Catching The Falling Knife

Six month chart of Schlumberger (SLB)

from Charles Schwab

I have always found it somewhat comical how Wall Street comes up with expressions and metaphors to describe certain events and circumstances in the market, often without some explanation about what the terms are supposed to mean. A "Black Swan" event, for example, refers to some development or crisis that is totally unexpected, out of the blue. That is the experts' way of warning that something really bad could always happen that would roil the markets, but we don't know what that might be or when it might happen. Well, of course that is true. That is also known as "life." More colorful, albeit morbid, is the "Dead Cat Bounce," intended to describe a stock that is in a downtrend but pauses for a temporary move to the upside. Apologies to cat lovers everywhere. The "Risk On" trade is when investors and traders are favoring riskier assets such as stocks; "Risk Off" means they are piling into less risky assets such as Treasury securities. More obvious in meaning is the subject of today's post, timely because investors might be tempted to search for bargain stocks among the ruins of the energy sector. The danger with falling stocks is that they just might keep falling, inflicting a different kind of pain that is no less real than the wound from an ill-timed grasp at that falling knife.

Even someone whose only understanding of Wall Street is from watching Leonardo DiCaprio as the "Wolf" of that storied location probably knows that investing is all about buying low and selling high. So, it would be logical to conclude that a good time to buy energy stocks is when everyone else is throwing them away, that time being about right now. But here we need to understand two qualifiers to the general "buy low" rule. First, just because a stock has declined in price by a significant amount does not make it a bargain. If that $200 shirt you've been eyeing gets marked down to $100, it probably is a bargain, assuming you are going to wear it. (I could point to a few items in my closet that I bought primarily because they were marked down--I never wear them). If I buy the shirt at $100, I'm going to be quite frustrated if I then see it marked down to $50. My sense of having scored a bargain will evaporate quite quickly. At least, though, I have the economic "utility" of a shirt on my back, something that stocks offer only when they go up. Yes, we buy stocks so they will appreciate in value, and that brings us to the second point, a piece of wisdom offered by an analyst on CNBC (can't recall his name): "Valuation in and of itself is not a catalyst." That's important, because it reminds us that the unrelenting question we should ask about any stock is, What is Going to Make This Stock Go Up?

Where the oil stocks are concerned, we strongly suspect that it will take a mighty recovery in the price of oil to lift the shares out of the doldrums. I am amazed at the number of people who seem to think that oil, having fallen more than 50%, has hit its low, and that the risk is that the price per barrel will just languish here. Let's examine that assumption more closely, using the above graph of Schlumberger (SLB, $77) as our point of departure. SLB is the bluest of the blue chips in the oil service sector, and the decline in its share price from $118 to $77 ( about 35%) makes for a tempting investment. Furthermore, the stock pays an annual dividend of $1.60, which at a share price of $80 translates into a 2% yield. Before the stock broke below $80, I considered making the case that $80--and the resulting 2.0% dividend yield--would provide support--the lower the stock price of SLB goes, the higher its dividend yield, something very compelling in a world of rock-bottom interest rates. But that is assuming that business does not get so bad for Schlumberger that they have to cut the dividend. With a dividend payout ratio of just 30% (12 month earnings of $5.32), there is some cushion here, at least for now. But things could get a lot worse for stocks in the oil sector if the price per barrel of the commodity falls even further, as some analysts have suggested it just might, to somewhere around $40.

The economics behind all of this is that oil is a commodity. Unlike Proctor and Gamble (PG, $90), which can slap a brand name on some sodium flouride and call it "Crest toothpaste," the oil companies are faced with a price of oil that is set in the overall market, and no individual company pumping the stuff out of the ground can affect that price (OPEC could, but they have refused to cut production). If you were selling another commodity, say cotton, for example, as a cotton farmer, you would face the same situation. And if the price of cotton falls dramatically, your income would suffer, and you might postpone purchasing that new tractor you've been considering. That's exactly what's going on in the energy sector. The oil companies will not be making as much money, and so their demand for the services of SLB is going to wane. The price of oil has to fall far enough to sideline capital expenditure projects until, at some point, supply comes back into balance with demand. That's just how commodity cycles work. That's what economists call a "new equilibrium," and no one really knows whether that price is $50 or $40 or something lower. And no one knows when this will happen. So we have the issue that oil prices have fallen so much, and we don't know how much further they might fall, and we don't know when they might recover. This paints a pretty ugly picture for the sector, and every enterprise that depends on it.

So, even as consumers enjoy the boost in real income resulting from cheaper energy, there is much carnage unfolding in the energy sector. Some of the marginal operators have issued a lot of debt in the junk bond market, so we might see some dominoes start to fall there. The boost to the economy from lower energy prices is thought to outweigh the negative effects in the energy sector, and that is probably true if the deflationary pressures don't spread too far and wide. I am just thankful that I don't own a truck stop in the North Dakota oil fields.

Life is short. Get busy.

Jim 

Disclosure/ Disclaimer: My family members and/or I own shares of SLB and PG. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as the advice to buy or sell any security.