Thank you all for tuning in to the call, which comes to you today from Chicago. The chart that we faxed out was the Nikkei and the comment was “Koizumi’s Big Gamble”. I think that what we’re talking about here is a potentially huge development in the global markets. Because what’s at stake here is nothing less than the question as to whether Japan has completed its Triple Waterfall.
And that has big implications even for those of you who aren’t particularly interested in what Japanese stocks do. So, let me begin by saying that one of the key ingredients of the Triple Waterfall concept is that during the long period of the Triple Waterfall collapse, that the inversely-correlated assets to that asset outperform.
And because US stocks are inversely-correlated to Japanese stocks because in global portfolios these are the two biggest markets and together they make up about three-quarters of the total market cap of the world, then one of big reasons why the S&P was such a sensational market to be in during the 90’s was because Japan was going down.
And so capital flows, of course, where it’s going to get the biggest returns. So, the reasons why Japan was in trouble didn’t apply to the US and the whole concept of the Triple Waterfall is you go through a long period of pain and punishment and then you adjust and then you’re ready to enter a new bull market.
Well, what we know is that the huge period of US outperformance lead by NASDAQ, but of course the S&P participated, created all sorts of hubris within the US and setting things up for underperformance there. But notwithstanding the recovery of the Nikkei that we’ve had, it’s been still looking like a third stage of a Triple Waterfall. But there’s been a sign very recently that it may be coming out and in fact on a twelve month year over year basis now, it’s closing its gap with the S&P.
Now, in order for us to be absolutely satisfied that the Triple Waterfall is over, what we have to have a decisive technical breakout on the Nikkei, but we also need to see that it’s outperforming the S&P. And that’s not been the case but when that does happen, one for he things that will also happen is that the Yen will assuredly outperform the Dollar and so therefore it could fit in to this broader concept of overall dollar weakness and a decline in the relative attractiveness of US assets.
Therefore, the fact that on a chart basis, the Nikkei is looking like it’s breaking out on the upside and could challenge its high of 2002, that would be a huge technical breakout, if it’s confirmed. And then if it also starts to solidly outperform the S&P on a sustained basis, we could say that Japan’s Triple Waterfall is over and gradually what this will mean is money will flow from US stocks into Japanese stocks.
Meanwhile, we’ve also had information that the banking sector in Japan really does have hopes. After ninety-one months of falling loans, apparently…the performance of the bank stocks lately in Japan has been fabulous. If Koizumi wins his battle over the postal system, then this will have enormous implications right through the stock market but also through the global financial system. Because we’re looking at trillions of dollars that at the moment is tied up in unproductive investments to a considerable degree. Unproductive in the sense they buy Japanese government bonds and they also fund building bridges to nowhere.
In addition, because of the existence of the postal system, what it does is create, in effect, unfair competition for the banks in attracting deposits because it has the government guarantee and historically this is what lead the banks to offer higher interest rates than they really should have and at the peak of Japan’s Triple Waterfall, the banks were lending money out at virtually the rate they were paying on deposits, making no profit on it and relying entirely on real estate profits.
So, that’s why the real estate bubble was exactly co-extensive with the Nikkei bubble. They burst together and for the first time in thirteen years, there’s been an uptick in an index they maintain of real estate prices in Japan. In other words, you start looking at these things and you see that they are coming together.
Now, if something this momentous is going on, you would expect some other things to change. And it’s interesting that since the Nikkei started this sustained rally that you see on the chart and as it broke out above 12,000, this coincided with a peak in the US Dollar Index, a bottoming in gold and coincided with the strong rally that we’ve had in the Canadian Dollar. Because at the same time, Asian currencies were moving up because another development was occurring. China moved up the Yuan. And although people dismiss this as a trivial development, it was major.
Now you know that my thesis for the last two years has been that there is an unwritten pact between China and Japan about currency stability. It’s actually been in place, really, since 1998, but it’s almost codified. And the understanding was that Japan could not weaken its currency relative to the Yuan. Therefore China was only going to raise its currency value when the Yen was itself strengthening.
And all of this is happening together.
Now you could argue that a lot of this is coincidental, but since there’s a list of about twelve things that have changed and they’re all occurring together and they all lead to the same conclusion that if Koizumi should triumph, we could have a major change in a lot of these ratios in the world. And they would not be good for the S&P but they would be good for other kinds of financial assets.
Now, what Koizumi is planning to do, the reason this is so historic, is that Japan has been a political monoculture and for all but eleven months since MacArthur left, the Liberal Democratic Party – which is as liberal and democratic as the Holy Roman empire was holy and Roman – has been ruling Japan. And it’s been a series of coalitions within the LDP representing various vested interests that have run the country. A gerontocracy which reflects the demographics of Japan.
But naturally what you have there with one party rule, is a classic example of Lord Acton’s dictum that all power corrupts and absolute power tends to corrupt absolutely. And this is the case in the democratic world anywhere that you have one party rule lasting forever. For example, as in most US big cities up until recently, where the Republicans were able to break the stranglehold in New York with first Giuliani and then Bloomberg.
Now, I would argue that if Koizumi wins, that will actually the end of that kind of one party rule, because he is actually going to the voters over the heads of the leading elders within his own party. The fact that they voted down his proposal in the upper house of thie Diet, was a sign of the fact that Koizumi was in effect, going to make real democracy work. I mean the idea of a Japanese election fought over principles and where the voters have a specific major item to vote on and also to vote on backing a particular man for a program against the LDP…this is really radical for Japan.
And in response to phone calls I got from clients asking me about all of this, I said the best outcome would be if Koizumi is voted down in the upper house of the Diet and then he calls a snap election and wins the snap election. He did lose in the upper house of the Diet and the Yen faltered on that news and then really started rallying because I would look on this as a case in which the old guard really and seriously miscalculated and that Koizumi may in fact carry off the unique feat of winning an election based on principles. And then that opens the door for all sorts of other reforms within Japan.
So, put this together and we’ve got a really momentous development. I’m still trying to get my mind around all the other things that will change if this happens.
And by the way, another neat feature about it, the date of the election is September the eleventh. So the future of Japan may well go back to 9/11, but it will be a good 9/11, except of course for the gerontocracy which will look back to this as being a catastrophe for their rule.
Well, in the meantime, what other financial assets should one be looking at as a possibility as a way of playing this, apart from Japanese stocks? And there’s going to be nervousness back and forth, but fortunately we’re only talking about a month to get this out of the way. And you would not expect the Japanese stock market to go soaring high with sixty six dollar and fifty cent oil because of course Japan has to import virtually all its oil. And historically high oil prices have been seen as a negative for Japanese assets.
So, therefore, to suggest that you should be buying Nikkei futures here would be pushing the envelope a bit.
Now, of course the move in oil prices we’re getting now is from a different kind of source and one that I want to discuss with you because I’m not sure how long it’s going to last. Up until now, the move off the lows in oil has been lead by crude. There’s been variations in prices of refined products and variations in the crack spread and those kinds of things, but in general what you could do was take oil production in the world of barrels per day and take demand in barrels per day and you could understand why oil prices were going up.
What is happening now is different. US inventories of crude oil are rising and I assume they’re rising in the world and yet oil prices are rising as if we had an amazing shortage of crude oil. So why is this? Well, it comes back to something we’ve talked about on and off, which is it’s about time to start talking of “crude oil”. It’s like talking about the human race. Some generalizations are valid, but since the human race includes such heterogeneity, for precision sometimes you like to break it down into different kinds of categories.
And what’s happening here is that the inability of OPEC to add new production of light oil and the Hubbard’s Peak of traditional oil fields which are collectively light oil fields, means that what is happening is the apparent balance that’s out there is misleading because there’s not enough light oil coming. And so refiners could spend the money, those of them who haven’t, to adapt to heavy oil, but it will take time.
In addition, what is happening is we are getting a big change in the demand curves because of various government environmental rules, particularly on what’s happening in Europe with the emphasis on diesel. So we’re getting extra demand on distillates and all of this…plus this creates a shortage of jet fuel and that means that the profit margins for those who can handle light and create all of these high-margin products mean that gasoline is no longer freely available and that’s the thing that most people watch.
So, the fact remains though, if crude oil inventories keep building up, no matter what they are, then what we’re going to have is some kind of break.
But meantime what it means is that the companies lilke Valero and Tesoro and Conoco Philips are making unbelievable, I think, margins on refining oil because they’re set up to take the heavy stuff, but the price for what they sell the heavy products on is set in the crack spread off the light.
So, we have a situation where I’m amazed that that energy bill passed Congress the way it did without all sorts of protests because it came through at a time where every side of the oil industry – producers, refiners, drillers…everybody is making record profits, and yet there was no nationalization or no new controls of any kind imposed in it. Which means that the Latte Liberals have been driven out of the seats of power.
And the idea that people could, as recently as the last Federal election, blame high oil prices on a plot between the Bush family and the Saudi royal family, that the guy who did this was given a standing ovation at the Democrats national convention, Michael Moore, means that the public has said we’re going to move on from this. We understand that although we don’t understand all the reasons in oil, we understand there’s basically a problem of supply at a time that demand keeps building up and that’s lead out of China.
And the Chinese story, we’re getting more and more indications that the figures that we’ve gotten on Chinese oil imports are subject to arguments because it turns out that some gas stations in China are refusing to sell gas because of the price controls on gasoline at a time of rising oil prices.
Now to some extent they were trying to offset this when they raised the value of the Yuan, but crude oil prices have run ahead of that. So, it means probably that in China, given that their economic growth is continuing full tilt, we’re going to see a pickup in the open demand that’s going on there. They’ll probably have to move off their price controls there because they’ve got all those cars and they’re going to demand the gasoline.
In other words, the world is adjusting, one way or the other. Haltingly and erratically, it’s adjusting to the reality of Hubbard’s Peak decline in the fields out there. The fact that the Saudis cannot bring on any new light oil and whatever they can bring on is going to be heavy. And that the kinds of things that governments are going to demand from a clean air standpoint will mean massive refinery investments. And the industry still has problems on getting approvals to build new refineries and still scratching a head a little bit, if they build refinery capacity to meet heavy oil, if we believe what Daniel Yergin is saying that there’s going to be a flood of new light oil and therefore they will have spent the money badly.
So, this is a case in which wrong research leads to bad results. So even a company that’s got as much money in the till as ExxonMobil, Lee Raymond is saying there isn’t enough out there in assured profits to make it worthwhile to expand refining capacity. Now Lee Raymond is not going to be running ExxonMobil much longer, but he has been one of the true titans of that industry and the fact he is still expressing doubts about the the way in which oil supplies will work for refining means that there’s not going to be any mad rush to create new refineries.
So we get back from this circuitous route that the kind of problems there are in the refining process and in the change of demand for the kind of products that are produced in refining in effect mean that the bidding for light crude comes at a time that overall crude supplies seem adequate, light crude is not.
Still, I don’t think you can postulate a move to $70 or $75 oil as long as total oil inventories continue to swell. Now we’re going into the fourth quarter which is traditionally the time of highest demand because there you have of course heavy production of distillates because of heating oil. So it may be that we’re not yet at the peak, but I find it hard to believe that we’re going to hold these price levels.
Haven’t changed my view though that you want to own the oil stocks and that the oil sands stocks which have been on a tear, still look very attractive here. Because the oil industry’s fundamental problem, which is it’s cash-rich and reserves-poor, when you’ve got that kind of disconnect, what it means is reserves are going to be valued higher. It’s pretty simple.
So, something is going to happen to unzip the purses of the industry and I suspect that a big focus of that is going to come on the oil sands. So although these stocks have had a lovely run lately, I don’t think it’s over.
Now, before we get to the question period, I would like to mention that this week so far, I’ve actually been working on a special report on Avian flu and Sherry Cooper and I together have prepared a document which will be coming out hopefully later today. A special report on Avian flu. Now I realize that for a lot of you on the call this may be a subject that you aren’t interested in and besides you’ve read the press reports on it, I would like to urge all of you to read this report.
This is the first time that Sherry and I have done a joint study, it’s a pretty big one. We believe there’s a very important story there for investors. So, it’s still…the final proofreading is going on and I don’t know whether it will come out today, it will certainly be out by Monday. But when that does hit your desk, I would suggest that you do take the time to read it.
One last thing that I haven’t talked about the mining stocks, but when I get the opportunity to do a Basic Points, after we get this out of the way, that is going to be the subject of the next Basic Points because I feel that though these stocks have been overlooked because of the runaway market for oil stocks, that on a new money basis, you’re better off putting your money into the mining stocks than the oil stocks.
First time I’ve said that in a long time. To me, the biggest risks in these stocks is that oil prices do go to $70 or $75, because what that does is really slows down the global economy.
I think we’ve had the problem with the economic forecasts that the economists, a lot of them had said $50 oil was going to be something to drag down the economy. It went to $50, nothing happened, we just kept on growing and the economic statistics have continued to be better than a lot of people thought. So, there’s now a feeling that the experts were wrong and so we don’t even need to worry about it.
I might say that that has been the pattern in the past on epidemics too, but that’s another story which is covered in another kind of document.
So, there’s no way we can continue to take money away from consumers and allocate it to oil producers and to OPEC without it having some kind of negative impact on the economy, particularly since the oil companies do not have a way of spending all that money, except in bidding up the value of each others assets.
There just isn’t that much that they can do out there. Yes they can build refineries, if they can get permits approved and deal with local litigation and local councils and all of that, but on in OPEC, anybody who’s read Matt Simmons book has to be skeptical that OPEC is going to do much useful stuff with the huge rewards they’re reaping from $60 oil. So, what we have then is a situation which market forces are not working productively.
Ordinarily when you raise the price of a commodity, you generate new supply and the market signal is we need more supply, so we do that. Not clear that that’s going to happen here. So what we have then is a form of tax increase on the rest of the economy. Including, by the way, the mining companies, who have big energy costs. Particularly of course the aluminum companies because aluminum isn’t like the other mines. Finished aluminum is sort of congealed electricity.
So I would say a balanced portfolio of commodities for the next twelve months would have a good balance between the metals and the oils. Because I think we may reach a stage where there’s a form of inverse correlation between these two kinds of stocks.
Meanwhile, almost unnoticed, we’re starting to get good rallies and now that we’ve got gold breaking out, we’ve finally got a situation where the XAU, the gold index, is one of the best performing sub-indices on the market.
So, we come back to where this began.
The move in Japan is historic. It comes, perhaps no coincidence, at the time of a historic move in China where they moved away from a ten year price fixing situation of total stability. Now we see that across Asia, the Asian stock markets are going to new highs, Asian currencies are appreciating. What we’re saying is maybe the first sign that the Pacific century is going to unfold, because there’s been talk of China’s century and so forth, but in the long run what we need is the Pacific century, which is also that Japan gets out of its funk, because that’s such a gigantic economy relative to the rest of them in Asia that best that it get in to gear.
For the first time it’s realistic to make that statement as a possibility that investors should be looking at, in which case the implications for financial assets are enormous and we’ve just begun to talk about them.
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