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

Why Investors Need Bonds

If you doubted the benefits of holding U.S. Treasury securities heading into yesterday's market carnage, I'm sure you feel differently today.

Treasury bonds have ranked as one of the worst inflation-adjusted investments since 2002, barely keeping pace with inflation, and adjusted for taxes, have declined over the last three and five-year periods. Indeed, other bonds like emerging market debt and high-yield bonds have soared since 2002 as investors have been well rewarded for embracing risk. But that trend came crashing down on February 27 amid the worst sell-off for global stocks since March 2003. 

The majority of investments and asset classes plunged yesterday with the exception of some foreign currencies (euro, yen) and Treasury bonds. Even gold, long viewed as a hedge against market mayhem, succumbed to heavy selling as traders and market participants sought immediate liquidity from cash and cash equivalents.

February 27 was an ugly day when virtually no investment umbrella out there protected you from the storm.

But Treasury securities enjoyed a strong day, rising about 1% as the S&P 500 Index fell 3.5% and the MSCI World Index lost 2.5%.

Treasury bonds might not offer the best long-term returns going forward as interest rates remain historically low, but they do serve as a key hedge against downside market volatility. This was the case from 2000 to 2002 as stocks plunged and again in 1998 and 1987 amid other market crises. Investors need high quality bonds to shelter their portfolios from stock market swoons.

The correlation between common stocks and Treasury bonds has turned negative since 1997, meaning bonds zig when stocks zag. Again, I'm not talking about high-yield (junk) or emerging market bonds; I'm referring exclusively to Treasury bonds.

The odds of a U.S. economic recession are low. But if we suffer more bad days like February 27, I'll be selling more stocks, buying bonds and raising cash.      

GCC Only Region to Rally on Black Tuesday

When the government wants investors to temper their irrational exuberance, watch out!

That's the case with China and India in 2007 as both markets are severely overheated following massive gains over the last 18 months. In China's case, the stock markets in Shanghai and Shenzhen only recently emerged from a 5-year bear market while in Mumbai, stocks have more than tripled since 2002. But on February 27, China's government won the upper hand as local markets plunged 10% -- the largest single-day drop in a decade.

Chinese authorities are concerned that investors are borrowing heavily to speculate in stocks. In 2006, the Shanghai SE soared 130%, driving more casino-type invetsors into the market hoping to  make a quick killing.

The sell-off today in China has spilled over globally, knocking bourses sharply lower in Europe, South America, North America and across the Pacific. But interestingly, only one  region posted a gain today -- the Gulf states.

The Gulf states, part of the Gulf Cooperation Council (GCC) include the United Arab Emirates, Saudi Arabia, Oman, Qatar, Bahrain and Kuwait. From 2000 to 2005, this region was home to some of the most spectacular profits for stock market investors, smashing the returns generated in most other emerging markets. Many of these markets gained more than 300% over that five-year period. But in 2006, markets suffered a major correction that ultimately turned into a bear market. Regional tensions with Iran, sharply lower oil prices since last July and overheated economies all fed into the bears' claws.

Although the Gulf states are still struggling to emerge from a bear market this winter, signs of a bottom are near. Oil prices have rallied $12 off their mid-January lows and hopes are running high that Iran will eventually soften its hard stance on nuclear proliferation.

And talk about value. The Dow Jones Arabia Titans Index trades at just 5 times trailing earnings and yields 6.4% -- the highest-yielding region in the world. On February 27, a day when most bourses are tanking following China's nosedive, stocks in Qatar rose 1.2% and +0.7% in Abu Dhabi. Other regional markets also gained, including Casablanca (+2%), Amman (+0.8%) and Cairo (+0.2%).

And what about China?  It's a healthy development that stocks are correcting following a nonstop rally driven by record initial public offerings and booming liquidity flows. I doubt she'll crash, but a good sell-off is necessary and not only in China. All markets have enjoyed a huge rally over the last few years. And all markets are vulnerable to a correction, except the Gulf states.   

This spring, I'll be plugging the world's best-performing Gulf Cooperation Council (GCC) fund in my Global Mutual Fund Investor (GMFI). Don't miss it!      

One BRIC Down

BRICs, or benchmarks that invest in Brazil, Russia, India and China, have been all the rage among mutual fund sponsors over the last two years. And investors have caught on, shoving billions of dollars into the high-flying sector following mind-boggling stock market gains since 2002. A crop of exchange-traded-funds and mutual funds dedicated to BRICs have surfaced since 2005.

Of the four giant markets, I think India is the biggest "bubble" this decade and ripe for a major collapse folowing a fourfold increase since 2002. The other three BRICs look better, both fundamentally and technically, based on stock market patterns.

Brazil has definitely resurrected its economy this decade driven by a bull market in commodities, a bulging trade surplus, plunging debt issuance and a strong currency. China, after suffering a severe bear market from 2001 to mid-2005, has turned the corner on the heels of surging liquidity as initial public offerings swell the market amid 10% GDP growth. And Russia, the best-performing bourse in the world since 1998, is now the largest emerging market in the world, according to Morgan Stanley, with ballooning budget and trade surpluses, vast energy wealth and home to some of the largest resource companies in the world. But I've got a problem with India.

India, no doubt, is a great emerging market with superb long-term potential. I doubt it'll overtake China as an emerging market growth engine, but it's certainly worth tracking. India's economy expanded by 8.6% in 2006 and its BSE Sensitive Index has been on an absolute tear this decade. India is now the services industry capital of the world. Many large multinationals now have their international call-centers based in India due to cheap labour, an educated population and because English is widely spoken.

But India is severely overheating. The economy is so strong that the central bank has vocally expressed concern that inflation is rising too rapidly, currently over 5.5%. And government officials have repeatedly warned since last fall that the stock market is too high and showing signs of speculative excess. Last week, the BSE Sensitive Index declined 5.6%, its worst weekly performance since last spring. Stocks remain the most expensive on record in Mumbai.

Do yourself a favor: If you own stocks in India, get out now and buy the market again following the next crash. It's coming.

Record Art Sales a Bad Sign

Over the last 35 years, every bull market peak in stocks was preceded by a speculative frenzy in the art market. That was the case in 1972, 1987, 1989 and 2000. And in early 2007, all signs point to a peak in art sales at both Christie's and Sotheby's.

Christie's International sold a record $4.67 billion dollars' worth of art last year, up 36% from 2005 levels.  To further solidify the end of the feeding frenzy for the overheated art market, Christie's is also raising commission prices for big-ticket fine and decorative art.

Naturally, you can only raise commissions when demand is buoyant. Inflation is definitely in the art market now as bidders continue to prop-up all sorts of art, including Masterpieces. Previous "bubbles" in the art market all resulted in big declines for lesser quality work, starting at the height of the last mania in the late 1990s.

The art market and the stock market show a very strong correlation.  Though I'm not forecasting a bear market for stocks until 2009, the trend in art is an ominous sign for stock market investors as it signals incredible swathes of cash are chasing alternative investments at ludicrously high prices.

We all know every trend comes to an end. And right now, art is a screaming SELL.

Have a great weekend.   

One Step Closer to Carry-Trade Death

The Bank of Japan (BJO) raised borrowing costs by 0.25% to 0.50% yesterday, slowly drawing the curtains down on the infamous yen carry-trade.

The buzz around markets over the last five years is the Japanese yen carry-trade, which involves borrowing in low-yielding yen and reinvesting those proceeds into higher-yielding assets. In a perfect world, the speculator pays a low rate of interest on the yen-based loan, the yen weakens and the underlying investments converted from yen sharply appreciate. It's been a huge money-machine for hedge funds, private banks and other traders over the last few years, many cashing-in on booming stocks and commodities prices. But when bumps appear, things get pretty ugly.

Last May, the Bank of Japan first announced its intentions to start raising interest rates on the heels of positive economic growth momentum -- the first time the central bank contemplated raising rates in a decade. Immediately, global markets shuddered with stocks, bonds, commodities and high-yielding currencies all plunging in mid-May. Markets thereafter stabilized on the premise the BOJ wouldn't aggressively raise rates. It was the most vocal warning from a central bank in a long time with Japan giving traders and market participants nine months to prepare for another rate hike. That rate hike occurred on February 21.

I've always believed that you can't have investors trading the same markets, making a bundle, indefinitely. At some point, investing becomes a zero-sum game. And with leverage, the yen carry-trade will eventually end very badly, probably leading to a first-class financial market meltdown. I can't say when it'll occur, but I have no doubt the Japanese yen -- extremely cheap, will eventually rally as the BOJ continues to gradually raise interest rates. We're not at the boiling point, yet -- but the pot is certainly simmering for the yen carry-trade.

   

Base Metals Frenzy Not Over

The base metals continue to dominate commodities trading in 2007.

Despite suffering a massive correction last summer, the base metals complex continues to lead the commodity bull market since 2002.  Over the last three years, the Dow Jones-AIG Base Metals Index has surged 50% per annum, blowing away other commodities, including gold and silver. And the rally that began almost six years ago remains secular, driven by severe supply shortages and booming demand from China.

Aluminum, steel-scrap, copper, zinc, tin, lead and nickel prices have all gone ballistic over the last several years. China, without a doubt, is the prime driver of this major bull market. For example, in 1990, China consumed just 8% of total global zinc supply; as of 2005, she devoured 27% of total supply. Ratios for other base metals are just as compelling as China continues to rapidly grew her economy, moderninze her infrastructure and use any short-term weakness in base metals to hoard more inventory. That's what happened last fall when copper prices peaked; China uses short-term corrections in base metals to increase her storage facilities and reduce her adjusted cost-base.

Other metals are also on the fly early in 2007, including nickel. Used to make stainless steel, spot nickel closed just above $40,000 a metric ton in late February -- an all-time high. And tin prices closed at their highest levels in 17 years this month at $13,700 a metric ton. It's the same story with lead, titanium, rhodium, steel-scrap and even aluminum, a laggard in the bull market until last year.

Historically, big percentage gains for the base metals has eventually resulted in new supply hitting the market. It's the same trend for other commodities, too, which ultimately decline as producers increase supplies to meet rising demand. But this decade, and for the first time in the world's history, China, India and other fast-growing emerging markets are all growing at the same time, putting a serious strain on production growth.

Base metals are a special case within the commodity complex because you can't just flick a switch and get a new mine operating; companies now face record costs to meet new production demand, including soaring labour costs, high resource prices affecting input costs and in some countries, hostile governments nationalizing domestic natural resource production. It all adds up to a major, long-term secular bull market in prices. Provided global interest rates and credit growth remain buoyant for the next several years, this rally won't end soon. Commodities require fiscal stimulus or bank credit creation to stimulate economic growth. And I don't think any government right now is striving to choke-off economic growth, certainly not like they did in the 1970s.

Plus, don't forget that compared to 35 years ago, the world didn't have China growing at 10% per annum or India at 9% annually, just to name a few large emerging markets. The entire global supply and demand chain is under major stress under the weight of more than 2.2 billion people joining the global economy. The result means higher prices for most raw materials, including some of the laggards, which will ultimately join this rally.

For my Commodity Trend Alert (CTA) service, now in its sixth year, I'm buying zinc producers, energy stocks, oil futures, junior gold mining shares and agricultural commodities. The world is still growing, central banks are reluctantly raising rates and global liquidity remains very buoyant. The conditions that brought us here six years ago remain finrly in place.

The last several months have indeed been tough for commodity bulls -- but it ain't over by a long shot. Use short-term weakness to buy or accumulate commodities now.         

Here Comes Global Stock-Trading!

International stock-trading is coming soon at E-Trade Financial.

Sometime in the second quarter, E-Trade will join Fidelity Investments and Charles Schwab offering international stocks to its customers.  This is a great platform for global investors and I'm excited about this development because it'll allow investors in the United States to finally trade stocks, including REITs, listed overseas. Some of the best values now include distressed REITs in Hong Kong.

E-Trade will allow investors to trade in six foreign markets initially, eventually widening the scope to include 42 international markets. Currently, Charles Schwab and Fidelity Investments offer over 40 global markets.

What some investors don't know is that many ADRs, or American Depositary Receipts, don't provide good liquidity. ADRs are foreign company stocks traded in the United States in U.S. dollars, either on the NYSE or the OTC market. Though ADRs are convenient to buy for U.S. investors, many of them are very illiquid, offering poor spreads. In fact, most of the time, investors would be far better off buying those foreign-traded stocks in their home market, not in the United States. That's because foreign-traded stocks usually harbor greater liquidity from a broader base of domestic institutional investors. Some exceptions apply, mainly to large multinationals traded in New York, like British Petroleum and Deutsche Bank, to name only a few. But for smaller stocks, including many emerging market large-cap stocks, you're much better off buying domestically.

The advent of global low-fee trading is great news for investors. For a global outfit like ours at Sovereign Society, it opens up the world to many more investment opportunities, denominated in stronger foreign currencies and away from mainstream investments in the United States. 

The Misery Index

Are things that good out there? Is it too good to be true?

At 40, my generation has never had it this good.  I was just a child back in the 1970s when inflation was out of control, interest rates were soaring, unemployment was in the double-digits and marginal tax rates hit 70% in the United States. The first part of the 1970s was the worst time to be invested in common stocks with the S&P 500 Index suffering its worst 24-month decline from 1973 to 1974 since the Great Depression.

Enter Ronald Reagan in 1980. After a decade of too much government, Reagan slashed taxes, cut unemployment, boosted the economy and revolutionized a moribund economy. He also slashed Big government.

Since 1980, stocks, bonds, real estate, foreign equities, art and collectibles have all surged in value. Even adjusted for the U.S. dollar's decline versus the world's hardest currencies over the last 27 years, investors have earned big bucks in all asset classes. I think it would be pretty hard for any investor to complain about his portfolio's growth over the last 27 years.

Now let's move forward...

The Misery Index, calculated by adding inflation and unemployment, peaked at 21.9% in 1980; today, it sits at just 7.2%.  This index is really a testimony to a relatively strong U.S. and foreign economy, high productivity growth, lower marginal tax rates and disinflation. But things change.

If I had to bet, I'd say that by 2009 the Misery Index will start rising again.

Over the next 12-24 months, I think we'll see higher inflation, mainly due to bulging military spending (just like Vietnam in the early 1970s), rising unemployment, higher interest rates and possibly, a trade war between the United States, Europe and China.  These events will likely converge at the same time, resulting in, well, more misery.

Things do change. As an investor, it's far safer to anticipate change than having to forcefully react to change. By 2009, I'll be at least 35-50% in cash. I hate misery.

Corporate Raider Targets Telecoms

They might not be long-term investors, but they're definitely smart investors.

Shareholder activist, Carl Icahn, best known for busting-up Eastern Airlines through his Texas Air Holdings entity in the 1980s, has made a fortune targeting cash-rich companies or distressed securities selling below their intrinsic value. Icahn recently earned a bundle riding Time Warner Corporation and has a real knack for making incredible amounts of money by applying shareholder pressure after amassing a minority stake in a targeted company.

Icahn is now applying all sorts of pressure on telecommunications equipment manufacturer, Motorola Incorporated. 

Many telecommunications companies, like Motorola, are sitting on piles of cash. Still miles below their all-time high in 2000, telecom stocks remain one of the last true vestiges of value in a roaring stock market since 2003.  In addition to Motorola, Nokia and LM Ericsson also harbor billions in cash right now. 

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Motorola has $11.2 billion dollars in cash, earning a lowly 3% on its cash-pile. Icahn, who amassed a 1.4% stake in Motorola recently, is seeking a seat on the company's board to get approval to use that cash to make the company buy back its stock.

In the United States, huge cash piles are not a phenomenon confined to just telecom equipment companies. Many other sectors of the market now have their highest cash levels in more than 15 years after reducing debt, cutting employment earlier this decade and posting strong earnings results over the last three years.

If I was a Motorola shareholder, I'd be a pretty happy investor right now. I have no doubt Mr. Icahn will drive the stock price much higher before this raid is over.

Have a good weekend.   

Mutual Funds or the Publicly-Traded Sponsor?

One of the great anomalies in the investment management game is the performance of a mutual fund family's  flagship product versus the shares of its publicly-traded asset management company. The results have literally been mind-blowing over the last 20 years.

For example, T. Rowe Price, the venerable money-manager based in Baltimore, is probably one of the better mutual fund companies in the world. They levy below average expenses and many of their mutual funds have logged solid long-term returns historically. But the publicly-traded outfit, T. Rowe Price Corporation, traded on NASDAQ, has blown away the results generated by the group's top-performing funds. And the reason is simple enough: Mutual funds levy fees, and those fees are pretty massive for some of the larger behemoths running a few hundred billion dollars under management. Even more telling, some of the more "average" fund groups, which charge much more than T. Rowe Price, make even more money even though the products they sell to the public basically stink or fail to match their benchmark index.

In the United States, the average total expense ratio levied by mutual funds is 1.43%, according to Morningstar. That's a pretty fat number when you're running several hundred million or a couple of billion dollars.

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In that light, it was incredible to see the first hedge fund group trade on the NYSE last week, despite harboring excellent long-term returns for its investors. The principals, by the way, were already loaded and didn't need the money from this offering.

Fortress Investment Group raised north of $700 million dollars last week and became the first hedge fund to list in the United States. Hedge funds, by the way, charge an average 2% management fee and another 15-20% incentive fee on net new profits. It's an enormously profitable business for the sponsors, if they raise enough money to meet margins. For investors, alternative investments are largely a disappointment.

The average hedge fund continues to lag versus benchmarks since this bull market began in 2003. True, they generally fared well and grew capital, however marginally, during the 2000 to 2002 bear market and deserve a place in a diversified portfolio. But over the last four years, investors have paid big fees to hedge funds to trail the market. And what about those "incredible" private equity funds, all the rage on Wall Street lately? These guys charge even fatter fees and averaged just 5.9% per annum over the last five years. In my book, that's lousy performance.

In the end, the majority of actively-managed mutual funds and hedge funds fail to beat the market. Increasingly, it looks like the best way for investors to make money is to avoid most of these products and instead, buy the publicly-traded asset management houses. After all, investing is all about margins. And fees just keep getting fatter every year.