Sell Everything Else…
Excellent. Australia has a brand new mining tax just in time for a huge correction in commodities. Yesterday we mentioned the probability that the bond crisis in Europe was inherently deflationary. Europe’s debt reckoning will result in massive deleveraging in the financial system. And the last time that happened, a lot of long-term speculative bets on commodities were liquidated.
That was back in 2008. And as you no doubt recall, Aussie resources stocks were absolutely hammered. Commodity prices fell. And the Aussie dollar plunged. A shorter, pre-central bank intervention version of that scenario may already be in motion.
But let’s look at a more recent date in the past: May 19th. That’s the day Swiss-based Glencore, the worlds largest commodity trader and sometimes producer, went public in London and Hong Kong. In mid-June we wrote the following about Glencore’s initial public offering (IPO):
Was Glencore’s IPO a sell signal for commodities? Well, another global credit crisis-this time induced by a de-facto sovereign-debt default in Greece-certainly would be bearish for commodities. The major central banks of the world have expanded their balance sheets by trillions of dollars since the onset of the GFC in 2007. They have a lot less flexibility at the moment.
The ugly and frightening truth is that Europe’s banking system is probably going to have to be recapitalised before this is all said and done. So is America’s. And come to think of it, so is China’s. Widespread insolvency and flat-out bankruptcy in the world’s financial sector are probably not bullish for commodity demand.
The only caveat is that outright debt monetisation would be wildly inflationary-central banks creating trillions in digital cash to provide emergency lending and liquidity should financial institutions again become deeply distrustful of one another. But even then, spiralling inflation caused by huge currency devaluations is not the same thing as a demand-led bull market in raw materials.
Since then, Greece has given way to Italy, Spain, and France. Bond yields in all three places are rising. The stress on the European banking sector is growing too. Reuters reports that lending in Europe is freezing up again as US banks cut off loans to Europe and European banks cut off loans to each other. This week has seen 178 Eurozone banks demand $247 billion in last-resort funding from the European Central Bank (ECB).
And to be fair, it’s not just Europe. The US Federal Reserve scared the geewillickers out of the market overnight when it asked 31 US banks with assets over $50 billion to submit themselves to new stress tests. The Fed wants to especially know if six banks – Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley and Wells Fargo – can survive a more severe recession.
We can save them the trouble: most definitely not. Highly leveraged financial institutions are going to get creamed in the coming deleveraging. But of course, the purpose of said stress tests is not to actually tell the public about the health of the banking sector. It’s to reassure the public that everything is fine, even when it isn’t.
In a press release, the Federal Reserve Board stated, “Institutions will be expected to have credible plans that show they have sufficient capital so that they can continue to lend to households and businesses, even under adverse conditions.” The Fed has given the banks until January 9th, 2012 to put together a good plan.
As we wrote in June, “Widespread insolvency and flat-out bankruptcy in the world’s financial sector are probably not bullish for commodity demand.” It was true then and it’s true now. And now you also have to reckon with likely recessions in Europe and America and a warning from the International Monetary Fund that China’s banking system, “could be severely impacted if several major shocks materialized concurrently.”
So events have played out pretty much as we expected when we wrote about Glencore’s IPO in June. As you can see from the chart below, the London-listed share price made a low in August, rebounded, and is now trending sharply lower. The collapse of futures trader MF Global wouldn’t have been good news for Glencore, either. Why?
Click here to enlarge
The Future for Commodities
Well, you’d think that a disorderly unwinding of a lot of commodity trades would be bad for traders like Glencore. At least that’s what we’d think. But when Glencore announced its third quarter results last Thursday, it focused on its commodity production figures and not the profit or loss from its trading desk.
The company reported a 40% increase in copper production, a 19% increase in zinc production, an 18% increase in coal production. It also announced that the first tanker of oil from one of its projects in Equatorial Guinea will offload in December. It’s getting into the energy game, which is probably a good thing.
But the silence on its own trading desk was puzzling. In the only company report we could find on the subject, the company had exactly one line to say about its trading operations. It reported that, “Within our marketing operations, trading remains solid.” Consolidated revenues were reported. But they weren’t broken out on a line-item basis to see what operating segments were producing the biggest profits…or the biggest losses.
We’ve taken the liberty of including BHP Billiton’s US listed share on the same chart with Glencore’s London listing above. They aren’t exactly mirror images. But you can see the similarities. And that brings us to an important point.
If Glencore gets clobbered by the unwinding of leverage in the financial sector, it sure looks like BHP and other Aussie majors are going to get clobbered too. We’d include the Australian dollar in that analysis, too. In fact, traders are already betting the Reserve Bank of Australia will lower rates this year and next in light of the lower growth forecasts coming from Europe and America.
The lower growth forecasts, of course, are balderdash. A big financial deleveraging will send the market lower. It will also, eventually, make people realise the entire real economy has been distorted by too much debt. But what about Glencore’s immediate future?
Well, some of the IPO participants will see their lock-up period expire tomorrow. This lock-up period was designed to prevent IPO insiders from “flipping” their holdings in the first few days after a share goes public. IPO participants usually have the chance to buy shares below the IPO price, so you can see why flipping would be attractive.
Glencore’s London-listing is down over 30% from its IPO price. A total of 5.2% of the shares on offer will join the stock’s free float tomorrow. That means the IPO insiders – including hedge fund BlackRock, a state-owned Chinese mining firm, and the sovereign wealth fund of Abu Dhabi – are free to sell their shares, if they so choose.
But wait! Glencore is also a member of several major indices, including the FTSE and some MSCI indices. As the number of shares in the free float increase, Glencore’s weighting in those indices will also increase. And that means any hedge funds or exchange-traded funds that track the FTSE and MSCI will have to increase their holdings of Glencore.
Thus a paradox illustrating the absurdity of the financial system. On the one hand you have built-in selling pressure in the form of IPO insiders who will want to take a profit and may have been sold shares well below the IPO price (although perhaps not 30% below). On the other hand, you have tracker funds that are compelled to buy a share if they are faithfully to replicate the performance of the underlying index of which the share is a member.
Very little of either decision – to buy or to sell – has much to do with the underlying value of the security and its ability to generate earnings for shareholders. And both decisions are seemingly divorced from the huge deleveraging drama going on in the financial markets – a drama which will be a mortal threat to some commodity traders.
This is a version of the same paradox presented by high-frequency trading and computer algorithms come to think of it. In that case, you have pre-programmed buying and selling patterns that react to the price action in the market. For example, a program executes a “buy” on an index because it’s dropped a certain percentage, or executes a sell when it’s risen a certain percentage.
There are many variations and permutations of this strategy. Lots of quants are programmers are busy trying to design algorithms that beat the market, or eke out small gains with high-frequency trades. But the point is similar to the Glencore situation: the trading action is getting more and more divorced from the underlying value of the securities in question.
This is why the stock market is such a dangerous place now. That’s not to say you can’t make a buck. But in order to do so, you have to become a speculator (as Richard Karn pointed out at the Gold Symposium last week). The investment industry hasn’t been very forthright in telling people that, for example, when you’re buying Glencore you’re betting on higher commodity prices.
Commodities Ripe For a Pounding
We’re going to stick with our prediction from yesterday. The deleveraging forced by Europe’s banking crisis will hammer commodities and stocks. After the pain threshold of the public has been reached, in will step the central bankers with their monetary morphine. You might see some temporary pricing relief at that point. But…
The general point is that financial markets suck right now. If you’re going to be in them, your best bet is to own the actual owners of tangible assets, not companies laden with debt or companies whose revenues depend on credit expansion and bank lending. And for Australians, this, at least, provides some relief.
Commodities to Look Out For
Small resource companies that produce or extract commodities are like tiny call options on real assets. As the financial sector does its slow motion implosion, these minnows won’t be immune. But what they’ll have is real stuff in the ground. That is a lot more valuable than fake paper or real debt.
The deleveraging in the financial markets will give you the chance to buy these little call options on real assets at much lower prices. And in fact, you may want the ones that have proven reserves but are not producing yet, or can halt production and keep the good stuff in the ground as the economy recovers from its credit withdrawal.
Even this strategy is dangerous and speculative. But it can work. As we write, the three shale related stocks we recommended to Australian Wealth Gameplan readers in June are beating the market absolutely and relatively. Each of the three shale shares is up over 60% from its original price, all during a time when the All Ords are down 15%. How is that possible?
Well, the shale shares are little call options on the strategic value of energy resources. The Arab Spring has become the Arab Winter, as the burning and blood in Cairo suggests. Russian warships sail to Syria. The home of the world’s largest proven oil reserves is falling into more disorder by the day.
As we wrote in June, this trend favours other kinds of energy produced in other places. For now, not even the mining tax can kill the strength behind the energy trend. Having written that, it’s highly likely all three shares will fall by 10% in the next few days. But the overall idea could be the most useful idea of 2012: buy companies that don’t have debt and produce real assets. Sell everything else.
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