- Copper plunges as in 2011.
- Oil drops in face of extreme bullish sentiment.
- Can stocks resist those trends?
Background: Blogging in 2011, I wrote an article a month or two before that summer's global financial near-meltdown. It was titled, Important Battle at $4 Copper. Over this past weekend, had I had more time, I was planning an article titled, "Important Battle at $3 Copper." LOL, events beat me to the punch. There was not much of a battle at $3, at least so far. Copper simply collapsed through it. West Texas Intermediate oil, which unlike copper's price has little to do with China, also has moved down. Thursday was a confirmatory day of sorts in that amongst general stock weakness, offshore oil drillers were notably weak. Despite low trailing 12 month P/E's and attractive dividend yields, TransOcean (NYSE:RIG) and Noble (NYSE:NE) fell to new 12-month low prices. This is significant in the DoctoRx world, because these drillers are value plays, often trading at or below book value along with low P/E's. In contrast, most of the market trades very richly, suggesting that the old rules of value could come into play in the near or foreseeable future, should business trends turn negative.
This article suggests caution toward traditional equity plays right now, and suggests that gold stocks may be an interesting speculation whose time might just have come.
Introduction: FINVIZ continues to provide free charts showing price and the net positioning of speculators versus commercial interests. Some patterns have recurred, and one seen in the futures market for West Texas Oil is interesting. Note the extremes in speculator bullishness that have coincided with upcoming or imminent peaks in oil prices:
The first thing we see is that the green line, representing the net positioning of commercial hedgers and thus equal and opposite to the net positioning of speculators, is now at the most extreme short position since at least late 2008, when the chart begins. When this green line has moved over the past few years to relatively more negative, extreme positioning (representing progressive bullish extremes amongst speculators), often the oil price has moved up a bit longer but in every case, lower lows have followed. Winter 2011 and mid-2013 are examples.
I would expect something similar coming soon, or else there will be no bounce.
The pattern in copper is also interesting:
Let us look at what happened in 2011. Everyone "knew" that reflation was working, and had gone too far. Commodities prices showed that the authorities had pumped too much, too soon. Bullish bets on oil in the winter of 2011 were "confirmed" by the Libyan war and by the nuclear tragedy in Fukushima, Japan. Copper similarly had soared, and bullish sentiment was also rampant. So, the authorities ended QE 2, which had hastily been implemented in the summer-fall period of 2010 after the end of QE 1 in mid-year was followed by a mini-crash. The fall in global markets following the end of QE 3 in mid-2011 was associated with a crash in copper prices, even as gold and platinum continued to rise.
Not shown, but if one reduces the time scale to the past year, we see that the speculators have generally been short copper and have generally been right. Especially given that they are not extremely short per the latest reporting, there is no contrarian case from this data that copper is about to reverse and head sharply up. It might of course do so, but it may simply be that the trend is lower and that the speculators got this one right and are correctly sitting tight.
The above commodities raise the question of what is going on in the U.S. economy. Did bad winter weather merely cause deferral of productive economic activity, with a surge underway or coming soon? Or is/was there a slowdown for non-weather reasons? It somehow seems potentially a bit too easy to point to China re copper's crash and leave it at that. Maybe, but let's look more closely at the U.S.
Here at home, where is the evidence for the economy to do well as QE 3 fades away and as the budget deficit as a percent of GDP shrinks to about 2%? From Business Insider, here are two graphs that look bearish to me:
The article itself shows that the jump in profits was due to the absence of large write-offs that occurred in 2012.
The lack of economic acceleration shown above is also seen in other data. For example, the Labor Department produces "JOLTS" data monthly. Bill McBride of Calculated Risk summarizes it with his typically high-quality graphing skills. Here is his latest graph based on the most recent data release. It looks suspiciously like the 2006-7 data, with the top blue line coming closer and closer to the yellow line, which itself has now dropped below its obvious uptrend line as it had by 2007:
We shall see, and perhaps winter weather and/or random fluctuations have caused this data to compress, but on its face, it could be a sign of a hiring slowdown.
A slowdown is also consistent with Gallup's polling data. Americans are now self-reporting lower daily spending than they did a year ago- the first such decline I have noted in quite some time. This is based on a 14-day rolling average, and thus should have little to do with storms that occurred more than two weeks ago. This data is not inconsistent with the borderline recessionary year-on-year retail sales data Doug Short has graphed:
The combination of the JOLTS data looking similar to the way it did in 2007 and the year-on-year decline in average consumer spending suggests that the U.S. may be on the cusp of another recession. In this setting, even though China is the most obvious cause of the sharp decline in copper price, China's slowdown itself could have a strong relation to weakening export markets.
Once again we may be seeing what we saw in 2006-8, namely a shrinkage of the Federal deficit to about 2% of GDP and progressive loss of Federal Reserve ease occurring in association with the end of an economic up-cycle.
A reason for stock market investors to be suspicious about this is the vast number of corporations seeing declines in consensus analysts' earning estimates for 2014 and/or 2015. Almost randomly, I went to Yahoo! Finance's web site for estimates for the following companies, and found they all had declining estimates for both 2014 and 2015: PepsiCo (NYSE:PEP), Coca-Cola (NYSE:KO), Procter & Gamble (NYSE:PG), Citigroup (NYSE:C), JPMorgan Chase (NYSE:JPM), McDonald's (NYSE:MCD), Nucor (NYSE:NUE), Bed Bath & Beyond (NASDAQ:BBBY), Intel (NASDAQ:INTC) (decline for 2014, flat estimates for 2015), International Business Machines (NYSE:IBM), Merck (NYSE:MRK), General Mills (NYSE:GIS), Wal-Mart (NYSE:WMT), Ross Stores (NASDAQ:ROST), Exxon Mobil (NYSE:XOM), Consolidated Edison (NYSE:ED), Southern Company (NYSE:SO), Schlumberger (NYSE:SLB), etc.
The prevalence of both sluggish sales and difficulty meeting unchallenging earnings estimates is consistent with the very low inflation readings found at PriceStats. The recent decline in the price of oil, if sustained, will help inflation rates stay low or perhaps drop even lower.
Europe may be broadly in deflation, defined a certain way, as discussed by the British columnist Ambrose Evans-Pritchard in a recent column:
Most of western Europe is already in outright deflation. So are the Balkans, the Baltic states and the old Habsburg core.
The Continent has left its flank open to an external shock from Asia. There is a high chance that this will occur as China attempts to extricate itself from a $24 trillion credit misadventure by debasing its currency to regain lost competitiveness and bail out its export industry.
There are, of course, tight financial and economic links between western Europe and the United States.
How can investors profit from this situation? One strategy to consider is to note that the combination of falling oil prices and falling inflation will almost certainly lead the Federal Reserve to adopt more of an easing bias, and that will be positive for gold and silver prices. Normally, gold miners are poor investments, but the one time they do well is when the price of gold is rising but the price of oil is falling. This is because energy is the second leading cost input for miners after labor. Thus, the highly speculative Global X Gold Explorers ETF (NYSEARCA:GLDX) is acting well:
Splits: May 16, 2013 [1:4]
After a vicious decline, it was widely reported in the gold bug circles that near the price bottom, massive insider buying was occurring in the junior gold miners. It's too soon to say, but it might be that gold miners and associated investments such as silver bullion (and of course gold bullion itself) could be this year's surprise speculative hit sector as many solar stocks were last year. The large cap miners have finally started acting like businesses accountable to their shareholders rather than geologists/explorers.
Another less speculative (but still risky) but interesting investment that would come out of another reflationary effort is the quiet group of funds run by the Spicer family of Canada. Unlike the well-known Sprott funds, physical gold can be purchased at a 5% discount from its bullion value through Central Gold Trust (NYSEMKT:GTU). An approximate 50-50 mix of gold and silver bullion can be purchased through the original physical bullion fund, Central Fund of Canada Limited (NYSEMKT:CEF), which is also currently trading at about a 5% discount from net asset value. Both the above funds have modest operating expense ratios, so the current discounts from NAV appear fair to me.
There is a disconnect in the above which needs addressing: how can weakness in copper and oil prices support speculative investing in something as dangerous and usually unprofitable as mining stocks?
My answer is that the downdraft in copper is at variance with the actions of the Continuous Commodity Index, which is tracked by the lightly-traded ETF called the GreenHaven Continuous Commodity
Thus a bullish position toward gold and silver is in tune with the action of other, non-metallic commodities, even ignoring the Ukrainian/Crimean situation (which does not impress me from the standpoint of gold).
Discussion: We shall simply have to see how the action of the agricultural and other up-trending commodities including gold squares with the action of oil and copper.
One possibility is that past is prologue, but that as in Japan, the persistence of near-zero short-term interest rates is no guarantee against at least a mild recession or near-recession. Remember, the second derivative of both fiscal and monetary policy are now antagonistic toward upside economic surprises, which is the opposite of the situation in early 2009 as the economy was worsening but when the stock market was bottoming.
The markets are always prone to surprise us, and recessions by their inherent nature must surprise most people -- otherwise they could not occur, and businesses would not find themselves with too many inventories and/or personnel that surprisingly had to be slashed.
Given all the money the Fed has printed in the past year, why is the 14-day average daily spending tracked by Gallup a statistically significant amount lower than a year ago? Why are so many giant companies seeing no sales growth and difficulty merely meeting earnings expectations?
My bias is to take the message of Doctor Copper seriously. Modern late cycle patterns show a confusing mix of inflation and deflation, as unbridled stimulus meets bursting bubbles. This was certainly the case in 2007 into 2008, as housing deflation met commodities inflation. We may now be seeing deflation out of China and elsewhere whilst gold and silver, and perhaps ag commodities, revive back to their inflationary selves.
This is not one of my highest conviction articles, but we are now in year seven since the last recession began; therefore this expansion is long in the tooth. The U.S. interest rate structure and inflation rate are at risk of going more Japanese than people realize. I for one am not taking a lot of chances here, though I have initiated for the second time this year a long position in GLDX and its senior partner in the gold mining sector, Market Vectors Gold Miners ETF (NYSEARCA:GDX).
Why look away from the general stock market? For the same reason many/most investors looked away from the bond market after yields crashed to historic lows after Lehman and again in 2011-12 and for a while into 2013. Valuations are now near record highs. Measuring and graphing both a version of Tobin's q and Robert Shiller's cyclically-averaged P/E (NYSEARCA:CAPE), economist Andrew Smithers shows that the average of those two fundamental measures is about at the peak 1929 level and below only levels seen briefly in the run-up to the millennium in 1999 and 2000:
He says in the text related to the graph:
Both q and CAPE include data for the year ending 31st December, 2013. At that date the S&P 500 was at 1848 and US non-financials were overvalued by 73% according to q and quoted shares, including financials, were overvalued by 81% according to CAPE. (It should be noted that we use geometric rather than arithmetic means in our calculations.)
As at 6th March, 2014 with the S&P 500 at 1877, the overvaluation by the relevant measures was 76% for non-financials and 83% for quoted shares.
This is strong stuff. CAPE is higher, per the graph, than the peak level in 1929.
In my view, the financial markets have moved from fear and loathing of stocks and over-belief in bonds beginning with the Depression, trends that were gradually corrected over time and culminating in fear and loathing of both stocks and bonds by the 1978-1982 time frame. Then the markets moved to over-belief in stocks and a lesser degree of fear and loathing of bonds by 1999-2000. The following graph from Multpl.com shows historically high interest rates still were in Y2K:
The above is of the 10-year Treasury bond (NOTE) rate. At around 6% in 2000, that yield was higher than the graph shows except for the 1979 period and beyond. With an average and median historical yield for the 10 year somewhat over 4% by 2008, it is only the post-Lehman period wherein rates are actually historically low, going all the way back to 1960.
However, stock valuations began to get historically high in the 1987 period and got very high by the early 1990s (various Multpl.com charts; this is of the P/E):
(Note the extraordinarily high P/E in 2008 was exaggerated by a huge write-off at an oil company).
In any case, it's my expectation that since bonds are only about five years into a historically low interest rate cycle but stocks have not been historically depressed for more than a few weeks at any time since the 1980s, the odds favor either both stocks and bonds acting poorly as valuations for each asset class normalize, or else bonds outperform stocks as bonds are the fresher secular bull market.
But I'm basically a fan of neither asset class on an intermediate-term basis, and thus am looking to tangibles and cash to beat the averages over time.
Conclusion: U.S. investors can ignore stock market drops related to a copper surfeit in China and saber-rattling over the Ukraine and Crimea. However, extensive evidence presented above suggests a slow-nominal growth economy with the possibility that consumer spending could be roughly flat or even mildly declining in nominal terms, and very possibly could be declining on a per capita, inflation-adjusted basis. When looked at in context with declines in sensitive raw materials prices and with historically very high valuations of equities, the concept of moving to an underweight position with equities makes sense.
If so, the corrections in the monetary metals may allow profitable investment therein. Silver trades below a price it reached two different times in 1980, and gold crashed from $1900 in 2011 to a double bottom around $1200 last year. Just as various correlations of the Fed's balance sheet and the S&P 500 level suggest a much higher stock market, so do and did correlations exist of the budget deficit and the price of gold when gold was in its boom phase. Those suggested that gold "should" be $2000 by now. Maybe that number is actually achievable sooner rather than later.
Trend-followers may appreciate that the precious metals miners did well on Thursday, March 12, and some may buy in Friday. Out of the deflationary signals of Doc Copper and perhaps oil, and the general sluggishness of nominal GDP data in the U.S., western Europe and elsewhere, the paradox of high gold prices and bargain hunters in depressed mining stocks may create a surprise winner.
Investors must be aware that this theme is highly speculative. The simpler way to invest if fundamentals are deteriorating under the surface with high equity valuations is to pile up the cash and/or buy Treasuries. Finally, I would note that companies with strong fundamentals face limited competition and, as was the case from 1998-2000, could be extremely strong performers as investors pile into a shrinking number of names with growing and even accelerating earnings streams.