Organic Contraction at BHP

“Progress is just confusion at a higher level,” said the late, great strategist John Boyd. And so you could describe yesterday as a day of great progress in the financial markets. Today, we will try and weave the separate strands together for you in a narrative that makes sense.

Let’s begin with BHP. The company announced yesterday it was cutting six thousand jobs globally. It will shut down the nickel operation at the Ravensthorpe mine indefinitely and reducing production at the Mt. Keith Nickel mine. What’s more, it will reduce coking coal production by 15% in Queensland and lay off 1,000 workers. BHP is the world’s largest producer of coking coal, so this tell you how much the global demand for steel has fallen off.

For its, troubles BHP is taking a $1.6 billion charge against earnings. But if you had any doubt, this is clear evidence that an organic contraction is now firmly under way in the global mining sector. With the leverage gone from futures markets and the credit gone from lending markets, the mining industry is behaving more or less as it has in past cycles.

What should you do? It is hard to make an argument for base metals and industrial commodities when you have a full blown recession in global industrial production. The saving grace for the resource sector is that market economics (cycles) are still in force. Production will contract and many firms will be swallowed up or disappear.

Then, after the liquidation of non-productive investment, and when demand begins to grow again, it will eclipse reduced supply. But that is not likely to happen this year. It’s hard to see a recovery in either earnings or final demand this year. Or perhaps even next year.

That doesn’t rule out AGMOIL , though. Yesterday, we mentioned that there are three major resource sectors that DO look like they have the chance to increase earnings through scarcity/higher prices this year: agriculture, precious metals, and oil and energy.

As for agriculture, our U.S. colleague Chris Mayer writes on the subject in today’s essay. You’ve read about gold here before, so we won’t repeat it. And oil and energy stocks are the topic of this month’s Diggers and Drillers. You can read more about them in the January issue, or in next week’s Markets and Money.

One further point on this. If you take the simple Permanent Portfolio strategy we outlined yesterday, it is not hard to fit the AGMOIL ideas into it. For example, investors with a higher tolerance for risk who want more money in equities and less in cash might choose to put more money into energy stocks.

Or, if you like a little leverage in your 25% allocations, there are leveraged ETFs for currencies, indexes, and precious metals. One might go long the Swiss Franc with the Swiss Franc Currency Shares ETF (NYSE:FXF). Or one might buy put options on the British Pound Sterling Currency ETF (NYSE:FXB), although you’d have to careful on that as volumes look a little light for the puts.

Why those two currencies? The Swiss Franc has a reputation for being better managed than other paper currencies. Jim Rogers likes it. Jim is not as fond of the Pound Sterling, which he says is, “finished.” “I would urge you to sell any sterling you might have,” Rogers told Bloomberg. “It’s finished. I hate to say it, but I would not put any money in the U.K.”

Swiss Franc and Gold ETFs Could Fit in the Permanent Portfolio and Beat the S&P 500

By the way, a word of warning. ETFs are no sure bet as a way to profit from currency moves. The chart above shows that the Swiss Franc ETF and the Gold ETF (NYSE:GLD) have both outperformed the S&P 500 on a relative basis over the last six months. But yesterday, State Street (NYSE: STT), which is one of Wall Street’s leading custodians (it holds securities in safekeeping for investors) reported a 71% drop in Q4 earnings related to losses in its bond portfolio.

Investors punished the stock, sending it down over 60%. But the investors were more worried about further unrealised losses that could, ahem, “impair” its capital. We’re not sure how the ETFs run by State Street would be affected by more…impairment. We’ll look into it. And we’re not saying ETFs can’t be a handy tool to use in various Permanent Portfolio Models that have different levels of risk.

It’s just a good reminder that in an age of asset deflation, everything in the equity market has risk, even if it’s a security designed to correlate to an asset (like gold or oil), or double the downside performance of the S&P (the Rydex family of funds). The ETF managers use leverage and management to achieve their returns. And that is certainly not without risk these days.

But hey, isn’t the stock market all about risk? Entrepreneurs take risks. And the investors who back winning entrepreneurs are rewarded. It’s pretty straight forward. That’s why Harry Browne had an allocation of 25% to growth stocks in his Permanent Portfolio, designed to prepare for the coming devaluation. You want an investment that grows at a much faster rate than the rate of inflation (which comes after asset deflation has hammered financial assets).

Kris Sayce thinks he’s found just such an investment. Or investments! “I’ve been telling Australian Small Cap Investigator subscribers that they should only be considering two types of share market investment at the moment. One is stocks that are paying a sustainable dividend at a decent yield. The other is growth stocks – but only in the small cap sector.

“In a market like this we don’t know which companies are going to be around tomorrow morning let alone in six months. And that goes for any company – big or small. So, in a high risk environment like today you want to be looking at a high potential return for your growth stocks. Buying blue chip growth to get a 10-15% return over 12 months isn’t worth it. But if you have even just 10%-25% of your portfolio in a number of small cap stocks you could be looking at returns of 50%, 100% or 200% in 12 months.”

“And if the stock market continues to go down? Well, hopefully your dividend payers will continue to pay, and your downside on the small caps is not likely to be much greater than if you were in blue chips, and you have put at risk a much smaller allocation of your portfolio. Small cap growth and any-cap income are the two best plays for 2009.”

Hear hear ! And now hear this! Great Britain could be headed for bankruptcy, according to an article in yesterday’s Telegraph. The article reports that London is in danger of becoming Reykjavik on the Thames.

Brown writes that in Britain, “The possibility of national bankruptcy is not unrealistic.” “It is finally dawning on the Government,” he adds, “that the liabilities of the British banks grew to be so vast in the boom years that they now eclipse the entire economy. Unfortunately, the Treasury is pledged to honour those liabilities because it has guaranteed not to let a British bank go down.”

Now you begin to see why Rogers is so bearish on the Pound. The British government may not have the resources to honour the liabilities of British banks, at least not without raising taxes or printing a great deal of money. Raising taxes drives away wealth producers. This is what happens when you turn your economy into a leveraged hedge fund that takes massive risks. So what do you think the Bank of England will do?

Start the presses! Here come da money printing.

Not that that dealing with the Credit Depression is exclusively a British problem. The Brits face national insolvency. Here in Australia, it’s a lack of lending. Enter the Rudd.

“The federal Government could soon become lender of last resort to Australian businesses, with the creation of a multi-billion-dollar scheme partly funded through the sale of commonwealth bonds,” reports today’s Australian. This is not the same as money printing, mind you. But it does show you how quickly the nationalisation of lending is being accomplished (or embraced) in Anglo-Saxon countries.

And a quick follow up to yesterday’s discussion of technically vulnerable Australian bank stocks. ASIC has extended the short-selling ban on stocks by another six weeks, as of last night. You can bet that the extension was directly related to the carnage in American and British banking stocks the day before. But we’re not so sure it’ll work. Here’s why…

Current shareholders of commercial banks in both America and Australia realise that if asset values are falling and capital must be replenished, it’s going to have to come from somewhere. That somewhere is likely the government or the Central Bank.

For example, in America, the six large banks (Citigroup, Bank of America, Wells Fargo, JP Morgan, Morgan Stanley, and Goldman Sachs) have combined assets of $8.6 trillion and combined liabilities of around $8.5 trillion. Does the U.S. government even have the resources to guarantee those liabilities or provide for losses in those assets?

Maybe it does. Maybe it doesn’t. Either way, current shareholders realise that nationalisation or help from the government is going to come with conditions. In other words, current shareholders will get diluted if the Feds get involved. Or it will come with some kind of condition on mandatory lending to business and households (not something banks want to do at the moment).

That’s why shareholders in North American and Europe said “Sayonara!” to bank stocks on Tuesday. They’re getting out before the government gets in. They’re probably also realising that in a Credit Depression it’s pretty hard for banks to grow earnings. There’s not much a shorting ban can do to prevent existing shareholders from heading for the exits.

What’s next? A ban on all selling?

Yesterday we promised a discussion about fair value versus mark-to-market accounting. It will have to wait. How to repair financial sector balance sheets is suddenly the urgent question of the new Obama Administration. But the subject is too complicated for today.

Instead, a note on breathing to help you through your day. In “The Art of Learning,” former chess prodigy Josh Waitzkin (Searching for Bobby Fischer) writes about how to learn. Waitzkin was a world chess champion at a young age, and later taught himself the art of Tai Chi push hands and one won a world title at that too. It turns out breathing is important to everything!

“A large obstacle to a calm, healthy, present existence,” he writes, “is the constant interruption of our natural breathing patterns. A thought or ringing phone or honking car interrupts an out-breath and so we stop and begin to inhale. Then we have another thought and stop before exhaling.”

“The result is shallow breathing and deficient flushing of carbon dioxide from our systems, so our cells never have as much pure oxygen as they could. Tai Chi meditation is, among other things, a haven of unimpaired oxygenation.”

All life is oxidation. So don’t just inhale. Exhale too! Happy breathing until tomorrow.

Dan Denning
for Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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hmmm, I do recall John Cain and his VEDC lending lots of money to stimulate the economy or something like that and in the end Joan Kirner had to sell the State Bank of Victoria to pay for all the debt. But hey, love him or hate him Jeff Kennett did get it all sorted out in the end. All’s well that end well : )

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