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Wall Street Spin Creates Opportunity

With very little economic news to digest today, the broad stock indexes are flip-flopping around breakeven as they look for direction following yesterday’s gains. At this point, if stock prices can simply hold the recent gains, the bulls can begin to claim victory as we move into the fourth quarter to close the year. Wall Street has been pounding home the mantra that the forthcoming economic slowdown will result in less demand for commodities, and that is why we are seeing lower prices for precious metals and commodities, especially oil. With the economic slowdown, where is the corresponding decline in stock prices? If the global economy is truly slowing, we should also see corporate earnings come under pressure, and possibly a contraction of price to earnings multiples…but it’s not happening.

At the lunch hour we have stocks slightly in positive territory and bond prices are modestly higher, pushing the yield on ten-year Treasuries down to 4.75%. The U.S. dollar opened higher against most major currencies, but has been sliding lower as the day progresses, and energy prices are mixed following the inventory data from the Energy Department.

Weekly Economic Data

First, a quick look at the weekly Wednesday reports, then back to the current spin on Wall Street. Energy analysts expected a drawdown of 1.9 million barrels of crude oil, but the number came in larger than expected at minus 2.9 million barrels. Gasoline inventories were expected to grow by 1.0 million barrels, but instead only grew by 100,000 barrels. The lower than expected inventories has crude $.49 higher at $64.25 and wholesale unleaded gasoline is higher by two cents at $1.57 a gallon. Distillate inventories were expected to move higher by 2.0 million barrels, but instead grew by a much larger 4.7 million barrels. Heating oil is down a penny at $1.75 a gallon and natural gas just turned positive by a penny to $5.59/mbtu’s. Overall I would have expected better gains based on the draw-downs in crude and gasoline with shorts coming in to cover, but downward pressure remains in the energy complex.

The second weekly report came from the Mortgage Bankers Association saying their applications index rose by 3.2% from the prior week with the purchase index higher by 5.3% and the re-fi index higher by 0.1%. The 30-year fixed rate rose one basis point higher to 6.32% and the average one-year ARM rose five basis points to 5.96%. According to MarketWatch, “With spreads tightening between adjustable rates and fixed rates, adjustable-rate loans accounted for just 25.5% of loans, the lowest ARM share in nearly three years.” The Fed has removed the “froth” from the housing market, but many analysts are asking the question, “Have they gone too far?”

Back to the Spin

With elections just two months down the road, it is politically VERY expedient to depict the markets as healthy with slowing growth, since “growth” keeps a bid in stock prices and “slowing” keeps a bid in the bond markets, assuming inflation is not a problem. When commodity prices are hammered lower, paper assets are free to move higher in price. The inflation data has been deliberately managed to keep “inflation expectations” at a minimum. Inflation is clearly present in the pipeline, but when we see energy and metals prices tumbling (temporarily), we get a false sense that inflation is under control.

Seventy percent of our economy depends on consumer spending, and the big spin on the Street says the lower gasoline prices are putting money in the consumer’s pockets. While it is true to a point, how much are you really saving each month? If you put 100 gallons into your car each month, a fifty cent per gallon lower price at the pump only gets you $50 a month. It looks good on paper, but how much is that really going to help your budget for the Christmas shopping season? The oil companies made the big profits through the summer months; now it’s time for the oil boys to take a back seat position while retailers and manufacturers around the globe take center stage for the fourth quarter. I have said previously that ALL PLAYERS (including China) want to make their numbers for the fourth quarter (roughly two-thirds of retail profits happen in the fourth quarter each year). Nobody wants to tip the apple cart right now.

I think it’s also important to note how all the negative news out of the Middle East has diminished. We are going to work things out with Iran, Israel and Hezbollah have backed down from overt hostilities, and oil is flowing freely. This removes the “terrorist” premium in crude oil prices. Another thing to notice is what they are not talking about very much….militants attacked the U.S. Embassy in Syria yesterday, but we aren’t hearing much about it. So far the little I have read about the incident has U.S. officials praising Syrian officials for their response, but Syrian officials responded with sharp criticism of the United States. A statement from the Syrian Embassy in Washington said, “It is regrettable that U.S. policies in the Middle East have fueled extremism, terrorism and anti-U.S. sentiment.” On the surface it appears many of the geopolitical tensions have eased, but nothing has really changed except the message discipline and spin from the mainstream media!

Another item that hasn’t really changed is the monetary inflation that has fueled the boom in commodity prices. The cost of money has moved higher (interest rates), but the supply of money also continues to move higher. The result of monetary inflation is higher prices. Please note this quote as a reminder from Puru Saxena:

“THE BIG PICTURE – We are now living in an inflationary war cycle. Over the coming decade, I expect massive inflation (money-supply growth) and worsening geopolitical conflicts. During such a hostile environment, commodities (especially gold and silver) are likely to outperform every asset class.”

It is timely to rein-in geopolitical tensions and to diminish inflationary expectations. Based primarily on the housing slowdown, the economy in the U.S. is cooling down, but globally things are still red-hot! From the headlines on Monday, I noted three items in particular:

1)   European Central Bank council member Garganas said inflation as well as economic growth may be stronger than expected while accommodation remains present in the system.

2)   Japanese PPI rose 3.4% year over year in August. This was the largest increase in 25 years….(but there is no inflation).

3)   CPI in the U.K. rose 0.4% in August (4.8% annual rate) from the previous month and is up 2.5% year over year. The year/year gain is the largest since the index began being calculated in 1997.

On Monday we also learned the Chinese trade surplus rose to a record $18.8 billion. China’s trade surplus year to date is $94.7 billion, while their trade surplus for all of 2005 was $102 billion. They are tracking this year to have a year-end trade surplus around $140 billion. They are making some big money with Chinese manufacturing!! Yesterday we got news of yet another record for the U.S. trade deficit at $68.04 billion for July. The deficit was 5% higher than June and is the largest month to month increase in nearly a year. Lower oil prices will help reduce our trade deficit, but the most alarming number for me in the trade report shows U.S. exports LOWER by 1.1%. The global economy is expanding, but they are not increasing their purchases from U.S. manufacturers.

With all the recent headlines on commodity prices coming down, this article from Bloomberg caught my attention:

Copper Declines in London After China Says Output Growth Slowed

Sept. 13 (Bloomberg) -- Copper fell to a three-week low in London after China, the world's largest user of the metal, said industrial production rose at the slowest pace in 17 months.

Output at manufacturers and power plants climbed 15.7 percent in August from a year earlier, China's statistic bureau said today. That's the smallest gain since March 2005. Copper has quadrupled in the past five years as China used the metal to build factories and power-transmission lines.

Copper is down 15 percent from a record $8,800 on May 11 and had dropped 7.5 percent in the past week.

(Isn’t that just a darn shame they could only grow by 15.7%. They make it sound like copper is ready to fall off a cliff, but look at their comments on the fundamentals.)

Limited Supply

Copper stockpiles monitored by the LME jumped 2,200 tons, or 1.8 percent, to 122,050 tons, the exchange said today in a daily report. Still, the inventory is equal to less than three days of global consumption.

In addition to expanding consumption, limited supply of metals including copper has boosted prices, said Jeremy Goldwyn, global head of industrial commodities at London-based Sucden U.K. Ltd. ``The key is demand from China and the U.S.,'' he said in an interview.

The bottom line is the simple fact that global production of copper is barely keeping up with demand requirements. It will take years to bring more copper production online. Let’s take a quick look at a copper chart to see what the price of copper has to say:

Over the last two months copper has held support at the $3.25 level. The current consolidation could easily resolve itself to the downside, but I will be watching closely to see if the fundamentals of supply and demand change enough to drop the price solidly below the $3.00 level. They can spin a slowdown here in the U.S. to temporarily drive commodity prices lower, but is the global economy going to slow enough to bring copper back down to $2.00 or even under $1.00 where it stood for many years? I don’t think so! Commodities have made their initial adjustment since central banks around the globe have been gunning the money supply in recent years. Longer-term the global demand for commodities will outweigh the short-term spin and consolidation in the markets…unless someone cares to tell the Chinese to get rid of their newly purchased cars and go back to riding bicycles!

Just a Correction

At the top of this article I said, “Wall Street Spin Creates Opportunity.” I don’t believe for a second the commodity bull market has come to an abrupt end. This is merely a consolidation of the huge gains of the past year or so. This whole Wall Street Spin Machine is creating buying opportunities in the energy and metals sectors. It could well take another month or two (get past the elections in November) to see the consolidations run their course, but I still expect the long-term resolution to be higher prices for commodities.

To go one step further, I want to take a long-term look at the relationship of copper to silver. Both metals are critical elements for manufacturing; there are basically no substitutes, especially for the electronics/high tech industries. These metals also have the common denominators of low supply and very long lead-times to bring new production to market. Here’s a look at a ten-year chart of the relative prices for copper and silver:

To read this ratio chart, please note that StockCharts.com does not use decimal points when reporting the copper price. What this chart says is that it takes roughly 3.5 pounds of copper to buy one ounce of silver. Historically, you can see from 1998 through 2005 it took anywhere from five pounds to nine pounds of copper to buy one ounce of silver. For this relationship to return to its historical norm around six pounds of copper for every ounce of silver, either copper must come down or silver must rise or some combination of the two. This says silver should outperform copper in the coming months and years. With the ratio back at six pounds of copper equals one ounce of silver, $11.00 silver means copper caves-in from $3.38 (today’s close) to $1.83 a pound. If copper were to remain at $3.38, the historical relationship implies a silver price of $20.28.

Silver Chart Update

In my WrapUp dated August 2^nd, I posted the following silver chart with the commentary in brown:

Over the last two months I have been buying gold and silver mining stocks for my clients and have deployed roughly 50% of their investment capital to the precious metals sector. Gold and silver have been declining in production while fiat funny money is growing by 10% around the globe. I especially like companies with exposure to silver along with a few of the junior exploration companies.

The chart and analysis served me well as it told me to be cautious with silver around $13.30, and I took profits in my client’s accounts with gains of 20% to 40% from the primary silver producers. I did in fact also hold some core-positions in the junior mining shares, and some have gone slightly underwater, but taking profits has more than offset the declines in the core positions. Now let’s have a look at how the consolidation has progressed since August 2nd:

The upper resistance line I drew on 8/2 told me to be alert for a pullback with the price above $13 an ounce. The second clue I got to take profits was the divergence in momentum and price. You can see the price made a new three-month high on 9/5 at $13.37, but we did not get confirmation from the Relative Strength Index. On August 9th the price was $12.74 with an RSI of 65.66. The most recent high of $13.37 on 9/5 only registered a reading of 64.06 for the RSI. Higher price with lower momentum usually means a correction is near. Even at $10 an ounce the bull market for silver is completely intact!

Back to the Market's Close

Well, how about this stock market that wants to rally in the face of a slowing economy! Stocks are supposed to be a forward-looking indicator of the economy, so we scratch our heads and wonder, “Can it last?” By the closing bell, the Dow Industrials gained 45 points to 11,543, the NASDAQ Composite moved 11 points higher to 2,227 and the S&P 500 added five points to 1,318. This ramping of stock prices will create an excellent opportunity to short stocks or stock indexes in the coming weeks. If you are not inclined to short the market, at least be on your toes to take some money off the table and get out of the “cookie cutter” growth mutual funds.

Actually, very little changed from what I wrote around the noon-hour. The dollar was weaker versus the yen, but had no change versus the euro. Bond prices closed slightly higher, gasoline and crude oil got a tiny bounce higher, grains were flat and meat prices declined. In terms of volatility, there isn’t much to write home about. The market makers will continue playing their games to spin stocks higher and interest rates lower. Just know that this commodity bull is far from over. The current corrections are creating some great buying opportunities!

Have a Great Evening!

Mike Hartman

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