The chart below shows the forward p/e ratio for the S&P 500. Valuation has come down significantly over the past few months, and now sits just below the 10 year average.
This doesn’t necessarily mean the market is a ‘buy’ right now. As legendary investor (and one of the few to experience several market cycles) Bob Farrell wrote in his 10 rules: “Excesses in one direction will lead to an opposite excess in the other direction.”
Because I know you’re wondering, here are the rest of Bob Farrell’s 10 rules for investing:
- Markets tend to return to the mean over time
- Excesses in one direction will lead to an opposite excess in the other direction
- There are no new eras — excesses are never permanent
- Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways
- The public buys the most at the top and the least at the bottom
- Fear and greed are stronger than long-term resolve
- Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names
- Bear markets have three stages — sharp down, reflexive rebound and a drawn-out fundamental downtrend
- When all the experts and forecasts agree — something else is going to happen
- Bull markets are more fun than bear markets
While the market isn’t a screaming ‘buy’ right now, one sector stands out: Energy. Not only is the Energy sector forward p/e the lowest of all sectors, it is about 1/3 below its 10 year average.
With WTI around $110-115 and natural gas around $8.30, energy producers are poised for a fantastic Q2 (and beyond, if prices hold up). Anecdotally, I’ve heard that most energy companies don’t plan to plough excess cashflow back into the business. This means higher dividends, stock buybacks and debt repayments. Furthermore, the lack of investment will tighten future supplies while the world re-opens (including China, which has announced measures to relax lockdowns) possibly putting a floor under energy prices.
While high energy prices might be great for energy companies, it’s not great for civilization in general. Fossil fuels are used to produce and transport food. Natural gas is used to create fertilizer. Energy is needed to deliver products. Petroleum is used to produce plastics and chemicals.
Energy is life.
Modern humanity is built off the back of kilojoules made available by hydrocarbons. At a low extraction cost, fossil fuels provide a windfall for humanity as the benefits (excluding negative externalities, such as pollution) far outweigh the costs.
Look around. Assuming you’re not sitting on a beach somewhere, almost everything you see was made possible by fossil fuels. In fact, cheap and easily accessible kilojoules provided you an abundance that our ancestors would disbelieve.
Consequently, rising cost of energy = rising cost of life.
“Drill baby drill”, some will say. The trouble is new easily accessible oil reserves are not easily found anymore. New projects require higher prices to be feasible. Moreover, the external consequences of additional fossil fuel use is becoming apparent as average global temperatures slowly climb.
The world is stuck between a rock and a hard place. Consuming more energy will lead to worse weather events, leading to higher food prices. Producing less energy will lead to higher energy prices and the cost of everything rises. So where does the cost of living go over the long term?
If we are on the path to continuous high prices combined with declining marginal productivity (because a kilojoule now costs more), incomes won’t keep up and an increasing amount of personal resources will be devoted to paying for basic needs at the expense of discretionary items. Ultimately, this will lead to the slow destruction of purchasing power and standard of living, and a widening of wealth inequality. If this continues, ultimately the broadly-dispersed wealth – the backbone of the middle class – created during the last 100 years will gradually erode.