I did not anticipate that U.S. stock market returns would hit 30% this year (we were more bearish on emerging markets equities–but we certainly did not foresee their -6% return this year).

With the exception of the Greek (+39%), Finnish (+38%) and Irish (+37%) markets, the U.S. was the best-performing stock market in the world this year. The U.S. Consumer Discretionary sector returned 40%, while Healthcare returned 39%. This extraordinary performance in U.S. stocks sends a strong signal to the doubters, the terrorists and socialists: U.S. capitalism remains alive and well. U.S. commerce, innovation, and ingenuity will not be stopped.

That said, we are much more cautious on the U.S. stock market outlook for 2014. As mentioned, this year’s performance of 30% was extraordinary, especially with the major U.S. indices making all-time highs week after week. In our opinion, the market has already discounted a stable global macro environment, improving U.S. employment in higher-paying healthcare and engineering professions, as well as future productivity improvements stemming from increasing automation and the U.S. energy revolution. As such, we believe U.S. stocks will return 5% to 10% in 2014, or slightly below the historical average. We anticipate the S&P 500 to settle in the 1,900 to 2000 range by the end of 2014. This is equivalent to a return rating of “4″ for Developed Equities (on a scale of 1-10).

As part of our 2014-16 “barbell” investment strategy, we recommend selective risk-taking within various industries in the global equity markets. As discussed in our latest issue (please contact us for a copy), we believe there will be a buying opportunity in gold (-29% YTD) and low-cost gold producers sometime in H1 2014 (note that we recommended a short position in gold in January of this year). More details are forthcoming in our next global macro newsletter in January 2014.

I now want to address a couple of clients’ questions or concerns regarding valuations of U.S. equities. Firstly, yes, U.S. stocks are the most expensive relative to that of Europe, Japan, or Emerging Markets (using traditional ratios such as P/E, P/B, and PEG). While we are slightly concerned (this is why we are only targeting a 5-10% return in the S&P 500 in 2014), clients should recall that valuations–even on an individual stock level–have not been a great timing indicator. Firstly, none of our proprietary fundamental, technical, or sentiment indicators are flashing strong sell signals–signals that were paramount to us exiting/shorting the U.S. stock market during the March 2000 and October 2007 peaks. Secondly, the valuation factor (namely, the price-to-book ratio) only comes second to the momentum indicator (12-month price change) in terms of predicting performance in relative individual stock timing. In fact, investing in value stocks (i.e. cheaper on a P/B basis) has been a big loser for sustained periods of time, namely the 1930s, the late 1990s, and 2007-08. One academic study after another has shown that momentum investing is superior in most periods in global stock market history.

That said, we certainly keep track of valuations–both absolute and relative valuations. We never bought the S&P at a trailing 40 P/E ratio in early 2000; we became very concerned once the 10-year Treasury yield rose above the S&P earnings yield in late 1999. As of December 19, 2013, the S&P earnings yield (chart below courtesy Goldman Sachs) is still 3.5% higher than the 10-year Treasury yield. This 3.5% yield gap is just below its 10-year average but is still high on a historical basis (1976-present). That is, U.S. stocks are still cheap relative to U.S. Treasuries.

GSvaluationFinally, after 18 months of consistent outflows, U.S. equity fund flows turned positive in January this year (source: ICI). By the summer, investors began rotating their investments from bonds to stocks for the first time since late 2008 (chart below courtesy Goldman Sachs). Since fund flow trends tend to last for many months (401(k) investors don’t change their investment selections very often), we believe U.S. equity fund inflows will remain strong in 2014–further supporting U.S. stocks. We will not become concerned until the S&P 500 rises above 2,000 or the 10-year Treasury yield surpasses 3.5%.


A Component of our Barbell Investment Strategy: U.S. Commercial Real Estate

Long-time readers will know that I (Henry) have been advocating a consistently bullish position on the U.S. economy, citing the U.S. energy production renaissance, the technology revolution driven by additive manufacturing, cleantech, and finally the general adaptiveness of the U.S. entrepreneurial class and capitalist system. We have been especially bullish on U.S. commercial real estate. While commercial and multi-family real estate prices have risen substantially in prime, “trophy” markets over the last 12 months, we believe there remains numerous investment opportunities in the non-trophy areas–i.e. properties that have not been sought out by international investors.

Specifically, much of the CMBS originated during the bubble period of 2004, 2005, 2006 and 2007 will be maturing over the next four years. As shown in the chart below, approximately $500 billion of CMBS will mature during 2014-17. Given the aggressive underwriting standards during 2004-07, much of these maturing CMBS will not qualify for refinancing. In other words, there will be significant forced selling of U.S. commercial real estate properties over the next four years. We believe such forced selling represent a once-in-a-generation buying opportunity for clients looking for steady cash-flowing properties and as a hedge against future inflation or US$ devaluation.

CMBSmaturitiesSource: AEGON, Trepp

Investing in U.S. commercial real estate or multi-family housing is a sound strategy for a wide variety of investment or economic scenarios, especially in a world experiencing significant social and economic change. The decades surrounding the turns-of-the-century have typically ushered in revolutionary change. e.g. A person who fell into a coma in 1790 and woke up in 1820 would no longer recognize the world. France has lost its dominant position as a European power, while England began its empire-building ambitions. After the War of 1812, the U.S. cemented its position and was no longer a fragile republic dependent on England. Similarly, a person who fell into a coma in 1890 and woke up in 1920 would find himself utterly confused. The U.S. replaced England as the world’s dominant industrial power; Europe’s map had been reorganized and many of the 19th century empires no longer existed (e.g. Austria-Hungary and the 2,000-year old Chinese dynastic system). 37 million perished during WWI, while the terms of the Treaty of Versailles would sow the seeds for WWII. Trust companies, such as Standard Oil and American Tobacco, were busted, while the Federal Reserve sprang up among the ashes of the Panic of 1907.

Fast forward to 1990. A person who has been asleep in the last 23 years would not recognize the world today. The Soviet Union, our greatest enemy, no longer exists. Japan, slated to become the world’s most powerful economy, is no longer (that) relevant. Instead, China is now regarded as America’s greatest competitor. In 1990, India’s economy was close to collapse–today, it is the world’s 9th largest economy–just behind that of Italy and ahead of Russia. Instead of an Indian bailout, the world bailed out Greece, Ireland, Portugal, and Spain. Italy came close to needing a bailout–an unimaginable scenario just a decade ago.

We are also enjoying a new domestic energy revolution, driven by productivity in shale drilling, horizontal drilling, and Lower Tertiary drilling. Solar is already replacing base-load power generation in Germany during a sunny day. By 2020, California will source 33% of the state’s energy from renewables.

On the other hand, there remains significant, new challenges to the U.S. economy and society. Overall debt levels remain high, while unfunded liabilities–in the form of future retirement and healthcare benefits–will bankrupt some developed countries if they are not curtailed (the present value of unfunded U.S. Social Security and Medicaid benefits is more than $60 trillion). Unless we implement more efficient healthcare cures and delivery services, we will inevitably default on these benefits–through more stringent eligibility requirements, inflation of the U.S. dollar, or outright default (Detroit is going through this as we speak).

In other words, both the U.S. economy and society will undergo significant fundamental changes over the next 5-10 years–for good or for ill. We thus recommend a barbell investment strategy over the next 5-10 years, i.e. selective risk-taking while employing a sound capital preservation strategy (contact me for more info). We believe our recommended position in U.S. commercial real estate or multi-family housing is a very attraction option on either end of the investment barbell, i.e. it should do well in the vast majority of different scenarios we could possibly imagine–either significantly higher inflation or a society transformed by clean energy and automation (e.g. self-driving cars). The maturity of approximately $500 billion of CMBS–which will trigger significant selling from motivated sellers during the next several years– is thus a perfect opportunity to purchase commercial real estate or multi-family housing to take advantage of these fundamental, macro trends that we foresee over the next 5-10 years.

U.S. Shale Depletion Worries are Overblown

Note: Drilling in the Lower Tertiary over the last three years indicate an additional 15 billion barrels of recoverable oil remain in the Gulf of Mexico. To put this in perspective, the EIA estimates U.S. total oil reserves of 26 billion barrels. An additional 15 billion barrels of reserves will propel the U.S. from 14th to 10th in a global ranking of countries with the most recoverable oil reserves. Because of this, Wood Mckenzie projects oil production in the Gulf of Mexico to reach 2 million barrels/day by 2020–up from 1.3 million barrels/day to a record high. As we have mentioned, the days of U.S. energy independence–fueled by a renaissance in domestic production, as well as significant investments and breakthroughs in renewable energy–are inevitable. Drilling and production in the Lower Tertiary is simply another part of the energy independence equation.

Onto our main commentary: The worries over oil and gas well depletion rates are nothing new. During the 1970s, natural gas wells in Texas only averaged a 16% first-year decline rate. By the late 1990s, this hit an all-time high of 56%. As a young natural gas analyst in Houston, TX during 2000-01, I was stunned by these high depletion rates, and was convinced that domestic natural gas production would more than halve over the next decade.

TX Decline RatesSource: Oil & Gas Journal, Gary S. Swindell & Associates

At the very least, such depletion rates, even with flat demand growth, would require a substantial amount of Canadian and LNG imports. Obviously, this turned out to be a false assumption, courtesy of the adoption of horizontal drilling rigs and the commercialization of shale fracking. Here’s what I learned: Higher depletion rates were not a function of less productive wells; rather, they were a function of better extraction technologies, as well as investors’ demand for higher IRRs at the expense of higher long-term production if short-term production was capped (IRRs increase substantially if production, and thus monetization, is front-loaded). We simply turned into a culture where we could and did suck out the oil and gas faster than ever before.

Make no mistake: It is important to track and analyze depletion rates in the six most prolific shale areas–the Bakken, Eagle Ford, Haynesville, Marcellus, Niobrara, and Permian–as these six key fields accounted for nearly 90% of domestic oil production growth, and nearly 100% of all domestic natural gas production growth during 2011-12.

dpmapv3-wtitleTo that end, the Energy Information Administration (EIA) publishes a monthly “Drilling Productivity Report” that tracks depletion rates of legacy fields and initial production rates of new fields in these six key shale plays. As long as initial production on new fields outpaces the decline in production of legacy fields, the increase in oil and gas production in these six shale plays will continue. The latest evidence suggests this remains true. For example, early indications in the Eagle Ford Shale suggest that both oil and natural gas production rose to another new high this month, as production from new wells outpaces the decline in legacy production.


Finally, current rig counts and recent productivity gains in both the Bakken and Eagle Ford regions suggest new production growth should comfortably offset future decline rates. In addition, production growth actually accelerated in the Niobrara and Permian. In other words, there is ample evidence suggesting that shale oil and natural gas production in these six shale areas will continue to grow–and to drive U.S. energy independence–for months, if not years to come.



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