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

Skyrocketing Commodities will Dent Corporate Earnings

Commodities continue to disconnect from economic trends in the United States – the first time in modern history that a major decoupling has occurred between the world’s largest economy and raw materials. Even as the economy tips into recession this quarter and the weight of a major bear market in housing derails domestic consumption, commodities continue to hit new highs almost daily since January.

The bad news for stock market investors is that input costs for most industries are soaring over the last 12 months and likely to get worse this quarter with benchmark commodity indices already up more than 15% in 2008 and surging a cumulative 30% year-over-year. Indeed, only a few commodities are stuck at the same levels compared to five years ago; with the exception of live cattle, lean hogs and orange juice, the rest of the complex is literally on fire lately and still hitting new nominal highs almost daily.

Crude oil, now at $102 per barrel and at the same inflation-adjusted level it was back in 1980, is bound to crimp earnings and the consumer. The stock market will continue to tread water with crude north of $100 per barrel. I would certainly be a lot more positive on the economy and earnings if oil declined $25 or $30 a barrel from current levels; I still expect crude to decline this year – long overbought and in the wake of a U.S., and now a Japanese slowdown, is bound to come down to the $70 or $65 level over the next six months, if not sooner.

Commodities are now in hyper overdrive in 2008. This is where institutions and individuals alike start pouring billions of dollars or euro into benchmarks hoping to ride one of the last rising asset classes amid a bear market in most financial assets since last October. It’s rapidly becoming a feeding frenzy, not unlike the NASDAQ train-wreck in the late 1990s.

Until a severe correction arrives for commodities – especially crude oil, stocks won’t make any progress. Stocks are going to head lower as oil and the rest of the complex continue to boom, inflation rallies and the dollar wobbles. This is no time to overweight stocks.

I’ll see you on Monday. Have a good weekend.

Dollar-bloc Currencies and Swiss Franc Approaching Par-Value

The U.S. dollar bear market continues in 2008 as the buck breaks down against a range of foreign currencies, including gold and most commodities. Below is a chart of the U.S. Dollar Index, which breached important support levels on Wednesday.

The dollar cracked important resistance levels against the euro and pierced the 1.50 level and now trades above 1.51.

But the big news isn’t what the dollar is doing versus the euro; rather, what’s truly impressive is the performance of the dollar-bloc and the Swiss franc as these units approach par-value against the sagging dollar for the first time in history.

The Canadian dollar, one of the best-performing currencies in 2007 versus the U.S. dollar, has already breached par-value over the last four months and sits at a 2% premium this morning against the greenback. The loonie, until recently, was the top performing dollar-bloc currency since 2006.

But since November, other currencies in the dollar-bloc, especially down-under and in Asia have assumed leadership and now trade at historical levels.

On Wednesday, a parade of foreign currencies hit milestones vis-à-vis the buck, including the Swiss franc, now trading at just a 6% premium at 1.06 to the U.S. dollar.

Outside of Europe, the Aussie and kiwi also hit multi-year highs; the Australian dollar, one of the few currencies still supported by rising interest rates also trades at a 6% premium or at a 24-year high. The kiwi trades at its highest level since floating its currency in 1985.

In Asia, the Singapore dollar, my favorite regional currency because of consistently smart budget and trade balances, hit an 11-year high against the U.S. dollar. The Philippine peso, Malaysian ringgit, and Taiwanese dollar also hit their highest levels in years.

The U.S. dollar will probably peak against the European units shortly. The big moves in this area are way overdone as Europe suffocates with a contraction in bank lending, a real estate bust in several markets and an overvalued euro. At some point, the ECB will deflate the currency by cutting interest rates. But in Asia, home to the biggest currency misalignments in the world, the dollar has further to fall. Continue to accumulate Asian currencies in 2008.

Bonds have Proved Stocks Wrong; What about Commodities?

The smart money is always on bonds.

Historically, bonds have forecast economic trends far more effectively than stocks. That proved to be true about 18 months ago when Treasury bond yields turned inverted, or a phenomenon marked by short-term rates yielding more than long-term rates.

Stocks thereafter proved to be a bad investment as bonds discounted an economic slowdown or worse, and since January 2007, are in the loss column when measured by the S&P 500 Index and the MSCI World Index. Many other indices are also in the red, despite a rally over the last few days.

If bond markets correctly predicted the current U.S. slowdown or economic recession more than a year ago, what does the same barometer say about commodities? With bond yields plunging since last July, shouldn’t commodities prices also be heading lower along with common stocks? After all, the world’s largest economy is probably in recession this quarter, mired by a wicked credit slump, housing bear market and a consumption slowdown.

Actually, commodities are trading under their own beat since last fall, defying the U.S. economic cycle. Over the last 12 months, the CRB Index has surged more than 25% while the S&P 500 Index has declined 5% and global equities have been essentially flat.

We are truly living in interesting times. For the first time in the post-WW II period, there’s been a remarkable disconnect between raw materials and U.S. stock prices.

Equities peaked last July, and although they managed to muster a relief rally in September following a trashing last summer, commodities are now sitting at all-time highs in late February. Commodities did crack in August as the first signs of inter-bank lending stress surfaced; but they’ve rallied ever since and continue to hit new highs almost daily with just about everything making their way into the record books over the last several weeks (see above chart).

So what gives?

The answer lies with China and other developing economies. Barely a factor in the last bull market for commodities in the 1970s, these countries are home to the world’s new concentration of wealth. It’s truly amazing to see a slowdown occur in the United States while simultaneously witnessing extended rallies for all commodity benchmarks.

Maybe bonds are not the perfect forecasting tool after all. Or, perhaps this is the blow-off rally for commodities as the cliff draws closer. Time will tell.

Time to Bail-Out: Chinese Property Sector Crash Threatens Broader Market

At 37 times trailing earnings and arguably the world’s biggest stock-market bubble, Chinese stocks are poised to peak in 2008. And if the local property sector is a guideline, the correction or crash will be quite severe.

No other foreign emerging market has drawn more coverage and especially, international capital to domestic shares than Mainland China since 2006. Chinese stocks, which collapsed in 2004 and 2005, have more than tripled off their mid-2005 lows. In fact, TSI recommended a Chinese ETF in August 2005 and sold this profitable position 12 months ago at a double-digit gain.

Obviously a Bubble

New funds have surfaced by the dozen over the last 24 months, including innovative acronyms like BRICs and Chindia, or funds investing in Chinese, Indian, Brazilian and Russia stocks. But in China’s case, the huge rally in local markets has also resulted in sheer speculation driving mammoth initial public offerings to the forefront of global capital markets since early last year. China’s largest companies now rank in the top ten of the world’s biggest stocks based on market capitalization, including China Life, which went public in 2007.

But a major stock-market bubble now reins in China and new and existing investors should brace themselves for a serious hit.

Chinese Property Stocks Smashed

Since the start of November, local Chinese property stocks listed in Hong Kong have crashed 40% or more as the government’s initiative to cool the booming economy begins to work. The Chinese central bank has repeatedly raised short-term lending rates in small increments since 2004 to offset rampant lending and rapid economic growth, and in some cases, reckless bank loans to sub-par developers.

In January, Chinese inflation hit 7.3%, the highest 12-month rate in more than a decade. Rising inflation and an overheating economy means trouble for real estate speculators and central bank policymakers alike as they struggle to contain rising prices. And the bubble is now starting to deflate.

The biggest threat to China’s real estate market lies in the southern cities of Shenzhen and Guangzhou – now congesting huge gains over the last several years -- and cooling rapidly. According to ABN Amro in Hong Kong, new-home sales in Shenzhen have slowed to fewer than 20 units per day from 200 units only recently. A glut of homes has now surfaced and in many ways, China’s real estate boom is looking eerily similar to America’s, which came to crashing halt in 2006.

A Common Link: Residential Real Estate

In the United States, residential REITs, or real estate investment trusts, were the first crack in the real estate bull market 13 months ago. The sub-prime crisis has now spread to infect other segments of the vast U.S. real estate market, including commercial properties, many struggling to secure financing amid a tightening of credit.

Since hitting an all-time high in February 2007, U.S. REITs have crashed almost 40%, and continue to decline in 2008.

A similar fait probably awaits the Chinese residential property sector as local developers witness declines in sales volume after a massive four-year rally. A bear market has already struck many Chinese property developers and the odds of the sell-off spreading to the non-residential sector are quite high.

Closer to a Bust

Rising inflation, a strengthening currency and a deflating property sector in many Chinese cities is a harbinger of a major correction or crash in local shares. This has been China’s stock-market pattern since 1993 – boom and bust. China is one of the few economies in the world where local stocks don’t necessarily reflect economic expansion as reflected by the recent 2004-2005 market bust even as GDP expanded by more than 9% per annum.

Ahead of the Beijing Games this summer, I suspect the Chinese government and monetary authorities will do everything they can to keep the economy humming. But if you think sub-prime is a major crisis, and it is, wait until China’s property bubble spreads to the non-residential sector and ultimately drives the country to low single-digit economic growth over the next 12-18 months.
If you own Chinese shares, consider selling your positions now and re-entering at far lower values following the next bear market. That’s exactly what TSI did in August 2005 just as the market bottomed.

All emerging economic powers have suffered recessions or worse on their way to greatness; China will be no exception.

Buy Signal? Investors Dump Equity Funds Since January

Usually the worst market-timers, individual investors in the United States and elsewhere have been dumping stock mutual funds in a big way since January amid a major sell-off. But history suggests that investors might be dumping equity funds at exactly the wrong time as U.S., Canadian and European interest rates start to decline.

According to data from the Investment Company Institute in the United States, mutual fund investors redeemed $32.9 billion dollars’ worth of stock funds last month – the highest liquidation figure since July 2002 – just three months prior to the bottom of that bear market.

And in Canada, Italy and France, figures show the same trend. Mutual fund investors are dumping their stock funds and running into the relative safety of money-market funds.

But is the trend a bullish signal for contrarian investors after a bear market decline for many global markets since last October?

I don’t think so. Though I’m expecting global markets to rally in a big way over the next few weeks after a relentless sell-off since mid-October, the big picture for corporate earnings isn’t exactly bright this year. I think earnings estimates are way too optimistic and that implies equities are still too expensive. The entire spectrum of the credit market is still under attack, banks are continuously writing off their bad debts and increasingly, won’t make loans to even credit-worthy clients as they struggle to repair balance-sheets. None of this suggests a return to boom-times soon.

The good news is that as the year progresses, equities will eventually form a bottom as massive Federal Reserve credit expansion combined with help from other major central banks, will thwart this bear market. Mutual fund investors are not good market-timers; but this time, I think they might be right to raise cash and take money out of the market. The bear market is not over.

Reverse-Indexing Critical in Bear Market

If I had to bet, I’d say we’re about 50% through the current phase of this bear market. That means stocks probably have another series of painful losses ahead and investors should remain fully hedged as volatility heightens.

The words “fully hedged” mean several important strategic alternatives.

First, in a bear market, investors should hold cash.

As a rule, that means no more than 35% for most long-term investors and money-managers. You always want to be in a position to “buy” and that’s why you’ve got to have cash handy.

Second, and just as important, hedging also means betting against stocks using reverse-index exchange-traded-funds (ETFs) or mutual funds.

Your level of risk, age and total stock-market exposure will dictate how much you should apportion to a reverse-index ETF.

For example, if you hold a portfolio of mostly international stocks, then EFZ or the ProShares MSCI EAFE Short ETF should be used to hedge your long equity positions. I’d say someone in his 40s with at least five years or more to invest should apportion about 10 to 15% in a reverse-index to offset equity losses.

Finally, other hedges with negative correlations to common stocks include Treasury bonds, foreign currencies, select commodities and hedge funds such as distressed debt and asset-backed lending strategies.

I’ll be back on Monday. Have a nice weekend.

Black Tea Joins Breakfast Club Bull Market

I drink 2 or 3 cups of tea daily because it’s good for you. It’s medically proven to effectively reduce the odds of cancer. Some teas are more powerful than others, including green tea and black tea.

Now the rest of the world is catching on as global tea consumption booms and supplies decline, spawning the birth of another bull market in a relatively obscure segment of the soft agricultural market. Though coffee and cocoa prices have leapt recently, most investors don’t realize another bull market is already underway for the Breakfast Club.

As tea prices surge, other traditional brews are already enjoying big gains.

Coffee has rallied 36% over the last 12 months as Arabica beans sit at a 10-year high. Cocoa now trades at a 24-year high, up 45% year-over-year. In both cases, supplies have shrunk as demand continues to rise.

Kenya, the world’s largest exporter of black tea, is projected to reduce its net exports by 10% this year amid civil unrest and bustling Chinese demand, which is growing at 13% annualized along with rising consumption in North Africa and the Middle East.

Soft commodities are now in the lead since mid-2007 leading most other raw materials in total returns. The grains, until recently, have led the bull market since late 2006 and now the soft commodities are taking over as sugar, coffee, cocoa and black tea join the party. Other edibles like milk and butter are skyrocketing, too, but remain elusive trades for the retail investor.

One way to invest in tea is to buy a plantation. Obviously, that’s a little difficult for most retail investors seeking daily liquidity. Instead, I’ve located a tea plantation investment that diversifies across several such markets, including black tea.

Commodity Trend Alert has focused on three primary themes over the last 12 months.
These include the precious metals, the grains and the soft agricultural commodities. Now, I’m looking to add tea and eventually, a play on cocoa through one of the world’s leading confectionary companies. Cocoa prices, I believe, have run too high and are heavily overbought as hedge funds run the gun. Importantly, cocoa supplies are going to rise in 2008 and that will bring prices back down to earth. This should help boost the margins for the world’s largest chocolate manufacturers even as dairy prices remain firm.

In March, I’ll be plugging a leading confectionary company trading near a multi-year low, paying a 3.5% yield and now cornered by activist investors seeking to unlock its value. Also, I’ll be delving into tea.

I’ll be speaking tomorrow at our St Kitts Emergency Money Summit early in the morning and tied-up all day with consultations. But I’ll be back Friday with another post.

Market “Bubble” Lies in Credit, not Stocks

This bear market is primarily a credit concern, not an equity “bubble.”

Historically, most bear markets concentrate on common stocks as earnings compression results in sharply lower values ahead of an economic recession. And ahead of declining equity values, central banks typically tighten credit conditions – better defined as a classic liquidity squeeze.

But that’s not the case today, nor was it the case back in 2001 when the Federal Reserve began aggressively cutting interest rates. It’s rare in financial history that a prolonged bear market can occur amid easing liquidity conditions, but that’s exactly what happened seven years ago, and it appears to be repeating once again in 2008.

This bear market is predicated mainly on credit, and it’s still spreading. From sub-prime to leveraged loans, auction securities and bond insurers, this entire credit bubble has started the painful unwinding process.

From 2003 until July 2007, bond yields across the yield spectrum were incredibly low and financing deals, including leveraged loans, was a cinch as cheap money prevailed. The Greenspan Fed had no business cutting rates to 1%; that fueled an incredible rush to credit that spread to real estate, emerging markets, commodities, and of course, spawned the Japanese yen carry-trade.

As a result, corporate credit spreads touched all-time lows heading into last summer’s sub-prime fiasco, including high-yield securities, commercial paper and mortgage-backed securities. Then the party ended.

As for common stocks, they continue to look quite attractive compared to government bond yields at this point. Yes, earnings will compress and analysts’ expectations are too bright for the first half of 2008; but as the year progresses I think markets will find a bottom. I’m sticking to my original forecast that stocks will finish the year in positive territory. Government bonds are overbought, stocks are oversold.

For the last two years, I’ve been warning against ultra-low credit spreads and how interest rates on the riskiest paper or debt had to rise. I’ve adamantly warned against buying emerging market debt, junk bonds and most other fixed-income securities since 2005 because rates were simply too low or spreads barely above the risk-free yield available on T-bonds. I still feel that way, with the exception of high quality investment-grade corporate debt.

For the first time in years, I’m looking to buy corporate bonds this spring as spreads look quite attractive compared to T-bonds in a low interest rate environment. My upcoming recommendations in the March issue of The Sovereign Individual focus on two long-dated corporate issuers, both rated A or better that have big capital gains potential as the Fed and eventually, the ECB, unleash another era of cheap money.

Duped into Bottom-Fishing or Savvy Investing? Persian Gulf SWFs Pump Billions into Bank Stocks

Qatar this morning announced that it would spend as much as $15 billion dollars buying distressed European and U.S. bank stocks over the next 12 months. Qatar also reported buying a stake in Credit Suisse, Switzerland’s second-largest bank. Credit Suisse, unlike rival UBS, has mostly evaded the sub-prime meltdown.

Increasingly, Asian and Persian Gulf states are buying significant stakes in Western banks, pummeled by the ongoing and seemingly endless tirade of sub-prime and other mortgage-backed write-downs since last year.

The Gulf States -- with several trillion dollars of oil-related wealth, are boosting the influence of their rapidly expanding SWFs, or Sovereign Wealth Funds. These state-sponsored investment vehicles are not activist investors like hedge funds and for the most part, governments and banking executives continue to welcome SWF capital amid a shortage of funds.

But are the SWFs making a shrewd investment at low prices or are they being duped by European and American chief executives into some sort of false hope? I think the former, but at a price.

SWFs won’t make a quick killing in bank stocks because most of these companies have now diluted future shareholders’ equity.

When a multi-national blue-chip bank has declined 50% from its high and continues to pay an above-average dividend yield in excess of benchmark government bond yields and money-market rates, vultures become interested. Citigroup, UBS and Morgan Stanley have all attracted SWF capital over the last six months and many others will also become targets in their plight for desperate capital.

To be sure, some bank stocks that have been unfairly hit by sub-prime – harboring low- to-no sub-prime exposure, will recover quickly when this bear market ends. But many of the bigger players won’t double in value overnight. That’s because they’ve sold a part of their future earnings away through new share offerings and rights issues. That won’t boost long-term shareholders’ return on equity.

SWFs, more than anything else, have found a better risk-adjusted outlet for their massive war-chest of U.S. dollars. Instead of parking these assets in low yielding U.S. Treasury bonds, they’ve changed their strategy and over time will definitely earn a greater return on invested capital in bank shares than staid T-bonds. But in my eyes, many banks won’t be a good long-term investment once this debacle ends.

Zero Percent Looks Good in 2008

A zero percent rate of return might not be enthusiastically embraced by investors, but in a bear market since January, it’s looking pretty decent.

The MSCI Frontier Markets Index is unchanged in 2008 and has actually logged a 1% gain thus far in February – another bad month for stocks.

The Frontier Markets only recently became investable and includes many exotic bourses like Vietnam, Nigeria, Bahrain, Kuwait and others to name only a few. These markets are still largely unfollowed by the global investment community and therefore correlations between these bourses and New York remains quite low or even negative at times. That’s a plus for portfolio diversification.

Since October 31, global equities have declined in a big way, tipping most countries into bear market territory. But since the end of October, the Frontier Markets have posted an impressive 4% total return. That compares to a 14% plunge for the MSCI World Index of mature economies and a 15% drop for the MSCI Emerging Markets Index.

Just a few months ago everyone was talking about how the emerging markets had finally “decoupled” from Wall Street. Indeed, not even a credit crisis in the United States could affect Brazil or China. Well, kiss that theory good-bye! Investors are now embracing “recoupling” once again as downside volatility reminds emerging market investors it’s a two-way street regarding performance.

There’s no doubt the Frontier Markets belong in a long-term diversified portfolio since this is where the greatest stock-market gains lie in the future. Many of these volatile exchanges will one day grow into bigger markets, just like Taiwan, Thailand and Malaysia did about 35-40 years ago when they first “emerged.”

A few offshore mutual funds are now offering access to Frontier Markets. The bad news is that I have yet to locate a product that’s offered to retail investors.

I’ll keep you posted of any new developments, including mutual funds dedicated to the Frontier Markets. If you discover such a product, please let me know so we can all share the information here.

Have a good weekend. See you Monday.