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Nesbitt Burns Institutional Client Conference Call for December 29, 2005
Don Coxe
Chicago
Thank you all for tuning in to the call, the last this year, which comes to you from Chicago. It’s my chance to wish you all a Happy New Year. I hope that for the institutional investors on the line that it’s been a pretty happy year for them, relative performance.
But it’s not been a very happy year for the large-cap US stocks as measured in the big indices such as the Dow and the S&P. But it’s been a good year for global stock markets, been a good year for global bond markets. I think that if it’s ever a case of the market climbing a wall of worry, given the fact of all the worries out there which are reflected back by the clients, then maybe this rather modest rally we’re seeing has a little bit of heft in it going in to the new year.
Well, it’s obvious that what we need to do is begin by talking about the big-cap problem in the US market. And I think that it’s…it’s a bit of a surprise because it seems to spread right across the market. In the sense that if you look at the performance of the classic big index, take the Dow Industrials, they’re up 0.3% this year, which is, you know, within the area of no returns whatsoever, other than the dividends.
The transports, though, which are a smaller-cap index and a very different kind of index are up 12½%, so that’s been a good year for that group, notwithstanding, of course, the airline bankruptcies. But, what you had there is a spillover from the commodity boom and from the US trade deficit in terms of the performance of the rails. NASDAQ has given a lusty 2.5% return. This is one case where some big-cap stocks really did give a good performance, but the list is still short, dominated of course, by the amazing performance of Google.
When you get into the commodity groups, what’s fascinating…I mean we’ve had great performance from the commodity stocks. If you take, for example, the XOI, which is all the US oil stocks, we got a 37% return year-to-date. And if we take the TSE-capped Mining Index, that’s a 45%-er this year.
But it’s interesting how, within the US market, how poor the returns have been on the mega-caps. You know, ExxonMobil is only up 10% this year and Chevron’s only up 7½%. But if you go into lower-cap stocks, even a big one like Conoco, which is up 33, Marathon up 61 and then the pure refiners, with Valero up 128 and Tesoro up 90. What you can see was this was a year in which you were better off in smaller-caps and mid-caps even if you got the weighting right in terms of your exposure to energy.
Now, within the mining group, it was not so clear because of course, we don’t have mega-cap mining stocks within the indices here. So, the tremendous 46% out of Phelps Dodge this year and the strong returns for the big multinational mining stocks, with BHP up 40%, Rio Tinto up 53%. But Rio Tinto’s performance has been given a bit of a financial steroid in terms of a major buyback program. Rio Tinto had chosen not to buy other companies but to buy back its own stock.
So these stocks, though, are tied in to global indices and that’s been a big part of the story because it’s been a year in which the US was not the place to have your money. You could go almost anywhere else, certainly north of the border, south of the border and across the oceans.
And this week the FTSE Index in London broke out solidly on a four-year high. And that’s a reassuring index for American investors, because for reasons that aren’t entirely clear, that index has had pretty good predictive record as to changes in direction at New York. Now whether that pattern will remain through next year, we’ll have to find out.
But the FTSE reflects the fact that the global economy is seen to be a somewhat better bet for next year than the US economy. If you look at the way the stock markets of the world have been performing, the suggestion is that the US is going to move from being the world leader in terms of economic and profit performance to falling back in the pack. That’s if you take the stock market alone.
Now, you can’t always use what happened in one year as your benchmark for the next year because there’s so much of a pattern of doing exactly the reverse. But if we take more recent performance, which is the Investor’s Business Daily survey of 197 industry groups, what we see is that in the last six months, the precious metal stocks have the second best performing group, that’s out of 197. And the base metal stocks are fifth.
So, the mining stocks, in the last half of the year have been the place to be. And I’m not prepared to take them off the buy list, notwithstanding the fact that staying up in that single-digit ranking is very, very difficult indeed.
But if we look at the multiples on the mining stocks, with Phelps at about 71/2, BHP at 11.6, Inco at 13, Anglo American at 14 and Rio Tinto all by itself at 18 because of the buyback, given the huge earnings gains that we’ve had this year we should again have strong earnings even if we don’t have metal prices staying quite at the level they are now. And of course the only thing that will determine that is if in fact, we do have a global economic slowdown. Because the analysts are still using, on forward earnings projections, an assumption of lower prices for the metals.
Now, the metals really did get – the metals themselves – tremendous returns this year. And if you compare copper, which is up 61% this year…now that wasn’t, of course, a Page One story. The Page One story was the increase in natural gas. But natural gas was almost an identical return for the year, 61%. And crude oil was nowhere near that, at 45%.
So although the huge rises in energy prices were what caught everybody’s attention and were viewed as a bearish factor, particularly for the US economy, what quietly was going on in the background is the theme that we talked about in our August issue of Basic Points, where we talked about with all the excitement about energy, people were not noticing the borborygmi* in the bowels of the earth as something big was unfolding in the mining group.
The mining group still remains a situation where it’s only got one-tenth of the weight of the oils in the US market. So it’s still a small-cap group. And so, if current metals prices hold, or if indeed we get higher prices next year as a result of the global economy not slowing down, then this group should, I think, command a higher P/E ratio and therefore it will remain a leader next year. But the performance this year has been so wonderful that naturally one is cautious about saying you could do it back-to-back.
What is clear, that despite the performance of these stocks, what has not changed is the markets consensus about how they are valued relative to the rest of the index. Collectively, the energy stocks and the mining stocks are trading at a discount to the markets multiple in the US, so what we have failed to do, despite the tremendous performance of these companies in their earnings and their stock prices, is that there has not been a change of the consensus about what these stocks fundamentally are.
They are still viewed as cyclical, lower-quality stocks and therefore not entitled to have a high P/E ratio. I mean, the fact that ExxonMobil, the second biggest market-cap company in the world trades at 10 and Chevron at under 8 and Conoco at 6 is an indication that investors do not see that anything has changed in the fundamentals. They see a short-term squeeze here and they are also, I think, somewhat captivated by all the bad press and bad political flak that the industry has been getting in the US.
[tongue-in-cheek on]
To some extent there’s a reaction because there’s this special tax that’s going to be imposed on Big Oil companies next year in the US. This was as a result of that profound and brilliant left-wing insight which is that the way to lower the cost of gasoline, heating oil and natural gas is to have an excess profit tax on the big oil companies, not on the smaller ones, but on the big companies.
Now, this is such a breakthrough in thinking that I sort of apologize to listeners here for not having thought of this as the answer to our problems. But, we’ll hand it to them. And the fact that they were able to get a majority through Congress on that, shows the great wisdom in Washington in dealing with the energy problems. And apparently the stock market, dazzled by this wisdom, is saying “Well therefore, we can’t assign a high value to these companies.”
[tongue-in-cheek off]
I suspect that that kind of perception is going to fade as the coming year unfolds. Because these are high-quality earnings in these stocks. And if the companies are able to make progress next year on their reserve life indices, then it will take away the most rational reason for not assigning a high P/E ratio to them. Which is that their existing business model doesn’t appear to be sustainable, because their reserve life indices are mid to low teens and that one thing that was very clear this year is that the playgrounds for Big Oil are being taken off and handed over to other purposes.
In a way, one of the bit stories of the year was the huge change within Russia. And it culminated just this week with the resignation or the squeezing out of the only really free market-oriented person around Vladimir Putin who’s Andre Illarionov and the fact that he’s finally thrown in the towel means that Putin is now surrounded by ex-KGB operatives and other grey figures whose commitment to free markets is very superficial.
The fact that one of his fellow KGB agents has been moved in to being the putative boss at Gazprom is an indication of what game will unfold as Putin - who has such a weak hand to play, because your talking about an economy in Russia which, ex-oil, is smaller than the Netherlands - he wants to use this for restoring Russia’s influence, so to speak in Europe and Asia. And the first step in this is their proposed price increases they want to impose on the Ukraine and on other ex parts of the Soviet empire who have dared to move ahead on democracy.
So there’s a dual pricing structure. Belarus gets gas cheap and Ukraine is going to have to pay more. They’re trying to resolve this issue as we speak, but one of the reasons why the Europeans are being very cooperative and helping Ukraine on this is because the pipelines that carry the gas into Western Europe pass through Ukraine and there’s been a practice in the past that the Ukrainians would tap into those lines.
Europe is now facing, even apart from the political influence, significant price increases in its natural gas going forward and that has implications for the US chemical stocks. Because $11 natural gas has been said by people such as the CEO of Dow Chemical to be a true killer for the plastics industry in the United States. And they aren’t interested in expanding their production in the US, but they are interested in expanding their production in parts of the world where they have access to moderately or cheaply priced natural gas. Europe in particular, because Europe has these long-term deals, they thought, for gas from the former Soviet Union.
It’s not clear how all this was going to play out, but what is clear is that natural gas is beginning to look like the energy product that’s going to have the biggest percentage sustained price increases going forward, because of a variety of factors, one of which of course is that in the US, the lower 48 states have failed to replace their production now for more than twenty years. And that the two things that were going to hold down gas prices, namely a huge increase in liquefied natural gas imports and the pipeline from the Arctic, those aren’t working out.
The natives are restless in the Yukon and the Northwest Territories of Canada and they haven’t agreed to pipeline terms. And the oil industry itself is driven between two proposals on pipelines. They want the one that would come down through Canada. The Governor of Alaska wants them to run a pipeline down and to have an LNG plant in Alaska and ship the gas down the West Coast and that is now being litigated as an argument of anti-trust because the oil industry isn’t agreeing as to what they see is the wrong way of dealing with it.
I cite that only as illustration that we’re going to be seeing bad press about Big Oil for a long, long time to come because this is not an industry which has a constituency in the media, that is, a supportive constituency. And the US position on energy prices just deteriorates from year to year as imports of energy keep rising and the US becomes more dependent on pricing structures globally.
So, how much do you discount a P/E ratio for bad press and occasional vexatious litigation? Well, one way of getting around that, of course, is to buy the Canadian stocks. And no surprise, the group that was really the star in our market down here this year was the Canadian integrated oil & gas stocks. And that of course is lead by Suncor, which are up 64% year to date. And we think that there’s no reason that that is going to fade out in the near-term because we’ve got the SEC decision to come down, we expect, sometime next year.
Although it’s quite apparent the SEC has lots of things on its hands. They’re going to be releasing a new policy on executive compensation and the whole question on how pensions and healthcare are going to be reported is going to be handled in a new fashion.
Chris Cox, no relation to me, is clearly a guy who wants to see that overall reporting of US corporations is better. He is not an Eliot Spitzer figure. What I think you can say is the kinds of reforms that he proposes to bring in, are going to cut the ground out from Eliot Spitzer, because he will be left without any obvious new dragons to slay. And I think that…I’m not suggesting that that’s the motivation here.
To the extent that Mr. Spitzer did focus his searchlights on some dark corners, this has been beneficial. But it’s clear that substantial sections of the business community and of Wall Street itself feel that some of his most recent crusades have been based mostly on making public allegations of fraud and awful things against leading businesses, corporations and leaders, but not being able to win anything in court. And the essence, of course, of a great prosecutor is that he wins cases in court.
So I suspect that another story that will unfold next year is whether or not there’s follow-through on a lot of cases out there such as an AIG and Greenberg and things like this, where they will fizzle out because there isn’t enough to take to a jury.
Well, the big topic of discussion right now as we come in to year-end is the flat or occasionally, minute-by-minute, inversion of the yield curve. And this is a big topic because if we do have an inverted yield curve, then it’s not a 100% certainty based on recent economic cycles, but a high probability of, at the very least, a severe slowdown in the US and in fact, an outright recession.
Now if we look at the yield, right now, on the 2-Year note in the US, is trading at even yield, 4.37, with the 10-Year note. And the 30-Year bond is only at 4.53. And the 30-Year bond is sort of a curiosity here, because it’s not a 30-Year, although it’s going to get a new supply coming in either late January or February, I forget which, when they re-open the T-Bonds. But the fact that we’re flat from the 2-Year to the 10-Year is a sign that I think the financial section of the market is going to have problems. It’s clearly had some problems recently.
It’s very difficult for bankers to make the kinds of money they have in the past with that kind of yield curve. Greenspan created a gigantic bailout and subsidy for the US banking system in the early 1990’s by maintaining a steep yield curve at a time when there were so many financial institutions going down because of the commercial real estate collapse.
So, the system now is liquid and in good shape and it can withstand this kind of thing. But what it does mean, I think, is that the reason we’ve been advocating for people buying financial stocks is to emphasize the great dividend payers, that reasoning will continue going forward because earnings are going to be problematic for the group.
Finally, just before we get to the questions, the concept of the great dividend-payers becomes even more important when you’ve got a year in which the biggest indices don’t go up much. So that the dividend stocks – those that grow their dividends faster than inflation – we think that concept is going to gain more strength going forward as people realize that the old arguments that you could always count on the spectacular capital gains returns, as those arguments start to dwindle in the face of the adjustments of society to the new demography, which is going to be with us for decades going forward, which implies slower economic growth, much, much heavier costs for looking after people, those kinds of concerns are going to be with us year in year out.
What it does mean is that the comparative advantage of those economies that do not have generous pension and healthcare systems, in a free trade environment, competing with the old, shall we say economies where each year a bigger and bigger share of GDP, both out of private savings and government spending goes for looking after the elderly in sickness and in health…that kind of trend is going to, I think, continue something else that we’ve seen in the last three years, which is that emerging market stocks outperform those of the OECD.
And so we end the year with the concept that we’ve been talking about for the last three years. Which is, that the clearest investment theme out there, is to be investing in the companies who produce what China and India – as the gigantic emerging economies – what they need to buy and not investing in companies who produce what China and India produce and export. That pattern is so well-established, and it means that I think the weightings within global equity portfolios for the commodity stocks, which have risen now for three straight years, next year will rise again, no matter what happens to the stock markets.
So, that’s the summary. It’s been a good year. I’m very grateful for the support that you people on the call and Basic Points readers have given to our work this year. And I’m optimistic that the kinds of things that we’ve evolved together about how you approach markets in this millennium, that those will gain relevance and traction going forwards.
That’s it. Any questions?
Caller 1: Good morning Don and Happy New Year to you. The fact that all the countries are exporting to the US and making money and re-investing the money they make back in the US market in bonds and stocks, doesn’t that really throw out the old canard about a recession with an inverted yield curve and all of that? Isn’t it really, even though it sounds like a laugh, different this time?
Don Coxe: Well there’s no doubt, Arthur, that we’ve seen the effects of this so far. Because mortgage rates wouldn’t be anywhere near where they are were it not for The Great Symbiosis and with that 1.3 trillion in Treasuries and mortgage-backeds that China and Japan have accumulated in the last 3 ½ years.
So, this circular process which is fascinating because what it recalls in a funny kind of way is the system done in the days of the early stages of the British empire with its trade with Africa, its North American colonies and what you had was a situation where they would send the ships down, bring slaves in from Africa and trade them for rum and things like this and they wouldn’t let the American colonies manufacture their own goods, they had to import from the mother country.
What you had was a circularity of process and the wealth, then, was designed to accumulate in Mother England. Well, that process broke down because of two things. First of all, Wilbur Force and people from Samuel Johnson onward said that the slave trade is a moral monstrosity and cannot continue. So you took that component out of it. And of course, the American Revolution.
So what that did, is forced Britain into changing its economy completely. And what they did was they changed their emphasis over toward India and trade with the Far East. But, what you’ve got here is a circularity where America becomes more and more dependent on the decisions of people who don’t have a long-term record of being wildly pro-American and are going to pursue what they perceive as their own best interests.
And in the case of China, it’s…this is a very prickly nation indeed. And to the extent that they decide maybe that one of the best ways to improve their economy, now that it’s maturing somewhat is to lower the cost of commodities for their companies, then a rise in the value of the Renminbi can be achieved simply by not re-investing the US trade surplus back in the US.
As to those other investors abroad, OPEC has been buying more Treasuries, but OPEC has not been a reliable source of funding in the past. Now they’ve got to invest the money somewhere, that’s true, but it’s hard to make the case that something like this is sustainable…well it’s certainly not sustainable forever, and what you don’t want to do is say “Well, it’s worked for the last three years, so at least another year or two are almost in the bag.” Maybe so and maybe not.
But what we do know, is if it starts to unravel, for whatever reason, we’re going to have some real problems now that we’ve got our household savings rate down to zero. That doesn’t give much of a cushion, because in a recession your savings rate goes up and that’s one of the things that makes the recession, is the sense that people, well, they’ve got to improve their savings. And to the extent that America’s savings finally start to go up, that can only be achieved, in effect, at the expense of economic growth.
So, looking at the relative performance of the stock markets, Arthur,it would seem to me that stock markets are expressing some skepticism about the sustainability of this process. Because the clear underperformance of the US…and despite the fact that this is one of the two best performing economies in the G-7, this does indicate where the decisions are being made by private investors, that there’s a better place to go. And so, it comes down to relying on dictators or in the case of Japan, a society that is bound to raise its own interest rates at some point as their economy recovers.
So, it is one of those things that can go wrong, it will go wrong someday, but maybe it won’t go wrong for a year or two. That’s the best you can say about it. Thank you. Any other questions?
Operator: There are no further questions in the queue.
Don Coxe: Well, thank you all for tuning in to this call and to the others, my reference to a horrible period of history was not to suggest that there’s a true parallel there, but it’s to illustrate that any time you’ve got the major economic center thinking that things will last the same way for it, history says that something comes along to change all that. And so, the US financing system is one that clearly is going to evolve. And frankly, the kinds of investments we’re recommending mean you’re taking a bet on the global economy. And therefore, I think we’re on the right side of what will be the next big evolution.
And on that note, I wish you the best for the new year. The next conference call will come on January 20th, because we’re off for our annual Caribbean vacation. Thanks again.
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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* Vocabulary Builder:
bor·bo·ryg·mus
n. pl. bor·bo·ryg·mi (-m )
A rumbling noise produced by the movement of gas through the intestines.
Nesbitt Burns Institutional Client Conference Call for December 29, 2005
Don Coxe
Chicago
Thank you all for tuning in to the call, the last this year, which comes to you from Chicago. It’s my chance to wish you all a Happy New Year. I hope that for the institutional investors on the line that it’s been a pretty happy year for them, relative performance.
But it’s not been a very happy year for the large-cap US stocks as measured in the big indices such as the Dow and the S&P. But it’s been a good year for global stock markets, been a good year for global bond markets. I think that if it’s ever a case of the market climbing a wall of worry, given the fact of all the worries out there which are reflected back by the clients, then maybe this rather modest rally we’re seeing has a little bit of heft in it going in to the new year.
Well, it’s obvious that what we need to do is begin by talking about the big-cap problem in the US market. And I think that it’s…it’s a bit of a surprise because it seems to spread right across the market. In the sense that if you look at the performance of the classic big index, take the Dow Industrials, they’re up 0.3% this year, which is, you know, within the area of no returns whatsoever, other than the dividends.
The transports, though, which are a smaller-cap index and a very different kind of index are up 12½%, so that’s been a good year for that group, notwithstanding, of course, the airline bankruptcies. But, what you had there is a spillover from the commodity boom and from the US trade deficit in terms of the performance of the rails. NASDAQ has given a lusty 2.5% return. This is one case where some big-cap stocks really did give a good performance, but the list is still short, dominated of course, by the amazing performance of Google.
When you get into the commodity groups, what’s fascinating…I mean we’ve had great performance from the commodity stocks. If you take, for example, the XOI, which is all the US oil stocks, we got a 37% return year-to-date. And if we take the TSE-capped Mining Index, that’s a 45%-er this year.
But it’s interesting how, within the US market, how poor the returns have been on the mega-caps. You know, ExxonMobil is only up 10% this year and Chevron’s only up 7½%. But if you go into lower-cap stocks, even a big one like Conoco, which is up 33, Marathon up 61 and then the pure refiners, with Valero up 128 and Tesoro up 90. What you can see was this was a year in which you were better off in smaller-caps and mid-caps even if you got the weighting right in terms of your exposure to energy.
Now, within the mining group, it was not so clear because of course, we don’t have mega-cap mining stocks within the indices here. So, the tremendous 46% out of Phelps Dodge this year and the strong returns for the big multinational mining stocks, with BHP up 40%, Rio Tinto up 53%. But Rio Tinto’s performance has been given a bit of a financial steroid in terms of a major buyback program. Rio Tinto had chosen not to buy other companies but to buy back its own stock.
So these stocks, though, are tied in to global indices and that’s been a big part of the story because it’s been a year in which the US was not the place to have your money. You could go almost anywhere else, certainly north of the border, south of the border and across the oceans.
And this week the FTSE Index in London broke out solidly on a four-year high. And that’s a reassuring index for American investors, because for reasons that aren’t entirely clear, that index has had pretty good predictive record as to changes in direction at New York. Now whether that pattern will remain through next year, we’ll have to find out.
But the FTSE reflects the fact that the global economy is seen to be a somewhat better bet for next year than the US economy. If you look at the way the stock markets of the world have been performing, the suggestion is that the US is going to move from being the world leader in terms of economic and profit performance to falling back in the pack. That’s if you take the stock market alone.
Now, you can’t always use what happened in one year as your benchmark for the next year because there’s so much of a pattern of doing exactly the reverse. But if we take more recent performance, which is the Investor’s Business Daily survey of 197 industry groups, what we see is that in the last six months, the precious metal stocks have the second best performing group, that’s out of 197. And the base metal stocks are fifth.
So, the mining stocks, in the last half of the year have been the place to be. And I’m not prepared to take them off the buy list, notwithstanding the fact that staying up in that single-digit ranking is very, very difficult indeed.
But if we look at the multiples on the mining stocks, with Phelps at about 71/2, BHP at 11.6, Inco at 13, Anglo American at 14 and Rio Tinto all by itself at 18 because of the buyback, given the huge earnings gains that we’ve had this year we should again have strong earnings even if we don’t have metal prices staying quite at the level they are now. And of course the only thing that will determine that is if in fact, we do have a global economic slowdown. Because the analysts are still using, on forward earnings projections, an assumption of lower prices for the metals.
Now, the metals really did get – the metals themselves – tremendous returns this year. And if you compare copper, which is up 61% this year…now that wasn’t, of course, a Page One story. The Page One story was the increase in natural gas. But natural gas was almost an identical return for the year, 61%. And crude oil was nowhere near that, at 45%.
So although the huge rises in energy prices were what caught everybody’s attention and were viewed as a bearish factor, particularly for the US economy, what quietly was going on in the background is the theme that we talked about in our August issue of Basic Points, where we talked about with all the excitement about energy, people were not noticing the borborygmi* in the bowels of the earth as something big was unfolding in the mining group.
The mining group still remains a situation where it’s only got one-tenth of the weight of the oils in the US market. So it’s still a small-cap group. And so, if current metals prices hold, or if indeed we get higher prices next year as a result of the global economy not slowing down, then this group should, I think, command a higher P/E ratio and therefore it will remain a leader next year. But the performance this year has been so wonderful that naturally one is cautious about saying you could do it back-to-back.
What is clear, that despite the performance of these stocks, what has not changed is the markets consensus about how they are valued relative to the rest of the index. Collectively, the energy stocks and the mining stocks are trading at a discount to the markets multiple in the US, so what we have failed to do, despite the tremendous performance of these companies in their earnings and their stock prices, is that there has not been a change of the consensus about what these stocks fundamentally are.
They are still viewed as cyclical, lower-quality stocks and therefore not entitled to have a high P/E ratio. I mean, the fact that ExxonMobil, the second biggest market-cap company in the world trades at 10 and Chevron at under 8 and Conoco at 6 is an indication that investors do not see that anything has changed in the fundamentals. They see a short-term squeeze here and they are also, I think, somewhat captivated by all the bad press and bad political flak that the industry has been getting in the US.
[tongue-in-cheek on]
To some extent there’s a reaction because there’s this special tax that’s going to be imposed on Big Oil companies next year in the US. This was as a result of that profound and brilliant left-wing insight which is that the way to lower the cost of gasoline, heating oil and natural gas is to have an excess profit tax on the big oil companies, not on the smaller ones, but on the big companies.
Now, this is such a breakthrough in thinking that I sort of apologize to listeners here for not having thought of this as the answer to our problems. But, we’ll hand it to them. And the fact that they were able to get a majority through Congress on that, shows the great wisdom in Washington in dealing with the energy problems. And apparently the stock market, dazzled by this wisdom, is saying “Well therefore, we can’t assign a high value to these companies.”
[tongue-in-cheek off]
I suspect that that kind of perception is going to fade as the coming year unfolds. Because these are high-quality earnings in these stocks. And if the companies are able to make progress next year on their reserve life indices, then it will take away the most rational reason for not assigning a high P/E ratio to them. Which is that their existing business model doesn’t appear to be sustainable, because their reserve life indices are mid to low teens and that one thing that was very clear this year is that the playgrounds for Big Oil are being taken off and handed over to other purposes.
In a way, one of the bit stories of the year was the huge change within Russia. And it culminated just this week with the resignation or the squeezing out of the only really free market-oriented person around Vladimir Putin who’s Andre Illarionov and the fact that he’s finally thrown in the towel means that Putin is now surrounded by ex-KGB operatives and other grey figures whose commitment to free markets is very superficial.
The fact that one of his fellow KGB agents has been moved in to being the putative boss at Gazprom is an indication of what game will unfold as Putin - who has such a weak hand to play, because your talking about an economy in Russia which, ex-oil, is smaller than the Netherlands - he wants to use this for restoring Russia’s influence, so to speak in Europe and Asia. And the first step in this is their proposed price increases they want to impose on the Ukraine and on other ex parts of the Soviet empire who have dared to move ahead on democracy.
So there’s a dual pricing structure. Belarus gets gas cheap and Ukraine is going to have to pay more. They’re trying to resolve this issue as we speak, but one of the reasons why the Europeans are being very cooperative and helping Ukraine on this is because the pipelines that carry the gas into Western Europe pass through Ukraine and there’s been a practice in the past that the Ukrainians would tap into those lines.
Europe is now facing, even apart from the political influence, significant price increases in its natural gas going forward and that has implications for the US chemical stocks. Because $11 natural gas has been said by people such as the CEO of Dow Chemical to be a true killer for the plastics industry in the United States. And they aren’t interested in expanding their production in the US, but they are interested in expanding their production in parts of the world where they have access to moderately or cheaply priced natural gas. Europe in particular, because Europe has these long-term deals, they thought, for gas from the former Soviet Union.
It’s not clear how all this was going to play out, but what is clear is that natural gas is beginning to look like the energy product that’s going to have the biggest percentage sustained price increases going forward, because of a variety of factors, one of which of course is that in the US, the lower 48 states have failed to replace their production now for more than twenty years. And that the two things that were going to hold down gas prices, namely a huge increase in liquefied natural gas imports and the pipeline from the Arctic, those aren’t working out.
The natives are restless in the Yukon and the Northwest Territories of Canada and they haven’t agreed to pipeline terms. And the oil industry itself is driven between two proposals on pipelines. They want the one that would come down through Canada. The Governor of Alaska wants them to run a pipeline down and to have an LNG plant in Alaska and ship the gas down the West Coast and that is now being litigated as an argument of anti-trust because the oil industry isn’t agreeing as to what they see is the wrong way of dealing with it.
I cite that only as illustration that we’re going to be seeing bad press about Big Oil for a long, long time to come because this is not an industry which has a constituency in the media, that is, a supportive constituency. And the US position on energy prices just deteriorates from year to year as imports of energy keep rising and the US becomes more dependent on pricing structures globally.
So, how much do you discount a P/E ratio for bad press and occasional vexatious litigation? Well, one way of getting around that, of course, is to buy the Canadian stocks. And no surprise, the group that was really the star in our market down here this year was the Canadian integrated oil & gas stocks. And that of course is lead by Suncor, which are up 64% year to date. And we think that there’s no reason that that is going to fade out in the near-term because we’ve got the SEC decision to come down, we expect, sometime next year.
Although it’s quite apparent the SEC has lots of things on its hands. They’re going to be releasing a new policy on executive compensation and the whole question on how pensions and healthcare are going to be reported is going to be handled in a new fashion.
Chris Cox, no relation to me, is clearly a guy who wants to see that overall reporting of US corporations is better. He is not an Eliot Spitzer figure. What I think you can say is the kinds of reforms that he proposes to bring in, are going to cut the ground out from Eliot Spitzer, because he will be left without any obvious new dragons to slay. And I think that…I’m not suggesting that that’s the motivation here.
To the extent that Mr. Spitzer did focus his searchlights on some dark corners, this has been beneficial. But it’s clear that substantial sections of the business community and of Wall Street itself feel that some of his most recent crusades have been based mostly on making public allegations of fraud and awful things against leading businesses, corporations and leaders, but not being able to win anything in court. And the essence, of course, of a great prosecutor is that he wins cases in court.
So I suspect that another story that will unfold next year is whether or not there’s follow-through on a lot of cases out there such as an AIG and Greenberg and things like this, where they will fizzle out because there isn’t enough to take to a jury.
Well, the big topic of discussion right now as we come in to year-end is the flat or occasionally, minute-by-minute, inversion of the yield curve. And this is a big topic because if we do have an inverted yield curve, then it’s not a 100% certainty based on recent economic cycles, but a high probability of, at the very least, a severe slowdown in the US and in fact, an outright recession.
Now if we look at the yield, right now, on the 2-Year note in the US, is trading at even yield, 4.37, with the 10-Year note. And the 30-Year bond is only at 4.53. And the 30-Year bond is sort of a curiosity here, because it’s not a 30-Year, although it’s going to get a new supply coming in either late January or February, I forget which, when they re-open the T-Bonds. But the fact that we’re flat from the 2-Year to the 10-Year is a sign that I think the financial section of the market is going to have problems. It’s clearly had some problems recently.
It’s very difficult for bankers to make the kinds of money they have in the past with that kind of yield curve. Greenspan created a gigantic bailout and subsidy for the US banking system in the early 1990’s by maintaining a steep yield curve at a time when there were so many financial institutions going down because of the commercial real estate collapse.
So, the system now is liquid and in good shape and it can withstand this kind of thing. But what it does mean, I think, is that the reason we’ve been advocating for people buying financial stocks is to emphasize the great dividend payers, that reasoning will continue going forward because earnings are going to be problematic for the group.
Finally, just before we get to the questions, the concept of the great dividend-payers becomes even more important when you’ve got a year in which the biggest indices don’t go up much. So that the dividend stocks – those that grow their dividends faster than inflation – we think that concept is going to gain more strength going forward as people realize that the old arguments that you could always count on the spectacular capital gains returns, as those arguments start to dwindle in the face of the adjustments of society to the new demography, which is going to be with us for decades going forward, which implies slower economic growth, much, much heavier costs for looking after people, those kinds of concerns are going to be with us year in year out.
What it does mean is that the comparative advantage of those economies that do not have generous pension and healthcare systems, in a free trade environment, competing with the old, shall we say economies where each year a bigger and bigger share of GDP, both out of private savings and government spending goes for looking after the elderly in sickness and in health…that kind of trend is going to, I think, continue something else that we’ve seen in the last three years, which is that emerging market stocks outperform those of the OECD.
And so we end the year with the concept that we’ve been talking about for the last three years. Which is, that the clearest investment theme out there, is to be investing in the companies who produce what China and India – as the gigantic emerging economies – what they need to buy and not investing in companies who produce what China and India produce and export. That pattern is so well-established, and it means that I think the weightings within global equity portfolios for the commodity stocks, which have risen now for three straight years, next year will rise again, no matter what happens to the stock markets.
So, that’s the summary. It’s been a good year. I’m very grateful for the support that you people on the call and Basic Points readers have given to our work this year. And I’m optimistic that the kinds of things that we’ve evolved together about how you approach markets in this millennium, that those will gain relevance and traction going forwards.
That’s it. Any questions?
Caller 1: Good morning Don and Happy New Year to you. The fact that all the countries are exporting to the US and making money and re-investing the money they make back in the US market in bonds and stocks, doesn’t that really throw out the old canard about a recession with an inverted yield curve and all of that? Isn’t it really, even though it sounds like a laugh, different this time?
Don Coxe: Well there’s no doubt, Arthur, that we’ve seen the effects of this so far. Because mortgage rates wouldn’t be anywhere near where they are were it not for The Great Symbiosis and with that 1.3 trillion in Treasuries and mortgage-backeds that China and Japan have accumulated in the last 3 ½ years.
So, this circular process which is fascinating because what it recalls in a funny kind of way is the system done in the days of the early stages of the British empire with its trade with Africa, its North American colonies and what you had was a situation where they would send the ships down, bring slaves in from Africa and trade them for rum and things like this and they wouldn’t let the American colonies manufacture their own goods, they had to import from the mother country.
What you had was a circularity of process and the wealth, then, was designed to accumulate in Mother England. Well, that process broke down because of two things. First of all, Wilbur Force and people from Samuel Johnson onward said that the slave trade is a moral monstrosity and cannot continue. So you took that component out of it. And of course, the American Revolution.
So what that did, is forced Britain into changing its economy completely. And what they did was they changed their emphasis over toward India and trade with the Far East. But, what you’ve got here is a circularity where America becomes more and more dependent on the decisions of people who don’t have a long-term record of being wildly pro-American and are going to pursue what they perceive as their own best interests.
And in the case of China, it’s…this is a very prickly nation indeed. And to the extent that they decide maybe that one of the best ways to improve their economy, now that it’s maturing somewhat is to lower the cost of commodities for their companies, then a rise in the value of the Renminbi can be achieved simply by not re-investing the US trade surplus back in the US.
As to those other investors abroad, OPEC has been buying more Treasuries, but OPEC has not been a reliable source of funding in the past. Now they’ve got to invest the money somewhere, that’s true, but it’s hard to make the case that something like this is sustainable…well it’s certainly not sustainable forever, and what you don’t want to do is say “Well, it’s worked for the last three years, so at least another year or two are almost in the bag.” Maybe so and maybe not.
But what we do know, is if it starts to unravel, for whatever reason, we’re going to have some real problems now that we’ve got our household savings rate down to zero. That doesn’t give much of a cushion, because in a recession your savings rate goes up and that’s one of the things that makes the recession, is the sense that people, well, they’ve got to improve their savings. And to the extent that America’s savings finally start to go up, that can only be achieved, in effect, at the expense of economic growth.
So, looking at the relative performance of the stock markets, Arthur,it would seem to me that stock markets are expressing some skepticism about the sustainability of this process. Because the clear underperformance of the US…and despite the fact that this is one of the two best performing economies in the G-7, this does indicate where the decisions are being made by private investors, that there’s a better place to go. And so, it comes down to relying on dictators or in the case of Japan, a society that is bound to raise its own interest rates at some point as their economy recovers.
So, it is one of those things that can go wrong, it will go wrong someday, but maybe it won’t go wrong for a year or two. That’s the best you can say about it. Thank you. Any other questions?
Operator: There are no further questions in the queue.
Don Coxe: Well, thank you all for tuning in to this call and to the others, my reference to a horrible period of history was not to suggest that there’s a true parallel there, but it’s to illustrate that any time you’ve got the major economic center thinking that things will last the same way for it, history says that something comes along to change all that. And so, the US financing system is one that clearly is going to evolve. And frankly, the kinds of investments we’re recommending mean you’re taking a bet on the global economy. And therefore, I think we’re on the right side of what will be the next big evolution.
And on that note, I wish you the best for the new year. The next conference call will come on January 20th, because we’re off for our annual Caribbean vacation. Thanks again.
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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