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Smead Capital Management is a registered investment advisor headquartered in Seattle, WA; founded in 2007. The company was formed to allow investors to benefit from long-term ownership of common stocks meeting the firm’s eight proprietary investment criteria. The firm manages a US Large Cap... More
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  • Math, History And Psychology

    In my 32 years in the investment business, success in common stock investing seems to come down to math, history and psychology. At Smead Capital Management (NYSE:SCM), we have built our investment discipline and our eight proprietary criteria around these academic subjects. With the stock markets gyrating wildly the last few weeks, we thought it would be helpful to see where we are today in each of these disciplines. We will start with our view on the math section.

    MATH

    We believe the math of common stock investing is pretty simple. Without leverage, you can only lose your original investment. Your gains can be unlimited over the longest term (long duration). Most of the benefit (90%) of diversification is reached by owning a twelve-to-eighteen stock portfolio. Valuation matters dearly to portfolio results. Stocks purchased at depressed prices (as a group) outperform those which are more expensive over both shorter (1 year) and longer-run time periods.

    Turnover creates expense and is the enemy of performance. Long-term common stock performance fits on a bell curve. In a portfolio of well-selected common stocks, most of the long-term gains are going to come from 20% of the portfolio. This is only true if the most successful shares are held to a fault. Every stock which goes up ten-fold, must have first doubled, tripled and quadrupled. The only good reason to sell shares in a successful common stock of high quality is if it gets what we call "maniacal" pricing or if it no longer meets our eight proprietary criteria. Maniacal pricing to us means a PE ratio more than two times the average of the prior ten years.

    One hundred percent of the stocks that go to zero fell by 20%, 40% and 60% before ultimately losing 100% of their value. Poor stock price performance among our portfolio holdings requires us to refocus on the fundamentals to preserve capital. Other than maniacal pricing, worrying about price performance of fundamentally strong businesses is damaging to performance and success.

    Our observation over 32 years is that no one can consistently predict either the stock market or the US economy. Therefore, breaking any of the mathematical disciplines mentioned above, based on stock market or economic predictions, has the potential to ruin the benefit of common stock investing. Paying someone to make directional stock market or economic predictions automatically reduces portfolio results by its cost. Stocks, as measured by Ibbotson and Associates, have outperformed the other major liquid asset classes over long stretches of time (30-50 years). However, to get this added return you must accept some extreme variability of returns.

    In the view of SCM, most of the best mathematicians in the investment business spend their time trying to predict the direction of the stock market or the size of the GDP of the US economy. This over-crowded playing field should function like all other crowded playing fields have over the last 32 years. Use of macroeconomic forecasting should make for very low returns in the stock market and in asset allocation because too many people are "trying to squeeze blood out of a turnip". We believe individual security analyses is as unpopular as it just about ever gets and will have a much easier time than it normally would in providing additional return for those who use math to practice it.

    HISTORY

    Next we will focus on history and the importance of that academic discipline to us as common stock portfolio managers here at Smead Capital Management (SCM).

    Edmund Burke said, "Those who don't know history are doomed to repeat it." We at SCM like to think in terms of taking advantage of what we know about history to make money owning good quality common stocks. Mark Twain said, "History doesn't repeat itself, but it does rhyme!" We believe these are the most important statements on how history should affect portfolio management decisions. In our opinion, you must know the history of the markets and you must trust the "rhymes" to be effective and successful.

    We will use some historical examples to back up Burke and Twain's argument. History shows that there have been regular bouts of financial euphoria. In his book, "A Short History of Financial Euphoria", John Kenneth Galbraith used the Tulip Mania of the 17th century and the "South Sea Bubble" of the 18th century to help people understand how dangerous excessive optimism is in business. The aftermath of these speculative episodes was drastic and debilitating losses. Here is how Galbraith described the lead up into the height of the euphoria:

    "The price of the object of speculation goes up. Securities, land, objects d'art, and other property, when bought today are worth more tomorrow. This increase and the prospect attract new buyers; the new buyers assure a further increase. Yet more are attracted; yet buy; the increase continues. The speculation building on itself provides its own momentum.

    This process, once it is recognized, is clearly evident, and especially so after the fact. So also, if more subjectively, are the basic attitudes of the participants. These take two forms. There are those who are persuaded that some new price-enhancing circumstance is in control, and they expect the market to stay up and go up, perhaps indefinitely. It is adjusting to a new situation, a new world of greatly, even infinitely increasing returns and resulting values. Then there are those, superficially more astute and generally fewer in number, who perceive or believe themselves to perceive the speculative mood of the moment. They are in to ride the upward wave; their particular genius, they are convinced, will allow them to get out before the speculation runs its course. They will get the maximum reward from the increase as it continues; they will be out before the eventual fall."

    History shows that these speculative episodes will happen and those who know history are to avoid participation in these episodes. It was tulips in the Netherlands, common stock in the South Seas, Western Railroads in the 1860's and 1870's, technology like cars, planes and radios in the 1920's, the internet in the late 1990's and residential real estate in 2005. We believe you must understand and know the history of these events and avoid participation in them once they get speculative!

    Folks have wondered why we believe that China's economy and their miraculous last thirty years of economic growth aren't sustainable. The answer is simple. CHINA HAS ALREADY QUALIFIED AS THE BENEFICIARY OF A SPECULATIVE EPISODE. THIS KIND OF UNINTERRUPTED ECONOMIC SUCCESS HAS ALWAYS ENDED BADLY IN ALL RECORDED ECONOMIC HISTORY! China has not had an economic contraction in thirty years. As Galbraith pointed out, China is in a new world of greatly, even infinitely increasing returns and resulting values. In China, it's all about GDP growth, because their internal stock market broke down four years ago and even that has not stopped the euphoria associated with China's future. The speculative episode just moved to houses from stocks in China.

    The most successful economy of all time, the US economy, grew 9% compounded from 1800 to 1900. However, there were 18 recessions, 3 depressions and 3 all-out panics. The economy was cleansed of its sins by regular economic contractions. As Warren Buffett says, "Only when the tide goes out do you discover who is swimming naked." In China, the tide has never been allowed to go out. Bad loans, fraud and poor investments have never been exposed and the masses have not been forced to learn and improve their economic behavior.

    This is why Twain's quote about history rhyming is so important. Every time that one of these episodes comes along, investors and professional portfolio managers focus on the difference in the current episode to the past ones. History repeats itself, but not identically! Therefore, the temptation is to focus on the difference and repeat the mistakes. This is true at both positive and negative extremes. A few examples might be helpful.

    We were in a deep recession with as high as 10.8% unemployment in 1981-82. Incredibly high interest rates crippled the economy and smokestack America. Budget deficits were high and the US national debt grew immensely. Stocks were out of favor and 1981-82 was a great time to buy many good quality common stocks.

    Along came the meltdown of 2007-2009, with a deep recession which included 10% unemployment. Very few professional investors were buyers or holders of good quality common stocks back in late 2008 or early 2009. The 2009 market bottom was triggered by too much debt and the massive deleveraging which has occurred since then. Everyone told us not to buy because, "It's different this time." In 1981-82 it was the price of money which crippled the economy and in 2009 it was the huge principle balances which crippled it.

    Fortunately for us and unfortunately for those who couldn't sense the rhyme, 2009 was a great time to buy good quality US common stocks. Those who focused on the differences and ignored the rhyme missed the entire comeback the stock market has made since March of 2009. It grieves us to see the massive amount of capital which resides in doomsday-oriented mutual funds and ETFs, whose path to success would be our country's failure to make a full comeback in this deleveraging process. So far, the optimists have outperformed and the 1982 playbook proved to be effective.

    We believe the latest history to trust is the rhyme between the US economy and stock market in 1952 and today. In both cases, the US economy had high unemployment, huge government debt, massive recent stimulus, the Federal Reserve Board capping long-term interest rates, historically high profits as a percentage of GDP and what we believe are cheap large-cap stocks. Back then we funded the Marshall Plan to help Europe and Japan, as well as the GI Bill. Today, it is enormous unemployment compensation and deficit spending. Despite all those headwinds and a reversion to the mean in corporate profits as a percentage of GDP, the Dow Jones Industrial Average rose from 260 in 1952 to near 1000 in 1966. Those who ignored the headwinds created wealth and those who sat on the sidelines or hoped to make money from the misery of others ended up poorer. Will those circumstances play out differently this time? Or will this situation rhyme with 1952? At SCM, we are paid to trust the rhymes!

    Here is how Galbraith concluded his thesis on the history of euphoria:

    "At the risk of repetition-restatement of what one hopes is now evident-let the lessons be summarized. The circumstances that induce the recurrent lapses into financial dementia have not changed in any truly operative fashion since the Tulip Mania of 1636-37. Individuals and institutions are captured by the wondrous satisfaction from accruing wealth. The associated illusion of insight is protected, in turn by the oft-noted public impression that intelligence, one's own and that of others, marches in close step with the possession of money. Out of that belief, thus instilled, then comes action-the bidding up of values, whether in land, securities, or, as recently, art. The upward movement confirms the commitment to personal and group wisdom. And so on to the moment of mass disillusion and the crash. This last, it will now be sufficiently evident, never comes gently. It is always accompanied by a desperate and largely unsuccessful effort to get out."

    PSYCHOLOGY

    Over the years, we have heard Charlie Munger state that Psychology is the most underrated and underutilized of the major academic disciplines in business and investing. Andy Grove backed this up in a Fortune magazine interview by telling about the best business advice he had ever received. His City College of New York professor told him, "When everybody knows that something is so, it means nobody knows nothin'." At Smead Capital Management (SCM), we like to say that successful investing is the defeat of human nature. We will dig into the academic discipline of psychology and speak to using it to invest successfully.

    Why is psychology an underrated and under-utilized discipline in business? We believe there are four reasons. First, it is counter-intuitive. Psychology requires you to toss out logic and rationality. When there are either seemingly unsolvable economic or business problems, psychology demands at the extreme that you bet against the obvious. When a never ending stream of good news causes logical and rational experts to predict more of the same, you must "circle the wagons" (John Kenneth Galbraith-A Short History of Financial Euphoria). Currently, the US stock market suffers from what Randall Forsyth at Barron's calls "rational despair". It is an unhealthy pessimism in the same way that 'irrational exuberance" was a destructive optimism. These are psychological phenomena.

    Second, psychology never got the best scholars or professors. In the late 1970's, psychology was considered an easy class and a default major for those on rehab from economics or math or history or chemistry. Psychology has been considered somewhat of a "voodoo" discipline. It helps us explain things, but can it really solve anyone's problems. Psychology is the unwanted step-child of higher academics.

    Third, psychology kills the ability of intelligence to equate to successful investing. A PhD in Economics or Math and a librarian are likely to know math and history better than anyone you know. However, the math you need to be a successful investor is learned by the end of the seventh grade, in our opinion. If you are comfortable doing percentages and have the ability to understand crowd psychology, you can be a wealth creator in the US stock market. Over-educated people have a tendency to over think situations. Ben Graham said that as soon as the complex math gets thrown into the situation, you know that trouble is brewing. Here is how he said it in 1958:

    "Mathematics is ordinarily considered as producing precise, dependable results. But in the stock market, the more elaborate and obtuse the mathematics, the more uncertain and speculative the conclusions we draw there from. Whenever calculus is brought in, or higher algebra, you can take it as a warning signal that the operator is trying to substitute theory for experience."

    Just ask the folks at Long-Term Capital Management or analyze the investment returns of all the money being run today based on macroeconomic/mathematical genius in mutual funds, ETFs and hedge funds. Is the average institutional investor getting what they are paying for? Is there any chance the category is going to do well when it reaches down into the retail investment world? It is one of the psychological signs that we look for.

    Lastly, psychology is hard to measure. At SCM, we look at sentiment polls, insider buying, media coverage, asset allocation, anecdotal evidence and just about anything else which confirms that the crowd has moved to one side of a market. Reading the psychology is mostly learned by participating in the markets and through years of experience. The primary benefit of experience is having been in similar situations before. Professional golfers talk about dealing with the psychology of being the leader on Sunday in a pro golf tourney. Professional investors measure psychology in the same way. It is a gut feel and a learned discipline.

    Andy Grove's thought points out that psychology in business is most valuable at extremes. At SCM, we operate under the assumption that if 80% of the participants in a market are bullish or bearish, the exact opposite of their opinion is the right bet. A few examples would be helpful. Everyone knew by 1999 that the internet was "going to change our life" and that you must own companies which would benefit from that huge secular trend. They couldn't have been more wrong. The sentiment polls showed historically high levels of bullishness among individual and institutional investors. A Paine Webber/Gallup poll of their clients with less than five years experience showed that they expected 22.6% compounded returns over the next ten years. They got two 40% bear market declines and a lost decade in the stock market.

    A Bespoke website poll at the bottom of the stock market on March 9th of 2009 showed that 89% of those polled felt that the US stock market was headed lower and 59% felt that it would bottom at or below 5000 on the Dow. It was trading at 6480 at the time. One year ago, the Barron's "Big Money Poll" showed that 73% of those polled were bearish on US Treasury Bonds and only 5% were bullish. The tiny minority was the big winner over one year. At the risk of being repetitive, psychology is very useful at extremes.

    This same psychology is useful in the shares of individual common stocks. We have a rule at SCM. Whatever we own that gets questioned, objected to or made fun of by those we come in contact with, is likely to outperform in the following three years. In 2008, we got a regular diet of criticism for owning Starbucks (NASDAQ:SBUX). Every day, someone would call us and say, "Nobody is going to want to pay $4 for a cup of coffee" or "those guys will never get their mojo back".

    We've received the most questions recently on Bank of America (NYSE:BAC) and Gannett (NYSE:GCI). Quite a contrast, since Warren Buffett seems to be buying up every community newspaper in the country and pumped $5 billion into Bank of America preferred stock with warrants to buy the common attached. We have been questioned for avoiding energy, basic material and heavy industrial shares in light of the secular crowd belief in the "global synchronized trade". China's secular trend smells, feels and acts like the internet bubble to us, so we have to sit it out.

    In summary, we at SCM believe that the academic disciplines of Math, History and Psychology are important to undergirding the investment discipline of those who seek to create wealth in common stock investing. All three in concert is our preference and don't forget to pay psychology its proper respect.

    The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. All of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date stated in this missive and do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.

    Disclosure: I am long SBUX, BAC, GCI.

    Jul 20 1:22 PM | Link | Comment!
  • Money Manager Pride Goeth Before Destruction
    Printable Version Printable Version

    Dear Fellow Investors:

    At Smead Capital Management we have made it a high priority to pay attention to the investors who have proven over decades that their work proves worthy of great respect and admiration. In baseball, you can make the All-Star team with one great season, but to make the Hall of Fame, you need a long career at very high levels of success to be inducted. Our industry is wonderful because we can look very closely at the investments and writing of these people we have great respect for.

    All great money managers reach a point in their career where adulation and self confidence detracts from their better judgment. This interruption in judgment usually coincides with the discipline in use becoming the most popular discipline in the marketplace or the investing style being overdue for a three to five-year correction. Studies of the equity managers with the best long term records show that the best underperform the S&P 500 Index 35% of the time. The pride associated with multi-decade success and the reinforcement of an army of folks enjoying your work is probably the most dangerous thing that can happen in the money management business.

    To understand these phenomena, we will review the work of Warren Buffett, Bill Miller and Kenneth Heebner on a backward-looking basis. Then we will examine Jeremy Grantham and Bill Gross looking forward. Our supposition is the following. These men make up a short list of five of the best money managers of all time! However, there is a point in their career when their pride can get in the way of their better judgment and capital can get destroyed.

    Warren Buffett is the most successful money manager of all time, in our opinion. His long-term compounding of book value at a rate in excess of 20% is legendary. To this day, I’d rather be a fly on the wall in his office than one in anybody else’s office in money management. In 1998, he was uniformly admired by the media, by a slew of book writers and by a huge army of professional and individual investors. He wrote in his 1996 annual shareholder letter that stocks like Coke (NYSE:KO) and Gillette (now part of Proctor and Gamble) were the “inevitables”. In Buffett’s eyes, these companies had such dominant moats, sustainable profit margins, strong balance sheets and other strengths that he could ignore the fact that they reached PE multiples of as high as 57 times trailing earnings. These stocks were “maniacal” and were trading at PE multiples which doomed their stock prices for ten years. Coke peaked at around $88 in 1998 and bottomed in 2009 around $38 per share. Warren’s big mistake list is so small that you need a magnifying glass to read it. I believe that everything going on around him in 1998, the adulation and the uninterrupted success got the better of him. His popularity dropped in 1999 as the Tech Bubble went into its highest gear. By early 2000, many writers were asking if Warren Buffett’s investment discipline was old-fashioned and out-dated.

    Bill Miller beat the S&P 500 Index for 15 years from 1991-2005. He has the unusual ability to recognize deeply out of favor stocks in widely diverse industries and then has the constitution to hold his winners for many years. He specializes in high reward and volatile positions and is unafraid to average down far longer than most admirable money managers. By the end of those 15 years his streak was followed heavily by the media, his parent company (Legg Mason) boomed and financial advisors nationwide poured billions of dollars into the two funds that he manages. We at SCM believe that he is as brilliant a thinker and money manager today as he was in 2005. He’s only out-performed the market once since 2005 in the year 2009. His five-year numbers are 99th percentile in his category. We assume that the circumstances brought pride into the picture and that these last five years have been incredibly humbling.

    Kenneth Heebner manages money in a way that is unfathomable to this writer. He takes concentrated positions based on strong opinions and analysis. He had the best 15-year track record among mutual fund managers in 2008. He produced stunning results in the first eight years of the decade of the 2000’s. However, he turns his portfolio over aggressively and constantly. In May of 2008, he was called “the best money manager around” and featured on the cover of Fortune magazine. Enormous adulation was heaped on him by the media and billions flowed into his mutual funds. At the top of the commodity markets in the late spring of 2008, Ken Heebner was massively over-weighted in energy, basic materials and heavy industrial companies. He immediately went from there to an aggressive over-weighted position in financials. His performance over the three years since the overwhelming adulation has been dismal. He is one of the most talented managers of money, but pride temporarily got the best of him.

    Jeremy Grantham and Bill Gross are Hall of Fame money managers. Grantham leads the firm of Grantham Mayo Van Otterloo (NYSEMKT:GMO) which is a leading strategic wide-asset allocation firm. He has been unusually accurate in his long-term predictions in everything from lumber to large caps and emerging markets to energy. His firm is drowning in new money and his specialty area, asset allocation, is the darling of institutions, registered investment advisors, consulting firms and financial advisors. Even stock pickers like us pay attention to Grantham’s thoughts on asset allocation and GMO’s 7-year prediction for inflation-adjusted forward performance expectations. He has been spot on and his research director, Ben Inker, has done some of the best investment research in the marketplace. Grantham is currently known for his “7 lean years” thesis and in his latest quarterly letter titled “Danger: Children at Play” he nearly exhausted himself taking victory laps around the nine pages and an addendum. This comes just three months after Grantham boldly predicted that commodities were in a “paradigm shift” and had , in effect, reached a “permanently” higher plateau!

    Bill Gross is the most successful bond mutual fund manager in history. His company, PIMCO, manages over $1 trillion for institutions and individual investors. During the bull market in bonds from 1981 to today, he has handled every environment well and produced a market beating track record. His monthly missives are followed closely by the same crowd which feasts on Grantham’s quarterly letter. The bond bull market in the US has culminated the last three years in an avalanche of money drowning bond managers like Bill Gross. Those investors, advisors and institutions will recite statistics about how much better bonds have done than stocks the last 10 and 20-year periods. Bill Gross even has a very similar forward thesis to Grantham’s which he calls the “New Normal”. It is a relatively negative belief that the US has more than a decade of penance to pay for the financial and real estate sins of the decade from 1998-2008. His firm travels around the world explaining how they are looking for bonds in countries which benefit from emerging market growth to protect against both currency declines and to get a decent rate of interest. When Bill Gross and other major players at PIMCO are on CNBC, the world seems to stop to find out what the markets wisest players have to say. The adulation from all corners is thick enough to cut with a knife and the pride in PIMCO’s opinion continues to rise.

    If this piece were a trial rather than a missive, it is safe to say that Jeremy Grantham and Bill Gross are in a very similar and guilty position compared to the Hall of Famers we mentioned in the beginning. Buffett stumbled when his favorite kind of stocks (large-cap/wide moat/strong balance sheet/powerful brands) were wildly popular. Bill Miller became the most respected equity mutual fund manager at the height of eclectic stock picking. Kenneth Heebner headed into the tank right after he got unusual media attention and his “go anywhere” discipline squeezed every dollar out of the marketplace it could. They have been in Jeremy and Bill’s shoes.

    Therefore, what could happen to ruin the party for these two great money managers? They would have to have a very rough three to five years of performance and the thesis they are operating on would have to be wrong. We believe bonds will never be more popular in the next thirty years than they are now. We believe that so many people are practicing wide asset allocation that it will be a “nightmare” the next five to ten years. We believe that a bear market has started in oil and commodity indexes which will embarrass today’s bulls. Lastly, we believe that the ability of the US economy to heal itself is being badly underestimated by these two great money managers.

    As contrarians, we can’t run away from the opinion of these great money managers fast enough. This is not because they aren’t deserving of Hall of Fame status, but because they are trapped in today’s two most popular disciplines with all the same adulation and pride that our other great managers had before them. Both favor emerging markets over the US, have confidence in commodities, assume China’s economy will grow uninterrupted; both think the US consumer is dead for years and both think that the US is a political disaster area. We will still admire them when those who fawn over them today no longer have respect for them. This will be after the “pride that leads to destruction” turns into humility in the marketplace.

    Best Wishes,

    William Smead

    The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Some of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date of this missive and do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.



    Disclosure: I am long BRK.B, BRK.A.
    Aug 16 11:43 AM | Link | Comment!
  • Late in the Party
    Printable Version Printable Version

    Dear Fellow Investors:

    At the annual meeting of Berkshire Hathaway in May of 2006, Warren Buffett was asked to comment on the commodity markets in the US and here is what he said:

    "I don't think there's a bubble in agricultural commodities like wheat, corn and soybeans. But in metals and oil there's been a terrific [price] move. It's like most trends: At the beginning, it's driven by fundamentals, and then speculation takes over. As the old saying goes, what the wise man does in the beginning, fools do in the end. With any asset class that has a big move, first the fundamentals attract speculation, then the speculation becomes dominant.”

    As we now know, the commodity bubble lasted until July of 2008 and ended up including agricultural commodities like wheat, corn and soybeans. I was in Walla Walla, Washington on July 15th in 2008 when wheat peaked out at around $10 per bushel. This coincided with oil hitting an intra-day high of $147 per barrel that same week. The folks who live around the area were benefitting from the fact that Southeastern Washington produces some of the best wheat crops in the nation. Even though the nation was in its deepest recession since 1981-82, you wouldn’t have known it by what was happening in Walla Walla. Speculation in commodities ran rampant in the spring of 2008 and drew special notice from the government’s main regulatory body, the Commodity Futures Trading Commission (CFTC).

    In 1999, a limited number of very smart people invested in the oil business and gold. Oil bottomed at around $11 per barrel and gold bottomed below $250 per ounce. With all the gas guzzlers which were being driven in the US, it was easy to see that at some point we would pay the price. I remember seeing an automobile industry survey at the time which had gas mileage listed nearly last on a list of the 25 most important factors to a car buyer in the US. At the same time, countries were selling gold holdings by necessity or choice. The wise men were buyers in the beginning during the time period between 1999 and 2004.

    Buffett’s thoughts appeared to have played out when the commodity markets broke in the summer of 2008. Oil dropped to $32 by March of 2009, wheat fell to $2.46 per bushel in October of 2009, and gold peaked at $1003 around March 14th of 2008 and bottomed at $712 in October of 2008. In the past when markets have boomed and busted in that kind of spectacular fashion it took as long as 5 to 10 years or more for those markets to get interesting again. Look at how long it took stocks to recover in the US after the depression and in Japan over the last 20 years. Commodities were hot in the 1970’s, but were incredibly dead from 1981 to 1999. It is usually hard to put Humpty Dumpty back together again.

    However, there has been an unusual and once in a lifetime phenomena at work in China. It started in late 2008 and it has caused this speculative phase to continue. The Totalitarian Communist Government of China recognized the politically unacceptable downside risk of going through a deep recession. China has the vast majority of its citizens in a position of not yet benefitting from the prosperity of “limited” capitalism. It is one thing to go through a recession when you can vote to “throw the bums out”, but it is entirely another one too go through economic contraction when your citizens have no voting power, free speech and freedom of religion.

    Once the decision was made to not run the risk of letting the Chinese economy cleanse itself, the government decided to massively increase the money supply and produce GDP growth through legendary construction stimulus..Residential real estate prices soared in China as a result of the confidence and the “easy money” this stimulus created. More than $2 trillion in loans for real estate development was made to special purpose entities at the municipal level to build condos, office buildings and even immense sports stadiums. These loans are equal to one third of the $6 trillion Chinese economy. A Communist Party Official, Yin Zhongqing, and other credible sources have estimated that as much as 70% of these loans will never be repaid. As a result of growing in an uninterrupted way, commodity use in China equals close to 40% of all the commodities consumed in the world each year, even though it is only 9.4% of the world’s GDP and 19% of the world’s population.

    With interest rates low and US investors trained for years to like commodities and trust the growth of emerging markets, the speculative fervor of 2008 was reborn in 2009-11. Speculative positions in major commodities like oil have exceeded those taken in 2008 by more than 50% as reported by the CFTC. We have described this explosive move since 2009 in commodities as “the greatest bear market rally” we’ve ever seen. Here is how Bloomberg reported the recent speculative activity on July 17th, 2011 in an article titled, Investors Boost Bullish Commodity Bets as Gold Demand Jumped on Debt Woes:

    “Speculators raised their net-long positions in 18 commodities by 15 percent to 1.09 million futures and options contracts in the week ended July 12, government data compiled by Bloomberg show. That’s the biggest gain since early August. Gold holdings surged the most since September 2009 as prices climbed to a record last week. A measure of bullish agriculture bets climbed the most in 11 months.”

    Buffett continued explaining speculative phases at the 2006 Annual Meeting this way:

    “Once a price history develops, and people hear that their neighbor made a lot of money on something, that impulse takes over, and we're seeing that in commodities and housing...Orgies tend to be wildest toward the end. It's like being Cinderella at the ball. You know that at midnight everything's going to turn back to pumpkins & mice. But you look around and say, 'one more dance,' and so does everyone else. The party does get to be more fun -- and besides, there are no clocks on the wall. And then suddenly the clock strikes 12, and everything turns back to pumpkins and mice."

    Therefore, the huge peak in commodity prices in July of 2008 occurred with a few hours left in Cinderella’s Ball. The long and spectacular move in commodity prices has turned into an institutional investment orgy in commodity indexes, while gold is the commodity of choice for the speculation of the individual investor masses. Commodities are being taken for “one more dance”, very much like college students who keep drinking beer at a party long after intoxication has set in.

    At Smead Capital Management, we believe that the clock is very close to striking 12 midnight in commodity prices for three main reasons. First, China’s effort to manipulate history and economics with construction spending is being exposed. The inflation occurring in China and the complete recapitalization of the Chinese banking system coming from a real estate crash will cause a deep economic contraction, in our opinion. Second, it has taken so much more speculative firepower to get oil back up to this year’s peak at $115 per barrel, compared to how much was required to go to $147 per barrel in 2008. Any good technical analyst would tell you that a lower peak on much higher volume is a “death knell” for a market. Lastly, China must tighten credit aggressively to slow inflation or they are going to see a protest the size of a province, not one contained in a square (Tiananmen 1989).

    Commodity over-indulgence, like other out of control circumstances, get the most exciting towards the end and this one is no different from the others in that respect. We think the end of this one will usher in huge revaluations in the capital markets in the US and abroad. Scott Sprinzen, an analyst at S&P, pointed out in a recent report that a significant slowdown in China could cause commodities to fall as much as 75%. His research shows that commodities decline to their cost of production when they fall out of favor. If he is right, they would certainly qualify as “pumpkins and mice”. It all looks to us like time is running short.

    Best Wishes,

    William Smead

    The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Some of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date of this missive and do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.



    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Jul 19 1:17 PM | Link | Comment!
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