Hi Mike,
I was so impressed by the following,that I am compelled to bore you with it:
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Thank you all for tuning into the call which comes to you Toronto. The
chart that we faxed out was a chart, two charts, the American Stock Exchange
Oil Index, the XOI and the Philadelphia Stock Exchange Gold and Silver
Index, and the tag line was "When Stuff Happens to Stuff". The title
actually comes from a David Hare play which I saw in London last year, about
the invasion of Iraq, a play at the National and that is coming to Broadway
this year. A very remarkable play, reconstructing - it's one of these
docudramas - the decision-making that went on in the Bush administration
with Tony Blair about the decision to go into Iraq. A remarkably
well-balanced play actually, but it's based on Don Rumsfeld's line, when he
was being question about the fact that things hadn't worked out so well.
His answer was "Stuff Happens".
And so, given the tremendous sell-off in the commodity stocks on Tuesday,
which is being replicated again today, this is obviously our theme for the
week. Lots to talk about.
So, the one thing I want to lead off with here is that I had the advantage
this week of going out to see institutional investors here in Toronto and
also to read the Canadian papers while I'm here, to see the way in which the
sell-off in the commodity stocks has been treated. And I've the good luck
to be up here in the last twelve months on days when there's been sell-offs
in the commodity stocks. And each time, I've had the great joy of reading
local experts being quoted as saying "We've reached the peak for the
commodity stocks." A long article in the Globe and Mail this week about
that, setting out why this time it was finally all over.
So, let's address that issue.
First of all, the Rule of Page Sixteen. Now, again, to the Canadians on the
call and to the Americans and Europeans on the call who are heavy investors
in the commodity stocks, let me say that the confirmation that this was not
a Page One story yet in the world comes - and I invite you to look back at
it - on the Wall Street Journal for Wednesday and their column "Abreast of
the Market". The headline was "Declines of GM, Google Dumped Stocks". The
first column and a half go through Google, General Motors stock, the huge
move upwards in Disney, the sell-off in the home building stocks, lead by
Toll Brothers, the move in Boston Scientific and then...way down in the
second column..."Gold stocks slid as the price of the commodity fell".
So, from the standpoint of the Wall Street Journal's people in looking in
the market at what happened that day, the fact that stocks that we've been
talking about at such length for the last three and a half years had a
miserable day...that wasn't the Big Story.
So, it's always helpful to have these kinds of things happen like what's
unfolding this week, because, I know that a lot of you out there, because I
hear this, are very concerned, because the commodity story has become a Page
One story and that we are close to, if not past, a peak. And so each time
there's a sell-off, they say "Oop, we had a chance to get out because there
were all these headlines and we didn't respond, because it had become a Page
One story." And when you see this kind of sell-off occur and you realize
that in the financial press outside Canada that it's not the lead story, it
confirms my view that what we have not done, despite the huge move up in
these stocks in the last four years, we have not attracted broad coverage
among investors.
After all, we've only taken the commodity stocks from a 5% weighting in the
S&P at the bottom, to a 9 ½% weighting. So, this is not the stuff of
bubbles. And the most recent quarter for which we have the earnings numbers
in the S&P, earnings were up 16%, but if you take out the oil stocks, they
were only up 11%. So we still have the phenomenon, that this small group in
weighting is the biggest force in producing overall earnings gains for the
US stock market. And what has not happened, is that the market has
re-priced them upwards, reflecting the changed outlook for them, which are,
collectively the stocks that are tied to growth in the global economy as
opposed to growth in the OECD.
And until that happens, what it means is these stocks are destined to
outperform. Because the huge change that's occurred this decade is that
we've moved away from a total dependence on the US economy to the powerful
growth, particularly in Asia. When people look at the changes that are
occurring in the world, they don't reflect on the most important change,
which is, that we have negative savings rates in both the US and Canada, at
the moment. And yet, long term interest rates haven't risen. And the
reason for that is that we are drawing on the savings of the Third World,
this time.
The crises that we had in the 1990's when the expression "An emerging market
is one you cannot emerge from in an emergency", all of those sell-offs in
those Asian economies, were driven by having currencies that were pegged
directly or indirectly to the Dollar, which was in this runaway bull market,
and they didn't have the foreign exchange reserves to back it.
Now, what we have, is we don't have overvalued Asian currencies, what we
have are consciously undervalued Asian currencies, backed by huge foreign
exchange reserves which keep growing.
And the recycling of those reserves into the US market means that there's
been a complete end-around from the Fed in this cycle. So that although the
Fed has more than quadrupled the Fed funds rate, we have not had the
economic slowdown that you would have anticipated. Yes, we had that one
percent growth in the fourth quarter of the US, but the economists are
virtually unanimous that this first quarter is going to be a huge quarter of
growth in the US.
Yes, a slowdown has to occur at some point, now that we have the yield curve
really decisively inverted, a fact which was confirmed by the fabulous
demand yesterday for the new issue of 30-Year bonds. But, the estimates
are, that I've seen are that global economic growth last year was 5%.
That's the number that's being _______.
Which means that maybe for the first time since the mid-90's, the Third
World decisively outperformed the First World, including the US economy. So
that, it's not the US consumer who is the sole and only support of the
economy. And therefore, it doesn't mean that the kinds of stocks that
directly are tied to the US consumer economy are the ones that define global
stock markets. Or it shouldn't be.
But instead, what we have is this situation that the institutional
investors, collectively, are focused on the kinds of weightings that they've
had in the past. So until we re-price the commodity stocks, until we move
them up into a P/E ratio approximating that of the broad market, we don't
have anything like a bubble.
After all, reviewing the 1990's, I'll just do it with one stock. In 1991,
Intel traded at eleven times earnings because it was correctly understood to
be a capital-spending cyclical stock. It gradually got re-priced into being
a growth stock and at the peak it was a seventy-one multiple. Now that's
what happens in the build-up in a Triple Waterfall or a bubble situation,
which is that this New Era thinking takes over. What we still have here is
a view that these are short-term cyclicals and industries that have lots of
highly-publicized problems and therefore the market is not prepared to
re-price them.
So the fundamental mispricing between the groups whose earnings gains are
far ahead of that of the broad market, remains. Now that doesn't mean we
can't have big sell-offs, but they are, in my view, buying opportunities.
So, with Phelps Dodge down seven points today in response to a six cent drop
in the price of copper, let's put that into perspective. What is the news
that we have in copper recently? Well, we're down to two and a half weeks
of supply on-hand. And we have two news stories of some significance for
copper, one of which...actually three. One of which is that the Chilean
copper company which is owned by the government is engaged in negotiations
with its unions.
Now they are planning $5.8 billion of investment, to bring on new copper
production later in this decade and early in the next decade. And the
figures for what they are going to have to spend, per tonne of copper
produced, means that they can't possibly make money on it without copper
prices of at least $1.50 a pound. And so the Chilean government people are
saying that they intend not to cave in to union demands saying "Look, with
copper at $2 a pound, we want gigantic wage increases."
Because Chilean copper production, the government-owned companies, who, by
the way, supply 90% of the budget surplus for Chile, these companies are at
peak production levels and they need to bring on new production or
otherwise, total production will fall from the year 2012 forward. And when
you're the world's leading producers, you have a responsibility to plan
ahead.
What has happened, that in terms of where inflation has been felt, it's hit
the mining industry very, very hard, they have people inflation, which is
trying to get trained people, because all sorts of smart people wouldn't go
into geology or mining engineering in the 1990's and the mine workers, this
is among global industries, one that has the oldest average age and it is
undoubtedly the oldest average age in the history of this industry.
And of course, they've got the fact that when they do capital spending they
have to do things like buy steel. They've got to buy the big tires, which
are in disastrously short supply, all of these things mean that to bring on
new production, like the oil sands in Canada, the fields that are going to
be brought on later in this decade, are going to have a much higher capital
cost than those that are producing now.
The mining industry then, faced with the fact that it's been harvesting the
low-hanging fruit which came from the discoveries made in the 50's, 60's and
70's. If it's going to meet growing demand coming out of China and India,
it's going to have to be bringing on high-cost capacity.
And so, therefore, what we know is, if we don't have these sustained high
prices which are generating these fabulous profits for the current producing
companies, then the squeeze will just continue and extend it. We have had a
drop in exploration expenditures by the twenty-five biggest mining companies
in the world - a major drop - because they aren't being incented to develop
new mines. No new major discoveries have been announced for four years, on
a global basis.
So, those are some of the stories. BHP Billiton, apparently, is indicating
they want to get out of one of their Peruvian copper mines, because of all
the complaints and arguments they're having and of course they've got a
weather eye on the upcoming Peruvian election where the polls are swinging
back and forth, but if the Chavez-backed candidate wins, then we have got
something approaching a crisis situation for copper for the next couple of
years.
Because, no new production coming on stream, a squeeze now, demand rising at
about three percent a year and many of the existing mines, their output in
pounds per copper is declining modestly, partly because naturally what they
do in good mine management when the price is higher than they expect, they
mine lower-grade ore. When prices were down at sixty and seventy cents a
pound, they high-graded their mines in the 90's, just to keep going.
So, now, when you've got two dollar copper, you mine lower-grade sections of
the ore body which extends the life of the mine but what it doesn't do is
produce the classic commodity response, which is the price goes up and the
output increases to meet the demand. All of this is a huge change.
And so that's the actual news that's out there, in the copper industry. And
so the fact that Phelps Dodge has now given up twenty dollars a share is an
indication of the fact that the momentum players who did get attracted, this
was the one thing that did happen, obviously, was that the momentum players
who were buying Google, they also bought what else moved. Which was the oil
and the mining stocks and gold stocks. So Google is getting blasted and
they're getting blasted along with it. So we,,,if you take out the momentum
players, what we have not done is carried through the re-pricing, which will
be ultimately the sign of the peak for this bull market in the commodities.
What's also interesting is the erratic behavior of gold. Because it seems
to have been tied, to a very considerable degree, to gyrations in the Yen
and short positions in the Yen. And now we've had a demand from the biggest
bank in Japan, well actually the biggest bank in the world, MUFG, calling on
the Bank of Japan to abandon its loose monetary policies and start raising
interest rates.
What that has done has reinforced the Greenspan shock. Isn't it remarkable?
Alan Greenspan has had more of an impact on the stock market since he
stepped down from the Fed than he had in his last few months on the job.
Nothing unbecame him in the job as the leaving of it. Because his off the
record comments to a Lehman dinner in which he predicted, apparently, a
strong US economy got passed around. And what this did was got the story
out there that the Fed is going to have to be much tighter than people
thought. Boy oh boy.
And this gets confirmed then when you get this steeply inverted yield curve
which suggests to people we're going to have a real squeeze out there. And
all this means that the economy-related stocks are the ones that are getting
the hardest hit in this sell-off.
Now I'm not an economist so I'm not going to comment on it, but what is
clear is that when you've got the 30-Year bond selling at a discount in
yield to the 2-Year note, something big is unfolding and it isn't good for
economic growth in the US.
Does that mean that you should sell all commodity cyclical stocks? No, if
you believe, which is what we've been trying to maintain for years, that the
fundamental source of demand is growth in Asia.
And, for example, the fact that China found sixteen percent more GDP on the
basis of a middle-class that they didn't know was there before, is a sign of
the maturing of the growth, which means it's not all dependent on exports to
the US. At a good one third of all the meetings I've been at in the last
three weeks with clients, the argument has been: well, the housing bubble in
the US is going to burst, that means US consumers won't have money to spend
and that means that China's GDP is going to fall sharply and therefore their
demand for commodities.
Well, that may in fact be what will unfold, but it is not a given that
you'll go from nine and a half percent growth in China to four percent, if
there's a slowdown in US consumer spending. Remember the standard of
deviation in changes in US consumer spending has been narrowing decade by
decade. And so, yes, a contraction of the US housing bubble will definitely
mean a drop in US consumer spending, but whether that is going to mean a
collapse in the Chinese economy, that's a big stretch.
But I will remind you, and those of you who have been faithful on Basic
Points and the calls, know that this large cottage industry out there which
has been predicting, confidently, a collapse in the Chinese economy. They
haven't all disappeared. And so they will just keep finding new reasons to
predict it.
Let me remind you that since 1979, since 1979, the Chinese economy has grown
at a rate of between 5 and 12 percent. Year in, year out. Yes, there is a
standard of deviation that's fairly wide there, but in recent years it's
been fairly narrow, around the 8 to 10 range.
And we're now at the stage where even if they slowed down to 5 percent, it
produces an increase in demand for commodities because we've raised the base
so high.
So, you're saying, perhaps some of you out there, the skeptics are saying
"The stock market is saying you're wrong." Well frankly the stock market
has been saying for a long time that we're wrong. Because the stock market
has not raised the P/E ratios on these stocks. As a matter of fact, the P/E
ratios have, if anything, modestly contracted.
So, you've got to look into the wind. It may seem like the wind is at your
back when the commodity prices are rising and stock prices are soaring and
all sorts of small-cap stocks and companies who aren't producing anything
are bubbling ahead. But as you'll know from these calls, we're generalists
here, we aren't experts, so we focus on the large-cap blue chips within the
commodity industries. And, frankly, these stocks just simply look like
better value today than they did two months ago and dramatically better
value than they did two years ago.
Because two years ago you had to make some pretty optimistic assumptions
about what was going to happen because we still had high inventories, in the
case of the metals. Now that we've lost over 85% of the inventories of
copper, nickel, lead and zinc in the Comex the London Metal Exchange and the
Shanghai Exchange, so we're closer to a hand-to-mouth situation. It's
really a situation where, even if we have some slowing down, it's unlikely
we're going to have a major retrenchment.
Furthermore, what we know is from the gigantic write-downs announced by the
copper producers, that huge amounts have been locked in on forward sales and
that means, once again, that the industry has run down its capital that it
should be getting out of this, the kind of capital that could be used to
expand production at least from existing mines, if not from new mines.
And so, we've had two hundred million dollars on a Rule 133 write-down,
losses from Phelps Dodge. Sixty million from Rio Tinto. Three hundred and
twenty million from the Polish copper company. That's just three of them so
far that have reported. Now you may say "Well, wait a minute, they've got
these write-downs then why would you want to own the stocks?"
I'm talking about a package approach to an industry, where because of the
deep backwardation, what it shows is the industry hasn't changed its views
and the only way we can finally have a top is when the industry gets carried
away with wild enthusiasm and announces massive expansions and doesn't worry
about the cost. That may come some day. Not going to come for a long time
in the future.
So, summing it up then, these times are meant to try us, those of us who are
believers that the world has in fact changed from the economy of the 1990's.
But the great body of opinion out there still is that this is still a short
cycle. And that nothing has really changed. That China and India are still
marginal.
Well, that body of opinion will be proved wrong.
That's it, any questions?
Caller 1: Two questions here. We've gone from about 18 percent energy
weighting in the TSX to about 30ish, do you foresee this topping out forty,
fifty percent. That's the first question. And the second question is, on
the P/E multiple expansion issue, prices have risen, comps have risen, but
the reserves haven't really risen and I'm just thinking in terms of growth
in line with P/E multiple expansion, I'm just trying to figure out a reason
why maybe multiples aren't expanding, maybe there's a better explanation.
Don Coxe: Okay, you've got several good points in there. Let's address it
as to the peak weighting that they have in the TSX. I don't think you're
going to get up to forty of fifty percent because I think a lot of these
companies are going to be bought out. As we've said over and over, the
reserve life index of Big Oil is the biggest single item in the world energy
valuation situation.
And what's interesting is the Cambridge Energy Research Associates
conference this week where they have reiterated their call for the SEC to
come up with a reasonable formula for oil sands oil, but this time they're
more specific. The filing that they did a year ago this month with the SEC
to allow oil companies to incorporate the reserve life index of oil sands
into their reserve life and the SEC has just sat on it.
What they've come out with at this conference now is to say that the SEC
should simply use the Society of Petroleum Engineers statement for how you
evaluate "unconventional" crude oil sources. And if there's consistency
between those two, then it would mean that a Big Oil company buying a
Canadian oil sands stock would be able to use that reserve life index, which
is fifty years or more. As things stand now, they cant do that. So, I
have a feeling that will get resolved.
The US understands the strategic importance of oil sands to America and to
have this accounting technicality which was brought in twenty-three years
ago at a time there were all sorts of oil shale scams being perpetrated on
an unsuspecting American public, that will get changed. And it won't take
much time after that for some substantial amounts of money to go in there.
After all, you had Lee Raymond four years ago at ExxonMobil saying if oil
prices get above forty dollars they won't stay there, because we and the
other major oil companies will bring on so much new production from Russia
and Venezuela that the price will go back down to twenty-five dollars.
Lee Raymond then said last year, no new capital will be committed to Russia
or Venezuela and when asked at the press conference, well where are you
going to get the oil, to protect your reserve life index, he said well
Nigeria is looking very good. It was only a week later that Shell had to
cut back 120,000 barrels a day of production from Nigeria because of new
rebel attacks.
So, the twelve biggest oil companies in the world, they're P/E ratio stays
low relative to the market because it tracks pretty closely to the reserve
life index of Big Oil. People are saying, "You don't have a business plan,
to stay in business." So, in terms of oil companies that have long-duration
reserves, they are a strategic investment and they're not just strategic to
the USA they are strategic to something that has money to spend freely as
opposed to a government which is in deep deficit.
And with all the money that they've got to spend, there's a logical place to
do it.
I was watching Lord Brown being interviewed this week, head of BP, which has
the best record of all the Big Oil companies in the last forty years of
bringing on new, major fields, and they said "Well in the light of soaring
oil prices are you increasing your capital spending? And he says "Well
we're very consistent. We spent money on upstream when we had low prices
and we're spending money upstream on high prices. But if prices stay where
they are, stay above sixty dollars, then we're going to spend the money on
dividends and stock buybacks. We're going to give it to our stockholders.
So, what he was basically saying, was, we're not going to pour money into
big upstream operations, we don't have a place to go. So frankly, you're
absolutely right that the question of the re-pricing, what we need on the
re-pricing is to have visibility in reserves, and I think it's going to help
to get a change in the SEC policy.
In the case of the mining stocks, where we don't have these reserve life
index problems, they just haven't moved up at all partly because mining
stocks are still only .2% of the S&P 500 and it just isn't a big enough deal
for big-money standard style investors to take note of. Thank you. Any
other questions?
Caller 2: What is the trigger point or the event that is going to cause the
market, if you will, to increase the price they're going to pay for the
commodity stocks both oil and metals?
Don Coxe: Well, if I knew that, then I'd be a brilliant person a forecasting
the market on a short-term basis. And I've never been very good at that.
My view is that the sensible approach is to take a five year time horizon to
where you see value that's going to be identified in the market place and
that you've got to have the courage to accept the fact that there's going to
be lots of volatility en route.
Frankly, that kind of approach to investing has worked well for me and for
the organizations I've been associated with over the years. We also have
the nice reassuring fact that since the Era of Triple Waterfalls began in
1970, that in every decade, whatever asset class did best and did worst in
the first five years of a decade, was the same performance in the second
five years.
And so on that bass, commodities were by far the best performing asset class
in the first give years of this decade and it's been a hundred percent
accurate, based on thirty years, that they should be the strongest in the
second half. And that tech stocks, which were the worst should still be the
worst in the second half. So I see no clear evidence to suggest that the
forecasting tools that I've been using should be abandoned just because
we've had a hellacious week in the market.
But it's interesting that, as I say, that Google the stock which had
been...if it hadn't been for Google and Apple, NASDAQ wouldn't have been up
last year. And the fact that Google is performing like a copper mine or an
oil company suggests that momentum players can be really savage once they
exit a group. But Google did get re-priced, substantially and it's because
it's one tech company that everybody came to love. It just kept going up.
And so the fact that this gigantic global love affair with Google could
suddenly fall on the rocks, suggests that maybe those who make money out of
rocks are going to be in better shape.
Any other questions?
Thank you all for tuning in, we'll talk to you next week.
Don Coxe profile from the BMO websites:
Donald G.M. Coxe is Chairman and Chief Strategist of Harris Investment
Management, and Chairman of Jones Heward Investments. Mr. Coxe has 27 years
experience in institutional investing, including a decade as CEO of a
Canadian investment counseling firm and six years on Wall Street as a
'sell-side' portfolio strategist advising institutional investors. In
addition, Mr. Coxe has experience with pension fund planning, including
liability analysis, and tactical asset allocation. His educational
background includes an undergraduate degree from the University of Toronto
and a law degree from Osgoode Hall Law School. Don joined Harris in
September, 1993.
Don Coxe Weekly Conference Call - Current
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