AI
Sunday, June 12, 2005 9:34:01 AM
*** Don Coxe Conference call (6-10-05) ***
With many thanks to TheSlowLane from SI's "Precious and Base Metal Investing" board for the transcript. (Link below)
(Link to audio version of CC located below text)
Latest from Coxe...
Nesbitt Burns Institutional Client Conference Call for June 10, 2005
Don Coxe
Chicago, IL
“How Long The Largo Movement of the Mining Sonata?”
Chart: S&P’s Toronto Stock Exchange Index
http://stocks.moneysense.ca/moneysense/chart.asp?symbol=CT:ISPTX
Thank you all for tuning in to the call, which comes to you from Chicago. The chart that we faxed out was of the S&P TSX Capped Mining Index and that index is a relatively new one, but the comment that we made on it, the question was “How Long The Largo Movement of the Mining Sonata?”
To explain that, we’re referring you back to an issue of Basic Points in October of ’03, which is when we really, in some detail, outlined our views about the future of the base metals industry.
I’m not expecting that everybody on the call has a full back file of Basic Points so I’m going to begin by reiterating the thesis of that piece, which is that the story of the mining stocks and of the mining industry in this decade may well look like the formula I used for the construction of a sonata, which is the basic form of the symphony and the concerto. In that format, the most commonly used version of it is a three movement version.
So often, and I used the Beethoven violin concerto as one of my thoughts there, although you start thinking through symphonies and concertos that happen to appeal to any of you on the call and you’ll find that so often what happens is the second movement will be the slow and sometimes the mournful movement. Now it could be Andante, I use Largo, as a very slow form of it.
The first movement is usually pretty fast by comparison, maybe Allegretto or even Allegro. And the final movement can be once again fast and more sprightly. In the violin concerto it’s the Rondo form.
The reason I use that structure is because it occurred to me that for people who have not been interested in these stocks for twenty years – which was the right attitude to have as serious investors as opposed to short term traders – that I’d like to give them a quick formula for thinking about what the longer term investment pattern was likely to be for the group.
And I was suggesting in this there would be a time when they would enter a soft patch and that would be the prelude to a tremendous long movement that might last some period of time and that that would be the one where the real returns would come.
Well, in looking at that index, as you see, it had, of course the slow section back last year which didn’t last long…big recovery. And we’ve had another slow section this year, but having said that, it’s not been all that bad, although I certainly hear from clients routinely that they’ve been very upset with the performance of the mining group. But this particular index which is one of the few that I know has not had all that bad a year – it’s up 9% as of this morning.
Of that though, it’s distorted by the performance of two heavyweight stocks – Inco, which is up 9%, and Falconbridge, which is up 21%. And that is itself distorted by the merger arrangements between Noranda and Falconbridge. So critics can say “Well, this overstates how an investor would have done.” But I couldn’t find a better index to use for this.
As you’ll see from the chart, there was a significant sell-off until very recently. For those who are looking on a global basis, it’s not been a great year to be with the stocks. BHP Billiton though is up 8.9%, but Rio Tinto on the other hand is up just under 1%. And then the real disaster areas have been the aluminum stocks, which have just been appalling. Alcan is down 36%. It raises some question then as to what is the commonality among these stocks?
Well, the aluminums have always been in a different category. Because the value of aluminum is the congealed electricity cost in them. It’s not the alumina and certainly not the bauxite. Because aluminum is either the first or second most widely dispersed of the earth’s crust, behind silicon…admittedly it occurs in concentration in only a few places in the world, but there’s lots of it around.
Whereas if we’re talking about copper, nickel, lead and zinc, then there’s only a few mines in the world that are really significant in that. Most of them are sulphide ore bodies. So the value of the approach that we take, which is the value of reserves in the ground in secure areas of the world – there’s only relatively few such deposits. And that’s what really drives this index.
In the case of the aluminums, they’re faced with high energy costs and if you read today’s story in the Wall Street Journal about Boeing’s sudden recovery in it’s battle with Airbus, you will see that one of the components of it is that they’re not going to be using aluminum in the wings and fuselage of the 787.
They’re going to be using a combination of plastics and carbon. And so it’s space age metal substitutes that have reduced demand for aluminum there and that’s particularly bad news for Alcan because one of the assumptions that they and Alcoa both made was that in the next generation of aircraft that was going to create the demand for them.
Having said that, it’s still only a small proportion of aluminum consumption, but it is a meaningful thing at least in the optics of investors in these stocks because it is the refining of a specialized kind of product where the margins develop. So you think of aluminum as a manufactured product as opposed to a pure commodity and it’s something closer to steel in that sense.
But given that copper is trading at nearly a seventeen year high you would have expected the index to have done better. Because King Copper is the key to the base metals and it’s not been a very exciting time to own these stocks. And so you might say “Is the sonata working?”
Well, why have the stocks sold off? We’ve discussed this in a recent issue of Basic Points but I’ll just review it. First of all, the OECD economies are slowing down. But everybody knows that at the margin, the key driver for the base metals is China. And China is slowing down as evidenced by the sharp decline in the Baltic Freight Index. So, the pessimists then say, “Oh well, a combination of a slowing down of base metal demand in the advanced industrial economies plus a slowing in China means disaster ahead and therefore there’s no such thing as a new long cycle.”
The argument here is that China is in effect, just a proxy for metal demand in the advanced industrial world because China lives off exports.
Now, like all half-truths, it’s worth analyzing the components of the statement. Because to the extent that Chinese exports are simply displacements of manufactured goods that would have been made otherwise in Europe or North America or Japan, then what you can say is that the robust demand for growth in China for copper, which is in the 20-30% range year in, year out, that’s not really China, it’s simply that demand is being met in the advanced industrial world.
And so the statement that we used in Basic Points to refer to the fact that two years ago US GDP was up over 3% but copper demand fell less than 3%, kthat’s not a meaningful statement these critics say because goods made out of copper were no longer made in the US, they were made in China and shipped to the US.
Well, it’s no surprise to the people on this call that our essential thesis on the base metals is the new middle class in China, followed by India- the hundreds of millions of people who are going to get middle class dwellings over the next fifteen years. And middle-class dwellings involve indoor plumbing, electricity, basic appliances and a significant number of those people are going to own cars.
That’s the real thesis here of a long third movement of this sonata. And there are going to be pauses along the way on this. One of the things that the critics are throwing at me is “Look at the real estate speculation in China and they’re trying to cool it down so therefore that’s going to kill demand for metals.”
Well it’s pretty hard to find a place on Earth, outside of Antarctica and the North Pole where there isn’t real estate speculation going on and so I don’t think that’s necessarily a knock on the China thesis. Furthermore, if, to the extent that the real estate speculation in places like Shanghai and so forth is so much oriented towards dwellings, then it fits the thesis because whether they are condos or stand-alone dwellings, they’re going to need metals.
And it’s that secular growth trend, as people move from subsistence living to middle-class living that I believe has re-shaped the story on metals.
But anybody who read the interview with the CEO of Rio Tinto this week in the Wall Street Journal will see what he thinks of that thesis – he described it as silly. And so, why do I dwell on this? Well, it’s because I want to rebut those of you out there who say “The commodity boom has clearly peaked, because everybody’s talking about it, it’s the new consensus. And so therefore, it’s time to sell these stocks.”
I couldn’t disagree more. First of all, each time I go up to Canada and spend a few days there and see the coverage of commodities in the Canadian press and compare it to the coverage of commodities other than oil in the press of Europe and the United States, I realized that the focus in Canada, naturally, is on these industries in a way that doesn’t happen down here.
Remember that diversified mines are 1/10th of 1% of the S&P. So the good people who produce the Wall Street Journal and Investor’s Business Daily and the business section of the New York Times and the other newspapers can’t spend a lot of time talking about an industry where American investors that are benchmarked to the lead index down here are going to have trivial exposure.
Now, will there be a third movement soon or are we still in a sustained Largo movement which is just going to get worse?
I think that that’s a realistic risk. And the reason for that is that there’s no question that the economic slowdown in the world is going to reduce demand for base metals. I never suggested that we were in a cycle that was just going to keep going up. There’s going to be slowdowns along the way.
What is the significant core concept here is that we have a new kind of compounded growth in demand from hundreds and hundreds of millions of people who were not consumers of base metals at all in the past. So therefore, as this compounded growth develops, what we’re going to have is sustained growth on any five-year period you want to name, in demand for the metals. Not withstanding the announcements of expansion of production of facilities and there are some of those, I don’t see this as something that changes the argument.
Because going back to the thesis that Chinese GDP growth as opposed to the growth in Chinese consumption of the base metals is roughly a 3:1 ratio, in other words, if China’s growth falls back to 6%, which some of the bears are suggesting, that suggests about an 18% growth, roughly, in the average demand for the industrial metals. And that still means that demand is going to rise very significantly. It’s the second, third and fourth derivative issue.
I’m NOT suggesting that China’s going to grow at 9% forever, although it managed to do that for two decades. Obviously as the economy matures, there’s going to be, first of all a bigger standard of deviation in the returns and there will be periods of time where it slows down. But I don’t see that as a reason for getting out of these stocks.
I realize those who have very short-term time horizons here have to fine-tune it on the basis of the stock market’s perception. Coming back to Phelps Dodge, one certainly sees how important it is to be able to catch the markets changes in sentiment.
Now that’s one of the two stocks that’s in the S&P 500 and we’re coming up to the end of the June quarter for Phelps and just to show you the problem you have as an investor in this, of the analysts who follow the stock, the mean estimate for the earnings in this quarter is 3.84 per share. The high estimate is five dollars and sixty cents and the low estimate is two dollars and fifty-five cents, that’s fifteen analysts.
Now, you would have thought that that kind of dispersion in earnings estimates would mean that they were looking at an average of about twenty five stocks or something and trying to predict…or companies in totally different industries…that they’d lumped in a fast food company with a tech company with a bank and then they said the average earnings growth of these will be such. This is one company that produces only two metals, copper and molybdenum.
So, I still believe there’s a major perception problem out there and it has to do with my thesis that the major investment opportunities come from an asset class where those who know it best, love it least, because they’ve been disappointed most.
So, we still have this perception that if it’s good now, it’s got to be bad very soon. And, so that kind of range of earnings forecasts…the December quarter of this year the earnings forecasts ranged from four dollars and sixteen cents to a buck eighty.
Yet, if you look at the forward curve for copper, there’s no possible justification for any of those low estimates. So, therefore what the analysts are predicting is some time between now and the middle of August, the global economy is going to roll over and fall into a deep pit, not the kind of pit from an open mining operation.
Maybe it will happen, but the only possible justification for that would be to deal with what the 10-year notes are trading at in yield. Lead by the German Bunds who moved down first and by that 10-year Treasury note at its amazing level. Mr. Greenspan this week, for the first time conceded that instead of suggesting that the bond market was being driven by totally irrational forces, he said well, it could be that they’re really predicting a slowdown.
Now we’re just back over four percent today in the 10-year note, but my own read on that is that it may well be that something else is unfolding in the bond markets, other than a prediction of a slowdown which will look like a recession if it isn’t a full recession.
The reason for that is, it could be that the classic way in which bonds have been evaluated is undergoing a change because of the presence of the hedge funds as being the biggest players in these instruments, other than Fannie and Freddie. Fannie and Freddie, in the past, were the players of the 10-year note. Obviously of course they used it to hedge against their mortgages. But the fact that around the world, the long sovereign credits have shown the same pattern, suggest that something more is at stake.
It may well be that what is happening is that the efficiency and liquidity of financial markets and the bond market – in particularly the fact that the use of derivatives means you can get into and get out of unimaginable quantities of these in no time with a few keystrokes, that what it does is it goes back to where we were in the bond market at the time Lord Keynes developed his theory of liquidity preference, when he explained the yield curve on the basis of the preference for liquidity. So that the reason why longer term bonds sold at higher yields than short-term bonds was that investors always wanted liquidity.
And that changed after World War II. That was a Depression-era thesis. Changed after it to the idea that long-term bonds were the forecasters of inflation. Well, here we are at a time where despite the fact that oil prices are up 40% in no time and that we’ve had huge cost increases for healthcare and various other things you could name and that we’ve got housing prices in bubble mode almost everywhere you look but inflation as measured by the key indices remains muted.
And that’s not just the US. The conspiracy theorists would have us believe that the US statistics are totally rigged, but they’re simply confirming what’s happening elsewhere in the world. Which is, that the globalist forces are outweighing the impact of the two kinds of inflation generators in the real economy as opposed to monetary creation. Namely, the cost of commodities and the pricing structure of local supplied services where there’s no external competition.
And that so much of the economy now can be driven by global forces and we have this relentless overcapacity in China and in Japan which means that prices keep getting hammered. This is a tentative thesis, but at least it offers some alternatives to the view that the 4% 10-Year note is automatically predicting a slowdown so much that we can expect a collapse in metals prices. At a buck fifty six on copper, and looking at the forward curve, going out a few years, you’re looking still at prices over a buck and a quarter. These stocks remain amazingly cheap.
So, I don’t know when we’re going to move into the third movement of the sonata, but I do feel that investors would be wise not to be lightening up here on the basis that the bond market is telling them they’ve got to get out of the deep cyclical group.
As for the oils, what we’re getting is continued confirmation that notwithstanding OPEC’s desires to produce more and notwithstanding that we have real experts like the Cambridge Energy Research Insititute predicting a huge drop in oil prices, the futures curve fails to confirm any of this.
December oil is fifty-four dollars and ninety cents and so as against the spot price, Sorry…December ’09 oil is is fifty-four dollars and ninety cents and this year’s December crude…fifty-seven. What we’ve got then is a situation where you just can’t find cheap oil around. And so the thesis of our most recent Basic Points, about the hedgehogs, remains something that you’ve got to look at as investors.
When you decide in the commodity group, why it is that you’re investing in the group, our thesis is that you should own these stocks on the basis of having secure reserves in the ground. And that those reserves are going to grow in value over the coming years and that that’s going to be the most easily capitalized form of value increase that I can see in the market in terms of acquiring assets at these prices now.
And so the patient value investor is going to be rewarded. And this is largely confirmed by the curves themselves. But for whatever reason, investors are not taking that into account and the companies themselves are not taking it into account, the copper companies are selling forward heavily and the oil companies are still announcing that they don’t want to get involved in projects because they’re seeing oil going to twenty-five bucks.
I think you’ve got to be prepared to be a true contrarian.
And I’m always amused by these surveys that portfolio managers…more than seventy-five percent of whom describe themselves as contrarian, I would argue that those who are overweight commodity stocks in their portfolios are the world’s preeminent contrarians at the moment. Because they’re going against those people that should know far more than they do – namely the people who run the companies and Wall Street analysts.
So, for those of you who are prepared to take that kind of risk, which is that collectively our viewpoint will prove to be wiser than that of those who professionally obviously know more than we do – that is the essential risk. Is that the experts collectively are wrong and one always hesitates to say that – and it’s because of their own human experience, in which case…coming back to the group that is described in this chart, we’re heading into, at some point – once we come out of this slow patch – a third movement, which will be dramatic. It will be in a major key. It will be fun.
Now you may say “Oh, but we’re going to have a recession first, that’s the signal.” The thing that is worrisome is that we’ve got flat yield curves now. We’ve got an inverted yield curve inBritainand anytime you get an inverted yield curve in the post-war era you’ve had a recession.
But if don’t actually invert the yield curves on a global basis and since the central banks are probably not, lead by the European Central Bank and the Fed, likely to consciously move their economies into an inverted yield curve, I would argue that the low level of interest rates that we have and the low level of inflation is such that a recession is not a better than 50% probability, but the pricing of these stocks is saying it is at least that.
I think that those that are pricing these stocks in the marketplace, because of a view of a recession and those that are running the companies and saying prices of their commodities are about to collapse, will prove to be wrong. We shall see.
That’s it, any questions?
Steven Bartelow: Back in ’94 when the Fed was raising and throwing the bond market into a nasty bear market and then we had a couple quarters in ’95 of GDP growth of less than 2%, that recessed growth feeling that we were having in “Oh dear, the Fed’s going to overdo it and here we’re going in to a recession”, well they backed off and they put their foot back on the accelerator and we’re off and running again. Do you see any similarities to today’s situation to what we saw about a decade ago?
Don Coxe: Well It certainly is a worry, Steven, because what we’ve had here is a sustained tightening by the Fed and if you use percentage terms here we’ve had a 200% increase, a trebling of the Fed funds rate, which sounds draconic. But boy a Fed funds rate of three or even three and a half percent…if back in 1994 you were looking at the Fed funds rate, as I recall in the eight percent range, so that was much more serious.
Now what could be serious this time is these low mortgage rates have stimulated speculation on a level never seen before and therefore that we could have some kind of economic collapse from that. But it wouldn’t be because the system was drained of liquidity, as it was in ’94. It would simply be that we’d run out of loose speculative cash to bid up the prices of real property.
But that’s saying, I have always been of the view, in terms of what can go really wrong, is something disasterous developing the mortgage-backed sector of the market. I mean back then the mortgage-backeds were sixteen percent of the Lehmann Aggregate Index and now it’s about thirty-six the last time I saw them.
And back then the prevailing view was that Fannie and Freddie were very strong financially. And here we’ve got institutions that have to keep re-stating their earnings back years. If they were anything other than Government-Sponsored Enterprises, some of these guys would have been prosecuted by Eliot Spitzer and they would be regarded as the worst sinners since Enron.
So, if you’ve got the situation where the main players in this market are of dubious financial strength – dubious in the sense that nobody really knows what their financial strength is – you can make a case that something awful could happen in the mortgage-backed sector, if we had a sudden sell-off in real estate prices. With all these interest-only loans and so forth, gosh knows what could happen.
You know the last time we had interest-only loans as a big deal, was in the 1920’s. And I seem to remember that didn’t turn out well.
So, you’re right to raise this issue Stephen, because this is the only area of the market where you can say speculation is on a gigantic scale. Sure, there’s areas within the stock market and within the junk bond market where people who specialize in that, and institutions may be creating wild distortions. But here you have a situation where it’s the combined attitude of hundreds of millions of people that is creating the speculative situation that somehow or other, we have to work through.
So, the sign that something is going to go wrong, will be, I believe, in that sector. But it’s going to have to be a global thing because we’re talking about the US, which is the only countries that produces the 30-year fixed mortgage and elsewhere in the world mortgages are shorter term and they certainly aren’t, 40% of those being issued, being interest-only. So we have the oddity that we have a worldwide phenomenon of a real estate bubble but the country where you can measure it best, how it’s being done, is the one that has products unique to that market.
So the long answer and the short answer to your question is, this is likely to be the most vulnerable point and 1994 is worth recalling because it was, indeed, a scary time. But the stock market barely broke even on the year despite all that, but I still remember what happened to Kidder, Peabody and to others from that time. And that was, up until NASDAQ’s crash, the worst period in the market. So, will it come again? Well, in a way, one can almost hope so, because otherwise housing is going to get priced out of the reach of anybody, even those who can get interest-only mortgages up to 90% of the face value.
Thank you.
Martin Horst(?): You were talking about the true contrarian position, when given the fact that a true contrarian right now should be a guy that actually buys stocks into the cyclicals but those stocks shouldn’t be…or you would be looking for a stock that isn’t hedging it’s position?
Don Coxe: That’s right.
Martin Horst: Now the Phelps Dodge and BHP as you mentioned earlier are hedging…aren’t they hedging a lot forward at this point in time?
Don Coxe: Yeah, the thing is for them, the amount of their forward sales is modest in relation to production, because the forward sales for the metals, the forward curve is modest in relation to the live product. In the oil industry on the other hand, the forward curve both as is measured in the commodities futures markets at NYMEX and most importantly the Over The Counter market is gigantic.
We saw, for example, twenty years ago that Metalgesellshaft went broke by selling gasoline forward twenty years and all of those sales were done on an OTC basis. The hydrocarbons market has always been deeper and now of course it’s gigantic.
So, the sheer scale of forward sales in the base metals is modest. So there’s one obvious distinction with this and that’s in the case of iron ore. Because in the case of iron ore, they do one year contracts where the price is fixed.
So you could argue that that is a short position, but this is and industry that although there is a spot market, it’s small because of the fact you have only a few producers who sell iron ore that goes across the seas and they make contracts with the major steel companies on that basis which the companies need. So it’s more analogous to the automobile industry where the contracts with the parts suppliers are done on a forward basis.
The oil industry has never been on that kind of thing, so therefore the futures market to that extent is done for non-commercial reasons and you can’t be in the iron ore business and a major producer and sell only to the spot market because you’re always trying to find small steel companies then.
So, I think in terms of the major mining companies that the risk you have, if copper went to a buck ninety a pound, yes Phelps Dodge would deeply regret that they had committed ten to twenty percent forward at that, but Phelps Dodge has zero debt and if they were mark to market or Rule 133, they would still be in a position where their earnings would be gigantic, but you’re right to raise the point.
If the metals market had the kind of debt in the forward curve of the OTC, then we’d have to start worrying about that, but at this point all we have to worry about with these companies is that China doesn’t go into a deep recession.
http://www.siliconinvestor.com/readmsg.aspx?msgid=21409165
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To listen to the audio presentation of the above CC (incl. Q&A session):
http://www.bmoharrisprivatebanking.com/webcast.asp
With many thanks to TheSlowLane from SI's "Precious and Base Metal Investing" board for the transcript. (Link below)
(Link to audio version of CC located below text)
Latest from Coxe...
Nesbitt Burns Institutional Client Conference Call for June 10, 2005
Don Coxe
Chicago, IL
“How Long The Largo Movement of the Mining Sonata?”
Chart: S&P’s Toronto Stock Exchange Index
http://stocks.moneysense.ca/moneysense/chart.asp?symbol=CT:ISPTX
Thank you all for tuning in to the call, which comes to you from Chicago. The chart that we faxed out was of the S&P TSX Capped Mining Index and that index is a relatively new one, but the comment that we made on it, the question was “How Long The Largo Movement of the Mining Sonata?”
To explain that, we’re referring you back to an issue of Basic Points in October of ’03, which is when we really, in some detail, outlined our views about the future of the base metals industry.
I’m not expecting that everybody on the call has a full back file of Basic Points so I’m going to begin by reiterating the thesis of that piece, which is that the story of the mining stocks and of the mining industry in this decade may well look like the formula I used for the construction of a sonata, which is the basic form of the symphony and the concerto. In that format, the most commonly used version of it is a three movement version.
So often, and I used the Beethoven violin concerto as one of my thoughts there, although you start thinking through symphonies and concertos that happen to appeal to any of you on the call and you’ll find that so often what happens is the second movement will be the slow and sometimes the mournful movement. Now it could be Andante, I use Largo, as a very slow form of it.
The first movement is usually pretty fast by comparison, maybe Allegretto or even Allegro. And the final movement can be once again fast and more sprightly. In the violin concerto it’s the Rondo form.
The reason I use that structure is because it occurred to me that for people who have not been interested in these stocks for twenty years – which was the right attitude to have as serious investors as opposed to short term traders – that I’d like to give them a quick formula for thinking about what the longer term investment pattern was likely to be for the group.
And I was suggesting in this there would be a time when they would enter a soft patch and that would be the prelude to a tremendous long movement that might last some period of time and that that would be the one where the real returns would come.
Well, in looking at that index, as you see, it had, of course the slow section back last year which didn’t last long…big recovery. And we’ve had another slow section this year, but having said that, it’s not been all that bad, although I certainly hear from clients routinely that they’ve been very upset with the performance of the mining group. But this particular index which is one of the few that I know has not had all that bad a year – it’s up 9% as of this morning.
Of that though, it’s distorted by the performance of two heavyweight stocks – Inco, which is up 9%, and Falconbridge, which is up 21%. And that is itself distorted by the merger arrangements between Noranda and Falconbridge. So critics can say “Well, this overstates how an investor would have done.” But I couldn’t find a better index to use for this.
As you’ll see from the chart, there was a significant sell-off until very recently. For those who are looking on a global basis, it’s not been a great year to be with the stocks. BHP Billiton though is up 8.9%, but Rio Tinto on the other hand is up just under 1%. And then the real disaster areas have been the aluminum stocks, which have just been appalling. Alcan is down 36%. It raises some question then as to what is the commonality among these stocks?
Well, the aluminums have always been in a different category. Because the value of aluminum is the congealed electricity cost in them. It’s not the alumina and certainly not the bauxite. Because aluminum is either the first or second most widely dispersed of the earth’s crust, behind silicon…admittedly it occurs in concentration in only a few places in the world, but there’s lots of it around.
Whereas if we’re talking about copper, nickel, lead and zinc, then there’s only a few mines in the world that are really significant in that. Most of them are sulphide ore bodies. So the value of the approach that we take, which is the value of reserves in the ground in secure areas of the world – there’s only relatively few such deposits. And that’s what really drives this index.
In the case of the aluminums, they’re faced with high energy costs and if you read today’s story in the Wall Street Journal about Boeing’s sudden recovery in it’s battle with Airbus, you will see that one of the components of it is that they’re not going to be using aluminum in the wings and fuselage of the 787.
They’re going to be using a combination of plastics and carbon. And so it’s space age metal substitutes that have reduced demand for aluminum there and that’s particularly bad news for Alcan because one of the assumptions that they and Alcoa both made was that in the next generation of aircraft that was going to create the demand for them.
Having said that, it’s still only a small proportion of aluminum consumption, but it is a meaningful thing at least in the optics of investors in these stocks because it is the refining of a specialized kind of product where the margins develop. So you think of aluminum as a manufactured product as opposed to a pure commodity and it’s something closer to steel in that sense.
But given that copper is trading at nearly a seventeen year high you would have expected the index to have done better. Because King Copper is the key to the base metals and it’s not been a very exciting time to own these stocks. And so you might say “Is the sonata working?”
Well, why have the stocks sold off? We’ve discussed this in a recent issue of Basic Points but I’ll just review it. First of all, the OECD economies are slowing down. But everybody knows that at the margin, the key driver for the base metals is China. And China is slowing down as evidenced by the sharp decline in the Baltic Freight Index. So, the pessimists then say, “Oh well, a combination of a slowing down of base metal demand in the advanced industrial economies plus a slowing in China means disaster ahead and therefore there’s no such thing as a new long cycle.”
The argument here is that China is in effect, just a proxy for metal demand in the advanced industrial world because China lives off exports.
Now, like all half-truths, it’s worth analyzing the components of the statement. Because to the extent that Chinese exports are simply displacements of manufactured goods that would have been made otherwise in Europe or North America or Japan, then what you can say is that the robust demand for growth in China for copper, which is in the 20-30% range year in, year out, that’s not really China, it’s simply that demand is being met in the advanced industrial world.
And so the statement that we used in Basic Points to refer to the fact that two years ago US GDP was up over 3% but copper demand fell less than 3%, kthat’s not a meaningful statement these critics say because goods made out of copper were no longer made in the US, they were made in China and shipped to the US.
Well, it’s no surprise to the people on this call that our essential thesis on the base metals is the new middle class in China, followed by India- the hundreds of millions of people who are going to get middle class dwellings over the next fifteen years. And middle-class dwellings involve indoor plumbing, electricity, basic appliances and a significant number of those people are going to own cars.
That’s the real thesis here of a long third movement of this sonata. And there are going to be pauses along the way on this. One of the things that the critics are throwing at me is “Look at the real estate speculation in China and they’re trying to cool it down so therefore that’s going to kill demand for metals.”
Well it’s pretty hard to find a place on Earth, outside of Antarctica and the North Pole where there isn’t real estate speculation going on and so I don’t think that’s necessarily a knock on the China thesis. Furthermore, if, to the extent that the real estate speculation in places like Shanghai and so forth is so much oriented towards dwellings, then it fits the thesis because whether they are condos or stand-alone dwellings, they’re going to need metals.
And it’s that secular growth trend, as people move from subsistence living to middle-class living that I believe has re-shaped the story on metals.
But anybody who read the interview with the CEO of Rio Tinto this week in the Wall Street Journal will see what he thinks of that thesis – he described it as silly. And so, why do I dwell on this? Well, it’s because I want to rebut those of you out there who say “The commodity boom has clearly peaked, because everybody’s talking about it, it’s the new consensus. And so therefore, it’s time to sell these stocks.”
I couldn’t disagree more. First of all, each time I go up to Canada and spend a few days there and see the coverage of commodities in the Canadian press and compare it to the coverage of commodities other than oil in the press of Europe and the United States, I realized that the focus in Canada, naturally, is on these industries in a way that doesn’t happen down here.
Remember that diversified mines are 1/10th of 1% of the S&P. So the good people who produce the Wall Street Journal and Investor’s Business Daily and the business section of the New York Times and the other newspapers can’t spend a lot of time talking about an industry where American investors that are benchmarked to the lead index down here are going to have trivial exposure.
Now, will there be a third movement soon or are we still in a sustained Largo movement which is just going to get worse?
I think that that’s a realistic risk. And the reason for that is that there’s no question that the economic slowdown in the world is going to reduce demand for base metals. I never suggested that we were in a cycle that was just going to keep going up. There’s going to be slowdowns along the way.
What is the significant core concept here is that we have a new kind of compounded growth in demand from hundreds and hundreds of millions of people who were not consumers of base metals at all in the past. So therefore, as this compounded growth develops, what we’re going to have is sustained growth on any five-year period you want to name, in demand for the metals. Not withstanding the announcements of expansion of production of facilities and there are some of those, I don’t see this as something that changes the argument.
Because going back to the thesis that Chinese GDP growth as opposed to the growth in Chinese consumption of the base metals is roughly a 3:1 ratio, in other words, if China’s growth falls back to 6%, which some of the bears are suggesting, that suggests about an 18% growth, roughly, in the average demand for the industrial metals. And that still means that demand is going to rise very significantly. It’s the second, third and fourth derivative issue.
I’m NOT suggesting that China’s going to grow at 9% forever, although it managed to do that for two decades. Obviously as the economy matures, there’s going to be, first of all a bigger standard of deviation in the returns and there will be periods of time where it slows down. But I don’t see that as a reason for getting out of these stocks.
I realize those who have very short-term time horizons here have to fine-tune it on the basis of the stock market’s perception. Coming back to Phelps Dodge, one certainly sees how important it is to be able to catch the markets changes in sentiment.
Now that’s one of the two stocks that’s in the S&P 500 and we’re coming up to the end of the June quarter for Phelps and just to show you the problem you have as an investor in this, of the analysts who follow the stock, the mean estimate for the earnings in this quarter is 3.84 per share. The high estimate is five dollars and sixty cents and the low estimate is two dollars and fifty-five cents, that’s fifteen analysts.
Now, you would have thought that that kind of dispersion in earnings estimates would mean that they were looking at an average of about twenty five stocks or something and trying to predict…or companies in totally different industries…that they’d lumped in a fast food company with a tech company with a bank and then they said the average earnings growth of these will be such. This is one company that produces only two metals, copper and molybdenum.
So, I still believe there’s a major perception problem out there and it has to do with my thesis that the major investment opportunities come from an asset class where those who know it best, love it least, because they’ve been disappointed most.
So, we still have this perception that if it’s good now, it’s got to be bad very soon. And, so that kind of range of earnings forecasts…the December quarter of this year the earnings forecasts ranged from four dollars and sixteen cents to a buck eighty.
Yet, if you look at the forward curve for copper, there’s no possible justification for any of those low estimates. So, therefore what the analysts are predicting is some time between now and the middle of August, the global economy is going to roll over and fall into a deep pit, not the kind of pit from an open mining operation.
Maybe it will happen, but the only possible justification for that would be to deal with what the 10-year notes are trading at in yield. Lead by the German Bunds who moved down first and by that 10-year Treasury note at its amazing level. Mr. Greenspan this week, for the first time conceded that instead of suggesting that the bond market was being driven by totally irrational forces, he said well, it could be that they’re really predicting a slowdown.
Now we’re just back over four percent today in the 10-year note, but my own read on that is that it may well be that something else is unfolding in the bond markets, other than a prediction of a slowdown which will look like a recession if it isn’t a full recession.
The reason for that is, it could be that the classic way in which bonds have been evaluated is undergoing a change because of the presence of the hedge funds as being the biggest players in these instruments, other than Fannie and Freddie. Fannie and Freddie, in the past, were the players of the 10-year note. Obviously of course they used it to hedge against their mortgages. But the fact that around the world, the long sovereign credits have shown the same pattern, suggest that something more is at stake.
It may well be that what is happening is that the efficiency and liquidity of financial markets and the bond market – in particularly the fact that the use of derivatives means you can get into and get out of unimaginable quantities of these in no time with a few keystrokes, that what it does is it goes back to where we were in the bond market at the time Lord Keynes developed his theory of liquidity preference, when he explained the yield curve on the basis of the preference for liquidity. So that the reason why longer term bonds sold at higher yields than short-term bonds was that investors always wanted liquidity.
And that changed after World War II. That was a Depression-era thesis. Changed after it to the idea that long-term bonds were the forecasters of inflation. Well, here we are at a time where despite the fact that oil prices are up 40% in no time and that we’ve had huge cost increases for healthcare and various other things you could name and that we’ve got housing prices in bubble mode almost everywhere you look but inflation as measured by the key indices remains muted.
And that’s not just the US. The conspiracy theorists would have us believe that the US statistics are totally rigged, but they’re simply confirming what’s happening elsewhere in the world. Which is, that the globalist forces are outweighing the impact of the two kinds of inflation generators in the real economy as opposed to monetary creation. Namely, the cost of commodities and the pricing structure of local supplied services where there’s no external competition.
And that so much of the economy now can be driven by global forces and we have this relentless overcapacity in China and in Japan which means that prices keep getting hammered. This is a tentative thesis, but at least it offers some alternatives to the view that the 4% 10-Year note is automatically predicting a slowdown so much that we can expect a collapse in metals prices. At a buck fifty six on copper, and looking at the forward curve, going out a few years, you’re looking still at prices over a buck and a quarter. These stocks remain amazingly cheap.
So, I don’t know when we’re going to move into the third movement of the sonata, but I do feel that investors would be wise not to be lightening up here on the basis that the bond market is telling them they’ve got to get out of the deep cyclical group.
As for the oils, what we’re getting is continued confirmation that notwithstanding OPEC’s desires to produce more and notwithstanding that we have real experts like the Cambridge Energy Research Insititute predicting a huge drop in oil prices, the futures curve fails to confirm any of this.
December oil is fifty-four dollars and ninety cents and so as against the spot price, Sorry…December ’09 oil is is fifty-four dollars and ninety cents and this year’s December crude…fifty-seven. What we’ve got then is a situation where you just can’t find cheap oil around. And so the thesis of our most recent Basic Points, about the hedgehogs, remains something that you’ve got to look at as investors.
When you decide in the commodity group, why it is that you’re investing in the group, our thesis is that you should own these stocks on the basis of having secure reserves in the ground. And that those reserves are going to grow in value over the coming years and that that’s going to be the most easily capitalized form of value increase that I can see in the market in terms of acquiring assets at these prices now.
And so the patient value investor is going to be rewarded. And this is largely confirmed by the curves themselves. But for whatever reason, investors are not taking that into account and the companies themselves are not taking it into account, the copper companies are selling forward heavily and the oil companies are still announcing that they don’t want to get involved in projects because they’re seeing oil going to twenty-five bucks.
I think you’ve got to be prepared to be a true contrarian.
And I’m always amused by these surveys that portfolio managers…more than seventy-five percent of whom describe themselves as contrarian, I would argue that those who are overweight commodity stocks in their portfolios are the world’s preeminent contrarians at the moment. Because they’re going against those people that should know far more than they do – namely the people who run the companies and Wall Street analysts.
So, for those of you who are prepared to take that kind of risk, which is that collectively our viewpoint will prove to be wiser than that of those who professionally obviously know more than we do – that is the essential risk. Is that the experts collectively are wrong and one always hesitates to say that – and it’s because of their own human experience, in which case…coming back to the group that is described in this chart, we’re heading into, at some point – once we come out of this slow patch – a third movement, which will be dramatic. It will be in a major key. It will be fun.
Now you may say “Oh, but we’re going to have a recession first, that’s the signal.” The thing that is worrisome is that we’ve got flat yield curves now. We’ve got an inverted yield curve inBritainand anytime you get an inverted yield curve in the post-war era you’ve had a recession.
But if don’t actually invert the yield curves on a global basis and since the central banks are probably not, lead by the European Central Bank and the Fed, likely to consciously move their economies into an inverted yield curve, I would argue that the low level of interest rates that we have and the low level of inflation is such that a recession is not a better than 50% probability, but the pricing of these stocks is saying it is at least that.
I think that those that are pricing these stocks in the marketplace, because of a view of a recession and those that are running the companies and saying prices of their commodities are about to collapse, will prove to be wrong. We shall see.
That’s it, any questions?
Steven Bartelow: Back in ’94 when the Fed was raising and throwing the bond market into a nasty bear market and then we had a couple quarters in ’95 of GDP growth of less than 2%, that recessed growth feeling that we were having in “Oh dear, the Fed’s going to overdo it and here we’re going in to a recession”, well they backed off and they put their foot back on the accelerator and we’re off and running again. Do you see any similarities to today’s situation to what we saw about a decade ago?
Don Coxe: Well It certainly is a worry, Steven, because what we’ve had here is a sustained tightening by the Fed and if you use percentage terms here we’ve had a 200% increase, a trebling of the Fed funds rate, which sounds draconic. But boy a Fed funds rate of three or even three and a half percent…if back in 1994 you were looking at the Fed funds rate, as I recall in the eight percent range, so that was much more serious.
Now what could be serious this time is these low mortgage rates have stimulated speculation on a level never seen before and therefore that we could have some kind of economic collapse from that. But it wouldn’t be because the system was drained of liquidity, as it was in ’94. It would simply be that we’d run out of loose speculative cash to bid up the prices of real property.
But that’s saying, I have always been of the view, in terms of what can go really wrong, is something disasterous developing the mortgage-backed sector of the market. I mean back then the mortgage-backeds were sixteen percent of the Lehmann Aggregate Index and now it’s about thirty-six the last time I saw them.
And back then the prevailing view was that Fannie and Freddie were very strong financially. And here we’ve got institutions that have to keep re-stating their earnings back years. If they were anything other than Government-Sponsored Enterprises, some of these guys would have been prosecuted by Eliot Spitzer and they would be regarded as the worst sinners since Enron.
So, if you’ve got the situation where the main players in this market are of dubious financial strength – dubious in the sense that nobody really knows what their financial strength is – you can make a case that something awful could happen in the mortgage-backed sector, if we had a sudden sell-off in real estate prices. With all these interest-only loans and so forth, gosh knows what could happen.
You know the last time we had interest-only loans as a big deal, was in the 1920’s. And I seem to remember that didn’t turn out well.
So, you’re right to raise this issue Stephen, because this is the only area of the market where you can say speculation is on a gigantic scale. Sure, there’s areas within the stock market and within the junk bond market where people who specialize in that, and institutions may be creating wild distortions. But here you have a situation where it’s the combined attitude of hundreds of millions of people that is creating the speculative situation that somehow or other, we have to work through.
So, the sign that something is going to go wrong, will be, I believe, in that sector. But it’s going to have to be a global thing because we’re talking about the US, which is the only countries that produces the 30-year fixed mortgage and elsewhere in the world mortgages are shorter term and they certainly aren’t, 40% of those being issued, being interest-only. So we have the oddity that we have a worldwide phenomenon of a real estate bubble but the country where you can measure it best, how it’s being done, is the one that has products unique to that market.
So the long answer and the short answer to your question is, this is likely to be the most vulnerable point and 1994 is worth recalling because it was, indeed, a scary time. But the stock market barely broke even on the year despite all that, but I still remember what happened to Kidder, Peabody and to others from that time. And that was, up until NASDAQ’s crash, the worst period in the market. So, will it come again? Well, in a way, one can almost hope so, because otherwise housing is going to get priced out of the reach of anybody, even those who can get interest-only mortgages up to 90% of the face value.
Thank you.
Martin Horst(?): You were talking about the true contrarian position, when given the fact that a true contrarian right now should be a guy that actually buys stocks into the cyclicals but those stocks shouldn’t be…or you would be looking for a stock that isn’t hedging it’s position?
Don Coxe: That’s right.
Martin Horst: Now the Phelps Dodge and BHP as you mentioned earlier are hedging…aren’t they hedging a lot forward at this point in time?
Don Coxe: Yeah, the thing is for them, the amount of their forward sales is modest in relation to production, because the forward sales for the metals, the forward curve is modest in relation to the live product. In the oil industry on the other hand, the forward curve both as is measured in the commodities futures markets at NYMEX and most importantly the Over The Counter market is gigantic.
We saw, for example, twenty years ago that Metalgesellshaft went broke by selling gasoline forward twenty years and all of those sales were done on an OTC basis. The hydrocarbons market has always been deeper and now of course it’s gigantic.
So, the sheer scale of forward sales in the base metals is modest. So there’s one obvious distinction with this and that’s in the case of iron ore. Because in the case of iron ore, they do one year contracts where the price is fixed.
So you could argue that that is a short position, but this is and industry that although there is a spot market, it’s small because of the fact you have only a few producers who sell iron ore that goes across the seas and they make contracts with the major steel companies on that basis which the companies need. So it’s more analogous to the automobile industry where the contracts with the parts suppliers are done on a forward basis.
The oil industry has never been on that kind of thing, so therefore the futures market to that extent is done for non-commercial reasons and you can’t be in the iron ore business and a major producer and sell only to the spot market because you’re always trying to find small steel companies then.
So, I think in terms of the major mining companies that the risk you have, if copper went to a buck ninety a pound, yes Phelps Dodge would deeply regret that they had committed ten to twenty percent forward at that, but Phelps Dodge has zero debt and if they were mark to market or Rule 133, they would still be in a position where their earnings would be gigantic, but you’re right to raise the point.
If the metals market had the kind of debt in the forward curve of the OTC, then we’d have to start worrying about that, but at this point all we have to worry about with these companies is that China doesn’t go into a deep recession.
http://www.siliconinvestor.com/readmsg.aspx?msgid=21409165
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To listen to the audio presentation of the above CC (incl. Q&A session):
http://www.bmoharrisprivatebanking.com/webcast.asp
Dan 
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