Eric Roseman's Eruptions: Stocks, Global Markets and Commodities BLOG

China too Hot for New Money

In August 2005, I decided to take the plunge and invest in what was the world's worst performing emerging market -- China. Now, 18 months later, I'm starting to reduce about half of my positions, largely taking profits off the table.

From its peak in 2001, Mainland Chinese stocks had crashed more than 60% heading into June 2005.  Yet, despite the market's malaise, the Chinese government was aggressively introducing bullish measures to support the market, including dividend and capital gains tax cuts, widening the availability of local A shares to foreign investors and finally closing many unprofitable state-owned companies that traded in Shanghai and Shenzhen. When a government, in the midst of a protracted stock-market crash, starts to introduce bold measures to arrest a decline, you buy. 

That investment has worked quite well for Sovereign Society members. But since last fall, I've downgraded that open position in China as a "hold" following a massive rally. Stocks in Shanghai  have rocketed 134% over the last 12 months, one of the best markets in the world. Indeed, Chinese stocks now trade at all-time highs with waves of money, both domestic and international, chasing the market. China, after Japan and Hong Kong, is now ranked as Asia's third-largest bourse based on stock-market capitalization at $1 trillion dollars. Though a big number, it pales to New York, currently valued at $26.5 trillion dollars, the world's largest bourse.

According to UBS, or Union Bank of Switzerland, Chinese stocks now trade at 33 times price-to-earnings (P/E), a pretty rich valuation  compared to just 24 months ago when they fetched below 10 times earnings.

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Reports from China now depict a market environment engulfed in absolute madness. Domestic investors are borrowing cash from their credit-cards to buy high-flying stocks while some are even taking out a mortgage to buy shares. The frenzy has drawn the attention of Chinese banking regulators, warning institutions not to make high-risk loans to stock investors. Margin lending, however, is not allowed in China.

The last time Chinese stocks were in a manic up-crash, from 1993 to 1996, stocks eventually went bust with Shanghai collapsing a cumulative 80% from late 1996 to 1998.   

Despite the feverish "bubble" in Chinese stocks, I don't think stocks will crash, at least not before the Beijing Games in 2008. There's too much at stake for the Chinese authorities to project a booming economy and stable stock-market ahead of the Olympics. But one thing is for sure: Stocks in Shanghai and Shenzhen are going to suffer a major hit, completely normal for any emerging market following a spectacular run, probably in 2007. At that point, I'd be a buyer again.

Despite trading at lofty levels, China should remain a peripheral position in every long-term portfolio. I have no doubt China will rank as one of the best-performing stock markets over the next 50 years and beyond. Buy on weakness.

Watch Motor City

Look to Detroit for clues on bond yields...

Bond yields in the United States continue to ratchet higher in January, hitting five-month highs. Indeed, with economic data this month feeding the market with rising growth expectations, bonds are getting drilled with the benchmark 10-year T-bond now trading at 4.9%. Just last month, the yield touched 4.4%.

In late June, Treasury bonds bottomed after months of losses with the yield topping-out at 5.28%.

The market has been discounting any chance of a Federal Reserve rate cut the first half of this year following a series of positive economic data lately, including rising consumer confidence, strong employment growth and signs that housing may finally be bottoming after a horrid 2006. I think the market is way ahead of itself and I'll tell you why.

In 2006, new and existing home sales recorded their worst sales in 17 years. The pace of the bear market in U.S. housing  may be ebbing, but it's not over.  Approximately $275 billion dollars' worth of adjustable rate mortgages are due this year -- and at higher financing rates, a bad sign for those individuals categorized as sub-prime borrowers.  Even stronger credits or borrowers are going to feel the pinch because a greater share of disposable income will be directed to financing their property, which is not rising in value. Historically, U.S. housing bear markets don't last 12 months; typically, declines in home values last at least 24-36 months before bottoming, suggesting this trend is far from over.

Next, the economy has yet to feel the full burden of what's going in the Motor City.

Detroit is home to a major chunk of the U.S. economy, approximately 10%. I remember reading over ten years ago that George Soros, one of the world's most formidable hedge fund managers in the 1970s and 1980s, stressed that auto sales are one of the closest indicators on his economic watch-list. He's right. The Big Three will report on auto production tomorrow and I'm thinking we're going to see some awful numbers. Ford Motor is losing billions, GM is no longer the world's largest car company with declining market share and Daimler-Chrysler's sales are dropping like a rock. I still think Ford will head into Chapter 11 one day, unless a foreign manufacturer makes a bid.

My point is this: If auto sales and production are declining for The Big Three, then how will the economy recover quickly from a slowdown that began in the third quarter? I don't buy it. Detroit is a major barometer for American manufacturing activity and I don't think the industry has seen the worst yet. In fact, I think it'll get much worse.

You might not make a bundle in Treasury bonds in 2007, but I think you'll earn a safe 10% on intermediate-term bonds and over 20% on long-term bonds, including coupon interest. We're heading into dangerous waters with earnings growth and employment peaking, mergers and acquisitions at hysterical levels and investors affording zero risk to owning speculative bonds like high-yield and emerging market debt. Credit spreads between high-risk debt and low-risk Treasuries has never been this tight.

More and more, I like T-bonds in 2007.

Global Funds as Your Core

Where's the first place a global investor should look to anchor their investment portfolio?   

Over the last sixteen years, I've used global equity funds as the core for my long-term growth portfolio. And I don't rely on indexing or passive investing, either. I concentrate on value-based mutual fund managers. 

Global equity funds invest worldwide, mostly in major-market economies and typically anchor their largest positions in the United States, Western Europe and Japan.  Though some of these products index-hug, keeping their country exposure in-synch with the benchmark MSCI World Index, many deviate from their index searching for high-value stocks or growth stocks, regardless of benchmark origination.

I like anchoring my portfolio with global funds because it gives me total world diversification, minimizes downside  risk and keeps costs down. Alternatively, if you anchor your portfolio with country and sector funds, you'll need a box of Rolaids to stomach the incessant volatility. Plus, you'll also pay more in management fees for sector and country funds. 

When looking for a good global fund, try to keep your expenses to a minimum, usually not more than 1.6% per annum for U.S.-based products and a maximum 2% for offshore funds, which typically charge higher fees.

Also, avoid fund managers that actively hedge-out their currency exposure; I prefer to hold global funds that don't hedge-out currency exposure, especially if it's a dollar-based mutual fund. That's because over the long-term, the American dollar has lost its purchasing power versus many international currencies; when you buy a fund that doesn't actively hedge-out its dollar exposure, you're benefiting from the dollar's decline, in addition to any security appreciation. It's a double-bonanza in a year like 2006 when more than half of the MSCI World Indexes' total return was derived from foreign currency appreciation, in addition to stock gains.

The best global funds in the world are updated every month in my Global Mutual Fund Investor (GMFI), now in its 15th year, including the best-performing foreign currency-based funds offshore.      

Rising Bond Yields Only Temporary

Bond yields are rising this month as the market begins to discount an imminent U.S. economic recovery and possibly, even higher Federal Reserve interest rates in 2007.

From their lows last June at 5.20%, the benchmark U.S. ten-year Treasury bond saw yields rally to 4.42% last fall. Today, yields sit at 4.88%, and likely to breach 5%, a point of excellent entry for new money. 

The consensus this year is that the American economy is going to recover sharply this quarter after a mid-cycle slowdown over the last six months. Housing, which is in a recession, continues to contract with existing-home sales plunging over the last 12 months -- their worst percentage decline since 1989. Later today, we'll see what new homes sales are painting for this distressed asset class.

The market is under the impression that real estate prices are going to recover quickly. I have my doubts. Historically, housing bear markets typically last at least 24-36 months before bottoming; this cycle is barely 12 months old. It's a little optimistic, I think, for the market to think real estate has bottomed this early with many regions still contracting. 

There's also a whopping $275 billion dollars of adjustable rate mortgages coming due in 2007 -- at higher rates. Though homeowners still have a job (employment growth thus far is strong), their debt-to-service ratio is climbing. More disposable income this year will be directed to monthly mortgage payments as rates have risen over the last year. By June, or sooner, I think we'll have a better idea where real estate prices are headed because many late-cycle speculators came aboard as prices were peaking; also, many speculators are sub-prime borrowers, or weak credits. Default rates will also rise as the year progresses.

I like high quality Treasury bonds for two reasons in 2007.

One, I think the credit market is terribly expensive with the riskiest bonds (junk, emerging markets) trading at all-time highs. This tells me that the credit cycle is very mature and at some point, spreads will tighten. When that happens, it'll be a disaster for many high-yield investors, including hedge funds.   

Second, there's still a major risk in real estate. The implosion in prices, especially in some of the hottest regions of the country, have not troughed. Like I said before, real estate bear markets don't come and go in less than 12 months. They're far more protracted. If this trend really turns to bust, you'll want T-bonds as a safe-haven.

Finally, I'm reading about OPEC members dumping Treasury bonds over the last few months amid plunging oil prices. As oil heads lower, surpluses are declining and OPEC is selling bonds. That may be the case, but we're in a secular bull market for oil. Higher prices are coming this year and that should support more T-bond purchases. Fact is OPEC is drowning in dollars and like the Chinese, will use the Treasury market as a parking place for its American currency. I don't see this trend changing any time soon, provided the United States keeps inflation low and the economy relatively strong.

Have a good weekend.

Ethanol: How to Invest for Maximum Profits

            

            With a newly elected Democratic and more ‘environmentally friendly’ Congress, President George Bush’s State of the Union Address urging to “act to increase energy production at home so America is less dependent on foreign oil,” and Prime Minister Stephen Harper’s recent promise to spend 1.5 billion dollars on alternative energy sources, more focus than ever seems to be surrounding alternative fuels.

 
            The buzz in the street seems to be about bio-fuel; more specifically, ethanol. Investors have increasingly focused their attention to this new play, investing in emerging companies to take advantage of the boom in this new renewable fuel source. High expectations came from companies like Aventine Renewable Energy and Verasun Energy, both of which had there IPO in the middle of last year. Their results, however, have been less than stellar, as their share prices currently remain well below their IPO price. This is due in major part with the decreasing price in ethanol, which tends to follow the price movement of oil.

 

            Ethanol is extracted from the starch or sugar of a large number of different renewable crop types. The main crop used for production in North America is corn. With the parabolic rise in corn prices that began in August of last year, ethanol producers have seen one of their major input costs almost double in 2006.

 

            Archer Daniels Midland, which controls roughly a quarter of the U.S. ethanol capacity, has acknowledged this fact. Its’ stock did well in 2006 as a whole; however, its share prices suffered a 30% hair-cut in the last quarter of the year. In the light of rising corn prices, Archer Daniels Midland has announced that they plan to shift their production away from corn based ethanol to embrace the methodology of the Brazilians.  Brazil is the largest sugarcane producer and has uses their crop to supply the country with over 40% of their fuel needs.

 

Perhaps the better way to approach the ethanol story as an investor is not necessarily investments in the ethanol producers, but in the elements that make up the fuel. With the number of new ethanol plants still increasing, it would seem the better choice for investment would not be in the new and existing ethanol producing companies, but in the inputs on which they rely. My favorites include corn, sugar and wheat. As an investor, you can now ride these futures contracts with ease, liquidity and zero margin. I just plugged my grain and ethanol play in this week’s Commodity Trend Alert (CTA).

 
            I’m not sure if the interest in ethanol will continue to boom. But if it does, I’m betting it’ll be far more rewarding to own the underlying futures contracts than the companies that produce the actual fuel additive.

Why this Bull Market Still Has Legs

Supply and demand. Corporate earnings. And low interest rates. That's the winning ticket for additional stock market gains in 2007. But at some point, this bull market will end, and very badly.

This current bull market rally, now in Year V, is an old bull by historical standards. Typically, stocks will suffer a bear market or at least a major correction somewhere in this cycle; but that's not been the case since early 2003 as equities have surged worldwide, defying predictions of a major correction. Volatility levels, which measure risk, continue to hover around 10-year lows as traders and investors scramble to buy stocks and forego downside market protection.

Although we will log a major correction this year (that's my official forecast), I think stocks will probably finish the year higher and escape a bear market.

One of the most compelling bits of data I've seen to support the stock market over the last six months is the growing bear market in U.S. real estate and the flow of funds into stocks. "Hot money" is chasing the new BIG thing, and that's common stocks.

Residential property prices continue to contract since last summer, hitting everyone in the real estate business, including speculators, homeowners, mortgage lenders, real estate agents and the home-improvement industry. As prices have softened and in some cases, tanked, in several parts of the nation, investors (and speculators) have recently sought new investments into equities. The Dow, which has hit numerous highs over the last four months, has attracted an enormous amount of funds since last fall while overseas markets have also been big beneficiaries of soaring stocks, more than doubling over the last three years.

Home prices stopped rising about 12 months ago while mutual fund inflows at the same time began to improve. Poeple who were looking to buy a second home or to speculate on property, are now focusing their efforts on the stock market because that's where the action is. As real estate prices continue to soften this year, I'm expecting even more mutual fund inflows as investors climb aboard the bandwagon.

Another enormous source of buying for world markets is the trend in mergers and acquisitions, feeding an incredible amount of liquidity and propping-up stock values. In 2006, an estimated $3.7 trillion dollars' worth of deals were sealed -- a record.

The bad news, however, is that mutual fund investors are notoriously late-cycle investors. They always arrive late. From 1998 to 2000, more money flowed into technology mutual funds than the entire period from 1990 to 2000.

Mutual fund investors are a fickle and volatile bunch, and tend to follow trends late in the game. This time won't be any different.   

A Bull and Bear Walk Into a Bar…

            

            An old lawyer use to brag that he was never worried about which way the economy turned. He said that in good times his firm would stay busy with mergers and acquisitions. In bad times, he added, his firm would stay busy with defaults and bankruptcies. Lawyers, however, are not the only ones that benefit from a recession-proof occupation. Another is your friendly neighborhood bartender. When times are good, people tend to celebrate with a drink. When times are bad, people tend to drown their sorrows in a drink. Both economic prosperity and desperation will most like bode well for the bartender.

As an investor, one would very much like to be as lucky with one’s portfolio as the lawyer and bartender are in bull and bear markets. Although it is impossible to buy shares in a law firm, perhaps there is a way to take advantage of the bartender’s recession-proof situation. Most likely, the alcohol that the lucky bartender is serving has been provided by a company by the name of Diageo plc. Diageo is the largest alcohol company in the world, supplying beer, wine and spirits to over 180 markets.

            According to an October 10^th O.E.C.D. report, global alcohol consumption is on the rise. For example, the report shows that the most recent five year data between 1999 and 2004 for Canada and the U.S.’s per capita liter consumption had increased 10% and 17% respectively. This has lead to great success for Diageo as well as its stock performance. Diageo trades as an A.D.S. (American Depositary Share) on the N.Y.S.E. under the ticker symbol DEO. It’s also an open position in the TSI Portfolio since April 2003, up 133%m including dividends. I plugged stock when she was near a 52-week low.

In 2006, Diageo’s total return was a healthy 39.96%, well above the S&P 500’s total return of 15.79%. As for its bear market performance, in 2001 Diageo total return was 7.51% compared to the S&P’s -11.89%. In fact, if one were unlucky enough to have invested in the S&P in early to mid 2000, the investment would still have not yet broken even. If, on the other hand, one would have invested in Diageo, the investment would have nearly tripled in value, as demonstrated by the following graph.

 

 

World's Original Commodity Bull Stays the Course

One of several investors who mentored me over the last 17 years remains a steadfast commodity bull. He was also one of the first bulls I know predicting the historical rally that started in natural resources five years ago.

Jim Rogers, investor extraordinaire and leading author on several books, including Hot Commodities, recently stated that despite the big drop in oil prices this month, he still sees the long-term trend well over $150 a barrel one day: "I'm just not smart enough to know how far down it will go and how long it will stay, but I do know that within the context of the bull market, oil will go over $100. It will go over $150. Whether that is in 2009 or 2013, I  don't have a clue, but I know it's going to happen."

Fundamentals for oil have not changed this year, but sentiment has soured to the point that most traders, including trend-followers, have closed their positions.  Other traders, riding the downtrend, have also purchased short positions against crude oil, anticipating further declines.  This is exactly the opposite of what occurred over the last five years, from late 2001 to mid-2006, as oil prices more than tripled. Traders rode the bull right to $77 a barrel in mid-July 2006 and then began to heavily short oil ahead of January as temperatures grew warmer in the Northeastern United States.

Oil consumption remains around 84.5 million barrels per day against supplies of roughly 86 million barrels. That's still a very tight market. Any surprise on either matrix, including colder weather or geopolitical concerns can drive prices sharply higher. I'm still buying oil this month, and lots of it.

How good is Jim Rogers at forecasting? Pretty darn good.

Back in an interview with me in 1994, he predicted the largest oil companies in Italy (ENI) and France (Total-Fina) would make investors a bundle because the United States had just banned U.S. oil companies and its Allies (British, Dutch) from drilling in "rogue" states, like Libya, Iraq and Iran. But the Italians and the French have defied the State Departments for years and as a result, have made a fortune for their shareholders.  Over the same period, stocks like Royal Dutch Shell and British Petroleum have been poor relative performers.

I recommended both European oil giants in my Commodity Trend Alert (CTA) back in July 2001. Today, ENI is up a cumulative 224% and Total-Fina, up 138%, including dividends.

Thanks, Mr. Rogers.

Breaking Every Promise to Business: The Worst Canadian PM

I'll vote for Canadian prime minister, Stephen Harper. That is, I'll vote him as the absolute worst prime minister since Joe Clark in 1979.

Elected in a minority government, the Conservative PM has broken every promise to business since elected. For a conservative, Harper should be pro-business, similar to George W. Bush in the United States. But the Canadian prime minister is literally a wrecking-ball when it comes to fiscal policies designed to help Canada. Like dominoes, one policy blunder after another is hurting Canada over the last 12 months, including the government's decision to tax income trusts.

On October 31, 2006, Harper dropped a bomb on the lucrative Canadian income trust sector when his government announced plans to start taxing income trusts pari-pasu as other Canadian corporations starting in 2011. Over the last three months, 25% of the sector's market-capitalization has been wiped-out, erasing more than C$30 billion dollars worth of asset class.  And who's feeling the heat? The millions of yield-hungry Canadians, starved for income in a low interest rate environment since 2002.

The income trust fiasco doesn't just hurt income earners, especially those in retirement. It's also destroying Canada's highly lucrative energy complex where many energy trusts rely on tax advantaged structures to help them explore for oil and gas, the backbone of Canada's natural resources industry.

With energy trusts no longer enjoying a tax advantage beyond 2011 and trading about 25-30% below their highs last summer, Harper has literally handed Canada's oil industry on a silver platter to venture capital funds; with many energy trusts selling below their net asset value and harboring positive cash-flows, despite sharply lower oil and gas prices lately, it's only a matter of time until international hedge funds, venture capital funds and private equity funds raid Canada's oil sector.

Meanwhile, the blizzard of selling in Canadian energy trusts since last November has also hit the Canadian dollar's bull market. After soaring more than 30% off the 2002 lows, the Canuck buck has declined 8% since last fall. No doubt a good chunk of that decline is attributed to the plunge in energy trusts; when investors, especially overseas, dump Canadian securities, they're also selling the Canadian dollar in the process. And a big chunk of foreign investors sold energy trusts last November.

In addition to almost destroying the energy trust sector and smashing the Canadian dollar, Harper's Conservatives reneged on other election promises.

Harper also raised the dividend tax rate on Canadians, too, despite promising not to raise taxes during his election campaign. And in 2006, our moronic prime minister also decided it was a good idea to repeal the GST tax refund for tourists visiting and shopping in Canada. No doubt that bright move will hurt retail sales and crimp Canada's tourism revenue. A strong Canadian dollar was already doing damage to tourism revenue over the last three years, particularly to Americans. Cross-border visits into Canada actually declined in 2006 and will undoubtedly fall further in 2007 as visitors miss the GST tax refund.   

A conservative government like this one in power is a bad joke.

I'm sorry I voted for the Harper Conservatives.   

Dollar Strength in 2007

The U.S. dollar is on a roll this month...

Every currency pundit in the world predicted the U.S. dollar would decline again in 2007. Although the year is just three weeks old, the buck's performance thus far has surprised global investors with a 2.3% gain versus the euro and similar gains across the board against other currencies, including the yen. The only major unit to rally against the strong dollar is the pound following a surprise rate hike by The Bank of England last week.

Heading into 2007, I was also predicting a lower dollar, but not a repeat of last year's 11.5% decline. I still think the dollar will soften this year, probably about 5% or less; but with every hedge fund on the planet betting against the dollar, the odds of a dive are unlikely, barring a real estate crash, a terrorist attack or an economic recession.

Here's another reason why I don't think the U.S. dollar will crack this year; one of the best contrarian indicators I follow to measure market sentiment, especially in currencies, is what mainstream investors are doing with their dollars. I remember, back in late 2004, as the dollar was tanking, many of my newer clients were compelling me to dump dollars for euro. I warned against dumping dollars in late 2004 because the currency had already plunged with everyone heavily shorting the dollar. One-sided bets in the market always eventually reverse -- and badly. In 2005, the dollar gained 12.8% versus the euro and started a cyclical rally in January of that year, just like it's doing right now.

At the moment, many investors are dumping dollars again for euro and other currencies. Though I implore investors to diversify their portfolios away from the dollar (it's performance long-term is pathetic), short-term swings can be violent and can result in big losses for investors. I'm hearing the same sentiment today as I did exactly two years ago ahead of a short-term dollar bounce.

My advice: Use any intermittent dollar strength to reduce your exposure and buy better-managed foreign currencies like the euro, Swiss franc, Canadian dollars, Chinese yuan and Singapore dollars. I also like the Japanese yen, the cheapest of all currencies in 2007. Most of all, I expect gold and silver to outpace all currencies, which has been the case since 2005.