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

Energy Prices Heading Higher, Coal is Cheap

Following a negative year in 2006, the energy complex is making a comeback in 2007 -- and we're at the cusp of another major rally that will test last July's high of $77 per barrel.

A rash of refinery breakdowns this spring coupled with fears of squeezed supplies from politically unstable countries like Nigeria, is forcing prices higher. Plus, after a benign hurricane season last year, we're just about to start another period of potentially more challenging storms, which threaten natural gas supplies.

The entire energy complex is coming alive again in 2007. Natural gas, long in a bear market since the start of 2006, has recovered sharply this year, ahead of oil prices. But the best values within the energy complex is also about to join this party -- coal.

Coal prices correlate strongly to West Texas Intermediate crude oil. From crude's low in late 2001, coal prices in the United States have soared as the demand for cheaper-burning fossil fuels has grown exponentially over the last six years -- especially in fast-growing China, which now imports coal.

As oil prices rise, coal prices usually follow suit, and vice-versa when oil prices decline as indeed happened from August 2006 until late January 2007. From their highs earlier in 2006, prices for U.S. coal remain about 15-25% off their highs, making the companies that produce the stuff interesting speculations again in 2007 All of these stocks have been hammered over the last 12 months, down more than 50% from their highs, at least for the second-tier producers.

I've plugged two coal companies in my Commodity Trend Alert (CTA) service since 2001: Fording Canadian Coal (+251%) and Foundation Coal (+80%). Both stocks were sold ahead of the crash in coal prices in January and February 2006. But now, I'm finding superb values again in this distressed sector. And my latest coal recommendation comes out tomorrow in CTA, celebrating its sixth year this July.

I'm en route to Panama this evening for the TSI Wealth Advantage conference -- one of my favorite events of the year. I'll be back tomorrow morning with a post from Miami.

U.S. Sub-prime Woes: Is the Worst Over?

The bear market in U.S. residential real estate began in July 2006. Over the last twelve months, new and existing home sales have plunged in the double-digits – the worst decline for housing since the late 1980s. Although the decline for this sector has indeed been steep and in some cases, spectacular, history suggests that this unwinding process has further to run as more lenders are squeezed in 2007.

First -- the good news.

Although financial risk has increased for lenders since last year and has exposed the consumer to declining household wealth, the current strains in the sub-prime mortgage market probably won’t tip the United States into recession in 2007. The banking system is heavily exposed to real estate but unlike previous real estate “bubbles” and subsequent bear markets, balance sheets are strong and asset quality is generally high. The most leveraged mortgage lenders have already been heavily punished by the stock market since February, paving the way for private equity and venture capital firms to scoop-up any residual distressed assets. Plus, the Federal Reserve will remain on the sidelines and in fact, probably cut lending rates over the next several months to breathe life into the real estate market.

On the other side of the coin, the housing market has now lost the sub-prime borrower, estimated at 15-20% of the entire mortgage-lending market. It will become much more difficult for high-risk borrowers to secure mortgages as lenders continue to tighten their standards. This assumes that the bear market will therefore take longer to adjust, thereby prolonging the slowdown not only in housing but also the broader U.S. economy. At just 1.3%, first quarter gross domestic product (GDP) is the slowest expansion since 2003 when the economy was just emerging from recession.

According to the Federal Deposit Insurance Corporation (FDIC), U.S. banks with the greatest residential real estate exposure at the end of 2006 include Wachovia at 33.4% of total real estate assets followed by Wells Fargo at 31.5%, and Bank of America at 23%. Again, the good news for the economy and the banking sector overall is that loan delinquency rates are still low by historical standards while the number of bank failures in this economic cycle remains very low or benign. For example, at the height of the last real estate crisis in October 1990, Citibank was having difficulty rolling over its commercial paper, a sign of major liquidity problems. The delinquency rate on commercial real estate loans exceeded 12% in 1991 while loan delinquency rates soared. Of course, the Savings & Loans crisis of 1990-1991 resulted in massive losses for residential mortgage-backed loans; the Resolution Trust Corporation (RTC) was thereafter created to clean-up the mess and stabilize the weakest segment of the banking system. Today’s sub-prime mortgage woes, though serious, do not compare to the devastation that afflicted the banking system 17 year ago.
The rest of the real estate industry in the United States is largely strong and performing well in 2007, which explains why most REITs, or real estate investment trusts, have not crashed. Some parts of the market are soft, including California, Arizona and Southern Florida, regions that appreciated by staggering amounts over the last seven years. But even in the most speculative markets, delinquency rates are still low.

Commercial mortgage-backed defaults sport even lower delinquency rates than residential property loans. Although banks have certainly boosted their exposure to all segments of the real estate industry since 2000, overall loan quality remains good and booming earnings until recently have created a cash reserve for most lenders.

The U.S. sub-prime loan crisis has further to unravel before bottoming. But again, most banks have sufficient capital reserves from years of strong earnings to cover their losses.

The major risks to the U.S. and global financial system in 2007 lie with Federal Reserve monetary policy, employment growth trends, consumer and corporate spending and systemic risk posed by hedge funds and other institutions laced with carry-trade loans and other synthetic derivatives. The housing bear market is not a major risk to the U.S. economic cycle; the markets have largely discounted this event by hitting new all-time highs almost daily since mid-April. However, investors should expect a major stock market correction this spring or summer as consumer spending, tied to a great extent to housing values, eventually start to spend less amid declining household wealth and possibly, rising unemployment.

The Burbuja is Bursting

The Spanish real estate sector has been red hot for the last decade. Real estate prices in Spain have almost tripled since 1997. Although Europe as a whole has seen impressive growth in the sector, Spanish companies seem to have benefited the most, outperforming the Bloomberg Europe Real Estate Index for the last four years.

The winning streak, however, has come to violent and sudden end, with real estate and banking stocks falling dramatically this week. The sell off in Spanish real estate and associated stocks was spawned from apprehension surrounding building company Astroc Mediterraneo SA and was amidst fears of a property crash brought about by a market slowdown due to rising interest rates

Like the sector as a whole, Astroc Mediterraneo has been on a tear since it had its IPO last year. With an initial offering price of €6.40, the share prices have soared to a high of €72.35. Within the last week, however, shares of Astroc Mediterraneo have experienced a whopping drop of 66 percent of their value. Similarly, shares of companies like Grupo Inmocaral, Immobiliaria Colonial, and Montebalito have experienced significant decline in their share prices. The effects of this decline, however, may extend far beyond the real estate sector, as construction represents 11 percent of Spanish GDP. A downturn in the real estate could spell out a major slowdown in the economy as a whole and could mean the loss of some 200,000 jobs associated with the sector.

The aftermath of the bursting bubble in the Spanish market might be a sign of what is about to happen on this side of the pond, particularly in the United States. Yesterday, the National Association of Realtors released the existing home sales number for March. The number was a great surprise to many, with sales dropping more than they have in almost two decades. The 8.4 percent decrease in sales was also accompanied by the 8th consecutive drop in home prices. With more and more news like this, the US will also feel the ripple effect throughout its economy of its own bursting ‘burbuja’.

What's Wrong with this Picture?

The list of economic woes afflicting the American economy has morphed into a shopping list of bearish data. Yet, despite the bad news affecting the world's largest economy virtually on a daily basis, stocks continue to hit new highs. What wrong with this picture? Should we be concerned at all, and just ride the wave of new highs as the market discounts all this bad news? I have my doubts.

Housing remains in a secular bear market -- and it won't end soon. Existing home sales plunged 8.4% in March, their largest decline in 18 years. Today, fresh data on new home sales will almost certainly paint another sobering picture on this protracted downtrend. Auto sales in the United States for the Big Three continue to sag with unemployment levels in that industry soaring and seriously hurting Detroit's economy. Together, housing and automotive are about 18% of the American economy's output.

But let's suppose the market has already discounted the worst of the housing and the auto industry's woes. Well, there's more bearish data and it should raise investors' concerns.

Corporate capital spending continues to decline since the beginning of the year, suggesting companies aren't positive on economic growth and future earnings. Instead, companies continue to pour hundreds of billions of dollars into stock buybacks and to a lesser extent, raising dividends to shareholders. In addition to slack corporate spending, the consumer looks increasingly fragile with most retailers off their best highs since last year. The Conference Board's index of leading indicators dropped below its level of a year earlier, which is a very bearish signal since a negative reading has accurately predicted every recession since 1967. finally, corporate earnings as measured by the S&P 500 Index have declined to the mid-single digits from double-digits 12 months earlier.

I hate to spoil this party, but I think this rally is mostly fluff. If you strip-out share buybacks and massive private equity trading volume from this market, you have a flat or down market in 2007. The supply of existing stock is being diluted at a record rate over the last several months as more companies become private. The only positive trend for earnings remains a weak dollar, a boon for U.S. multinationals.

Once again, he's my forecast, just in case you're margined and leveraged amid all this hype and considering raising some cash: Expect a brutal stock market correction this summer or fall and then load-up on stocks again in late October. The worst time to be invested in the market, including foreign stocks, is from May to September. Guess what? It's May 1st next Tuesday.

Grain Exchanges Refuse to go Public

One of the biggest investment themes since 2002 remains the red-hot derivative and commodity exchanges. Although several derivative exchanges have gone public since late 2002, the three grain exchanges in North America refuse to go public.

Starting in December 2002, the first of many initial public offerings in this sector, the Chicago Mercantile Exchange (CME), went public. Three months later, I plugged the CME at $46.75; today those shares are trading at a whopping $547.40, or an incredible 1,070%, excluding modest dividends. I've also plugged CBOT Holdings, or Chicago Board of Trade, in May 2006, now up 97% year-over-year. My latest derivative specialty exchange recommendation has not come alive yet, but I remain very bullish on its prospects.

In this business, it's all about earnings. And the specialty derivative exchanges are making a truckload.

Corporate earnings results thus far for Q1 for CBOT and CME have been superb while NYMEX is expected to report shortly. It's the same with the others, including ISE and ICE, both making a bundle.

Since 2000 and the subsequent boom of hedge fund assets worldwide, more investors and traders are using derivatives to either augment or protect their investments. These range from currency contracts, options and futures contracts tied to just about everything and a host other acronyms like CDOs, SWAPs, etc. It's an enormously profitable business, especially since the introduction of electronic trading whereby the exchanges have cut their overhead or labor costs.

Enter the other side of the business -- the grain exchanges. These companies have made a 360-degree turn over the last five years, earning more than three times their net income since the beginning of the decade. The boom in ethanol demand, rising exports to emerging markets and declining grain harvests outside of North America have propelled grain prices to their highest levels in years. But for individual investors, it's an investment theme that's hard to play because these three companies are not publicly-traded. And you have to have plenty of cash to buy a seat on the board because prices have skyrocketed more than tenfold this decade on the Kansas City Board of Trade, for example. The other two exchanges are the Winnipeg Commodity Exchange in Canada and the Minneapolis Grain Exchange.

I'm very bullish on the grains for the next decade and beyond. Volatile weather will continue to delay plantings and even destroy more crops coupled with rising demand for cleaner-burning fuels like ethanol. But if you want to play this theme, you've got to buy the only mutual fund dedicated to publicly and privately-traded exchanges, including the grain exchanges.

I'll tell you how to invest later this summer in Global Mutual Fund Investor (GMFI).

Global Stock Markets Still Heavily Correlated

This morning's Wall Street Journal makes a case that global equity markets are increasingly taking divergent paths and that correlation factors between markets are disappearing. Though I thoroughly love the Journal and have been an avid subscriber for 17 years, I've got to disagree with this poorly researched commentary.

Entitled "An Unrelated Story," the copy writers incorrectly paint a brighter picture for global investors since 2001, pointing out that U.S. stocks have lagged over the last several years versus high-flying international equities. Although the latter argument is indeed correct (the S&P 500 Index has risen 29% since January 1, 2002 versus 95% for the MSCI EAFE Index) , the copy fails to address what happens to correlation factors during down markets.

The only commentary about negative correlation analysis was the recent 5% one-day decline last week in Shanghai stocks; as Chinese equities declined last week, U.S. stock rose, according to the article. That's hardly an in-depth correlation study.

Here are some hard facts to throw cold water on this poorly written and researched article, which blatantly gives the individual investor the wrong impression about global diversification and correlation analysis: During severe market declines this decade and especially during the last bear market from 2000 to 2002, foreign stocks not only fared badly, but they actually declined 9% more than the S&P 500 Index, crashing 49%. And the MSCI World Index, which includes U.S. stocks, tanked 50%. From 2000 to 2002, the S&P 500 Index collapsed a cumulative 41%. The 2000 to 2002 bear market, by the way, was the worst three-year period for global stocks since the Great Depression.

Back in the 1980s, international markets actually provided a higher degree of negative market correlation to Wall Street. But since the 1990s and the widespread embrace of market-based capitalism and the end of the Soviet Union, the majority of markets actually correlate more, not less, to New York on bad days for stocks.
Correlations were very strong under several periods in the 1990s, including the August 1990 (Gulf War), 1994 (period of rising U.S. rates) and August-September 1998 (Long-Term Capital Management crisis)

In the 2000s, correlations have increased even more during bear markets and single-day mini-crashes.

The only regions to post gains from 2000 to 2002 were the Gulf Arab states and Eastern Europe; every other region went deep into the gutter. And one more caveat; Eastern European stocks during that three-year slaughter registered most of their dollar-based gains because of a strong euro, not soaring stocks.

Most recently, fears of a widening U.S. sub-prime crisis lead to major market declines on February 27 and March 13. Virtually every bourse worldwide was heavily down on both trading days as Wall Street took everyone to the basement.

In the end, foreign stock markets might indeed out-pace New York in a rising market or bull market, which has been the case since March 2003. But when the sellers return en masse -- forget it: Foreign stocks are no panacea. If you want negative correlation in a bear market, make sure to diversify in foreign currencies, high quality government bonds and T-bills.

The Next Big Thing in Mining: Slingshot Stocks

Junior mining stocks used to be the equivalent of sleaze in Canadian investment circles. Riddled by stock scandals, rigged share price manipulation schemes and mostly unethical promoters, Canadian junior mining stocks traded on the Vancouver Stock Exchange were literally the equivalent of the Wild West of speculation. The odds of winning on a mining stock were probably worse than a blackjack game in Las Vegas.

But starting in 1999, the Vancouver Stock Exchange and Alberta Stock Exchange merged to form the Toronto TSX Venture Exchange, Canada’s new home for junior mining, energy and technology issues. To be sure, it’s a much smarter index than its predecessor in Vancouver with far more stringent regulation and greater transparency. However, junior mining remains a very risky and volatile business – if you don’t know how to trade these little rockets.

From their lows last fall, many Canadian junior mining stocks have sky-rocketed more than fivefold from their multi-year lows. Of course, some of these stocks, with no earnings, traded for pennies on the dollar or under one dollar per share, better known as “penny” stocks. And with natural resources in a bull market since 2002, it’s no wonder we’re seeing all sorts of speculation in the TSX Venture Exchange over the last few years as the rally broadens to include all segments of mining, including the base metals and gold.

I’ve always focused on those mining companies with tangible earnings. Otherwise, investing in just sheer speculation, or like I said before, the equivalent of Vegas gambling. Instead, I’ve turned my attention since February to those junior and mid-cap mining stocks with earnings -- some even issue dividends.

The bull market in metals, which includes a vast universe of base metals like aluminum, zinc, copper, nickel, lead, tin and many other sub-metals like molybdenum, have literally gone through the roof since 2002 on a combination of booming overseas demand (mainly Chinese) and the tightest supplies since the late 1970s. Not only have large-cap stocks like BHP Billiton and Rio Tinto rallied sharply over the last five years, but now, we’re seeing more trading volume in the smaller mining stocks in this sector.

A multitude of mid-cap mining stocks in Canada, Australia and South Africa have more than quadrupled since 2003 as the base metals have surged. Though I still like the long-term prospects for some base metals, the majority are worth avoiding at this stage of the economic cycle as wild speculation has gripped the sector. From a risk-adjusted and future profit perspective, the precious metals mining stocks offer far better upside over the next few years as gold, silver, platinum and eventually palladium, all head much higher. In addition to the speculative but incredibly profitable junior-mining issues, many of the large-cap gold stocks are still 25-35% off their highs and are huge bargains at these prices.

Back in 2001, my mentor and friend, Jim Rogers (Investment Biker), urged me to consider the new bull market in raw materials; I was so convinced he was right, that I started an investment service six years ago with The Sovereign Society called Commodity trend Alert (CTA), long before most investors were speculating in natural resources. I’m very proud to acknowledge that our track record has been excellent, despite using no leverage, no margin and barely any options. It’s just pure contrarian, deep-value, natural resource stock-picking in Toronto, New York and occasionally, international markets.

To be sure, there’s still great money to be made in natural resource stocks. The “easy money,” however, has already been made in most of the large-cap commodity stocks; but following steep corrections, which are perfectly normal in this cycle, we’re still buying great companies after a 35% to 40% decline from their peak. At the moment, I’m looking at depressed coal (CTA earned 251% and another 80% on two coal stocks since 2003), energy stocks, and of course, junior and mid-cap mining.

In my recent CTA Dirt-Diggers Report, I plugged several junior-mining stocks. With the exception of one stock, all of them are way up, including one slingshot stock which has surged from under C$1 to over C$2.50 now.

Since February, I’ve plugged four Canadian junior mining stocks – one in diversified base metals, another in copper (and finished molybdenum) and two in the gold-mining sector. The average gain is now 25%, including gains in the Canadian dollar vis-à-vis the U.S. dollar, which has recovered from its six-month correction.

CTA’s top-performing junior mining stock was purchased in November 2005 (a platinum company) at C$1.52; today, that same stock trades at C$3.64.

There are more profits coming our way as gold, silver, platinum and palladium break new highs in this historical bull market. Every short-term correction of the primary trend, however brutal, should be viewed as an opportunity to add to your positions.

Arabian Capital Markets on Sale

The Arab world might not be on most investors' radar screen, but the Gulf Co-operation Council and other Middle Eastern markets now rank as the cheapest in the world following big bear markets.

I've been writing about Middle Eastern markets over the last six months and continue to find this exciting but high-risk region very compelling. Most regional stock exchanges from 2000 to 2006 literally went through the roof, gaining more than 350%, including Dubai, Cairo, Amman, Riyadh and even the bourse in Palestine. Even while most global markets were plummeting during the 2000-2002 bear market, these stocks were still soaring. Then, like all "bubbles," the region imploded starting earlier last year with most markets still down more than 25% from their all-time highs. Enter the investment opportunity.

According to the Dow Jones Arabian Titans Index, a composite of the region's largest stocks, Pan-Arabian blue-chips trade at just 4 times trailing earnings -- a massive 74% discount compared to the MSCI Emerging Markets Index. Equities in the region also boast a 3.7% dividend yield, almost double the rate currently available from global benchmarks. And year-to-date, the DJ Arabian Titans Index has gained 12.8%, continuing a recovery following a severe bear market in 2006.

In addition to stocks in the Arab world, local currencies also offer long-term upside. That's because some of the biggest concentration of U.S. dollar reserves are in countries like Saudi Arabia and the UAE. At some point, these and other regional markets will begin the long process of selling dollars and replacing these reserves with more euro, gold and eventually, an Asian-Pacific currency unit, if one is ever created.

Countries in the GCC, or Gulf Co-operation Council, harbor mostly positive trade balances and bulging foreign-exchange coffers, the result of enormous oil wealth accumulation. That makes owning stocks and bonds denominated in local currencies a good speculation over the next several years. Also, the Arab markets offer negative correlation to other stock-exchanges representing the MSCI World Index, providing a good degree of portfolio diversification.

In the May issue of my Global Mutual Fund Investor (GMFI), I'll tell you how to play the Arab world, recommending the world's top-performing money-manager based in Dubai.

Only One Reason to Own T-Bonds: Systemic Risk

There's no doubt in my mind that inflation is making a comeback in the latter half of the 2000s.

The accelerated disinflation of the last decade and all the benefits of high productivity growth are now behind us in 2007. And if I'm right about creeping inflation and major supply concerns developing for many commodities, then financial stocks, bonds and everything else that's interest rate sensitive is heading to the basement over the next 12-24 months.

I like high quality U.S. Treasury bonds for one reason: a hedge against a systemic financial crisis or meltdown. I don't like bonds for any other reason because over the next several years, the United States will have no choice but to hike interest rates to finance massive entitlement spending programs. Along with rising inflation caused by declining food harvests, soaring grain prices, a shrinking labor pool and a significant increase in global exchange-rate volatility, interest rates will rise.

All bonds, especially the riskiest segments, including emerging market debt and high-yield bonds, offer pitifully low spreads above risk-free T-bonds right now. In fact, spreads have remained near their lowest levels in history for all high-risk bonds since late 2005. I don't see any reason to own an emerging market bond when all you get is 1.6% more than a comparable ten-year T-bond. High-yield debt provides another 100 basis points in yield, but again, with default rates sitting at near record lows and spreads this tight, I don't want to own junk debt.

However, with every passing day this market rallies, the odds of a major sell-off or decline increases.

The mini-panics of February 27 and March 13, in retrospect, will look like a picnic compared to what lies ahead. U.S. economic growth is slowing, the labor market remains tight, wages are rising above the rate of inflation and productivity gains are disappearing. Plus, we've got a mania in private equity, fueling a major liquidity-driven market rally that will ultimately exhaust itself.

But the big threat lies in the banking sector.

Earnings for major U.S. banks are deteriorating as the sector continues to lag the broader market this year -- a bad omen for the primary trend. Indeed, banks will continue to struggle in the face of high short-term interest rates, a struggling yield-curve and deteriorating credit quality. I'm also not so sure the worst of the sub-prime mortgage fiasco is behind us. The government might yet have to bail-out this industry, similar to what occurred with the S&Ls in 1990-1991.

For now, markets are soaring. To be sure, overseas corporate earnings look better and a weaker dollar is a plus for international investors. But at some point, a colossal stock market correction lies ahead.

At 5% today, parking some money in cash is not a bad idea ahead of the best buying opportunity since late 2002.

Toronto Junior and Mid-Cap Mining Stocks on a Roll

In early February, I started to recommend a series of Canadian junior and mid-cap mining stocks in my Commodity Trend Alert service, now in its sixth year. Eight weeks later, these four stocks have posted gains averaging a 19.8% return; the latest stock, up 7.2%, was just recommended last Tuesday. Excluding my latest pick, we’re up an average 24% in just two months. Of the four stocks, two are gold-mining producers, one a diversified base metals miner and the last one, a copper producer. I don’t have to tell you what’s going on with the base metals lately – all trading at record highs, except aluminum.

My most profitable junior-mining recommendation to-date – and I only have five open positions in this sector, belongs to a Canadian platinum producer purchased at C$1.52 in November 2004; today, this stock trades at C$3.66, a 141% gain.

The Canadian juniors, and especially the mid-cap mining stocks, have broken-out of their recent trading ranges. Many mid-cap producers, including Bema Gold, Yamana Gold, Eldorado Gold, Kinross Gold and Rio Narcea, have either been purchased by larger mining companies or have recently graduated to first-tier mid-cap status as a result of massive rallies over the last few years. But the junior gold and mining stocks, long in the doghouse, have now embarked on a major rally with huge upside potential.

With gold, silver and most of the base metals trading at stratospheric levels, it now makes economic sense for the large-cap producers to add reserves through acquisitions or takeovers. Costs are soaring in the mining industry, including labor and energy costs; instead of adding capacity through expensive expansion projects, which might not yield additional reserves, a strategic acquisition makes smart financial sense because a company is absorbing proven reserves, not probable. This explains, at least partially, why we’re seeing a flurry of trading volume activity for the junior mines right now.

In my Panama presentation next month at The Sovereign Society’s Total Wealth Symposium, I’ll be delving into more great Canadian mining speculations with tremendous upside. Of course, if you can’t make it to Panama, give my CTA a risk-free trial. Remember, I’ve been at this for six years, long before many investors knew a bull market was developing for raw materials.