Recently I explained not only three reasons why income investors can expect Kinder Morgan Inc (KMI 3.46%) shares to soar in the long term, but also why Kinder Morgan makes for one of the best retirement stocks you can buy. However, one of the most important investing principles for long-term investing success is to control your fear when the market is crashing.
As Warren Buffett famously said, you want to "be greedy when others are fearful, and fearful when others are greedy."
It is not my intention to frighten anyone out of investing in Kinder Morgan, but to prepare investors for when the next crash occurs. By knowing ahead of time what risks Kinder Morgan shares face, you're more likely to buy shares at the optimum time and maximize both long-term returns.
Prolonged low natural gas prices in key markets
Henry Hub Natural Gas Spot Price data by YCharts.
This chart illustrates natural gas prices in three of the largest international markets: Japan, Europe, and the U.S. As you can see, the price can be highly volatile and is highly correlated with economic activity.
Analyst firm Wood Mackenzie projects that by 2024, both the demand for and supply of U.S. natural gas will increase 36%, driven by strong demand for liquefied natural gas (LNG) exports (to Asia and Europe), and U.S. power plants switching from coal to natural gas because of tougher CO2 emission regulations.
This increase in gas supply is the key near-term growth catalyst for Kinder Morgan, and prolonged economic recessions in key markets, such as Europe and Japan, could see demand for natural gas fall. This would reduce gas prices in these countries and decrease the demand for imports of U.S. gas, which might see Kinder Morgan's growth prospects decline from current estimates.
How likely are such recessions? Well, the IMF recently cut its 2014 global economic growth projections by 11% because of slowing economies in Europe, Japan, China, and South Korea.
It also warned that the probability of a European triple-dip recession had doubled from its earlier April forecast, to 38%. This is largely because of a slump in the continent's largest and most important economy, Germany, which reported -0.2% economic growth for the second quarter.
Meanwhile, Japan, the world's third largest economy, recently revised its second-quarter GDP growth figures from a terrible -6.8% to an even worse -7.1%. The cause was a 5.1% decline in consumption caused by the first sales tax hike in 17 years. Like Germany, Japan is now facing its worst economy since the financial crisis of 2009.
U.S. market correction
As my Foolish colleague Morgan Housel pointed out last year, the S&P 500 typically undergoes a 10%+ correction once per year. Despite the recent market decline (which peaked at a 7.5% decline), the market has now gone 3 years since its last double-digit percentage drop, making us overdue.
While many people cringe at the thought of such an event, corrections are a natural and necessary part of a healthy bull market cycle. This is because they allow valuations to return to more normal levels, resetting the market and priming it for further highs in the future. The result of nearly three years of a correction-less bull market is a cyclically adjusted P/E ratio (CAPE) of 25.53. Why does that matter?
Famed Yale Economist Robert Schiller invented the CAPE, which measures the inflation-adjusted average P/E ratio of the last 10 years, as an improved tool for determining when the market becomes overvalued. Historically, the median CAPE of the market since 1870 has been 15.93. During the recent market peak, the CAPE hit 26.12, indicating the market was 64% overvalued on a historical basis.
| Period | CAPE at Market Peak | Stock Market Decline |
|---|---|---|
| 1929-1932 | 33 | 85% |
| 1937-1938 | 22 | 45.30% |
| 1969-1970 | 21 | 27.60% |
| 1973-1974 | 19 | 42.50% |
| 1987-1988 | 18 | 19.70% |
| 2000-2001 | 42 | 29% |
| 2002-2003 | 30 | 27.50% |
| 2007-2009 | 27.3 | 51% |
| Historical Average | 26.54 | 40.95% |
| Recent Peak | 26.12 |
Sources: Multpl.com, "Don't Count on Soft Landing for Stocks" by Shawn Tully, Fortune magazine.
Please don't get me wrong: I'm not claiming a bear market, economic recession, or market crash are imminent. However, I provide this table to illustrate the important purpose a market correction serves. By deflating stock prices to more historic levels, a correction allows corporate earnings growth to catch up to share prices, thus allowing for a sustainable bull market in the future.
Political/water shortage risks to fracking
The U.S. Energy Information Administration (EIA), estimates that U.S. gas production will increase steadily through 2040.
This decades-long megatrend is why analyst firm IHS is projecting $640 billion in new midstream infrastructure investment through 2035, which represents a major growth catalyst for Kinder Morgan.
However, these projections don't take into account the potential for water shortages or political factors to derail the American fracking revolution.
On average, it takes 4.4 million gallons to frack a single oil or gas well, enough water to supply 11,000 average U.S. families for a day.
With the Western U.S., including gas-rich California and Texas, a severe drought is helping to fuel growing political opposition to the practice.
For example, in May, Santa Cruz county in California voted to ban fracking citing a concern over water usage and potential ground water contamination.
Even in frack-happy Texas, the technique is under threat. Recently, fracking opponents in Denton, Texas, got a referendum on this November's ballot that would ban fracking. Passage of the ban would likely result in major litigation battles, pitting oil and gas companies, royalty owners, and even the the state government against local communities.
Something similar occurred in Colorado, where in August, only a last-minute deal kept a referendum off the ballot that would allow local municipalities to ban fracking, which the state warned would trigger lawsuits against those cities that did so.
While I don't expect America's fracking boom to be completely halted by such political/water concerns, I do think investors should be aware that the risk of our nation's gas boom slowing faster than expected does exist.
Bottom line
Make no mistake about it, I love Kinder Morgan as a high-quality, high-yield dividend growth stock, and I think it should be on every investor's radar. I fully expect it to be one of the best long-term dividend investments in America, but there are short-medium-term risks that could send the share price crashing. By being aware of these risks, you are better prepared to buy when the price does crash, locking in great yields and improving your chances of beating the market in the long-term.
