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

Off to the Races: Canadian Dollar Hits 30-Year High, Rapidly Approaching Par Value against U.S. Dollar in 2007

Over the last two I’ve been forecasting par value for the Canadian dollar vis-à-vis the U.S. dollar. Despite several corrections along the way to US$0.93 cents currently, the odds are pretty good that the loonie will hit that threshold again this year.

On the road to par value, Canada has been home to bulging budget and trade surpluses, the biggest commodity boom since the 1970s, low interest rates and strong domestic consumption.

Been Down that Road Before…

Since March, the Canadian dollar has gained more than 10% against the American dollar, the best-performing currency in the world. Since hitting a 125-year low five years ago, the loonie has surged 33% and currently trades at its highest level since 1977. From 1971 until 1976, the loonie traded at par value or greater versus its largest trading partner, the United States. The election of the provincial separatist Parti Quebecois in 1976 finally drew the curtains down on the Canadian dollars’ bull market coupled with a peak in natural resource prices in 1980.

But Canada is basking in the sun in mid-2007…

Supported by its fourth-largest budget surplus in history for the latest fiscal year and booming commodity prices, Canada is truly enjoying an economic renaissance in the 2000s. The government has recorded ten consecutive budget surpluses; the latest surplus, at C$9.7 billion dollars ($9.1 billion) is mainly attributed to soaring tax revenues and comes at a time when the Harper Conservatives have increased spending.

It’s Mostly About Oil

Including the oil sands, Canada has an estimated 179 billion barrels of oil, recoverable with state-of-the-art technologies. After Saudi Arabia, Canada is home to the world’s second highest oil reserves. The Alberta oil sands are a major contributor to Canada’s export-machine since 2002. Provided crude oil prices remain above $40 per barrel, a level that’s economically feasible for producers, the bull market in the energy patch will continue for many years. This projection is also reinforced by Canada’s close proximity to the United States – the world’s biggest energy consumer. As America increasingly seeks to reduce its dependence on foreign oil, particularly from the Middle East, Canada is indeed in a geographic “sweet spot” with billions in recoverable reserves.

The G7’s #1 Economy

The bottom line for Canada’s balance-sheet is that even adjusted for tax cuts and spending increases, the budget surplus looks very solid in a global environment of generally rising budget deficits. No other country in the G7 harbors a fiscal balance remotely resembling Canada’s position; however, other countries, including Norway, the Gulf Arab states, Singapore, China, and Russia have surpluses greater than 1% of gross domestic product (GDP).

Though I believe the Canadian dollar will break par value versus the beleaguered American dollar over the next several months, I don’t expect the loonie to trade above par for very long.

Canada’s non-energy exports are in the midst of hemorrhaging with the manufacturing belt in Ontario and Quebec suffering heavy job losses amid an expensive currency. The Canadian economy, which derives less than 20% of its gross revenues from commodity exports, cannot indefinitely support a strong currency, especially compared to other resource currencies in Australia and South Africa who remain far less expensive versus the U.S. dollar. Also, foreign multinationals certainly have far less incentives to establish operations in a country where the effective cost base has increased over the last five years due a strong currency.

At some point, the Bank of Canada, which is forecast to hike lending rates again this summer, will be compelled to cut interest rates in order to rescue a growing contraction in manufacturing. Plus, any significant decline in energy prices or government legislation designed to block booming foreign corporate takeovers will halt the loonie’s ascent.

Global Small-Caps Trounce Large-Caps in Bull Market, Boosted by Plunging U.S. Dollar Since 2002

Nicer things come in bigger packages…

For the first time since the bull market began in 2003, U.S. smaller companies are trailing large-cap stocks in 2007. Though the performance differentiation is modest, the transition is worth noting because small stocks have blown away large company equities over the last four years. Large stocks as defined by the S&P 500 Index, is up 7% this year compared to 6.3% for the Russell 2000 Index of small-cap stocks. And when it comes to relative values, larger stocks are 36% less expensive compared to their smaller brethren with the trailing price-to-earnings multiple on the Russell 2000 at a whopping 28 times versus 18 times for the broader market.

But since March 2000 and the onset of the bear market, which ended in October 2002, U.S. small-caps have blasted past large-caps by a country mile, recording an impressive 65.2% total return compared to just 11.1% for the S&P 500 Index. Although smaller stocks have indeed raced ahead of larger companies historically, the results pale compared to the bull market in foreign stocks coupled with soaring international currencies against the declining dollar since 2002.

According to mutual fund-tracker, Morningstar Mutual Funds, foreign stock funds have more than doubled the return generated by U.S. smaller company funds since 2002.

The Morningstar Foreign Small/Mid Growth Fund Index has surged 23% per annum over the last five years, far outpacing any U.S. domestic mutual fund category, except REITs, up 21% annually over the same period. Even foreign large-cap stocks, which have also lagged behind international small-caps in this bull market has outpaced U.S. stocks. Since 2002, the Morningstar Foreign Large Growth Fund Index has gained 14.2% per annum compared to 10.1% for the Morningstar U.S. Small-Cap Growth Index and 6.8% for the Morningstar U.S. Large-Cap Growth Index.

Currency factors are also an important variable responsible for the impressive returns logged by international stocks since the dollar peaked more than five years ago.

According to Morgan Stanley Capital International/Barra, a leading service-provider of global investment benchmarks since 1969, local currency returns for the MSCI World Index of industrialized bourses has generated a 12.5% annualized return since 2002 in U.S. dollars compared to 9.9% measured in local currency terms. Indeed, dollar-based investors abroad have earned a handsome 2.6% of additional performance attribution from a weaker dollar over the last five years versus stocks measured in their local currency.
The MSCI World Index currently holds 48% of its constituent value in U.S. dollars, 32% in European currencies (mostly the euro), 10% in Japanese yen, 4% in Asia (excluding Japan) and 6% in South Africa and other markets. With the exception of the yen, which basically trades at the same level versus the dollar compared to five years ago, the euro-zone, sterling and the natural resource currencies of Canada, Australia, New Zealand and South Africa have all surged against the sagging buck since 2002.

Rising foreign currencies boost the value of your mutual funds’ total return when converted back into dollars. And Americans are lunging for international stock funds lately with 93% of total stock fund inflows directed to foreign equity mutual funds in 2006 – a record.

Back in the late 1990s, as U.S. markets were in the midst of their biggest rally since the 1920s, foreign stock fund flows were anemic, partly because of buoyant American markets and a strong dollar, which soared versus most foreign currencies from 1995 to 2001.

Current global trends, now in their fourth year, suggest the reverse might transpire over the next several months, especially if U.S. markets begin to outpace international exchanges and the dollar stabilizes following a five-year freefall.

Commodity ETF Boom a Bad Omen for Bull Market -- Eventually

Every bull market spawns the creation and introduction of new investment products, and the ongoing boom in raw materials is no exception.

Wall Street and other financial product innovators always launch new instruments after a bull market takes off for that respective asset class or sector. As prices rally, investor demand rises and sometimes, becomes hysterical. Case in point: the late 1990s bull market in technology stocks, which resulted in the worst crash for tech stocks in history. Seven years after the NASDAQ imploded, the index remains almost 50% below its all-time high.

Commodities, which bottomed in late 2001, have enjoyed big gains over the last six years with only one losing calendar year of performance logged in 2006, mainly due to declining energy prices. After years, and in some cases, more than two decades of declining production and falling capacity, prices for many industrial commodities have hit all-time highs over the last 12 months while precious metals hover near multi-decade highs and the grains at their highest level in years. Energy prices now trade at their highest levels, in nominal terms, in history, excluding natural gas.

But the danger signs are starting to emerge for commodities. Investments in exchange-traded-funds or ETFs tied to commodities might double to over $40 billion dollars in two years, according to London-based ETF Securities, a leading commodity ETF sponsor. And in the United States, a blizzard of new commodity ETFs have hit the market over the past 12 months, including ETFs tracking oil, natural gas, water stocks, base metals and even an ETF betting on declining oil prices. Three years ago, only three ETFs traded in commodities, mainly in gold.

The bull market in raw materials is not over. But to be sure, the easy money for most investors is now behind us, unless you know where to trade. For my Commodity Trend Alert service, now in its sixth year, we're riding live cattle, lean hogs (summer grilling has arrived!), oil and natural gas and the grains complex. All three sectors currently provide the best supply/demand imbalances, suggesting prices will rally hard this summer.

Are Hedge Funds Worth Your Dollars?

I've been following the hedge fund industry since I started in this business almost eighteen years ago. It's amazing how this industry has evolved since then, and unfortunately, for the worst.

Back in 1990, 610 hedge funds were operating with about $39 billion in assets, according to Hedge Fund Research. Today, that number has mushroomed to over 9,000 hedge funds worldwide with an estimated $1.3 trillion under management. That's an amazing bull market in asset growth as a huge wave of young and middle-aged professionals have left the big Wall Street and London's City high-finance firms to set-up their own shop this decade. And who wouldn't be lured by the incredible fee structure? Hedge funds typically charge a 2% total expense ratio (management, audit, legal) plus a 20% incentive fee on net new profits, if any.

But here's a statistic that tips the balance in favor of traditional funds over alternative investments like hedge funds: In the 1990s, the average hedge fund gained 18.3%, pretty much in tune with the S&P 500 Index. But so far this decade. the average hedge fund has mustered a 7.5% annual return versus 2.5% for the S&P 500 Index.

To be sure, hedge funds mostly protected capital in the worst bear market since the Nixon years from 2000 to 2002. However, it's fair to say that in a period of rising markets, hedge funds not only fail to beat the market, they also provide poor liquidity, charge huge fees and increasingly, lock-up your money for at least six months and sometimes, up to five years. For the record, though hedge funds held their own in the last bear market, an investor would have fared much better in REITs and long-term U.S. Treasury bonds -- without forking over those insidious fees.

Of course, some hedge funds belong in a diversified portfolio, especially those managers with a skill-based ability to engage in asset-backed lending, distressed debt, global long/short equity and convertible arbitrage. Unfortunately, since most hedge funds are concentrated in the long/short equity category and do not actively engage in short-selling (most managers have no clue how to short-sell profitably), investors are paying an incentive fee to what is essentially a glorified stock mutual fund manager failing to beat the market in a good year for equities. And when stocks reverse, most long/short equity hedge funds follow the market south.

Today, hedge funds are a business more than anything else. And regrettably, it's the sponsors, not the investors, who ultimately earn the biggest returns.

Mutual Fund Flows Signal Danger Ahead for Foreign Markets

One of the classic signs of investor sentiment is flashing a big warning right now.

According to the Investment Company Institute, a mutual fund trade group, U.S. investors plowed a record $160 billion dollars last year into stock funds with 93% of that total directed to foreign stock funds. That's the biggest flow into foreign equity funds on record. Back in 2003, as the U.S. and the rest of the world was embarking on another bull market, U.S. investors placed just 17% of total stock-fund inflows into foreign mutual funds.

Historically, investors have a bad track record when it comes to market-timing their purchases.

In the late 1990s, over 85% of all technology stock fund inflows occurred during the last 24 months of the bull market. And in the early 1990s, most mutual fund investors jumped aboard the emerging markets bandwagon in 1993, about a year before that party ended when Mexico devalued its currency. Now, the flavor of the decade once again since 2003 is the emerging markets, especially the BRICs or Brazil, Russia, India and China, where new products and indexes are still being created regularly to meet demand.

Another factor contributing to the boom in foreign stock fund sales is the weak U.S. dollar, down by almost two-thirds from its peak. A lower dollar boosts the returns generated from overseas stocks. And once again, sentiment for the dollar is heavily bearish with most investors looking to dump more of the currency on the heels of rising trade deficits, bulging budget deficits and a slowing economy.

Investors might be surprised when 12 months from now the United States might rank as one of the top-performing stock markets and the dollar, rallying off its lows and enjoying a cyclical recovery against most currencies.

Treasury Bonds, not Gold, Protect Capital Amid Big Market Declines

A Sovereign Society A-Letter subscriber sent me an interesting question yesterday that I thought deserved greater attention this morning.

The question pertained to gold and why it has historically failed as a diversification tool with negative market correlation under severe stock-market stress? Or, put another way, why has gold failed to rise when stocks post big single-day declines? Isn't gold supposed to be a "safe-haven" asset, attracting nervous money when stocks and financial markets are bleeding?

The answer to that question may surprise some gold-bugs. It will also shed light on Treasury bonds, which historically post bigger gains when stocks crash.

Historically, gold prices have been a poor diversification tool during massive stock-market declines, such as those that occurred in 1987 (stock-market crash) and August 1998 (Russian default, LTCM collapse). On both occasions, gold not only failed to diversify a portfolio when financial assets crashed, but fell just as hard. In a scramble for rapid liquidity, traders and investors sold gold and ran for cover into the dollar or foreign currencies, depending on which event is analyzed. Interestingly, however, since 1997, high-quality U.S. Treasury bonds have posted substantial gains amid big single-day market declines, hedging stock portfolios, unlike gold.

But if we look at longer term market declines, coined as bear markets, then the picture is definitely more compelling for gold. Yet again, even under these scenarios, T-bonds did much better than gold.

The last bear market, the worst three-year period for stocks since the Great Depression, saw the S&P 500 Index plunge more than 40% over that three-year period. But gold prices, which started 2000 at $288.50 per ounce, gained a cumulative 16% to $335 per ounce over the same period. Benchmark intermediate-term bonds in the United States gained a cumulative 35% during the same three-year span, far outpacing gold.

The fact is that gold is largely a liquidity-driven asset tied to a great extent to bank credit growth, the creation of fiat money and of course, inflation. The last gold bull market ended in 1980 because the Volcker Fed quashed inflation through double-digit interest rate hikes topping almost 18%. The biggest threat to gold is monetary policy, historically its arch enemy as rising rates kill-off liquidity into stocks, bonds, real estate and commodities.

If your goal is to hold an asset class with truly negative correlations to stocks during tumult, then go with Treasury bonds, foreign currency-denominated government bonds, T-bills and reverse index stock funds. Having said that, I still believe in gold as the ultimate monetary instrument. The longer term picture for the dollar and the global exchange-rate mechanism is bleak as governments print more money, expand bank credit and drown the world with debt. At some point, a major currency crisis will emerge, which will also probably mark the peak for this gold bull market in conjunction with bank failures and hedge funds falling like dominoes as this extended growth cycle eventually dies. At that point, you'll see gold at spectacular levels even the most bullish gold-bugs can't imagine.

One Step Closer to Currency Union in the GCC

A founding member of the Gulf Co-operation Council (GCC) since 1981, Kuwait announced it was abandoning its peg to the U.S. dollar yesterday. This is yet another sign of central banks tired of seeing their purchasing power eroded by a declining American dollar. It's also testimony to a cheap dollar because central banks are notorious from their ill-timed trades.

Following the path of other emerging market central banks over the last four years, Kuwait will spread its reserves across a basket of foreign currencies. Over the last few years, China, South Korea, Russia, Venezuela, Argentina and South Africa have gone down the same path, reducing their dollar reserves in favor of mainly the euro.

Kuwait, along with several other GCC states, pegged their currencies to the American dollar in 2003, just as the greenback was accelerating its bear market swoon. The dollar peaked versus the euro in 2002.

For years, the GCC members had debated whether or not to peg their currencies to the high-flying dollar, which surged against most currencies from 1995 to 2001. But by the time the GCC states agreed to peg their units, the dollar was already in a bear market. Talk about bad timing!

The largest economy in the GCC, Saudi Arabia, and a close U.S. ally, has no plans to drop the dollar. But other countries might, including booming UAE (United Arab Emirates) where inflation remains stubbornly high and exacerbated by a weak American dollar. The same goes for other GCC members, struggling to contain rising inflation.

Increasingly, the GCC is moving towards a single regional currency system, similar to the euro. Other regional trading blocs, including Asia and North America, are also ultimately heading in the same direction as trade-flows surge this decade. And creating a regional currency isn't just about dropping the buck, either. It does offer compelling economic benefits.

A common currency makes cross-border deals much easier and costs companies less.

Unfortunately, the long-term picture for the U.S. dollar looks increasingly fractured as it eventually loses its status as a reserve currency this century in favor of regional currency units probably partially backed by gold.

Buyout Frenzy Goes Ballistic

Day after day, there's another big deal or even several deals announced in the private equity sector. The size of the deals are becoming enormous as venture capital, private equity, hedge funds and even banks are tangling in the biggest buyout craze seen since the late 1980s.

As long as global interest rates remain relatively low and liquidity is buoyant, these and other deals will continue to dominate the world of high finance. Deal-flows are primarily driven by financing and low interest rates, allowing participants to structure and even innovate the terms of their credit or borrowing. How many deals were flowing during the high inflation-prone 1970s or early 1980s? None. But in the late 2000s, credit is cheap and companies obviously see good value in both public and private companies. This is the biggest buyout boom the world has ever witnessed and it won't end soon.

If the above analysis smells of hype or a balloon expanding endlessly, it is. But as long as interest rates and inflation remain low and earnings are still growing, this party will continue. I'm still expecting a major correction this summer, which will afford cash-ready investors with the best buying opportunity in at least 12 months, maybe longer. Profit-taking is around the corner, even amid boom times.

Yield-Curve Inversion Spreads to All Anglo-Saxon Economies

First it hit the United Kingdom, then the United States, Australia, New Zealand and now, Canada.

The dangers of yield-curve inversion remain in mid-2007. Marked by an anomaly in the bond market whereby short-term interest rates yield more than long-term rates, yield inversion has been an accurate barometer forecasting economic recessions since WW II. In all but one instance over the last sixty years has this indicator failed to materialize into a recession. Now, several Anglo-Saxon economies, which tend to historically march to the same economic drum, are in the midst of yield-curve inversion. The latest victim is Canada.

The Canadian yield-curve became inverted this week as short-term and long-term interest rates converged for this first time in this economic expansion. Indeed, it’s been a great ride for Canadian stocks and the CAD dollar over the last four years as economic growth has boomed, budget surpluses have swelled and the country has reduced its external debt. But if the economy is so hot, why are Canadian bonds inverting? Benchmark two-year Canadian government bonds now yield 4.23% versus 4.22% for ten-year bonds.

The same phenomenon has already occurred in the United Kingdom since last year whereby benchmark ten-year British gilts now yield an effective 5.13% compared to 5.57% for two-year gilts. In Australia, two-year debt yields 6.23% compared to 5.91% for ten-year bonds. And in New Zealand, two-year bonds fetch 7% versus 6.16% for ten-year debt.

One explanation for yield-curve inversion is the absolute boom in cross-border capital-flows, seeking a home in fixed-income securities, including government debt, which drives bond yields down. Also, with high-risk bonds like junk debt and emerging market bonds yielding the lowest spreads over government bonds in history, pension funds are probably another factor driving government bond yields down as they seek relative safety and yield.

Another observation partially explaining the yield-inversion phenomenon is strong currencies in most countries.

With the exception of the United States since 2002, strong currencies tend to import deflation, which is the case in Australia, New Zealand, Canada and even the United Kingdom, which complains inflation it too high; in reality, British CPI is historically low. A strong currency attracts international fund-flows, driving the currency higher and compressing bond yields. That’s another possibility for the yield-curve inversion.

But it’s not just the Anglo-Saxon economies harboring yield-curve inversion and recession risk.

Germany, Europe’s largest economy and in the midst of its strongest economic expansion this decade, is just five basis points (0.05%) away from yield inversion. Other members of the euro-zone naturally harbor the same interest rate fundamentals and are also close to inversion.

Bonds are where the smart money trades and invests. Although the stock market acts as a discount mechanism, typically forecasting economic events six months or so before they occur, it’s not a reliable barometer. Bonds, on the other hand, are far more sensitive to economic data and that’s where the “big” money lies.

Bonds are warning of economic recession in the United States and throughout most of the G-7, except Japan. If bonds are right, we’re at the cusp of a recession later this year, which implies stocks are the absolute worst place to be invested at the moment. That’s what bonds are saying now.

If I Was a Trader...

I've never embraced trading, nor do I advocate this strategy for investors. Though I know several people who are pretty good at churning their portfolios and capable of earning big bucks in a short period of time, it's usually a mug's game. For most investors, sticking to a long-term investment plan combined with solid companies is the best way to accumulate wealth.

But if I was a trader, I've got a host of contrarian bets I'd be making today in light of extreme valuations across asset classes and great bargains in other areas.

Remember, these are just "ideas" and nothing more. I'm not suggesting you call your broker and leverage your portfolio to buy live cattle or Japanese yen; these are just a series of thoughts I think you'll find interesting.

On the short side, I'd be betting against Chinese and Indian stocks and U.S. small-caps.

Governments in China and India continue to warn of stock market "bubbles" and economic overheating. India is raising rates to quash inflation, a bad sign for investors. When the government in the local market you're investing warns of "bubbles" and is raising lending rates, you know the end is coming soon. And U.S. small-caps, following a blistering run since 2003, are way overvalued in the midst of a slowdown in the United States, which at best, might support larger stocks in a sell-off. From a value-based perspective, the Russell 2000 Index of smaller companies at 41 times trailing earnings is no bargain-zone for me.

Still on the short side, the euro is too popular for my taste. Every investor and grandmother is selling dollars for euro; naturally, sentiment favors the euro only following a 65% rally off the dollars' high back in 2002. Too many investors are on the same side of this trade, which tells me the euro will correct, however briefly, against the dollar this summer.

Finally, the base metals are in a classic "bubble." In every bull market for commodities over the last few hundred years, soaring prices have always eventually met their end through rising production. By 2009, or sooner, companies will have raised production to meet soaring prices for things like nickel, tin, steel and zinc. The base metals have rallied too fast and too far since 2002 and will fall the hardest eventually. The ongoing boom in mergers in the base metals arena is also a classic sign of a top as companies chase production at all-time high prices.

On the long side, I'd be loading-up on the large-cap gold producers, slammed over the last 12 months as rising input costs reduce earnings. But this is only temporary. I'm expecting another wave of buyouts in the gold-mining sector as some laggards are now prey for the larger companies looking to boost production through strategic acquisitions. Barrick Gold will probably do most of the hunting, flushed with cash and looking to reduce its foreign assets amid increasingly hostile countries nationalizing natural resource interests.

Next is the Japanese yen. This currency continues to trade at a 20-year low versus a basket of major currencies. The yen, of course, continues to fund the world's speculative liquidity in the carry trade. I'm not sure when this dangerous game will end, but at some point, speculators will get crushed as the yen begins to rally. The yen at this level is just absolutely cheap. The same goes for Japanese small-caps, still in a bear market and easily the lowest-priced small-cap index in the world right now.

Lastly, I like several commodities now, including live cattle and lean hogs amid the All-American grilling season this summer and a host of soft commodities like the grains and cocoa.

Both Commodity Trend Alert (2001) and Global Mutual Fund Investor (1992) are currently riding these great long positions.

Tomorrow, I'll discuss the ongoing anomaly in the global bond market, namely in the Anglo-Saxon economies. You'll find this study quite shocking, I think.