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Get Ready for the Handoff!Dave Forest In this issue:
In 1980, only 30% of U.S. stocks were owned by institutional investors (also known as investment funds). By 2007, institutional ownership in the stock market rose to 70%. Funds today are a more critical factor than ever in driving share prices and market indices. There are a handful of large investors out there, and when they step the ground shakes. Commodities markets are no exception. Over the past decade, commodities have become a favorite play of big investors around the globe. This week we look at what funds have been doing lately, especially in the base metals markets. The useful metals were extremely volatile over the past several trading days. Could funds be part of the reason? We'll look at some of the market action, and some surprising data that shows an intricate dance developing between institutional and individual investors in the metals markets. I was very surprised by the conclusions these numbers suggest. Funds are extremely active in the metals markets, and they are having a significant effect. We'll also look at this week's data on foreign purchases of U.S. government bonds. There was a lot of press around the fact that China was a net seller in June. But what didn't get reported was that June bond sales as a whole hit an all-time record. We'll look at what happened and what it means for the dollar, America and the global economy. If you're a dollar bear, this one is definitely for you. Wild Week for Base Metals Base metals prices have gone schizophrenic. Three times this week copper jumped ten cents (per pound) or more in a trading session. Only to fall back ten cents in the next session. As I write, the red metal is making another spectacular run, up more than 15 cents in just a few hours. The rest of the base metals have been on a similar rollercoaster. Nickel has been bouncing between $8.50 and $9.00 per pound. Zinc between $0.80 and $0.85 (although zinc is showing the beginnings of a down-trend, making lower highs with each bounce). It's rare to see swings of this magnitude. Let alone so many of them in just one week. This is a skittish market. And understandably so. The base metals have been rising steadily for the last six months. Copper is up 135% since January. During most of that rise, investor sentiment has been universally positive. Almost everyone believed the stellar rise in metals prices was justified by China's massive imports of nickel, zinc, copper and a host of other commodities. The numbers supported this argument. Just last week, authorities in Beijing reported that China imported 118,000 tons of nickel in the first half of 2009. Up 60% from the same period last year. Then the "rally of a lifetime" hit a speed bump. On June 26, China's State Reserve Bureau announced that it would officially stop stockpiling metals. Metals prices took a breather, dropping off slightly in the first few weeks of July. Then the investment funds stepped in. In the last half of July, funds pumped half a billion dollars into commodities investments. And the buying continued in August, with fund managers picking up another half billion worth of commodities in the two weeks to August 13. Metals prices resumed their upward climb. Copper jumped from $2.20 to $2.90. Up 30% in just a few weeks. But the hectic action over the last several weeks has brought more uncertainty to the markets. Back in May and June when copper first topped $2/lb, most analysts and news reports were bullish on the prospects for the base metals. A quick economic recovery in China was supposed to mean more Chinese buying of metals, keeping prices buoyant. But with copper now nearing $3 just a few months later, investors are not so sure. The news pages are now hosting a tug of war between bulls and bears. This week the arguments grew particularly strong on both sides. Base metals sold off across the board after it was reported that the Chinese government may curb bank lending, potentially reducing the supply of money available for purchasing metal. And the bears jumped on a report from China Central Television stating that much of the recent rise in metals prices has been driven by speculative buying amongst unsophisticated investors in rural China who might quickly become sellers if prices turn downward. The bulls in turn pointed to improved economic data from around the planet. The Purchasing Managers' Index for the eurozone rose to a 15-month high of 50, indicating that the European regional economy may be on the verge of expanding. A similar story came out of the U.S., where the Federal Reserve reported that manufacturing activity in the Philadelphia area unexpectedly expanded this month, for the first time since last September. The world appears to be pulling out of the economic doldrums, which would certainly be positive for base metals demand. In Search of Clean Demand With all of this "he said, she said" between the bulls and bears, it's little wonder this was one of the most volatile weeks ever for base metals prices. There are just so many factors to consider these days. The state of the world economy. The health of the global manufacturing sector. The wildcard of Chinese metals demand and stockpile building. Add to this the fact that many manufacturers around the world have been using up their stockpiles of metals over the last several months, waiting to see how things would play out in the economy. Many of these firms are now going to have to restock their metals, making guesses about how strong demand will be and how much product they will need to manufacture. The risk is, they could end up buying more metal than they need (if demand for their products turns out to be lower than expected). In such a case, we will see "false" metals demand, as manufacturers buy metal that doesn't end up being used. Mistakes in restocking have major potential to distort prices in the short to medium term, giving investors a false indication of the strength of global demand. With all of the uncertainty in the metals markets, even the large mining companies are scratching their heads on what the future will bring for metals prices. BHP Billiton's Chief Executive Officer Marius Kloppers said this week that his company is struggling to get an accurate picture of what's happening on the ground. "We won't see clean demand until early next year," Kloppers noted. "Stocking events will probably play the major role for probably the next six months." And stocking isn't the only thing making it difficult to draw a bead on global supply and demand. As mentioned above, investment funds have been exerting increasing influence on the metals sector over the last few months. Between July and November of last year, funds were net sellers of commodities, pulling $3 billion out of the markets in just a few months. But since January the funds have been back, buying $8 billion worth of commodities over the last seven and half months. (All of this data is courtesy of Korea's Mirae Asset Securities.) This institutional buying has certainly helped carry metals prices higher. Indeed, there has been a growing correlation between fund investment and prices for most of the base metals, most notably copper. The only sustained decrease in the copper price during the last six months came in the first half of July. This drop just happened to coincide with three weeks when funds became net sellers of commodities (aside from these weeks, funds have only been net commodity sellers one other week in 2009). During these weeks, funds withdrew $450 million from the commodities sector. Copper fell 10%. Then the funds returned to the market, buying $850 million worth of commodities over the past four weeks. Copper jumped 30%. An interesting coincidence. The Handoff It's obvious that base metals have become an "institutional story". This week I read one report where a fund manager was recommending investment in nickel based on the argument that more and more funds are likely to buy into the metal because of its stellar price rise this summer. It's always concerning when investment strategies become based on "what the other guy is going to do" rather than on solid analysis and fundamentals. But it's unfortunately become common practice amongst fund managers to make money by spotting a trend with a good story to it and getting in based on the notion that "this will sell to other people." As one analyst put it so well, "The stock market has become a bunch of fund managers trying to outguess each other, being the first ones into a sector that's going to be the next big story for everyone else." Base metals certainly have been the latest big story. As noted above, the metals themselves are up significantly in 2009. And the stocks of mining companies have faired even better. The S&P Diversified Metals and Mining Sub-Index has risen 135% this year. Soundly beating every other sub-index in the S&P Materials. And nearly every other investment on the planet. This is the kind of performance that most fund managers can't ignore. Today, managers are increasingly judged on their performance relative to their peer funds. So if a handful of funds invest in the metals, and enjoy the kind of stellar gains we've seen this year, it grabs the attention of their competitors. Fund managers not invested in metals see that commodity-heavy funds are outperforming. These managers know that if they fail to duplicate this performance, their investors will ask why Mary-across-the-street is up 135% while they are missing the boat on commodities. This kind of underperformance can cost a manager his job, so there is pressure to jump into high-flying sectors like commodities. Even when that sector has already enjoyed a big move up, making its soundness as an investment questionable. Simply put, it's more defensible for a fund manager to fail doing what everyone else is doing, rather than risk making their own decisions and lagging the market for even a quarter or two. This "herd mentality" means that trends in motion tend to stay in motion. Rising metals prices (and share prices of miners) attract new buying from previously un-invested fund managers, which in turn pushes prices higher. A virtuous circle. This is how investment bubbles get blown. Another classic characteristic of bubbles is the passing of a hot sector from institutional to individual investors. At some point, fund managers realize that the investment has risen much higher than reason would dictate. They begin to sell their holdings, usually to individual investors who are just becoming excited about the story, having watched the spectacular gains to date. We've all heard the stories about shoeshine boys giving stock advice at the height of the 1929 bubble. As the old saying goes, "If you hear it from your broker, buy. If you hear it from your neighbor, sell." Today, it looks as if the transfer from institutional investors to individual buyers may be underway in the metals sector. True, it's a difficult task to tell who is buying. In most cases we have no idea whether it's New York hedge funds or Guangzhou pig farmers who are buying metals and pushing prices higher. But there are a few select places where we can "look inside" the market and see where buying is coming from. One of those places is Korea. Korean securities authorities collect weekly data on investment fund flows from different categories of investors, both professional (such as investment trust companies and pension funds) as well as individuals. This gives an idea whether buying is coming from the street or from the home. Yes, it's just one market out of hundreds around the world. But the Korean exchanges are well-developed, and a lot of money moves through them. Investors here are fairly representative. What do the data from Korea tell us? As the chart below shows, institutional investors have been playing "handoff" with individuals for the last few months. Investment flows from the two groups have moved almost exactly opposite. Through June and early July, investment funds were general sellers of commodities, unloading 850 billion won ($680 million) worth of investments. At the same time, individuals bought a net 250 billion won ($200 million) worth of commodities. Then the pattern reversed. In the last three weeks of July, institutions were net positive 270 billion won, while individuals were net negative 600 billion won.  In August, things have ratcheted up a notch. The inverse relationship between institutional and individual buying still holds, but the scale of investment has grown dramatically. In the week ended August 13 (the last week for which we have data), professional investors sold 320 billion won worth of commodities investments, while individuals picked up the slack by buying 330 billion won. A striking divergence. What does this mean? It appears as if institutional investors are losing their appetite for the metals. In general over the last two months, whenever any significant buying from individuals has come into the market, funds have taken the opportunity to lighten their holdings, becoming net sellers of metals. This was especially true in the second week of August, when a massive influx of individual buying (three times larger than the weekly high for the three preceding months) was met with a three-month high bout of institutional selling. Suspiciously, sales by funds were of almost exactly the same amount as the buying by individuals. Metals were quietly cycled from one group of investors to another. The most interesting question is, what will happen going forward? Based on the pattern of the last three months, if individual buying stays strong, funds will likely continue to unload their holdings, placing more and more metal in the hands of less-sophisticated investors. A key unknown is what might happen if individuals start selling. Will funds step into the market to buy, supporting metals prices the way they did in the last few weeks of July? Or will funds already have unloaded their holdings and moved on to bigger and fresher stories, leaving metals prices to fall with the whims of individual sellers? In past rallies, once funds finished cycling their investments to individuals it generally wasn't long until the party was over. "Mom and pop" investors are notoriously easy to spook, and once they own most of a sector (especially an overvalued one), it doesn't take much to touch off a cascade of selling. A New Record for U.S. Bonds Another important factor affecting base metals (and all commodities) is the strength of the U.S. dollar. And like the metals, the dollar had a see-saw week. Most notable was an early-week drop after it was reported that China sold a net $25 billion worth of U.S. Treasury securities in June. The market took this as possible evidence of a Chinese flight from the dollar, and sold off the USD. I talk a lot about the U.S. government bond market. Simply put, the lending of money to America by its neighbors has been a crucial factor in shaping the current economic landscape. Without countries like Japan and China financing U.S. debt over the past 30 years, America could not have grown at the pace it has. Quite likely the world economy would also have expanded much more slowly. Today, any change in lending would spell real trouble for the U.S. and the global economy. It is crucial for investors to watch this data. And as I've discussed several times in these pages, the data show U.S. bond sales to be relatively strong. I realize that many analysts have been calling for the world to move away from U.S. debt, and that there are sound reasons why other countries might look to diversify their foreign currency portfolios. But the data just don't show that bond sales are flagging in any meaningful way. The death of the dollar is, so far, greatly exaggerated. This week's data was no exception. Yes, the government of China did decrease its holdings of Treasury securities by $25 billion. But this isn't an unprecedented event. Between July and November of 2007, China sold off $22 billion in Treasuries. Then in January of 2008 they resumed buying, picking up $110 billion worth of Treasuries. Sometimes bond sales simply reflect a minor rebalancing of a country's portfolio rather than a decision to drop dollars at all cost. All of the excitement over China's net sales also drew attention away from a couple of other important facts about this bond data. On the whole, holdings of U.S. Treasuries by foreign governments increased by $8 billion. The Japanese, who have been largely absent from bond purchases this year, came back to the market in force, buying $35 billion in Treasuries. Their largest purchase in twelve months. The United Kingdom government also logged its largest net purchase of the year, picking up $50 billion. But the most important news was that foreign buyers outside of central banks also made major purchases in June. On the whole, foreigners picked up a net $105 billion worth of Treasury bonds and notes, and U.S. agency debt. This was the largest net purchase of U.S. debt by foreigners ever. The previous record was $92 billion in April 2008. (This was shortly before serious problems emerged in the global financial system. Are foreign buyers seeing something else on the horizon today?) And it's an abrupt about-face from the anemic buying seen in the first five months of 2009, where the highest monthly purchase had been only $40 billion in March. This is a large chunk of cash that will help the U.S. government cover its deficit spending. Yes, that spending is large and is likely to remain so. But to say that America and the dollar are on the verge of collapse ignores the information we have at hand. All signs are that foreigners (including China) are still willing to support the U.S. with lending as America tries to spend the world out of recession. Leaving on a Jet Plane I'm writing this letter in between packing my suitcases for travel to Calgary tomorrow morning. For most flights, my new home in Vancouver is a much better departure point than the prairies (especially for the Asian jaunts that are becoming ever-more common these days). But for Colombia, Calgary is far superior, offering a leave-in-the-morning, arrive-in-the-evening itinerary through Houston and Panama City that beats the Vancouver red-eye through Los Angeles in terms of comfort and general sanity. Fortunately my friend and partner Phil O'Neill is still manning things in Calgary, and is always generous with an airport pick-up. I'll spend tomorrow catching up with him on several projects we've got on the go for Notela Resource Advisors, before we catch the Sunday morning plane south to (eventually) Medellin. I'm taking along a three-hundred-page monograph on ore reserve estimation to read during the in-flight hours. I'll either be wiser or get better sleep for it! We'll be in Medellin for the first half of next week, visiting our new gold-copper porphyry project. Then it's off to Bogota to meet with the lawyers for final due diligence. It will be a hectic few days, although I'm sure that everyone involved will find time for a glass of Malbec and a good Bolivar cigar at some point. There are some things you just have to do when in Latin America. Next week's letter will likely be written on the plane on the way back, perhaps with some new thoughts on exploration and development geology spurred by a week of rock-kicking. The markets are sure to provide some fodder too, given how eventful things have been recently. I hope all of you are fairing well through this volatility, and moving ahead in your endeavors. Even in uncertain times, business must get done! Have a great weekend and talk to you next week. Here's to finding the truth in prices. Aug 21, 2009 Copyright ©2009-2010 Resource Publishers Inc. Note: To subscribe to Pierce Points please click here: www.piercepoints.com Pierce Points
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