January 2008 HRA Journal
"Tandemonium"
David and Eric
Coffin's
Hard Rock Analyst Journal
Jan 28, 2008
"The short version
of this month's convoluted message is that resource stocks will
outperform the market this year, and gold and silver stocks will
outperform other resources.
"Remember that there
is no real shortage of liquidity or money looking for a home.
There's a shortage of "homes" that don't look like
they will cave in. In liquid markets, traders gravitate to winners,
especially winners in sectors that have some buzz. That nicely
defines discovery companies in precious metals exploration with
gold aimed at the $1000 per ounce mark."
The dual themes of continued
weakness in western financial centres and on-going strength for
commodities due to eastern growth is now well established. Debate
has shifted to how these will play out against each other over
the next few quarters. Since we have suggested making cash for
the last four months, the question for us is when and where to
redeploy it.
Debt bundles are being pushed
into longer term sections of bank's asset sheets. This is to
forestall calling them write-offs, even at the cost of reducing
cash positions and forcing new equity infusions, which at least
recognizes the impossibility of marketing CDO paper.
At issue is whether auditors
are willing to see stale dated goods moved from inventory to
asset categories, wholesale. This was supposed to be liquid paper,
and many bank clients who bought it on the premise of being readily
redeemable regardless of covenants buried in the fine print.
It won't take many writs based on overly-confident cover
letters or emailed assurances by bankers before auditors fear
signing off on any value for CDOs. But it gets worse.
Underlying debtors are glomming
on to the reality that their sub-prime loans may have wonky ownerships,
and how they might benefit by that. CDO, or CMO (collateralised
mortgage obligations), are weak on who actually holds
title to assets borrowed against. There is already a court ruling
in the US stating that since clear ownership of the mortgages
can't be shown, owners of CMO containing them cannot foreclose.
If lenders can't foreclose on the houses meant to guarantee loans,
how can the loans be assets?
This ruling in late October,
from a judge in Ohio where foreclosures have been large, can
still be considered isolated. But of course any new precedent
is inherently isolated. Should you be thinking "legal gimmick",
try another perspective. If mortgage ownership is unclear, solvent
borrowers might begin wondering if their payments are actually
going [to] the right place. Putting loan payments
into T-bills while such issues are cleared up, at least if Ohio
claimant Deutsche Bank is involved, may become tempting.
Not all CDO is weakly papered
(from the lender's perspective), but it will take a lot
of expensive eye strain to ensure which do work as they are supposed
to. In short, a mess that has written off only a few $100 billion,
little more then a typical cycle write-off on just the sub-prime
mortgage, will continue locking up the debt system for a while
yet.
The valuation issue will take
most of the early year audit season to sort out. While this is
happening there could also be a rush to foreclose on anyone who
is in default. That is the only way to secure the assets, and
since most of the CDO mortgages defaults will be handled by brokers
specialising in the field they will be inclined at any rate to
shoot first and question later.
While the debt issue gets uglier
the Fed and some other central banks will be wrestling with the
trade-off between beating down inflation with high rates and
fighting off a property-deflation based recession with low ones.
The housing market is too large a part of the US assets base
to let it drag the economy into full blown deflation. So we expect
the flood of US paper to support low interest rates to continue.
Hopefully that flood would
help the US government get a handle on its own debt spending.
But given how little notice this concern (as opposed to tax levels)
is getting in the presidential run up, that hope may well be
in vain. Add to this understandable concern about the role of
the US in world affairs, and both the psychology and mechanisms
for a serious downturn in the US economy are in place.
From this come calls for much
lower base metal prices, by some. Those calls may be enough to
push them lower one more time. However, we continue to view Asian
demand as a fundamental underpinning for metals. If fear pushes
equity markets into a heavy bear mode every thing will drop.
But metals will recover as quickly as anything.
It's also worth remembering
that for all its reputation as low tech and low growth the extractive
sector has been and will continue to be one of the best profit
generators in the market. With "traditional" high earnings
sectors like financials coming apart resources stocks should
get more love than skeptics assume.
This cycle has been different
from its predecessors and there is no reason to think that changes
just because the US economy stumbles. Yes, the US is the world's
largest economy but US wealth creation this decade has been centered
on services, finance and real estate. All of those sectors are
already getting clobbered. That doesn't automatically
negate growth elsewhere.
Debt has underwritten a lot
of US consumer spending. Americans cutting back spending will
hurt, but it should be less painful than previous cycles. If
the money flows were all one way-US generated funds buying foreign
goods-the knock on effects would be worse.
Developing nations are lending
America the money to buy their goods. They don't want to lose
the orders, obviously, but the US current account deficit should
require less external funding if spending slows. Those funds
do have opportunity costs for developing economies. The money
can be put to use elsewhere. Many developing countries have done
a better job at finding new markets and developing internal demand
than they get credit for. This will help cushion the blow from
weaker US spending.
The credit crisis is a world
wide problem but it's focused in the US. Banks in all developed
countries will have losses but hopefully not enough to freeze
their operations in most regions. Some areas like Britain and
Spain look vulnerable since the real estate markets there got
just as nutty as those in the US.
World growth will slow somewhat
but the worst of it will be in the US. We continue to view employment
growth as a key statistic. The weakness of the December reading
has increased our caution. With Wall St messing up so spectacularly
the US consumer is being called on yet again to save the day.
Employment growth has been weakening for some time, but a 5%
or even 6% unemployment rate could still support some spending
growth, as long as the fiscal environment is supportive. This
assumes that central banks do their bit as we comment on below.
The Ted Watch
Markets moved from the Fed
Watch to the TED Watch in the past couple of months. The TED
spread tracks the difference in yields between US Treasuries
and Euro inter-bank spreads. The spread widened alarmingly in
August and then again in December as a new wave of bond defaults
surfaced.
As we noted in the past couple
of issues, the root cause is mistrust by banks of each other
and the opacity of the whole structured credit market. No one
knows who's holding the hot potato and they don't want to find
out the hard way its them.
There were so many funds clamoring
for higher coupon paper until mid 2007 that Wall St. started
using whatever credits it could get its hands on before simply
making up its own in the form of credit default swaps and other
derivatives.
Many companies that wrote these
derivatives or wrote insurance on bonds, often in the form of
default swaps, are undercapitalized. They may find new funding
but who would be crazy enough to put money into them at this
point? We're in for several quarters of bad news from financials
as they work off excesses and each new wave of write offs gets
admitted to.
A series of new forms of credit
debacle creates the potential for the sort of credit contraction
no one wants. Recent credit injections by centrals banks loosened
up the inter-bank markets a little but they will need to remain
vigilant.
The Bank of England was the
first, along with the Bank of Canada, to start the December rate
cuts. The Fed seemed behind the curve until mid-December and
the ECB is still suffering some denial, not withstanding the
late December credit injections.
The ECB's Jean Claude Trichet
is worried about inflation and no one would disagree it's a growing
problem. That problem pales in comparison to a true credit contraction
though. If banks stop lending the potential impact is far more
serious and central bank cuts at that point would be close to
useless. Japan made that mistake in 1990 and it took 15 years
to exit the deflationary spiral that followed.
The Fed and most other central
banks have woken up and we expect them to cut rates and continue
injecting credit as long as necessary. This is likely to promote
further Dollar weakness, on top of that expected from a slowing
US economy.
The greenback will bounce if
it looks like the US dodged the proverbial bullet and restarted
growth. Even in that case however the continued profligacy of
the US government will weigh on the greenback. If the ECB gets
stubborn and raises rates it will just weaken the Dollar further
though we think they would be foolish to do it. There are times
you simply have to accept the risk of inflation and this is definitely
one of those times.
This monetary backdrop is supportive
of commodities and precious metals in particular. This is already
a banner year for gold and we're only a few days into it. Gold
will have it own pullbacks but we expect it go higher still before
2008 ends, perhaps as high as $1,000. Silver will move with it,
particularly since its own doldrums seem to have ended.
As noted, base metals will
be prone to losses until traders are comfortable they have seen
demand bottoming. We do not think that will take that long to
occur. If the BRIC countries growth rates don't falter it will
happen sooner than most predict. The market turns several months
before economic stats make it official and commodity buyers in
the most affected sectors of the US starting cutting back 18
months ago.
The short version of this month's
convoluted message is that resource stocks will outperform the
market this year, and gold and silver stocks will outperform
other resources.
Precious metals stocks didn't
fare that well in the past 18 months. Costs were rising and traders
were holding off until they saw another up leg in the bullion
price. Well, that up leg is here now and precious metal stocks
again have leverage.
While it might seem contradictory
to focus on speculative stories in a teetering market we think
it makes sense. It's not realistic to expect resource,
or any other, stocks to defy gravity in a full on bear market.
The greatest potential for a large market fall comes in the next
few months. Barring that, speculative discovery stories should
have legs.
Remember that there is no real
shortage of liquidity or money looking for a home. There's a
shortage of "homes" that don't look like they will
cave in. In liquid markets, traders gravitate to winners, especially
winners in sectors that have some buzz. That nicely defines discovery
companies in precious metals exploration with gold aimed at the
$1000 per ounce mark.
David Coffin
& Eric Coffin
Editors HRA Journal
email: hra@publishers-mgmt.com
David Coffin
and Eric Coffin are the editors of the HRA Journal, HRA Dispatch
and HRA Special Delivery publications focused on metals exploration,
development and production stocks. They were among the first
to draw attention to the current commodities super cycle and
have generated one of the best track records in the business
thanks to decades of experience and contacts throughout the industry
that help them get the story to their readers first. Please visit
their website at www.hraadvisory.com for more information.
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