Here is Don Cox: I think his theory that the the weakness in the last three weeks is that hedge funds got called in when the yen carry trade was threatened with Japan raising interest rates, vs worldwide economic recession causing the fall is profound and valid looking at it straight on.
I just wish he would not whack my heros like Spitzer and Soro's so much-lol.
"Volatility With A Capital V"
Thank you all for tuning into the call which comes to you from Toronto.
The
chart that we faxed out was the Toronto Stock Exchange Capped Metals Index
since the beginning of the year and the comment was "Volatility With A
Capital V".
So, what I want to do is talk about the wild price swings we've been having
in the commodity stocks and to illustrate once again - I didn't plan this,
because I didn't know this at the time I did this - that Japan would blink
and that all of a sudden we would go back to lower volatility. But we've
established this week, for anybody who ever doubted it that the key to
understanding what's been going on in the global markets is the monetary
policy of the Bank of Japan. Notwithstanding that 99 and 44/100% of the
people who talk and write about it follow what the Fed is doing.
Okay, let's talk first of all about the huge swings that we've seen in the
mining stocks and the oil stocks as a result of the big pullback that we
had
in the commodity prices. Now as you know, those of you who listen to the
calls, the key to understanding what was happening in the commodity futures
was that the hedge funds who had been short those in the past, because they
followed Wall Street research, decided to get long. That helped to
contribute to the oil contango. And then, once they saw, having read the
reports from Phelps Dodge and then from Newmont, seeing that how much the
big mining companies were short on the metals, they decided that these
companies would not be prepared to add to their hedge positions if metals
prices rose, which meant that they had a free chance to go long, knowing
that they had a short squeeze on.
And it's one thing if you've got a short squeeze on but the party you're
trying to squeeze has got limitless resources. In this case, since they
produce the stuff, they can't really go broke, except on a technical, short
term basis. But, if you figure that what they are is the deer frozen in
the
headlights, that they've been getting beaten up too badly by it, then what
you do is you really ratchet it up and in this case, copper prices rose
100%
at the peak, in a matter of a few months.
And so, this was near catastrophic for the big copper companies which sold
short. But their response was really to stay out of it until, I gather,
very, very recently.
But meanwhile, you've got to use money for this. And as long as the BOJ
was
supplying it to you at 0.36%, it wasn't costing you much to take these
bets,
and of course they're levered bets anyway, because you're buying commodity
futures.
So, the huge parabolic moves that we saw in copper, zinc and aluminum and
gold, were ones where what you had was the combination of big short
positions by the mining companies and the hedge funds and they tend to
trade
together, saying "We've got them now, let's have some fun." And then the
Bank of Japan announced it was abandoning its zero interest rate policy.
And what we've seen is that risky asset classes of all kinds sold off.
Emerging markets...what happened to Bombay's exchange bombed, indeed. Just
a devastating sell off there. Emerging markets bonds, junk bonds, the
small-cap stocks versus large-caps...you name it. Everywhere where the
hedge funds had narrowed in the risk spread using the cheap borrowed money,
all of these spreads widened out. And in the case then of the metals and
oils commodities as they were forced out of their positions what we had was
a plunge in prices. I mean, copper, it went down as much as ninety-six
cents off its high. Gold which was at $720 got down to about $625, I mean,
this was just wild stuff. And of course what it made people think was
maybe
we're near some sort of crash.
In addition, what it did, was operated as a spring tonic for the gloomsters
who having been so upset by what's happened to commodities, were able to
come out, once again, along with the blossoms and proclaim that the
commodity bubble is bursting. May, each year, has been the time of this.
So, there's a seasonality to it and I'm not suggesting it's horticultural
in
nature, but what it does mean is that stocks such as CVRD and Phelps Dodge,
Freeport McMoran, these stocks get trashed at this time of the year. And
the only thing that I can see that's related to it is that what you have is
plant shutdowns in Germany in the summer. And Germany's such a huge
consumer of metals, so that what you get is a narrowing in of the forwards
on some of the metals at this time of the year. But that's really reaching
for it given the fact that we're down to two days inventory in copper.
So, let's just say we were ready for a sell off anyway and then once you
started taking the liquidity away from the hedge funds, then this was a
rout.
Now, how big are they? Well, for those of you who doubt the size of the
hedge funds, I invite you to look at today's FT, with an account of how
much
money the hedge funds made last year. And how much money they made last
year compared to the year before. And it's quite impressive. Because the
number one guy, Simons, took out a billion and a half. And Steve Cohen
who,
you know, always was near the top increased his earnings from $300 million
to $530 million, but fell back in the ranking.
So, it turns out to be in the top twenty-five, you need to make a huge
amount of money now, whereas before you got into the club pretty easily.
So
you would conclude from reading about the hedge funds profits at year
end...George Soros was $840 million last year, another good year for
somebody who proclaims that what the United States needs to do is raise
taxes and he operates out of a tax haven. And so what you can say then is
he is not biased in his views on these matters, he is speaking from a
matter
of total disinterest.
What is so impressive though is you see that in a year in which it was
tough
for long-only managers and conventional managers to do very well, just how
gigantic the profits were, of hedge funds. And so, the
combination...remember, they work on leverage, it's not that they're 100
times smarter than long-only managers, it's that they have such gigantic
leverage and they are borrowing at these incredibly small rates. So what
happens, as soon as they saw that there was going to be a constriction in
the flow of their money they started unwinding their positions. And we saw
how they're interconnected.
So, in that sense what we've gone through in the last three weeks is truly
instructive and it explains something that we commented on in the last
issue
of Basic Points of an underlying concern we're having about the financial
system. Which is that every time there's something exposed about
malfeasance, like slimebags at Putnam and at Strong mutual funds, what
happens is gigantic amounts of new regulations come in, which make it
difficult for any but the biggest organizations to continue. In the case
of
Harris Investment Management, you probably noticed that Phoenix has
acquired
our mutual fund family which was ranked number one in Barron's. And the
costs of compliance are just so far out of line now.
So, what we have is we have the irony then, that in the non-hedge fund
business, the ones where the people who have participated pay an investment
management fee of less than ½ a percent, that the level of regulation is
going up so that only the very biggest ones - including the ones who are
guilty of malfeasance, but they get to pay off the Spitzers of this world -
stay in business. But the totally unregulated people are becoming the
biggest forces in the markets. So that the regulators are spending more
and
more of their time micromanaging those who are losing their ability to
influence the markets and the unregulated, untaxed offshore types operating
onshore are manipulating the markets and they are unregulated, in any
meaningful sense whatever.
So, in one sense if you're a capitalist enthusiast or a Randian, you might
say "Well, good! They deserve to be allowed to be unregulated because
these
are real great old-style capitalists." Well, George Soros is such a great
old-style capitalist that he spent millions and millions and millions of
his
tax-free dollars trying to elect John Kerry and has proclaimed that he
wants
to dedicate his life to destroying George Bush.
So what we see is the irony of all this is that we have bifurcated the way
that the financial system operates. There's a total asymmetry between
those
who really can move the markets and those who are providing the actual flow
of public savings into the markets. And the only time we really see how
important this is is when the Amazonian flows that are being captured by
the
hedge funds suddenly shrink to mere Hudson River proportions. And then
what
we have is a tumult across the financial markets across the world. And
we're talking of a very few organizations here.
So, the volatility then, if we're looking forward from here, is less
volatility tied to economic news or those kinds of things, it's volatility
tied to the inflows for borrowing of the hedge funds and particularly those
that tend to trade together, the macro funds.
So, the thing that's shocked everybody, particularly me, was the Bank of
Japan blinked. And they pumped $5.4 billion US in and oh boy, look what
that did to the markets in the last 24 or 48 hours. Just amazing! And
yet,
the irony is that you'll see an editorial in today's Financial Times which
cites that the International Monetary Fund has called on Japan to continue
its zero interest rate policy and they say it's for the Japanese economy.
This is balderdash and bilge!
It's quite clear that the real users of the zero interest rate money aren't
Japanese companies because they could afford to pay ¼ or ½ of one percent
interest. No. The real users of this are these hedge funds and who have
been, you know, buying the riskiest investments in the world at premiums
over the risk-free investments and capitalizing such huge profits.
Now I'm not saying that this makes them evil or venal or anything like
this,
I'm saying that if their ability to function is first of all a function of
the fact that their competitors in the marketplace, for buying and selling
investments, are being tightly regulated by everybody from Eliot Spitzer on
down, they're free to take their bets wherever they want, not worrying
about
what anybody says about them.
And then on the other hand, if their source of funding is a bank that lends
out money at a zero rate interest in unlimited amounts and they're prepared
to get the International Monetary Fund in on their side if that banks says
it's prepared to charge as much as ¾ of one percent interest...this is a
sort of Alice in Wonderland world.
Well you may say "How does this relate to my investment portfolio here?"
Well, I have spoken at two dinners in Toronto this week. And at each one
of
them, when I came in to the hall, I was asked by people "Have you given up
your commodity story now, in the light of what the markets are saying?"
And
so, I guess...I'm getting a little impatient with the fact that people
don't
seem to understand that I "issue five-year forecasts" that are tied to my
views of triple waterfalls, which means things take decades to unfold and
to
unwind. And we're going to have setbacks along the way.
But this setback was not caused by some extremely bad news emanating from
the companies. It was not caused by commodity prices falling below the
levels that we had been using in our forecasts. They're still far above
what we were using in our buy stories. No. No. It was caused by the fear
reaction of a very few - that is, in number - hedge funds, who seeing their
liquidity drying up were calling in their riskier bets in all asset
classes.
And the commodities were hit disproportionately hard.
However, they've bounced back. And they bounced back for two reasons.
One,
because they got overdone. But the other is that, as we see, that Japan
blinked and has restored liquidity to the system. And this, in theory, is
to stimulate the Japanese economy, but what it's doing is increasing the
profits of the unregulated and untaxed. It's a funny kind of world we live
in.
From an investor's standpoint, what this does is shows once again that the
commodity stocks are still misunderstood in the marketplace. Because they
sold off far worse than did the commodities. I mean, copper did sell off
nearly a dollar, but that was a very brief series of trades and it's now
back within twenty-five cents of its all time high. But if you look at
Phelps Dodge and Freeport McMoran and Inco, what you see is that these
stocks are nowhere near their peak. And BHP Billiton...same kind of story.
So, it's ironic that the metals prices come back and the commodity stock
prices don't. So far on a one month percentage basis Alcoa's down 5 ½
percent, Alcan's down 4 percent and this is the kind of evidence...Phelps
Dodge is only down a third of 1 percent, but it's down fifteen bucks from
its high.
Now, I don't know exactly what the right price is for any of these stocks.
I never thought I could do that. But I do want you to understand as
investors that if the reason for which they're selling off is a fundamental
reason which is that it becomes obvious that a global recession has now
become a high-order of probability, then that's something I think you can
be
concerned about as investors. Because there's no doubt about it, the
commodity prices will fall.
And if we had a full-blown global recession, we'd probably see copper back
down to a dollar. And we'd see oil probably back down to maybe forty-five
to fifty dollars. I don't know. There may be overshoot. But if the
reason
they're selling off is because a group of hedge funds are forced to call in
extravagant bets, then you should not be even tempted to rethink your view
of the investment merits of these stocks. The fact that copper prices went
far above what people thought was justified...the stocks never followed
them
up to those peaks.
When I spoke at the Society of Economic Geologists convention, what was
brought home to me was two kinds of fears that the managers have. One is,
they're scared by what they see as the hedge funds taking over the futures
markets for their products. Because the futures markets were to them,
virtually an extension of their own operations.
Now this was a cozy and somewhat antiquated view, but there wasn't an
executive that I talked to in Colorado who thought that four dollar copper
was good for the industry. What they saw was that was something that was
going to cripple growth in demand for their products. And they would be
much happier with two dollar copper, they would profits far beyond their
forecasts, but copper would continue to grow modestly in demand and it
would
maintain its market share as compared to competitors, which are basically
aluminum and plastics. That was one fear.
The other is a fear that is certainly soundly-based, which is that as they
look at their inventory out there, if we use that expression - and that's
the expression they use - of resource properties, which means, mining
properties where some or a lot of drilling has been done and they have a
pretty good idea that they've got a mine there at such time as they're
ready
to go after it, what they feel is that inventory is being drained away as a
result of political risk.
And the political risk shows up in two ways. First of all, the absolute
political risk, which is that you suddenly find that a country you thought
you were safe in, nationalizes you or comes in with such punitive taxes
that
you're in trouble. Or in the case of the oil industry, Chavez simply
announces that the oil companies should not be allowed to include
Venezuelan
oil in their reserves because the oil belongs to Venezuela, not the
companies. And if the SEC agrees with that, it means that ExxonMobil and
ConocoPhillips probably go to single-digit reserve life indices.
So, that's one part of the political risk. But the other part of the
political risk is their sense that investors will conclude that because so
much of what's happening here is countries that were seen to be relatively
risk-free at the time that the companies made the commitments there, that
as
a result of elections in those countries - we're not talking about coups or
civil wars or those kinds of things that people were used to in the Third
World, we're talking about elections where what you get where what you get
is a radical left-winger coming in who proceeds to unilaterally re-write
the
rules in ways that are devastating to the profitability of companies.
They've got their money down on the table and they can't take it off. And
all of a sudden, what you've got is a new kind of croupier who's sweeping
it
all in. And even though your place was on the winning bet, they say "No,
we're only paying off on 32's on this role of the dice and not on anything
else. We're not paying off on all reds."
Well, this, from the standpoint of the mining companies is a truly
catastrophic situation. Because they don't have meaningful inventories,
collectively, in politically-secure areas of the world, those where you can
say "Well, we may have a government elected that we aren't exactly thrilled
about, but they aren't going to loot it from us."
So from their perspective - now I haven't been to an oil conference on this
lately, but I'm sure it's the same - they're saying "Well just a minute,
what have we got?" You know, there was a couple of conferences where it
was
pointed out that only six percent of the world's oil reserves are in
countries that are now politically risk-free, under current rules and
therefore that are open to the private sector oil companies. And yet the
private sector oil companies are the ones who do most of the drilling and
who have the responsibility in the eyes of the populace of seeing that
they're getting hydrocarbons at reasonable prices.
So from an investor standpoint then, what I believe is that although you
may
say all of this is negative news, if you have been investing according to
our criterion, which is, you're buying unhedged reserves in the ground in
politically secure areas of the world, the value of your investments is
rising at a much faster rate than I had expected, regardless of what may
happen in terms of short-term volatility in the stock market, driven
primarily by liquidity flows into hedge funds. That is not a completely
extraneous thing, but it's really an independent variable that from time to
time becomes a dependent variable.
And so, therefore, if you accept this view and you have a time horizon a
little longer than a few weeks, what you've got to say is, these mining
stocks and these oil stocks are worth dramatically more than they were at
the beginning of this year. Because the commodity prices are higher and
the
reserves in the ground in politically secure areas of the world have
shrunk.
And, then we talk about using Chip Goodyear's expression from this
conference, which is the embedded optionality. Which is, you've got
something out there which is just a resources but has not yet been
converted
into an asset, certainly not one that you can use under SEC rules. But
you've got it and you're pretty sure about it and therefore you've got the
option at any given time when you've got good markets, good prices and
you've got the cash flow to develop it.
What's happening is those kinds of things which are, shall we say, off
balance sheet assets, which are really at the heart of the way the mining
and oil companies operate. Which is something beyond the SEC rules and
those strict rules of valuation I was using. But it's their view about the
long-term future of the companies. It's sort of analogy to if you're
talking about Toll Brothers as homebuilders...lands they might have that
are
40 miles outside Tucson. And that they're not likely to develop for
another
15 years and therefore they're not going to count as a current asset. But
that they view as crucial to the ultimate long-term survivability of the
company.
Well, what's happening here is that those kinds of fringe assets are now
all
at risk because of this change in the political climate in so many
countries. And countries where these companies have been operating for
decades or in some cases, a century or more.
So, I'm certainly not giving up my enthusiasm for the commodity stocks. As
a matter of fact, everything that I've learned about in the last few weeks
during which time it's been tumultuous and frankly, I've had so many phone
calls and e-mails from worried people about this, is that the reason why I
was enthusiastic about these stocks in the first place, those reasons are
becoming more powerful as this story unfolds than less. But what I cannot
assure you is that there will not be more downside volatility, but it will
not be driven by the kind of bad news that would suggest that each of these
companies is a bad investment.
So that's really it. It depends on your stomach for risk. And risk as
defined as volatility risk as opposed to economic impairment risk.
Economic
impairment risk is if you own a mining company and its ore is at a grade
where it's only really profitable at a dollar-fifty copper and copper looks
like it's going to fall below a buck fifty. There you have a risk and you
better be very sure about your outlook for copper price, if you hold that
stock.
Or economic impairment risk is that you've got a huge exposure to the
metals
companies and you now get enough evidence out there to suggest a global
recession is coming. But if neither of those situations apply and if it's
simply that those who've been whipping around the price of the commodities
and the prices of the stocks, to earn themselves unbelievable earnings,
earnings bigger than that of many large corporations, that they are running
away temporarily from these as a result of some constriction in their free
cash flows, then you shouldn't be changing your view or you should be
looking at this as a buying opportunity.
So, wrapping it up then, I don't know how long the volatility will last.
Clearly we've got a surcease from it at the moment, because of the Bank of
Japan's injection of this money, but we can't rely on that as a continuum.
I think the Bank of Japan is dedicated to going forward with getting away
from a zero interest rate policy, so there will be some big adjustment
necessary by the hedge funds.
But if we're living in a world where what really drives the marketplace is
not the kind of investors that are long only, or are balanced funds, pure
hedge funds, long and short, but it's those who take gigantic bets long or
short and move in and out of asset classes and they're unregulated and if
they're getting virtually free money to finance themselves for it, if
they're the ones producing the price changes out there, then I cannot
predict any volatility changes based on the kind of tricks that I've
learned
over the decades.
So you'd better be resigned to the fact that we're going to have lots of
temperature changes and the weather at times is going to look pretty tough.
But the underlying conditions for investors are getting better, not worse.
That's it, any questions?
Caller #1: This is a little bit different from the issue of the liquidity
and hedge funds and it's more just an observation. There seems to be a
fixation on the weekly inventory storage numbers in the United States. And
what you never hear commented on is the fact that in terms of days of
forward cover, inventories are probably at lower levels, in other words,
using five-year numbers is probably somewhat deceptive, just because the
economy's growing and second, the reason that inventory numbers are higher
is likely that the amount of spare capacity in the world is down from about
8% to 2%. It's a little bit similar to the first point.
I'm just wondering if you have any comments, the bouncing around on the the
commodity prices and the stock market seems to be somewhat influenced by
these weekly numbers in addition to the whole hedge fund volatility and I'm
just wondering why people continue to be so fixated on that. I wonder if
you had any views.
Don Coxe: Well, thank you. The reason I haven't commented on it is because
what I did is change...as once we got Rule 133 in, which had the effect of
forcing Big Oil to stop forward selling its oil and we changed from
backwardation to contango, what that did was for consumers of oil, then
they
had always been able to rely on the forward curve as part of their
inventory, because it was cheaper inventory than spot oil. And that no
longer was the case and so therefore to the extent that any month's price
of
oil compounded was more than 50 cents a barrel above, you were being paid,
as a consumer, to buy the oil and store it, rather than just relying on the
futures.
So we naturally have had an increase in oil held, visible oil held above
ground, simply because of the fact that this is economically cheaper for
consumers to hold the visible oil now than to rely on the futures curve.
And we haven't changed the supply of oil at all. And so therefore, to me,
it comes back to the Rule of Page Sixteen. The Page One story each week is
the inventories. But to me the Page Sixteen story is any changes that
occur
in the futures curve. Because from the standpoing of consumers, they're
really more interested in that than they are about the oil inventories.
Because as you point out still the oil inventories are still a few days
only
and one major interruption or one civil war or anything and all those
inventories would prove to be nothing.
You see...I don't comment on them because I regard them as sort of nuisance
statistics. But, I guess people can be very critical of me for that,
saying
why don't I address something which is clearly of great concern to the
market place and does affect the stock prices. It affects the stock prices
day to day, it doesn't affect the underlying value of the
stocks...one...bloody...bit. And I've only got thirty minutes a week, so
what I try to do is comment on things that I don't see being adequately
covered, but I appreciate your question because maybe other listeners also
have said "Why is he ignoring all these statistics? Doesn't he read the
papers?" I think I read the papers about as profoundly as almost anybody
who's on this call. What I try to do is decide from that what it is that I
don't think most of you have had a lot of commentary on and that I think is
important.
So, to the extent that I'm quirky in this it's saying I think this is a
very
big story, but it's still only on Page Sixteen and maybe you missed it. So
that's...if you're giving me thirty minutes of your time on the weekend,
I'm
telling you this was a story worth looking at. And the weekly inventory
numbers may eventually become important, but at the moment, they are simply
the distraction and if they're used as a serious investment concept by
people, they shouldn't be allowed to manage anybody else's investment
money,
maybe not even their own. Thank you.
Any other questions?
Caller #2: I want to go back a little bit to the liquidity issue. I can
appreciate that has been obviously a very important driving force in what's
been going on. But you know, there are some other things, it seems to me,
were also being feared last week and I just want your comments on what's
happened with the long bond. I mean, the long bond went up to 5.25, a lot
of, as you're aware I'm sure, a lot of adjustable ARMs that will be
coming...will be renewed later this year and next year and it seems to me
that would, you know, part of the fear that happened last week, it seems,
was also that both Europe and Japan could not sustain or would not drive
global growth. And in fact the bond markets in...if you saw the bond rates
came down further in Germany as well as, I'm not sure about Japan, that
seems to me to be quite real. What's your view on this question, on the
housing market and obviously the effect on the consumer? Is that not a
risk
to global growth?
Don Coxe: Well it certainly is. It's just that the developments...when I
saw that what was happening in the commodities was the same thing as what
was happening in emerging markets and then spread product between the
lowest
quality and the highest quality, what it was part of a run away from risk.
And this wasn't tied directly to any new economic news. So therefore, it
was one overall story of a collection of over-levered investors who were
rushing to cover that was producing this disarray, smashing the Sensex
Index
at the same time it was giving these wild price swings in copper, nickel,
lead, zinc and aluminum.
But, you're absolutely right that the whole question about the US housing
story...as a matter of fact, I'm writing the next issue of Basic Points and
I'm spending quite a bit of time on trying to figure this story out. But
you're right that that is a fundamental number out there. But again, what
happened in the long end of the bond market, particularly the Treasury bond
market, this has been a huge area of activity, of these levered players.
And to the extent that they took off their bets there because they didn't
have liquidity, then what you had was a temporary steepening of that curve,
then it was offset as people started looking at some of these housing
numbers and saying "Hey, we got trouble ahead."
I plan to do a call very shortly about what I think is the next major move
coming in the bond market, which will be tied to that. But, I think this
is
still a little early for it, but in general my view is that - which I've
been saying in Basic Points for a year - that you should, all investors,
should have a section of their portfolio set aside for very long-term bonds
or zeroes, which is the best play against the strong perception of a coming
economic slowdown or recession. Doesn't have to actually happen. And
anything like that that appears to be the case is going to produce a rally
at the long end of the curve of momentous proportions.
So, that's...I appreciate your point here, but what the theme of this call
was, what would happen in commodities in particular was tied in to the
unwinding of leverage by a set of players out there. And now that we're
getting stability, the stability isn't coming because they have changed
their perception, it's simply because Japan blinked once again. And I
think
that is a huge story for people who are trying to figure out about
short-term volatility in the market, that it was an announcement by the
Bank
of Japan that they were restoring $5.4 billion into the money system that
"magically" produced this stability around the world.
This is a different kind of world than it was back in the days when the Fed
was the only central bank that really mattered.
Caller #2: And with the Fed probably stopping the raising of rates, it
will
probably be an added assurance that easy money will continue, because I
mean
nominal rates or real rates will probably still be under real growth rates.
Don Coxe: Right. Thank you. Any other questions? Thank you all for
tuning
in, we'll talk to you next week.
Don Coxe profile from the BMO websites:
Donald G.M. Coxe is Chairman and Chief Strategist of Harris Investment
Management, and Chairman of Jones Heward Investments. Mr. Coxe has 27 years
experience in institutional investing, including a decade as CEO of a
Canadian investment counseling firm and six years on Wall Street as a
'sell-side' portfolio strategist advising institutional investors. In
addition, Mr. Coxe has experience with pension fund planning, including
liability analysis, and tactical asset allocation. His educational
background includes an undergraduate degree from the University of Toronto
and a law degree from Osgoode Hall Law School. Don joined Harris in
September, 1993.
Don Coxe Weekly Conference Call - Current
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