This wholesale sell-off of resources is based on the same dumb logic of that sent oil to nearly $150 a barrel. When math-lab economics takes over as market toolkit there is little that can be done but watch the trade. The medium term issue will be the extent to which this volatility dives capital out of the markets altogether, but for now one can only checkmark fundamentals and wait for the algorithms to decide the tide has turned. Some are trying to justify the selling based on the commodity-bubble sing-song. Bubble is getting overused, and we know many of you have heard this from us before, but here again is our take on that.

An economic bubble is “trade in high volumes at prices considerably at variance from intrinsic values”, which of course requires understanding the intrinsic values.

The definition is from Wikipedia, one of the good ideas that came out of the “tech bubble” that ended the last century. That was a bubble because the aggregate value of the public companies in that space became hugely larger than a shift to internet commerce could possibly underpin. It was a classic bubble (in our view), presaged by similar over-capitalizing of radio, railways, and foreign climes that were also driven by new technology in the prior 150 years.

The “housing bubble” in the US is a bit trickier since there is a wide variance in housing prices even within a municipality. What did become apparent before this market burst was that cash was being undervalued relative to housing. How else could you explain so called mortgages written at 125% of the asking prices for property? That was the anomaly we, and a few others, were stunned by. Valuations got to a point where there was not enough underlying homeowner net income to keep the buyers coming.

A big part of what created this mess was an attempt to “commoditize”. “A commodity is anything for which there is demand, but which is supplied without qualitative differentiation across a market.” Copper is always copper and certainly is a commodity, while fine wine or art are subject to changing tastes and really aren’t.

Commoditizing mortgages required an assumption that all house buying is more or less equal, so that it did not need to be qualified. Just how egregiously this was being done (or not done, more to the point) has become apparent after a year of banks refusing to deal with each other. While we did caution that taking money out of the market was the best course of action a year ago, we have maintained a stance that “commodities” would recover fairly quickly due to Asian demand growth. We would understand, in light of recent “commodities bubble” headlines, if you wonder whether we drink our own bathwater.

A commodity bubble, based on Wikipedia or most others, would be “trade of goods that are essentially the same in all markets, in high volumes but without regard to intrinsic value.” We have defined bubble more simply as “continued price gains despite oversupply.” Our emphasis on supply indicates our commodity bias, but this works for any bubble if oversupply-of-capital is included to account for financial market slumps. On that basis there have been smaller sub-sector bubbles, like an oversupply of uranium explorers, but we don’t see a commodities bubble.

The closest “trade in high volumes” applies to most commodities are related derivatives contracts. There has been little significant oversupply to generate excess trade in the goods themselves. The reason so many goods shot up in price has been concern that, given current infrastructure, there might not be enough supply to cover demand growth. Prices did overheat, and exceeded “intrinsic value” by some standards since they caused demand to slacken. But that by itself is not a bubble – not a gross oversupply that requires a long period of weak pricing to consume.

The world is still trying to make up for long term undercapitalization of commodities. Even “crashing commodity prices” evidence this by still being at levels well above highs in previous cycles. We are not seeing anywhere near the build up in stocks we had at the beginning of this decade, despite a major slowing of US demand that is now two years old. Nor has there been a vast build up of new mines that the market should fear will overwhelm demand. Mine development has actually been slower than anticipated.

The above of course requires that the strong emerging economies grow despite weak times in the developed West and Japan.

China’s growth continues apace. Newly released figures for Q2 indicate China’s economic growth continued over 10%, that consumer spending was up 23% in July over the previous year despite higher energy costs, and that through the year to the end of July urban fixed assets spending was up 27% from the previous year period. The last figure does include some added impetus from the Olympics in Beijing and what rebuild has been possible since the earthquake in central China, but it is still huge growth. China’s trade surplus has on the other hand shrunk by almost 10% this year - but that has not blunted growth as the anti commodity crowd claimed it would.

India’s growth has slowed – from an average close to 9% over the previous three years to (gasp) a just revised estimate of 7.7% for this year. It was evidence of some slowing in India a few months back that hit export based companies badly and drove down the Mumbai stock exchange indices. They have since recovered, as they should in any country that can average that growth despite needing energy imports, and that has a serious red-tape parade ahead of getting most things done (unlike China).

China and India, plus oil and other commodities rich countries, are using the funds at home they had been lending through US and European bankers. You can still find some who think that the Beijing Olympics have somehow caused China’s growth, but really if this were the case the build in Vancouver would easily be doing the same for Canada’s economy given relative scales. As we had expected, a Western downturn has simply redirected funds back into the heavy growth economies - the ones that create growth in commodities markets.

China has in fact created most of the extra commodities supply needed to cover its own growth. The government had capped electricity prices, so there has been a bias to using it rather than generating it. There was actually a small surge in oil demand when China cut power subsidy to deal with rising crude prices, because power companies got some added margin to play with. The jump in coal prices were not due to Chinese imports, but rather because of reduced Chinese exports. But power plants are still not being built fast enough to cover new demand in China. That realization could be the next turning point for metals.

We are not wearing rose colored glasses, and we are not going to pretend that this market hasn’t got serious issues that will take some time to sort out. We certainly don’t underestimate the effect on portfolios of resource stocks being taken out to the wood shed this month since they form the bulk of our own holdings. We however also don’t think the fundamental shifts we have focused on have created a markedly different situation than we had expected. Low prices have driven several zinc mines out of operation, and that will continue while prices stay low. Despite high copper prices, there is still barely enough supply to maintain Asian growth despite the worst US housing slump in several generations. And Kitco, where we sometimes post public articles (http://www.kitco.com/) is telling its customers that supply constraints for bullion could lead to delays in delivering product. Kitco has been in the metals business for three decades, so it knows where to line up new supplies if anyone does.

The big issue now is that assets are not being valued by the markets. Just now, we are also in a trading induced sell off of commodities, partly due to lumping all of them with oil that is in a normal downswing after spiking beyond reason, and partly due to what we consider a weak reading of the fundamentals based on an assumption that emerging markets growth will dry up because of a downturn in the West. Trading slumps do reverse, and this one will. There are short term traders and funds bailing out of commodities in general, magnified by what was clearly margin-driven selling in the case of a number of stocks, and some metals as well.

An optimist might argue the past couple of sessions looked like capitulation (they did), but it makes more sense to wait for a clear upturn since resource stocks are also fighting against a negative tide in the overall markets. Precious metals are again shackled to oil and the US Dollar. The Dollar is being bought as the “least bad” alternative based on (irony definitely intended) export growth thanks to buying power elsewhere, but there won’t be long term relief. It looks like a bear market rally for the Dollar to us given continued bad fundamental news from the US, but this trade will have to play out first.

There have been some ugly financials released this week by new metal producers (thankfully not from HRA companies). Given the speed of price decline in metals and the tightening of credit markets, we think these walking wounded will have trouble surviving for long. Not good news per se, but we suspect the “sudden oversupply” of metal people are worried about, especially on the base metal side, will disappear quicker than the pessimists expect. Bankruptcies might scare a few more out of commodities, but this should actually hasten the pace of price bottoms forming as supplies contract.

Gold is officially in “bear market” territory. That moniker doesn’t mean much for something with the sort of price swings gold has displayed, but it is priced just above its long term trend line. The next few sessions will tell us whether gold bounces from here or moves towards a lower support level. We’d like to say something reassuringly positive, but it’s a toss up at this point. We think the $770-780 range might actually hold, but that will depend on swing traders in oil and currency markets. As noted in the last Journal, oil prices are again tugging all commodities down. We are not happy about the impacts of that but, again, as noted, we simply can’t see anything other than a large drop in the oil price kick-starting the developed world economies in the short run. On that level at least, falling oil prices represent short term pain for potential medium term gain.

Right now the market focus is on cash flow and near cash flow companies, and even these are weakly priced to potential. To get a sharp re-pricing of assets rich companies will require that the spate of buy-outs we have seen continues. It will, and unfortunately at fire sale pricing for the next while. But this is not the time to be selling in frustration and fear. Fall is, on average, the best season for resource stocks. Fall is near so we will wait this out and try to be ready to be able to bargain hunt with confidence at a bottom that we hope will not be long in arriving.

David Coffin and Eric Coffin
From the August 2008 HRA Dispatch