Don Coxe
October 1, 2004
Chicago
Chart: Natural Gas Contract
Comment: The Other Energy Problem for the Economy
Thank you and good morning everybody. The call comes to you from Denver. And the chart that we faxed out was the natural gas contract. The comment was “The Other Energy Problem for the Economy”.
We’ve got lots to talk about this morning because so much has happened in the past week. So, let’s get to it quickly. First of all, the gas story.
Now this is a significant one in so many ways, because we’re getting the first cold front in so long coming through. And in talking to our oil and gas group at Harris Nesbitt here in Denver, they explained that the move on the natural gas contract was because of the long range weather forecast, which start to come out this time of the year, and they are predicting cooler weather.
The reason why natural gas got hammered so badly was because we had this very cool summer. And therefore the time that you’d ordinarily have big demand for the electricity industry because of air conditioning didn’t materialize. And so what we’ve got is a lot of gas in storage.
But what’s significant and Ray Deacon pointed this out to me is that this is despite a big build-up in drilling for natural gas in the United States which didn’t produce the kind of results he would have expected. Which is a big part of this story, which is, we’re just running out of good drilling targets to get the hydrocarbons that we need. So, what the current issue of Basic Points – which went to press yesterday – what we’re dealing with is this crossover which has occurred in the analysis of what high energy prices mean to inflation and to investments generally.
And that we have somehow mystically moved from the concept that high oil prices particularly, mean higher inflation to the exactly reverse concept. Which is why we have come up with what would be a highly controversial recommendation, which is that equity-oriented investors should have a very different kind of bond portfolio than the bond portfolio you would get by tracking your local index, whether it’s the Lehman Aggregate Index or the Scotia McLeod Index or the European ____, your local index.
Because what is clear is that we’re getting the China Effect on the performance of inflation on a worldwide basis. Which is, that China is creating commodity inflation on a grand scale and this is a worldwide thing of course because commodities trading around the world. But that China is simultaneously producing disinflationary or deflationary effects, particularly in the US, with the gigantic trade surplus that they’re running which prevents finished goods prices from going up.
It also has the effect of those manufacturers and those distributors and so forth who are still in business in this that it’s holding down wage increases and it’s holding down capital spending. So what we’re getting then, is a double whammy effect on what people’s real incomes are going to be.
And all of this suggests that the optimistic economic forecasts may have to be scaled back. And the stock market is priced somewhere between 17 and 20 times earnings, that’s the S&P. And the groups that benefit from this China Effect, which are the commodities and the transportation groups in particular are on a combined basis about 10% of the index. And what we’ve got is problems for a huge range of companies in the rest of the index.
Now this is discussed in great detail in the long, long issue [of Basic Points], I warn you in advance. But, we hope that you’ll work your way through this, because what we’re saying is you need to build in a reduction of endogenous risk in your portfolios. And that longer-term bonds give you a low-cost form of put against economic disappointments.
And so therefore, the recommended change in the bond durations, which are a sharp increases for all the bond portfolios, will not seem appropriate for the specialty bond managers because they’re benchmarked off their local indices and it would be hard for them to explain to their clients why they’re going so long in duration. This is designed for balanced fund managers and it’s particularly important for high net worth investors.
And those of you who have been following our advice for the last three years should have huge embedded capital gains on the stock groups that we’ve been recommending. And we’re not saying that you take any money out of those groups. We’re still in the early phases of what will be the greatest commodity bull market of all time. And apart from the capital gains implications of cashing out, taking some money off the table just because you’ve got big gains – you may have trouble buying these stocks back because their total market cap on a global basis is so modest.
And so what we’re recommending then is that you stay with the groups that benefit from what is a gigantic transfer of wealth. And so come back to the rules that we’ve begun each year with, we start each year with all other things being equal, buy stocks of companies who produce what China needs to buy, Rule #2, all other things being equal, do not hold stocks of companies who produce what China produces.
So, next of course is the election. We had the debate last night. Since I was working with the Denver audience I didn’t see the debate, I stayed up late and watched the various network analyses of how the debate went and even the Fox news people had to admit that Kerry did well. He came across well. Bush, some of the observers said, looked somewhat tired. He had been out working through Florida in hurricane areas. And so what’s particularly significant, in the futures markets, where they evaluate the election outcome and will have real money bet on it, the Bush premium was chopped by 2 ½ percentage points.
He would still be ahead in this but it will take time to see how the polls work out but the general consensus that seemed to come from the various analysts was that this election is tight. So what that does of course is have a big impact on the groups that are most vulnerable to a Kerry victory. And right at the top of the list is the next topic which is the pharmaceutical stocks because they’ve been cited by the Kerry camp as the great villains in healthcare costs.
…
Dividend paying stocks are also at risk
[The Merck story should focus investors on a problem for a major group]
[Negative on major pharmaceuticals]
[Reference to Bill Gross comments on hedonics, Kurt Richebacher]
[WSJ story – over the last 7 years, bonds have hugely outperformed stocks, shows effect of triple waterfall crash]
[Problems of the Pension and Benefit Guaranty Corporation are going to be moving front and center as more and more companies dump their pension liabilities into PBGC. So this is a story that’s been on Page 16 and it’s moving to Page 1.]
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Quite frankly, the commodity stocks continue to look like bargains relative to the rest of the market. And if you take the approach that we’ve been advocating - which is you’re paying for the value of resources in the ground - then all you need to do to find out what these companies are worth is use a more realistic, as I would put it, assumption about the value of the commodity. Whether it’s oil or gas or copper or nickel or lead or zinc, you’re talking about something that is worth more than the market is currently paying for it.
And in a way, the fact that Noranda is being sold now, actually reinforces my view. Because, you’ll recall my dictum that the great investment opportunities come from an asset class where those who know it best, love it least because they’ve been disappointed most. So when Jack C. and the Brascan people finally give up on Noranda after they’ve suffered with it for twenty years, twenty-five years, what that illustrates is my belief that the people in these industries have been through so much that when they finally get a chance to sell out on a breakeven basis, they rush to liquidate.
But there are so few of these companies left and their total market cap is so tiny relative to global indices. So the Chinese are making a great deal for themselves and I’m not being particularly critical of the Brascan people on that, they’ve changed the focus of the company, but it illustrates that the people within these industries still have modest assumptions.
Ray Deacon was pointing out to me that the deals that are being done consistently here in this country on oil & gas companies, are benchmarked to 28 dollar and a half oil and gas taking one sixth of that as the value of gas. And this is the way properties are being transferred back and forth among the industry. In other words the industry is not raising its own assumption prices for buying and selling properties.
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For reasons that are not quite clear to us, the number of people that have been joining us on the web has skyrocketed. We’ve been reported by our service that we’re up from 7,000 to 25,000 on the web on a weekly call basis. And so for those of you who will be listening to us on the weekend, thank you for coming aboard and we shall talk to 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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