With many thanks to TheSlowLane from SI's "The Woodshed" board for the transcript. (Link below)
(Link to audio of CC located below text)
Nesbitt Burns Institutional Client Conference Call for March 24, 2005 Don Coxe Chicago
“A Review of the First Quarter”
Thank you all for tuning in to the call which comes to you from Chicago. The title simply is “A Review of the First Quarter”, so we didn’t send out any charts. I thought it would be better to review the first quarter today than next week when the call will come on Friday, which is April Fool’s Day. There’s enough perils in issuing forecasts on April Fool’s Day but to review the quarter on that day seemed to me to beg trouble.
We’re talking about it now because the quarter has been, I would have to say for most investors, a pretty disappointing quarter. That doesn’t mean it’s been disappointing for those who’ve been invested in the oils and the metals, but you know that just doesn’t do enough for most investors.
For example, the diversified mining stocks as a section of the S&P 500 have a weighting of 1/10th of 1%. So, the fact that they’ve dramatically outperformed the other 99.9% is not much consolation for investors. But one way of looking at the market year-to-date is - the source I love to quote to you is Investor’s Business Daily – daily summing up of the performance over the last six months of 197 separate sectors of the US market. So as we started today, the number one ranked group over six months was the Canadian exploration & production companies. These are the ones that are inter-listed, fifty-two of them. Number two was Metal Ores and that’s the base metal stocks. Number three, metal processors and fabricators. Number four, US oil and gas exploration and production. Number five, oil and gas field services. Number six, US refining and marketing.
So, pretty clear where the rewards have come over the last six months.
The oddest part of it is, when you’ve got such terrific results as that, with the groups that we’ve been talking to each other about for the last few years, the temptation is to say “Well, it can’t get better than this. On a relative performance basis, it can’t, and maybe this is the peak.”
Anyway, I’m putting the finishing touches to the second draft of the next issue of Basic Points and I’m reviewing all of this and have concluded that for the base metal and oil stocks, we are at something of a crossroads. Yogi Berra’s famous for saying, “When you come to a crossroad, go ahead.” So I’m going to go ahead.
[Editor’s note: I believe the expression is: “When you come to a fork in the road, pick it up.”]
Frankly, the arguments in favor of taking the money off the table here, aren’t persuasive to me for these stocks. Nevertheless, what we do have are genuine reasons for concern that the first quarter may turn out to be the high quarter for the year of the S&P 500 and benchmark indices generally.
The reason for that is that not only is the Fed in a tightening mode, the Bank of England has been in a tightening mode for some time. Global money supply growth has really slown down. And I’m not convinced that anything is going to come along to change that. My own favorite indicator, which is the adjusted US monetary base, has truly rolled over and in the last 12 months it’s grown less than US nominal GDP.
That’s a very, very severe constraint on economic growth. That, plus high oil prices, tell me that the economy has got to slow down. And I realize that’s not what the economists are saying, I don’t like to challenge them, but as a simple-minded person, I can only use a few indicators. And to me, I just need to look at what’s happening in the housing mortgage market and the housing bubble and then look at the situation of the consumer with these oil prices and the fact that the stimulus that Mr. Bush could give from the tax cuts, that that good news is already out there.
We have to congratulate him for responding to the recession with the right kinds of policies to get us out of the recession, but you can’t keep on cutting taxes and you can’t keep on cutting interest rates. That six percent of US GDP, which is bleeding away because of the current account, is the big reason why it’s very difficult to see how you stimulate the US economy from here.
Now that’s not what the Dollar is saying. And in looking back at the performance of the currencies over the first quarter, guess I have to say that I am somewhat surprised at how poorly the Euro has done. Canadian Dollar is pretty flat, but the big disappointment has been the Euro and that’s a separate story.
The story on the Euro is that not only is the Euro being hurt by the economic stasis in the Euro zone, whereas I’ve said before, bureaucrats multiply in the musk and slime of their own secretions, but it’s also now held back by a remarkable poll result, which quite frankly astonished me. It certainly caught the euro-elites by surprise. There’s a referendum coming up in France in May and all the polls had shown for years that the French would back any changes to the Constitution.
After all, the new constitution was prepared by one of the French elites, Giscard d’Estaing, and although there were always the cabaling criticisms of it that it didn’t go far enough, it was deemed to be a done deal, that the French were going to be one of the first out of the box to ratify the new European constitution.
Well, amazingly enough, the latest polls show that the No vote is slightly ahead. Now that’s been really bad for the Euro because what it suggests is there will be a period of real chaos in terms of the arrangements within the Euro zone.
Now if that weren’t bad enough, the thing that France is doing to save the vote is another reason for the Euro to be sold off, because Chirac, plus his lapdog, Schroeder, have come out and have scuppered the Veroso proposal to have a freer market in services across the Euro zone. This was going to be one of the things, this was the week that they were meeting, mid-course, to review their progress to make the Euro zone the most competitive and dynamic zone in the world.
Well, if flatulence and flab are signs of dynamism, then they’ve achieved their goal.
But holy cats, the fact that the one major thing that they were doing to become more effective, which was to make services more readily available across national boundaries, now that’s been knocked out. And it’s been knocked out precisely because the French don’t want to have their various service industries competing with service industries based in Eastern Europe.
Given that one of the reasons that people like me had some optimism at all for the Euro zone, it was that you had all these pretty well educated people from these new ten members who were eager to work and they were the most enthusiastic capitalists within the whole Euro zone because they had just gotten away from Communism. So what we said was, although these combined economies are small in relation to the established economies, what they are going to do is encourage flexibility and productivity gains among old Europe. Well old Europe has shown that it doesn’t want any of these kinds of things.
So all of this is truly negative for the Euro. And I confess to be really surprised and disappointed. This all happened toward the end of the first quarter because actually at one stage during the quarter, the Euro went to a new high. And so did gold. But now we’ve got, as a result of the Euro’s disappointment, we’ve got gold at 424.70…that’s not the lowest it’s been but it certainly not as high as I would have expected.
So, in terms of what went wrong in the first quarter, I think that the fact that the Euro zone failed to live up to their own economic forecast is not something that would produce great astonishment. But the fact that they have chosen to respond to this by reinforcing the shackles that they have was not something that I would have expected and that the French voters would suggest they were going to vote against the European constitution because it’s too liberal! That, by the way, is the reason for the opposition according to the polls, is that there’s too much economic freedom being pushed in this. And of course, the French love their subsidies and love the network of controls that they have.
The French have really designed the system well, because what it does is gives them the subsidies out of the productivity of Germany. Amazing thing is Germany is still the world’s largest exporter, despite having the highest wage rates in the world and all that network of laws that prevent you from firing people and holidays and spas and all of this stuff. So the Germans are still a remarkably productive society, and they contribute unbelievable amounts into the general coffers and there’s some left over after the French farmers have taken what they get out of it to go to such marginal redoubts at the end of the French empire such as Ireland and Greece.
They’ve really got things well organized as it is now and naturally they don’t want to change it. Well, apparently there’s not much chance of changing it. So this is going to force me to re-think my view about how the devaluation of the Dollar will proceed. Because one of things that I had assumed was we were going to 1.60 on the Euro, which was going to mean that the German automobile industry was going to really get hurt badly. You wouldn’t be seeing a lot of new BMW’s and Volkswagens and Mercedes coming in. And so, that the higher end of the US market would then become a chance for the Big Three to compete.
Well, if in fact the Euro is going to be held down as a result of this new evidence of the French ability to constrain things, I mean the French gave us the word “bureaucracy” and they’re good at it. I mean they really are good at it. The interesting thing is of course, not only that they’re good at it but they’re actually good at operating their own economy. They are a pretty productive society despite the thirty-five hour week, but what they’re really good at is making sure that their country, their companies get preferences and they’re really good at protecting what they’ve got.
They know how to manage the Euro bureaucracy well. So I’m grudging in admiration for them. Once again they seem to have done it, they’re making sure that the Euro zone operates for them and a perfect example is that the growth and stability pact which is the basis for the Maastricht and the basis for the Euro, the French were the first to defy it, then the Germans, then the Italians and they basically told the other countries who were in line – that rule only applies to the small economies, we can defy it with impunity.
So that’s another reason why the Euro is down, because one of the reasons why you wanted to own the Euro was, yeah, maybe you weren’t going to get strong economic growth because of all their rules and red tape and protectionism, but what you weren’t going to get was your value inflated away, because what you had was the Bundesbank being replaced by a central bank which had the same kind of flinty Teutonic determination to suppress inflation. And that you would not get budget deficits which would force the central bank into massive reflation of these system.
Well, without a recession what they’re doing is letting the kind of deficits that they spend their time denouncing George Bush for. George Bush’s deficits are largely because of the cost of policing the world. Amazing.
So, really in terms of the part of the world where the news was worst, I’d have to say in the first quarter, it had to be out of the Euro zone.
As far as the other part of the world, where the news was really bad last year, it just keeps getting better. Now it’s still got a long way to go, but the news out of the Middle East is a lot better than you would have expected six months ago. Or twelve months ago. The front page, the page one stories are still about people being blown up and that sort of thing.
But inside the paper are more and more stories about progress in Iraq and of course the Syrian situation is a sign that the old Arab dictatorships are having trouble hanging on. Egypt is going to make at least a step in the direction of open elections. Although they plan to throw in to jail for forgery the only person that was going to run against Barak, which indicates that progress for them will come slowly.
But overall, what we have is a situation where it no longer looks as if the Mideast is going to be run by a combination of the dictators and al Jazeera. It looks like people are being heard. I guess I’m turning more optimistic that we’re going to make progress. And certainly one that that has happened is we don’t have bad news from Iraq pounding the stock markets anymore. Not that the papers don’t make sure that we have bad news from Iraq on the front page, but the inside stories just get better and better.
The one today in the Financial Times, if you didn’t see it, about how the Iraqi public television has these interviews each day with the Jihadists and insurgents and terrorists that they’ve rounded up and it turns out that they are not the pious Islamists and the role models for young Arab boys who would be pious. It turns out that they are a really bizarre crowd and because of the fact that this is a network where I don’t know the age levels of all those on the phone, I won’t tell you some of the juicier parts of what are in that story but I invite you to read it.
It does suggest…already it’s having a big impact on opinion within Iraq. Because by taking away the mystique of these people as being self-sacrificing people who really were moving Islam forward, what it’s done is shown them to be a crowd of rotters and thieves and worse.
So all of this is part of winning the war on the ground. Those members that they can’t kill, they’ve got them in jail and they talk, turns out that they’ve got quite a story to tell.
As far as what it is we’re doing, the one thing and the other thing that certainly happened in the first quarter was that our long bond strategy, we stayed with it too long. Now we’ve broken out decisively through that 4.50 level, up, so even though we’ve had an improvement today in the long bond market, we’re still at 4.59 in the 10-year note and I think we’re in a new trading zone and in this next Basic Points I’m going to reduce my duration again back to where it was last July.
It’s clear that money supply growth now that we have is not enough for how strong the economy is. We’re going to have more of a squeeze on the system and although this isn’t going to be 1994 all over again, because we do not have as many inflationary pressures, and we do not have as much credit demand, we’ve got enough here that being long the bond market is no longer a logical strategy.
One of the big reasons I was long the bond market was because of the shortage of very long term bonds. And now we’ve got four European countries that have announced the issuance of and some have already done it, of fifty-year bonds so that whereas I was able to make the case that long duration bonds of sovereign credits were a sort of commodity in an aging society, now what we’re getting is a big new supply.
And so I wouldn’t be surprised if the US were forced to come that way too. On that score, I cannot report any great response to this current issue of Basic Points, where in effect I challenged the various American elites to address what I see as the sustained milking of the Social Security trust fund. There’s been nobody coming out and saying “Well, we gotta do something about this.” I haven’t given up the cause but it doesn’t look as if I’ve achieved anything with that.
But for those of you who do read the piece, you still should find it a fascinating story of how it is that you could get bi-partisan agreement, month after month, year after year, to take money as a condition of employment in the workplace, from workers, and distribute it into the general revenues so that the beneficiaries benefit in proportion to how much money they make. This is a totally regressive system and if they were doing it fairly, we wouldn’t be talking about 2017 or 2018 as being the moment at which this Social Security trust fund goes negative.
About the oil and the metal stocks. It’s been a very good quarter for them. I don’t see that going away. Yes, we have the problem that for most investors when they look at their portfolio, the only sector that they’ve really made money on in the last six months is the oils and the mines. And when they get nervous therefore about the overall stock market, the first temptation is to sell something that you’re ahead on, because you say “Oh dear, my profits are going to vanish.”
One of the reasons I didn’t take this rally from last summer seriously and I’ll reiterate it right from the beginning, I started taking money off the table late last fall, is because the rally was originally lead by the NASDAQ stocks. And I know this about triple waterfalls, is that in intervening rallies thereafter , if the doomed asset class is leading the market, then what this means is there’s too much liquidity in the system and what there is, is speculative activity predominating.
One of the big functions of a triple waterfall is to decisively move economic and financial leadership away from the asset class which is grossly overvalued and has too much capital investment in it.
So, therefore, I didn’t believe this NASDAQ rally. Now so far this year, though, NASDAQ has been underperforming. So that suggests to me that any correction will not be a major one.
That said, there’s one other negative that I’ve got to report and that is that the financial stocks in the recent weeks have been sharply underperforming the S&P. That is a bad news story. Because all, repeat all, serious financial bear markets that are driven not by…I mean in the case of the tech thing, that was not a financial bear market, that was the collapse of an asset class because of overinvestment and overspeculation, but something that occurs within the financial system itself, all of them are pre-figured by a decline in relative strength of the financials and particularly the big banks relative to the S&P.
And that’s the case recently. The faint hope I have and I’m not going to count on it is that it will turn out that this is only limited to the sleaze stocks. Now by that I mean the big banks where the problem that they have is primarily that the sleaze that they engaged in during the bubble period has come back to haunt them now and they’re facing prosecutions and lawsuits and therefore their stocks are underperforming. And therefore it’s not a systemic risk. I’m hesitating to draw such an exception from the rule that when the financials are underperforming that you should get out.
So, putting it all together, I am reducing my equity exposure a further five percent and I’m hoping that we’ll get all of this out of our system by the end of the second quarter, but this is not a time, I think, to be committing new money into the market. And I think we’d better watch to see how much the Fed does, whether we get a squeeze in the Eurodollar market as a result of Fed tightening and in particular, whether these financial stocks stabilize relative to the market. If that happens, then this will turn out to be simply a late winter case of the blahs.
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