Let the Good Times Roll


Can you be a world dominating company when there’s inherently cyclicality and volatility in the underlying price of the commodity you produce? Or even more simply can commodity stocks be world dominators?

We take up the same question we tackled in yesterday’s Daily Reckoning. If you accept the premise that you’re investing in a great transitional period in history where, generally speaking, standards of living are falling in the West and rising in the East, what Australian companies (if any) are in the best spot to dominate (or at least profit) from this trend?

It might not be as easy to profit as it sounds. Take volatility. According to Emma Connors in today’s Australian Financial Review, “A sharp increase in volatility in the always fast-moving commodities markets has underlined the difficulty inherent in forecasting prices.”

Despite this difficulty, the government is basing its budget forecasts on record high commodity prices and a record high terms of trade. It’s the huge gains in coal and iron ore prices that will contribute to a nominal 9.25% rise in GDP next year according to the Treasury forecasts. Remember, though, that you can subtract 6% from that rate, the undeclared rate of inflation.

In recent weekly updates to Australian Wealth Gameplan we’ve reported that Chinese steel prices and iron ore imports (along with ore prices in the spot market) have both been trending down. But in Bloomberg today we read that Chinese steel prices were up 4.7% last week, the most in eleven months. What gives?

We reckon this volatility is introduced by the $1.4 trillion in Chinese stimulus measures from last year. That spending coincided with a boom in fixed asset investment. Now, the question is how much of the demand and spending was driven by stimulus, and how much is sustainable?

“Chinese banks may struggle to recoup about 23 per cent of the $1.3 trillion they’ve lent to finance local government infrastructure projects, according to a person with knowledge of data collected by the nation’s regulator,” reports Andrea Papuc, also in Bloomberg. “About half of all loans needed to be serviced by secondary sources including guarantors because the ventures couldn’t generate revenues, the source said, declining to be identified because the information is confidential.”

Hmm. You mean Chinese banks went on a lending boom to finance projects that are not generating a return and the loans might damage bank capital? Sounds familiar, doesn’t it?

“The government has been grappling with how to rein in the credit fuelled stimulus before it leads to overheating, according to a July 14 report by Fitch Ratings analyst Charlene Chu. Lending hasn’t slowed as much as official data suggests because Chinese banks are shifting loans off balance sheets by repackaging them into investment products sold to investors, the report show.”

Hey, that doesn’t sound anything like the securitisation of subprime mortgages AT ALL, does it?

But rather than make allusions to the last credit bubble in which cheap money was fuelled into an asset class that was sold to investors but failed to generate a big return, we should just say that if the earnings growth of Aussie resource stocks depends on regular, predictable, steady Chinese demand, earnings growth is going to be really volatile.

That’s not to say that the iron ore and coal companies taking advantage of record export prices can’t be world dominators. They can be, if only based on their ownership of easily accessible, high quality ore bodies. But the underlying assumptions about the prices for those commodities may be overly stable, given the violent nature of bursting bubbles.

But hey, laissez le bon temps rouler, as they say in New Orleans. Let the good times roll. Tomorrow, how not to get rolled over.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.


  1. Stock Buying Hits Bull Market Record at Mutual Funds (see below).

    * Leah Schnurr, Stocks on brink of breakout, reuters.com, July 23, 2010:

    The options market also points to wide overall price movements next week as options volume continues to be low, said Steve Claussen, chief investment strategist at online brokerage OptionHouse.com in Chicago…
    “Summer rallies start because of low volume, since not a lot of people want to get in the way of selling anything, and then it suddenly builds, as people say, it starts to chase performance,” Claussen said.

    * Rick Ackerman, Forecast Leaves 232 Dow Points to Go, rickackerman.com, July 27, 2010:

    Stocks on Monday achieved a bit less than a third of the gains we had unenthusiastically projected for the week, with the Dow Industrials settling exactly 100 points above Friday’s close. We say we were unenthusiastic in forecasting a 350-point rally because share buyers themselves have shown little enthusiasm for the task. Even so, they’ve continued to lift offers more or less steadily, producing a rising trendline with a pitch of about 12 degrees. We’ve seen steeper grades driving through Nebraska, but that’s not the point. In fact, the lukewarm, steady buying that has persisted in July is exactly the kind of buying that typically accounts for most of the stock market’s gains most of the time. This summer’s rally has been punctuated by short squeezes and gap-up openings whenever conditions have been favorable, which has been about once or twice per week.

    * Stephanie Borise and Nikolaj Gammeltoft, U.S. Stocks, Copper Advance as Dollar Declines on Housing Data, bloomberg.com, July 26, 2010:

    Sales of U.S. new homes rose in June more than forecast following an unprecedented collapse the prior month, a signal the worst of the slump triggered by the end of a government tax credit is over. FedEx joined United Parcel Service Inc., the largest package delivery company, in lifting its earnings forecasts. Both are considered harbingers for the economy.

    “I’m more optimistic,” said Traxis Partners LLC’s Barton Biggs, who added that he doubled his equity holdings this month after slashing them in half. Biggs returned 38 percent in 2009, triple the industry average. “I’ve definitely changed my mind to the degree of risk out there,” he said.

    U.S. companies are beating forecasts, and analysts see the biggest two-year earnings increase since 1995. More than 83 percent of S&P 500 companies have exceeded the average analyst profit estimate since July 12. S&P 500 profits may rise 35 percent in 2010 and 17 percent in 2011, according to forecasts tracked by Bloomberg.

    Homebuilders in the S&P 500 rallied 3.6 percent, led by Pulte Group Inc. and Lennar Corp., and copper gained after sales of new U.S. homes increased 24 percent from May to an annual pace of 330,000, figures from the Commerce Department showed. The rate was the second-lowest in data going back to 1963 after May’s downwardly revised 267,000 pace.

    The Dow Jones Transportation Average jumped 2.6 percent to the highest level since May 14 after FedEx said higher demand for international express shipments prompted it to raise its earnings forecast. FedEx rallied 5.6 percent in U.S. trading. UPS climbed 1.9 percent. The company said July 22 that the U.S. economy will continue to recover.

    Stock Buying Hits Bull Market Record at Mutual Funds

    Lynn Thomasson, bloomberg.com, July 26, 2010:

    Mutual funds, pensions and endowments are spending more on stocks than at any time since the start of the bull market, just as individuals grow the most pessimistic in a year.
    Institutions pushed equities up to 68 percent of their holdings in July, the highest level in 15 months, from 63 percent in April, a Citigroup Inc. survey showed. The ratio of bullish to bearish respondents in a survey by the American Association of Individual Investors has fallen to 0.68, the lowest level since July 2009, based on a four-week average.
    The last time money managers and individuals were this far apart was at the beginning of 2009, before the Standard & Poor’s 500 Index began its 63 percent rally, according to data compiled by Bloomberg. It may signal another buying opportunity after concern the U.S. economy will fall into a recession wiped out $1.5 trillion from American equity values since April, according to Fritz Meyer, a Denver-based senior market strategist at Invesco Ltd., which oversees $558 billion.
    “That’s good news,” Meyer said. “The retail guy has gotten it wrong more than gotten it right. The odds favor a continued, reasonably healthy economic expansion.”
    Economic Expansion
    The U.S. equity benchmark has posted an average return of 8.8 percent in the 12 months after individuals’ skepticism rose this high in the past 23 years, according to data compiled by Bloomberg. Bulls are betting that forecasts for the fastest U.S. profit growth in 15 years and economic expansion averaging 3 percent through 2012 will help equities recover after the S&P 500 fell 13 percent in May and June.
    Stocks rallied today after new-home sales in the U.S. topped the median economist forecast and FedEx Corp., the Memphis, Tennessee-based package-delivery company, raised its earnings projection. The S&P 500 climbed 1.1 percent to a one- month high of 1,115.01 at 4 p.m. New York time.
    Bonds are a better investment than stocks, Jamil Baz, who helps oversee $23 billion as chief investment strategist for London-based hedge fund GLG Partners LP, told Bloomberg Television’s “InsideTrack” on July 22. Government reports this month showing private employers in the U.S. added fewer jobs than forecast in June and the lowest level of housing starts in eight months raised concern the economic recovery will falter.
    UPS Forecast
    Equities advanced last week as the S&P 500 gained 3.6 percent, poised for the biggest monthly increase since July 2009. Companies from Atlanta-based United Parcel Service Inc., the world’s largest package-delivery company, to Dallas-based AT&T Inc., the biggest U.S. phone company, climbed after increasing profit forecasts.
    The rally trimmed the index’s loss since April 23 to 9.4 percent. Equities slid the most since the bull market began in May and June on concern Europe’s debt crisis would derail the global economic recovery. Shares rebounded in the past three weeks as 84 percent of the 149 S&P 500 companies that reported results since July 12 topped the average analyst earnings estimates, Bloomberg data show.
    Profits may rise an average 35 percent in 2010 and 17 percent in 2011, according to forecasts tracked by Bloomberg. More than 160 S&P 500 companies are scheduled to post quarterly results this week, including Irving, Texas-based Exxon Mobil Corp., the biggest U.S. oil producer.
    Market Rout
    Confidence among smaller investors was shaken by the May 6 plunge that erased $862 billion from the market value of U.S. stocks in 20 minutes and the last bear market, said Frederic Dickson, chief market strategist at D.A. Davidson & Co. Professional investors are more likely to base decisions on the prospects for the biggest two-year advance in earnings among S&P 500 companies since 1995, according to Invesco’s Meyer.
    “My money is on the institutions getting it right,” said John Lynch, chief equity strategist at the Wells Fargo Funds Management division of San Francisco-based Wells Fargo & Co. that oversees $465 billion. Smaller investors “are reluctant to get back in until there is a clearer path, and we know that once the path is clear, it becomes a ‘greater-fool’ theory because the institutions will have already anticipated it.”
    The AAII measure of pessimism peaked on July 8 at 57 percent, the most since March 5, 2009. Bullishness has averaged 29 percent during the past four weeks, compared with 45 percent who were bearish, according to the weekly survey.
    Start of Rally
    The last time optimism fell this low relative to pessimism was July 17, 2009, one week after the S&P 500 began a 27 percent rally through today, data compiled by AAII and Bloomberg show. The Chicago-based group takes answers from a few hundred people each week through its website on whether they are bullish, bearish or neutral on the stock market for the next six months, according to editor Charles Rotblut.
    “Individual investors were spooked by the May 6 flash crash and they’re wondering if the stock market is a fair game,” said Dickson, chief market strategist at Great Falls, Montana-based D.A. Davidson, which oversees $25 billion. “Professionals realize there have been changes in the market to prevent a repeat of that. I don’t think that’s been communicated broadly to the retail investor.”
    The May 6 selloff briefly sent the Dow Jones Industrial Average down 9.2 percent, the biggest intraday loss since 1987, before it pared the drop to 3.2 percent. A “mismatch of liquidity,” selling in exchange-traded funds that fed into stocks, and the use of market orders turned an orderly decline into a rout, a report by federal regulators said May 18.
    SEC Test
    The Securities and Exchange Commission is testing a program through December that pauses trading for 5 minutes when an S&P 500 stock rises or falls 10 percent or more in less than 5 minutes. U.S. exchanges also offered rules last month to standardize the process for canceling erroneous stock trades.
    Individuals may limit gains in the S&P 500 as concerns about the economy and Europe’s debt crisis keep them out of the market, said Leo Grohowski of BNY Mellon Wealth Management. Federal Reserve Chairman Ben S. Bernanke said the economic outlook remains “unusually uncertain” in testimony to the Senate Banking Committee on July 21.
    Investors have withdrawn $41.2 billion from mutual funds that hold U.S. stocks since April 2009, while piling more than $470 billion into bond funds, according to data compiled by the Washington-based Investment Company Institute. Individuals accounted for the majority of U.S. mutual fund assets in 2009, owning 84 percent, the data show.
    Hedge Funds
    Hedge funds that wager on both gains and losses in equities have boosted speculation shares will fall, according to Bank of America Corp. The lightly regulated private pools of capital have on average 27 percent more money in bets on rising prices than falling prices, below the historical average of 35 percent to 40 percent, based on data from the Charlotte, North Carolina- based bank.
    “You’re seeing equities struggle because valuations and fundamentals look pretty good to the institutional investor, but the policy headwinds, the questions around sovereign debt, the macro concerns, are really worrying individual investors,” said Grohowski, who oversees more than $150 billion as chief investment officer at BNY Mellon Wealth Management in Boston. “There’s not one right and one wrong. We think the market is pretty reasonably valued.”
    The S&P 500 trades at 15.4 times annual earnings, compared with an average of 16.5, according to data compiled by Bloomberg that dates back to 1954. The index is cheaper relative to estimated earnings for the next 12 months, with a multiple of 12.2, the data show.
    Stocks Rally
    Mutual funds, endowments, hedge funds and pensions say they’re preparing for a rally, according to Citigroup’s questionnaire from 120 respondents among those groups. Fifty- four percent said U.S. equities may gain 10 percent to 20 percent, compared with 50 percent in the previous reading.
    Bill Miller, chairman and chief investment officer of Legg Mason Capital Management, said in a letter to investors last week that this is a “once-in-a-lifetime opportunity” to buy stocks of large U.S. companies. BlackRock Inc., the world’s largest asset manager, is “overweight” U.S. equities, said Bob Doll, vice chairman and chief equity strategist of the New York- based firm in a July 20 interview on Bloomberg Television’s “Morning Call with Susan Li.”
    “It’s been the individual investor that’s been a good contrarian indicator,” said Mark Luschini, chief investment strategist at Janney Montgomery Scott LLC, which oversees $50 billion in Philadelphia. “The stock market will continue to advance. It may be a grinding process, but it will continue to advance, ultimately pulling along retail investors that are notorious for buying high and selling low.

  2. Stock Market Retreat’s End May Be in Sight

    Marc R. Reinganum, bloomberg.com, July 23, 2010:

    Fear has been on the rise in equity markets, reflecting concerns over sovereign debt, the sustainability of the euro, slowing growth in China and persistent high unemployment in the U.S.

    The Standard & Poor’s 500 Index has declined 10 percent from this year’s high back on April 23. The VIX, an index of stock volatility that reflects investor fear, shot up to a level of 45.79 on May 20 from just 15.58 on April 12. The depth of this recession and the slow recovery, set against memories of the breathtaking stock market declines in 2008 and 2009, raise concerns that a rollercoaster-like double dip is next.

    The good news is that the current market pullback needs to be viewed as part of a normal correction in the broader context of strong recoveries, not as the start of a new, deep plunge. Since December 1925, I’ve identified six episodes when the U.S. stock market experienced large declines.

    In June 1932, the U.S. market had its most severe plunge, losing more than 83 percent of its value from the peak during the previous five years. The magnitude and length of time of this decline have fortunately been unmatched since then.

    But the market lows of 2009 come in second place in terms of severity and length. The market fell by more than 51 percent from its previous five-year peak, exceeding the 44 percent decline after the tech bubble crash that started in March 2000 and the 46 percent decline in September 1974.

    Market Recoveries

    What happens after the market reaches these extreme, multiyear market lows? In the first 12 months the stock market rebounds by 64 percent on average, a number somewhat skewed by the 156 percent surge from the June 1932 market low. Even the smallest one-year rebound of 27 percent, following the September 2002 post-tech bubble bust, well exceeds the typical 12-month return of the stock market. Clearly, strong one-year market returns characterized stock markets following extreme plunges.

    The story is similar five years after a major plunge, with the stock market advancing by an average of 161 percent. Thus, while the most dramatic stock market recoveries occur within the first year, the next four years still produce very solid market performance, and in none of these instances have investors come out behind.

    Against the backdrop of very positive market performance over one- and five-year periods following market stumbles, the stock market has always experienced pullbacks or corrections during the first two years after a plunge.

    Surrendering Gains

    For example, in 1932 the market rallied by 102 percent in just 61 days from its closing low; over the next 173 days, the market then retreated 36 percent. While severe, this correction didn’t surrender all the gains from the initial rally.

    In 1974, the market bottomed and rallied by 61 percent over the next 285 calendar days. It then entered a correction stage that lasted 78 days and declined by 14 percent.

    In each of the five extreme stock market low episodes prior to 2009, stocks backed off at least 10 percent from the initial rally within the first two years. On average, the stock market decline was 17 percent and occurred over 140 days.

    So what might one expect in the current market environment? On March 3, 2009, the U.S. stock market reached the lowest level since September 1996. In the following 11 months the market rose 80 percent, making it one of the strongest and longest rallies since 1925. The market peaked on April 23 before falling to its latest low on July 1, a 16 percent fall.

    While stocks have risen during the past three weeks, it’s worth asking whether this market-correction phase is finished?

    Predicting a Bottom

    Perhaps not. After all, the shortest correction period prior to this was 78 days. Still, the correction phase probably will end sometime this summer based on past experiences.

    Furthermore, the magnitude of potential stock market losses in the future is likely to be much more limited than those that occurred between April 23 and July 1.

    Predicting an exact market bottom is always a tenuous exercise, but past experience suggests that this type of dip, common after extreme market lows, will not turn into another plunge like that in 2008 and 2009.

    For patient investors who have waited on the sidelines, the coming few months may represent a very good opportunity to increase holdings of equities as the outlook for the next several years is solidly positive based on 85 years of market history.

  3. Watcher, only had time for your first message today. I have noted UPS and Fedex comments and comments on the raw materials side of the railroads. I will need time to get at it. These are forecasts rather than posted results.

    June US home sales were the worst since records began in 1963. It is summer, people always sell and move in the kids vacation and these measure just the contracts. Seasonally adjusted it is bad.

    Consumer sentiment last night a complete bummer, again.

    Now that “Mutual funds, pensions and endowments are spending more on stocks than at any time since the start of the bull market”. They were net selling stocks since the start of the bull market …. Now 54% say they think stocks will jump more than 10% that doesn’t leave a healthy majority after the walking the walk takes out quite a few of them. Sentiment surveys on guys who own a great big book of equities never impress me. I only go on what they have done.

  4. Watcher, this is what I am interested in currently. http://www.reuters.com/article/idCNN2720940320100727?rpc=44

    Not so much on the gain in earnings (will look at relative past period oil prices and one off’s etc) but the revenue side seasonally adjusted. I will have to drill deeper. Prima facie it says growth and takes me down a step or two.

    But again last night had durable orders are down, Fed beige book also showed steel, construction, transportation capital equipment all negative.

  5. S&P 500 May Jump 10% After Cluster Barrier: Technical Analysis

    Shani Raja, bloomberg.com, July 29, 2010:

    The Standard & Poor’s 500 Index may rally more than 10 percent if it overcomes a “cluster” of resistance, according to an analysis of chart patterns by IG Markets Ltd.

    The benchmark for U.S. equities may climb to this year’s intraday high of 1,219.80 from yesterday’s close of 1,106.13, according to Chris Weston, a Melbourne-based institutional dealer at IG Markets.

    That move is possible if the gauge rises above its 200-day moving average of 1,114.12, its 100-day moving average of 1,128.34, its previous high of 1,131.23 reached June 21 and finally above a key Fibonacci resistance level of 1,140.

    The S&P 500 “needs to break through this next cluster of resistance before we can start to become optimistic again,” Weston said, without specifying a time period.

    The S&P 500 has fallen 9.3 percent from this year’s high on April 26 on concern Europe’s government-debt crisis, China’s steps to curb property-price inflation and signs of weakening in the U.S. economy will crimp global growth.

    Since closing below its 200-day moving average on May 20, the S&P 500 crossed the average to close above it on June 15 and July 26.

    “It’s encouraging that the S&P 500 rose above its 200-day moving average,” Weston said. “But it’s done this before in the past few months, only to fall back.”


Leave a Reply

Letters will be edited for clarity, punctuation, spelling and length. Abusive or off-topic comments will not be posted. We will not post all comments.
If you would prefer to email the editor, you can do so by sending an email to letters@dailyreckoning.com.au