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Don Coxe
July 16, 2004
Chicago
Chart: BHP Billiton
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Thank you and thank you all for tuning in to the call which comes to you from Chicago. The chart that we faxed out was BHP Billiton and we’re showing it’s relative strength. We’ve chosen this one because it’s the world’s biggest mining company and it has institutional following around the world, very well-diversified, it also even has an oil and gas component of some substance. But, what I thought that was important here, was to look at the change in the relative strength in this in the light of the idea that we’ve had this big sell-off on relative strength and in absolute terms in the commodity stocks.
Now, this all started, the word developed that China was going to slow down. And when the China stocks started selling off, they sold off initially in response to SARS and Avian flu and then the evidence of the fact that China was overheating and experiencing all sorts of problems from it spread and a new cottage industry emerged of those predicting a crash in China.
So, given the fact that at all times it was a minority of investors who were playing these stocks, because their total market cap is so small, it didn’t take long for those with big profits to start unloading them. So we had a significant sell-off. And at the low point, which you see on the chart, for relative strength there which was in mid-May, it looked as if these stocks, and BHP is an example of them were giving up all their leadership. And then things turned around and they keep going to new high on relative strength on a year over year basis day after day. And within the Investor’s Business Daily each day of 197 industry groups, from near the bottom of the group back in May, they just keep moving up.
Meanwhile, of course, the other, the biggest weight in commodity stocks, the energy group, just keep gaining on relative strength and looking at the screen today, for example, CNQ and Encana have gone to new highs at least in US Dollar terms.
So for those who’ve been overweight commodities and have had any kind of exposure relative to the weights of these stocks in the index, it’s been a splendid run. Because what you have had is you’ve had more than 50% of your money in the oil stocks and although the golds have sharply underperformed, at all times our viewpoint has been on the golds, that it’s basically a play on the American Dollar. The American Dollar reached a low point of a buck twenty nine on the Euro.
Then when it looked like the US economy was going to be the strong economy within the G7 therre was a big rally in the Dollar, carrying it up to a buck sixteen on the Euro and it’s been giving quite a bit of that back, we’re at 124.46 today on the Euro. And so the result is gold has moved back up through the 400 level, but it’s in an area of major congestion at the 407-408 level which corresponds to something under 125 on the Euro which is also an area of congestion.
So, the gold story is independent of the demand/supply story which is that for the other commodities. And so for those who really were more interested in gold, because of the negative view on things it has not been as satisfactory a year. But, I always maintained the view that you need to have a significant overweight in gold, after all in the S&P 500 there’s only one stock you can own which is Newmont, because of the possibility that things can go badly in the world. And so gold remains the way that you hedge within your portfolio reducing endogenous portfolio risk.
The ideal result for investors is to make no money on their gold portfolio which means that the rest of their portfolio which is tied to expansion of global GDP and all those nice things should do very well.
So the reason I wanted to talk about this now, is because we’re coming into what is ordinarily sort of a doldrums period for the base metals. And frankly it’s ordinarily a period of doldrums for the energy sector because the refiners start to adjust their refineries to move into a greater exposure to heating oil on the basis that the summer driving season will end Labor Day.
Well, you know seasonality is a very useful thing to have to start with, but this year gasoline consumption has just kept very strong in the US and indeed worldwide. And although inventories of oil have built somewhat, they don’t remain at the levels where people can feel a high level of comfort about them because of the continuation of actual or threatened supply shocks for oil.
So what we have here with oil at 41.40 is we have something that is now showing to be a drag on global economic activity, it’s inescapable. Wherever you look, what you’ve got is the OECD leading economic indicator turning down, we’ve got one after another disappointing economic numbers out of the US. Meanwhile, this corresponds to the fact that the Chinese who are using a bit of a blunderbuss approach to their overheating, we’ve had just a collapse in Chinese money supply and it looks like the second quarter in China is going to come in barely positive GDP growth although we’ll still be up year over year close to 10%, but the growth rate from the first quarter to the second quarter, depending on who you believe on this, there’s been a collapse.
Now I want to distinguish in the China story between two parts of this collapse. One is the one that’s being done directly out of Beijing through credit controls applied to the banking system. They have not raised interest rates, they’ve boosted bank reserve requirements. And they’ve applied direct credit controls for loans for steel, aluminum and cement. And in addition they’ve also imposed credit controls for sort of speculative commercial real estate and residential apartments type real estate.
Because of the way in which the Chinese system operates, where you have an enormous amount of decision making out in the provinces, and rivalries among the provinces with each other to attract capital investment, what you have is a very uneven application of the controls.
But in addition to that, we’ve got another kind of control which is the market itself. We’ve got a situation where the ability of the country to supply enough electrical energy to meet the soaring demand, they’re just in ongoing trouble. Brownouts, blackouts, rationing and what they’re having to do of course is rely so heavily on the use of coal and what that means is that their air pollution problems, which a year ago were bad, in some places now are at the level where there’s really grim. Almost like the Keynesian London in terms of how bad they are for people for peoples health and what a constraint they impose in attracting the kind of capital investment that they want to do at the next phase of their growth cycle. Which is attracting high tech and operations such as semiconductor manufacturing, which require really good air quality.
So, what we have then, is a very mixed story on China. And that has lead to on again, off again reactions to what you want to do with the base metals. Meanwhile, the inventories of base metals have declined relentlessly, month after month. And so, notwithstanding the fact that China is in a stage of slowing down, what it still means is overall demand is high relative to available inventories. You see, when we had big inventories around of base metals before, we could accommodate 14-15% growth in China and we’d still be okay on a worldwide basis. Now, even if China slows down to barely observable growth, since we’re living hand to mouth on base metal inventories, what it means is that these prices have not gone back to their lows.
This morning copper broke through the 1.30 level and that’s been very good for the Phelps Dodge’s of this world and the Rio Tinto’s. And the sign of China’s attitude on this, if we needed any confirmation that China hasn’t given up on the growth story, is the announcement that a Chinese company is buying Noranda, so Noranda’s up a buck thirteen on the New York Exchange today.
Now, that Noranda story is worth focusing on, because what you have here is a beautiful example of the fact of skillful institutional investors, namely Brascan, saying we do not want to own these deep cyclical operations. We’ve struggled with Noranda for 20 years and now that we’ve finally got a price that we can bail out on without looking back, what we’re going to do is invest in real estate and utilities where we have a nice even growth rate in earnings. The market will not pay for cyclical earnings.
So what you have is a seller and the buyers though are strategic buyers. Now in a case like this, if you’re a cynic, what you can say is well, you don’t want to bet against Jack Cockwell. But if you’ve got my viewpoint, which is that we’re interested in a long-term story on the metals industry, what it was, is that Noranda is one of the few of dwindling base metal organizations that was available for sale.
So you had a bidding war between Rio, that’s the ticker symbol for the great big Brazilian iron ore company, CVRD, and China won.
Now, the idea that a Chinese company could take over Noranda…just think five years ago, of the odds of that happening. It’s a sign of the changing power in the world, it’s now the second biggest economy in the world, second biggest consumer of oil in the world. This is the kind of thing that I believe long-term investors should be wanting to bet on.
Having said that, there’s no doubt that we’re going to get over the next few months, lots of statistics showing that China has brought it’s growth rate down to the level which will not put as much pressure on commodities. Now that would be a joy in the case of world oil, because with oil at 41.40 it would be great for the rest of your portfolio if we get oil back down to 35 bucks.
Now, as you know, up until four months ago, Wall Street kept predicting $26 oil. And now they’re more or less throwing in the towel and we’re getting lots of stories about oil possibly going to 50. Which tells me that maybe we are close to a near-term peak in oil. I was much happier with those two years where I was telling you week after week that oil stocks were ridiculously underpriced because people were valuing oil in the ground at 16 bucks. Now, we’re getting more and more talk of valuing oil in the ground at much higher levels. And so maybe this is a time not to add to your oil exposure here, but to be looking to other things.
Having said that, world oil demand is going to stay very high and it’s going to continue to grow. In the fourth quarter, we’re going to have a deficit. If we accept the International Energy Agency’s numbers, we’re going to have a severe deficit between production, that is with OPEC operating flat out and the demand, because of course, of the heating oil demand in the northern hemisphere.
So, heating oil is amazing. Heating oil is at a buck eleven eighty and this is only in July. Wow! So it shows you just how little room for error we’ve got. And looking at my screen, Valero’s gone to a new high, it’s up another couple of bucks. The crack spread is at levels which are just fabulous for oil companies. I mean everything is working for them now.
And notwithstanding an extremely cool summer in the upper Midwest, natural gas of course has performed well, we’re at 5.96 for natural gas, partly driven of course by the heating oil squeeze. So, the overall commodity story is intact, but it’s going to change week to week and remember that those of you are the faithful on these calls, you’re still in the minority.
Any doubt about it, for those of you who watched me on CNBC last week and saw that when I made reference to the fact that Chinese demand was strong enough to drive commodity prices higher, Don [Bob] Pisani jumped all over me and said “Oh that’s an old story and we’re finished with that.” And then they switched me to the woman who does NASDAQ and she said “Well, we had a Chinese Internet IPO this week and it did badly, so obviously the China story is over”, as if I was recommending Chinese Internet stocks. It was quite funny actually though. Those of you who called in to me and saw the show, you said “Did you know that they were going to gang up on you that way?”. And the answer is no. But it shows you how on a hair trigger they are on the idea that you should be…that techs are once again in trouble and that you should be investing in the exact opposite way of technology. No question about which way the media are on that one.
So, from time to time I have people telling me “Oh well, Don, now your view is becoming the consensus view”. It is not. Yes, there’s a little more respect being accorded to it because of this phenomenon of China, but remember we’re still talking about a group of stocks that together form less than 9% of the S&P and they’re gaining weight almost month by month, but they’re still a minority and the majority wants the majority to outperform.
So I don’t think this is a time probably as I say to be increasing your weighting in the group. But I don’t think it’s a time to be selling. Now, what do I mean by that. Well, first of all, I assume that the faithful out there are already substantially overweight. Secondly, is that if the US economy continues to slow down, if Europe continues to slow down, if Latin America continues to slow down and if China continues to slow down, then what we’re going to have is a pause for the commodities collectively.
Now, the only thing as I’ve said over and over that can blow this thing away is a global recession. It’s hard for me to see a global recession out there, given that interest rates remain so low and given the stimulus that we’ve got built into the system. But, there’s no question that…I’m a great respector of the leading indicators, and leading indicators worldwide have turned down decisively. So I think we’ve got a pause here.
The United States…being in the upper Midwest here, talking to investor clients, there’s no question that we’re having a slowdown in the auto industry. Inventories have built up very heavily, no surprise, lead by the SUVs which are the only vehicles Detroit makes money on. So, what we’re going to have then is something – and it leads to my next theme – that the economy is going to soften enough that the Kerry camp will be able to say “You see, the Bush boom based on deficits was a phony boom, it’s over. We need better financial structure in Washington”. And then what we’re going to have, probably, is increasing investor perception that Kerry is going to win.
Now, as Ed Hyman and others have been noting, there’s a pretty good correlation this year between Bush’s rating in the polls to win and what’s happened to the S&P. And that’s because the investor class, as a class, is pro-Bush. Just about the only class these days, other than evangelicals, that is, it seems like. I’m now living out in Chicago where I’m surrounded by Democrats.
But, I guess I think that all of this is a reason for caution in the stock market. Because the combination of high oil prices, which are definitely a drag on consumer spending, that we’ve got the Fed in tightening mode and we’ve had a big drop in US money supply, not that they expanded as much as you’d have thought, given how low the Fed funds rate was, but all of this is the stuff of unwillingness of investors, I think, to make big commitments.
The S&P was flat for the first six months of the year and now what we’ve got is a situation where even when we get good news like we got on inflation and we got good news on IBM, the market opens strongly but it has trouble maintaining its move up. And look at the NASDAQ today. Up big, overnight [futures] and it’s already down on the day.
So, what I still believe, is that NASDAQ has got pretty serious problems. And there is a case to be made that NASDAQ is the driving force for the overall S&P. That when NASDAQ is going up, the S&P goes up, and when NASDAQ is going down the S&P goes down. Most of you who are on this call are institutional investors and live by relative performance. So, if you’re like our shop, we have to be fully invested in equities at all times. We aren’t allowed to hold cash. So what you care about is how you do relative to the market. So techs have been sharply underperforming the market since late June. I see no reason for that to change. The IBM earnings were very impressive but a lot of that came from currency gains because IBM has such enormous strength, particularly in Europe. And Big Blue has demonstrated that they are better able to withstand a slowing in demand from the corporate sector, than are some of the weaker players.
So, my view then is that we may have a softer summer than I had thought. You’ll recall from the last Basic Points that I said I was looking for a big increase in negative sentiment on the stock market and maybe stronger action by the Fed, pulling a sell-off which would mean I would raise equity exposure.
Now why do I continue to have then the willingness to reinstate an equity bias when I’m far below what the average pension fund is in recommended equity exposure. The reason for that is quite simple, that the kinds of companies I’m interested in, I can still see value out there in the market. And particularly for those of you who are prepared to accept the view of buying assets in the ground as opposed to just current earnings, you’re not going to get a long, long opportunity to stock up on the great commodity companies. Because I see them moving into stronger and stronger hands, of investors who are prepared to be patient with them.
So, therefore, I still believe that they are now the core investments for value investors and have been since 9/11. I’ll reiterate why 9/11 was such a flex point. 9/11 meant that the base metals completed their triple waterfall crash, because the industry had already consolidated over the long term and then it meant we had a new war. Whereas the end of the Cold War was a further disaster for the base metals because it meant there was a continued reduction in demand from the Pentagon for military hardware. And it meant that those vast resources in Russia were now being dumped out on the market because they couldn’t sell them to the Red Army.
Now with supply and demand in balance and the Pentagon in a rearmament mode, what you’ve got is a situation where the trend for base metals is up.
As for oil, it was quite apparent to anybody who looked seriously at the situation that supply and demand were in balance and all you had to factor in was rising demand from China and India and you could see that we were going to get a squeeze. Because, we had this notion that everybody always used the theoretical production rates worldwide as opposed to actual. And things go wrong.
So, on balance, stick with your positions but you may get a chance to add to them at somewhat better prices if people get worried that this slowdown is going to be something worse than a pause. And at some point that’s the kind of scare headlines you might read.
That’s my viewpoint, any questions?
Doug Webber: Don, is it not possible that the market has already discounted this economic downturn and that’s the reason for the flat performance in the first six months and that this summer we’ll start looking towards the economy that is out in ’05?
Don Coxe: Thanks Doug. I’d like to believe that except in that case the market is truly mystical in its prescience. I don’t know of any economist, other than Stephen Roach, who – and he had been bearish for three straight years – who said that we were suddenly going to have a slowing after the end of the second quarter. And so for the whole market to correctly anticipate this, was amazing. Now it may have been that the market kept saying “Look, in the past whenever you had oil prices up, you know, more than 20% year over year, the economy slowed”. And they used that as their indicator. But even some of the leading economists that I’ve seen who used oil prices as a big element in their forecasting kept saying it was going to be different this time.
So if that’s the case, my hat is off to the market and maybe you’ll be proved to be right, in which case it’s…that would be an astounding thing. But it’s as good as an argument as I’ve heard this morning, thank you.
Any other questions?
Arthur Gray: Good morning, Don. Would it not be fair from a philosophical standpoint to suggest that the reason this marget is trigger trigger, up and down the way it is is because of the 9,000 hedge funds are creating all the activity in the market and that the long-term investor has been sitting back and that your philosophy of continuing to invest in these commodity stocks is correct for those that take long-term positions but that the short-term thing is in the lap of the gods?
Don Coxe: Well, that’s an interesting concept Arthur, because you’re right that I tend to sort of compare it to the cycles that I’ve lived through myself and how the market behaved then. And when the hedge funds…are a relatively recent phenomenon. We only had a few of them in the ‘80’s and they were conspicuous success stories. And yeah, you’re right, they account for something like half the trading on the New York Stock Exchange now, so…but I was of the viewpoint that they sort of canceled each other out. Because what you had was such a multiplicity of strategies and that if you added all the hedge funds together what you had was an S&P index fund, for which you were paying 2% base plus 20% of profits.
Now that may be a very unsophisticated view. Some of my favorite clients are hedge funds and they’re ones who do take strong views. So maybe that will prove to be it. Now, in which case, Donaldson will be coming in to regulate the hedge funds at the worst of all possible times because it will prevent them from giving such efficiency to the market.
But yeah, having thousands of hedge funds means by definition that if the market…the VIX index has meant that we’ve had the lowest range of trading, one of the lowest for six months, in the history of the market. So that suggest to me that the hedge funds have been canceling each other out. That they don’t have a collective view.
But you’re right that it’s a hair trigger on a given day, that the market will suddenly make a move intraday of some substance, but day after day after day…this is a boring market. So maybe what we have is instead of the Madding Crowd, what we have is absolute balance and the hedge funds are as beautifully balanced as the American voters were in the last election about who was going to be the President, thereby canceling out all but 573 voters in Florida. Thank you.
Stephen O: Yes, good morning Don. One thing I read yesterday and which I found very interesting was the comment that hedge funds and other large speculators had open interest of 57,800 copper futures, the lowest since September 1998. So that really goes along with the view that people are not that interested out there.
Don Coxe: That’s fascinating! You see, I’ve had to be arguing against the viewpoint that high oil prices were the result of wild speculation and everybody would cite the open interest of speculators on this. But they wouldn’t point to the fact that oil was in a backwardation situation or a mild contango, indicating that the oil companies themselves were selling so much forward that they cancelled out the speculators. And so they called it hedging whereas those who were buying oil futures were called speculators.
And in the case of the metals, there’s…if you look at the copper futures, I wouldn’t doubt that if you talked to some of the people in some of the mining companies they have such cautious views on the outlook for it, that we may actually have a situation in which there is very little net speculative activity and this is a horrendous concept, I realize, but it may mean that commodity prices are driven entirely by supply and demand. Now, Wall Street of course would go into shock at that thought but let’s put that out as a possibility.
Thank you all for tuning in, we’ll talk to you next week.
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Don Coxe’s Profile from the BMO website:s
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.
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