Latest from Coxe:
"I’d like to reiterate for the benefit of all of you that I will not change my bullishness on these stocks and my recommendation to be overweight the stocks – even think about it – as long as the commodities themselves are holding up. What’s happening is we’re just getting lower and lower P/E ratios from what were already almost surreal."
Nesbitt Burns Institutional Client Conference Call for May 27, 2005
Don Coxe
Chicago, IL
Chart: Euro
Thank you for all tuning in to the call which comes to you today from Chicago. We faxed out the chart of the Euro and the question is what happens if the French and or the Dutch vote no.
This is a big story and I’ve been touching on it very lightly, I guess I was behind the curve on this one, that the sentiment, particularly in France, could be so negative. I finally became aware of just what was wrong. I had dinner a couple of weeks ago with a member of the French government. This was a social evening and he was very candid – he hadn’t made up his mind how to vote.
Everybody else at the dinner was European and from his standpoint, he made it clear that he felt France had really been the driving force in creating Europe and that French leadership was necessary to drive Europe forward and that now with all these new countries in – he didn’t mention any of the Anglo-Saxons – that this constitution would concentrate more decision making power in Brussels, taking it away from France which was the logical place to exercise the leadership so he didn’t know if he could bring himself to vote for it.
In looking at the kind of objections that are being raised within France – I’ll take that first – a lot of it is simply “vote no against Chirac”. So this is just plain cussedness at the fact that Chirac has failed to deliver on the kind of economic progress that they thought they were going to get. What really seems to have happened in France and in Germany is that the opening to the east, taking in those ten countries that had formerly been part of the Soviet bloc, what this has done is thrown in to sharp relief what the cost structure is of operating the economies of the Eurozone.
This is one of the reasons the Euro did so well for a while. From the standpoint of global investors – and I was part of this thinking – what you had here was a great combination because you now finally had a place where it made sense to do capital investment in the European market and what that would do was give European based companies a chance to build up production in areas where people were well-educated, good work ethics, much lower wage rates, much lower cost structures.
Well, that precisely is what has aroused the wrath of the voters in Germany and in France –not so much in Holland, I’ll get to that in a couple of minutes – which is that they are really used to their privileges.
The fact that there could be major strikes and dislocations over the government’s proposal that on the holiday of Pentecost that workers should donate the money from their working to the care of the ill was that big a deal – they have all these religious holidays, they have twice as many at least as the United States has and yet they are proud of the fact that since 1789 they are a secular nation
So what you have is leading the battle over this was the CJT, which is the Communist union and here they were shutting down the country where the could in order to preserve the observance of a Christian holiday.
Now all of this might just be good for snickers if it weren’t for the fact that we’re dealing here with something very major because if the French vote no on Sunday, then I think Chirac was quite frank and candid and probably accurate in saying that this was a no to Europe itself. In other words, what the French would be saying is “We’ll only take the concept of Europe on our terms and this must not include Liberalism.”
This illustrates once again the problems that we have in North America with our terminology. When I was growing up, the term “liberal” applied to the thinking of the heirs to John Stuart Mill and David Ricardo and John Locke. But then “liberal” got twisted in to being what the Europeans would call socialists.
And now the term that’s being used for it is “progressive” and that word is bad enough here in this country. We’ve got red that symbolizes the Republicans and Blue that symbolizes the Democrats, the exact opposite of what I was trained to believe. I worked for National Review magazine some time ago, which was the foundation journal of American journalism and was most proud of its blue border.
Here we have a situation where liberalism, which is what Chirac is opposing and saying he’s going to protect the French from, Liberalism is more open trade and less government regulation of the economy. Liberalism is a dirty word in France.
So with that kind of ideological problem, you can understand how it is that the Eurozone could slide gradually and genteelly from being a reasonably dynamic economy into one where one of the three biggest economies is already in a recession- that’s Italy – and France and Germany are hovering on the edge of it.
The unemployment rates of course are terrible and this is now a situation where if they can’t get the constitution approved althougt this doesn’t mean that things are going to break up, what it does mean is that they’re going to have to reassess what the European union is all about. And it’s not clear to me how they are going to do that. Now of course they were very ardent about the fact that this was going to be an imitation of what the US achieved in 1789, the idea that they had the people that were up to Madison, Hamilton, Jefferson and Benjamin Franklin…well, what they got is a 450 page book and I was amused to read in a lovely op-ed piece in today’s New York Times that the book begins with “His majesty, the King of the Belgians…”, so they would be voting on something which actually has reference to royalty at the beginning, pretty bizarre thing for republican France.
Now, of course they’re used to creating big things. The rule book that these ten countries had to sign in to, to become acceptable countries in the European Union, is 80,000 pages long. So, what’s happened is the French, who created the word bureaucracy, through their power in Brussels and their intellectual leadership – they’re very good at these things – created this set of rules and now they wanted to sort of codify a large part of these into a constitution.
Now once again, the French are supremely qualified for this, they’ve gone through so many constitutions. In that sense they’ve had more experience with the process than anyone else. If they reject this one, it doesn’t mean that Europe doesn’t have any set of rules, it’s got 80,000 pages of them, what it shows is it’s going to be that much more difficult to make any real progress on the real problems facing the Eurozone economy as they age and as they have to replace their workforce with Muslim immigrants.
Which leads me to Holland. Because the No vote in Holland has much less to do with the idea that decisions will be made in Brussels, that doesn’t seem to scare the Dutch too much. What it has a lot to do with is their experience with Islamic fundamentalism. And the murder of Theo van Gogh (?) was a horror story to the Dutch. There are, I believe, six public figures in Holland who cannot go out without armed guards because there have been Fatwas issued for their annihilation.
So, for the Dutch, who are the most tolerant and open people within the Eurozone, this has been a real shock. Apparently the vote in the polls really started to turn negative when Spain legitimized 700,000 illegal North African immigrants.
Given the shenken(?) rules that they have in the Eurozone, the Dutch, who already feel like they already have too many immigrants relative to the size of their country face that they cannot stop then what would be a huge number of them coming in to enjoy the benefits of the Dutch welfare state and creating even worse problems for them. So what you’re seeing there as a vote “No” in Holland has very little to do with what’s in the constitution itself but has a lot to do with the notion that the political class has betrayed us.
Now what’s the importance for North American investors in all this? Well, for a couple of years, there was about a .91 correlation between the Euro and gold, we’ll start off with that. We’re still pretty close. On a year over year basis, the Euro and gold are only about four percentage points apart in price performance. SO they are still close together, but what’s happened is that - and this may surprise some gold investors – gold has done better than the Euro as the Euro has sold off.
And the Euro’s sell-off was partly the US Dollar but there was also this special factor the early polls were showing the French would vote against the constititution and that’s just accelerated.
Now you know it’s been my view that the story on the Euro – and people say “How can you recommend the Euro, given the stasis in the Eurozone as opposed to the dynamism in the US?” And I said, currencies are all about assets. However, what’s happened here, if you’ve got assets in a zone where it may be losing its way, that could be a big negative.
Therefore, that plus the fact that the US economy is once again putting in a pretty good performance, as a matter of fact, excellent performance compared to what it seemed to be, we’ve now got quite a price spread between the money underlying the Euro which is namely the European Central Bank’s rate, which is 2% and where we expect to be with the Fed by year end. The whole outlook there has changed somewhat. I can remember when the European Central Bank rate was twice what the Fed’s rate was.
So, my argument that the US Dollar was going to enter a period of renewed weakness, which would be good for gold, is called into question in that the only two heavyweight currencies are the Yen, which continues to be propped up by Japan and the Euro. And the Euro is the only heavyweight currency that was not being manipulated. So that’s why it bore the brunt of the tremendous move upward against the Dollar as the Dollar was going down.
Now the Euro and the Canadian Dollar have traded somewhat close to each other. That shows you that the fundamental driver is still the US Dollar itself. It also shows you that whatever problems Canada may think it’s having right now, they aren’t as challenging as what the Eurozone is experiencing.
If the votes are “No”, which I think the market is pricing in here, it’ll be interesting to see whether in fact the Euro has already corrected for this. In that case, any rally of the Euro off here will produce an up move in gold. I think the Canadian Dollar will also move along with that and move back into the 80’s.
In some sense what you’ve got is three very different kinds of assets that can be affected in pricing by the vote on Sunday and then coming up early next month in Holland.
No matter how it turns out, the problems that have been laid into stark relief by the vote in North Rhein and Westfalia – imagine the SPD losing there, that’s really a remarkable event – all of this suggests the second largest economic zone in the world is getting into more and more serious trouble and meanwhile it’s demography is the second worst in the world, second only to Japan which has got a whole set of other problems.
So the USA is looking pretty good by comparison and although you wouldn’t know it from the kvetchings going on out there about how awful the US economy is with all the borrowing and with the housing bubble, looks pretty good compared to those two major alternatives.
I’d like to get back to the theme of what has been happening to the commodity stocks because I suspect that those who are on the call have shared my pain as we’ve watched the sell-off occur in them. One of the things that bothered me is that the stocks sold off so heavily while the commodities didn’t.
We’ve actually…we’re now in a position where spot crude is 51.40 and December crude is 53.15, so they are very close to their highs and yet a lot of the oil stocks are substantially down from where they were. In the case of the metals, at current price levels, 1.45 on copper, that’s only down a tad, admittedly that’s seven cents, but only a tad from its high, but you sure wouldn’t know that looking at the copper related stocks.
The current issue of Basic Points which goes to press this afternoon, we go into this in considerable detail. I’d like to reiterate for the benefit of all of you that I will not change my bullishness on these stocks and my recommendation to be overweight the stocks – even think about it – as long as the commodities themselves are holding up. What’s happening is we’re just getting lower and lower P/E ratios from what were already almost surreal.
If you look at the P/E ratios for Phelps Dodge and for CVRD – which is the big Brazilian company whose ticker symbol is RIO – you’re looking at 5 to 6, depending on what pricing assumptions you use for copper. In the case of Phelps Dodge, the company is free of debt. You got Inco at 9. I’ve done a list of the 17 biggest, reviewed in this current issue and we’re looking at a combined P/E ratio which is just in the 9,10,11 range for these stocks.
Now there’s a wide, varying group of assumptions on this. If you take these stocks out, if you take the oils and the mines out of the market, you’re looking at a market that’s priced into the high teens. So what you have is the oddity that just about the only stock groups that benefit from a strong China and India are selling at a gigantic P/E discount to a whole bunch of stock groups that have much, much to lose from the strength in China and India.
That to me is truly remarkable because what it means is you’ve got a dogmatism about valuation based on the last fifty years, rather than looking at the way the world has changed. As I was told by a couple of managers while I was doing my tour of managers in the Northeast, “Look, we know about these stocks. You buy ‘em when their P/E’s are high and sell ‘em when their P/E’s are low.”
Yeah, that was true when the US ruled the world and Europe was number two, and Japan was number three and they had somewhat similar cost structures, but now that you’re looking at – in the case of China – an economy where workers are prepared to work sixty hours a week for a buck fifty an hour and they’ve got modern logistics, they’re able to use Western brands and steal Western technology…this is a different game.
It seems to me that one of the things you want to do as an investor is be overweight the companies that stand to benefit from this, instead of having them trading at what is – if you combine the absolute and relative P/E’s of the mining group now, and look at them on an historic basis – they’re almost as low as they’ve been since 1960. And that strikes me as a bad case of valuation.
My view is that these stocks - which were cheap before – are really cheap now. That doesn’t rule out that they can’t become incredibly cheap.
I invite you to read the front page story on Mr. Forest and his new iron mine in Australia, the front page of the Journal today, not that I’m taking any position on whether this iron ore mine is going to come off, but what’s interesting about it is the fact that he could have come this far on a project this big with so little backing. Simply because of the desperation of the buyers of iron ore in China. Iron ore is not one of the ones we comment on most often, but it illustrates the fact that there just aren’t many sources of supply for these metals.
Therefore the companies that have the ore bodies that are in production, have the know-how, these companies are becoming more and more important. They are becoming crucial to the realization of the state plans and the individual dreams of the nations that have over two billion people.
One way or another, I think that we’ll find, in the second half of this decade, it’ll be a repeat of the first half, which by the way it’s been in all the decades since the 60’s, which is that the top performing stock groups will be the mines and the oils.
That means that we’ll have to find some new enthusiasts because it turns out that when these stocks were doing well year end and through February that a lot of these players were short term momentum players and hedge funds that were just taking something that moved. And when it stopped moving up they lost their enthusiasm. And then when they were using them in inverse correlation bets on the US economy and the global economy whereby they would go long the commodity stocks and short the 10-year note futures…as soon as they saw that trade looking bad, they got hit on both sides of it, so they exited.
So here we have the 10-year note trading at a yield of 4.08 with the US economy growing at 3 ½% in the first quarter of this year and inflation being still at a level where the real Fed funds rate is almost negligible – and that’s by calculating imputed rent on a basis which is truly surreal when you see what’s happening to housing prices here – the idea that living costs are still not growing…remarkable.
So let me just put this together for you. The vote this weekend is a big deal, because if the No’s win it, then what it means is that Euro-angst, which is already a significant factor is going to be accelerated.
One can criticize the French elites, but at least they’re very candid about the fact that they’re only happy when they’re running things and if they don’t they’re going to take their marbles and go home. The problem is, there’s nobody to replace them. They have been the intellectual strength of building Europe. Although I’ve made lots of sneering comments about Jacques ____(?) on these calls over the last fifteen years, the fact remains that he’s a brilliant guy, he has a vision of Europe and it’s one that was in fact shared by millions and millions and millions of people, even though it was one that was about as Gallo-centric as you can imagine.
So the question is, if this is all going to crumble, what replaces it and I don’t see that there’s anything to replace it. And then you’ve got the problem of bunch of distinct economies, different languages and demographies that are really scary. All of that is a negative for any kind of global investing philosophy. Because at the heart, the P/E ratio is an expression of the dynamism of the corporate sector of the world together. I’m using the MSCI Global Index for this. And if we’re going to have a real retreat in the Eurozone, nobody wins from that.
In that sense, I’m bracing myself for the fact that there will be a No vote and it’ll be interesting to see then how the Euro elites reconstruct things after that, because there’s lots of things that they do share a view on. It’s not that extreme liberalism that the socialists are alleging here, it is trying to modernize those economies so that they’ve got a future. So we all have a stake in that.
That’s it, any questions?
For the Americans on the call, have a happy Memorial Day weekend and to you all, we’ll see you next week.
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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.
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