In natural resource investment markets, one can be a contrarian or one can be a victim, and the choice is one’s own.
Having once been a victim, I chose the other path. Natural resource industries are cyclical, volatile, emotional, over-regulated and capital-intensive. That’s the good news. If you accept markets for what they are, while other speculators operate in ignorance, you have an advantage in the market. Being a contrarian is hard. That’s the other good news. Most speculators cannot act in contrarian fashion, for reasons we discuss later.
During the first of this year, the prevailing sentiment among natural resource investors was that the sky was rosy for the sector. Emerging markets, particularly China and India, were driving resource demand, as billions of people aspired to the western lifestyle. Meanwhile, politically-inspired supply constraints like “NIMBY-ism”, nationalism and resource taxation constrained new supply initiatives, making existing capacity more valuable. Meanwhile, absurd monetary and credit practices increased the appeal of real, tangible assets. The only answer to that combination of circumstances was an aggressively positive attitude towards natural resource investments, ESPECIALLY because the stocks were performing well.
What has changed? Are resource stocks now a “sell?” Have we, in sixty days, restored the productive capacity of industries that suffered from 25 years of underinvestment? Has the political and social unrest in Iran, Venezuela and Nigeria subsided to the extent that raw materials consumers are comfortable with their reliability as suppliers? Have absurd monetary and credit practices become less of a concern to anyone?
So what has changed? Perception and the price of opportunity!
Many of you have experienced one or more resource cycles. For others, this is your first voyage. Down cycles in the resource business are messy affairs. The current cycle has been no different. The small-cap stocks, for example, are becoming even more volatile than they have traditionally been, driven by several interconnected phenomenon. First, the markets are now international, with Asian, Middle Eastern and European money flowing into and out of very thin markets, often buying and selling for reasons unrelated to the real prospects of the individual underlying equities.
Large institutions, particularly open-ended mutual funds, are big players in tiny markets. In times when the public perceptions of these markets is good, money flows into resource and small cap funds and is deployed by newly minted investment geniuses into increasingly irrationally priced equities; as perceptions change and the money disintermediates, managers must liquidate increasingly cheap positions. These managers don’t have the luxury of selling what they want. They sell what they can. Smaller institutions like hedge funds and liquidity funds have been huge players in these markets, and as their performance falters they too migrate from being aggressive buyers to aggressive sellers. Finally, individual participation in equity markets is at an all time high, with millions of bull-market-spawned, internet-wired speculators trading speculative equities with less than perfect knowledge about the businesses that underlie those trading vehicles. The information most of the participants rely on for their investment decisions is delivered by the markets themselves, the blind leading the blind.
The mob bids up the market, the mob sells the market down. What is the rational speculator to do? Buy stocks on sale.
Volatility is not just a condition, it’s a tool. If it is a tool that you are unwilling or unable to utilize, you should consider a different investment medium.
Markets are emotional too, and that is also good news! We are programmed to seek pleasure, and avoid pain. We hate to be wrong alone, seeking solace in the crowd. Our expectations for the future are set by our experiences in the immediate past. When we experience success in a market, we experience pleasure, and as pleasure seekers we are eager to repeat the sensation. We feel smart, confident, even smug. We understand this stuff, we’ve learned our lessons, experienced the risks, overcome the adversity… bring on the rewards. Bluntly, we confuse a bull market with brains. When markets get cheap on our watch, our most recent memory is pain, which we seek to avoid. We either blame the market, the government, the Moslems, the tri-lateral commission, or rarely, ourselves. But, eager to avoid blame, no price is too cheap; until at last it is no longer cheap, and we muster up the courage to re-enter.
In the short term, markets are a voting machine, a measure of the mob’s emotion and prejudice. Letting a mob, whose median intelligence and access to information is less than your own, dictate your actions is tantamount to assigning yourself a large handicap. In the long term, markets are weighing machines, swinging on a pendulum between undervalued and overvalued. Being a pawnbroker to the mob, buying goods on sale when the mob is depressed, and selling back marked up goods when the market is elated, is what markets are for. Do what is rationally easy, not what is emotionally easy… if you can’t find much to buy rationally, start selling. If a market goes “no bid”, put one up.
I personally see us in the mid-stage of a broad bull market in resources. At this instant, we are in a “wall of worry” correction. The world has woken up to the potential of resource markets, expectations have been frothy, but the inevitable supply increases that crush a market have not occurred, and will not occur for some time, because of the huge capital investments and long lead times inherent to these industries. I think most of the free money (the stealth bull market) has been made. My strategy will be to cycle out of popular sectors, (Uranium), into unpopular sectors, (Canadian natural gas), buy panics (hello, anyone listening?) and sell rallies. Supply increases have not yet occurred, although the capital spending cycle has rendered them inevitable. Demand, even in the face of strong price increases, is very strong. Emerging market demand is part of that story, insidious inflation is another factor. If we adjust the prices that we experienced forty years ago, or twenty years ago, to constant dollars, we see that commodity prices are high only in nominal, not in real terms.
Finally, the credit conundrum is, well, a conundrum. On the one hand, there is no doubt that part of the resource demand is artificial, a response to a liquidity-driven boom. More rational credit supplies can and will impact the broad economy, with profound implications for commodity demand. Limiting mortgages to people who can afford to pay back the loan will constrain demand for building materials. On the other hand, the idiotic increases in the money supply we are seeing now will make money worth less, and “stuff” worth more.
So where does this leave us? Right where we started: being contrarians, or victims.
Being a contrarian is better.
for The Daily Reckoning Australia
Rick Rule is Founder and President of Global Resource Investments Ltd. http://www.gril.net/