   |
|||
Momentum ManiaDave Forest
Was this a pivotal week? For the first time since March 6, the Dow Jones Industrial Average closed lower for the week. I'm not a technical analyst, but I know people who do follow technicals attach a lot of weight to this sort of loss in momentum. And momentum has been a critical factor in driving the markets higher over the last couple of months. This week we look at how investors have been "riding the wave" of rising stock and commodity prices recently. Much of the buying that drove these price increases was not based on fundamental analysis of the market. People simply felt good that the market was going up again and wanted to get in on the trend. This last month we've seen some interesting reports from OPEC and natural gas regulators in the U.S. on the effects this kind of speculation has had on energy markets. The results are startling. Speculators have been pushing prices hard. Making it tough for fundamental investors to understand what's really happening in these markets. We'll also keep up our "deflation watch". I wrote last week about how deflation could grip the U.S. (and the world) despite the $1 trillion in new money supply the government created over the last nine months. As expected, I took a lot of heat for these comments from the inflationist camp and believers in $2,000 gold. I'm going to take more heat this week as we look at why base metals production costs are likely to deflate in China. And how record levels of domestic U.S. government bond purchases could spell trouble for the American economy. As an aside, I did get a modicum of support from deflation sympathizers. Especially regarding my arguments about why the gold price is likely to stay even while gold stocks prosper. The following submitted quote was particularly apt, "Gold is not bought by poor people hoping to become rich, but by rich people hoping not to become poor." (Thanks to Jonathan Challis.) Whether you're in the inflation or deflation camp (or undecided, as many of us are), the critical thing is to keep looking at the data. Anything is possible in this economic environment. We're seeing both money creation and wealth destruction on an unprecedented scale. As the old saying goes, something's gotta give. We need to keep an open mind and keeping looking for leading indicators that tell us what that something is. This week's letter should help in that regard. Let's get to it. Everyone's A Speculator Is the current rally in stocks and commodities sustainable? I've had a lot of long talks about this with my associates lately. This week, one of my friends commented that he is avoiding the current markets because they have "lost touch" with fundamentals. As he put it, "Everyone is a speculator now." The observation has merit. Investors buy things based on a careful appraisal of value. If a stock or a bar of gold or a Malibu vacation home are selling for a price below their intrinsic value, the investor buys. When the price rises significantly above that intrinsic value, the investor sells. Speculators operate differently. The speculator has little or no regard for value. They buy when they believe there is a strong chance someone else will want to buy the stock, gold or vacation home at a higher price than the speculator is paying. Speculation is often based on momentum. When a stock rises in price (for fundamental or other reasons) the positive performance attracts further buying. Buyers assume the rising price is indicative of something good happening with the company in question. Or indicative of growing interest in the stock that will attract further buying. The momentum becomes a kind of "pyramid scheme". You make money as long as someone buys in after you. This kind of speculation can drive a stock well above its fundamental value. Remember the tech days when companies with no earnings had billion dollar capitalizations. Today, we are witnessing widespread speculation. People are making investments based on their guesses about what "the other guy" is going to do. Not on fundamental analysis of economic and business conditions. This is worrisome. The U.S. natural gas market is a perfect example. In the last three weeks, NYMEX front-month gas rose from $3.25 to $4.50. A 40% gain. Impressive performance. But what was the cause? During that period U.S. gas in storage increased by 200 billion cubic feet (a 10% rise). The amount of gas in storage is well above the five-year average for this time of year. In fact, it's one of the highest storage levels we've seen in the last five years. At the same time, gas consumption is falling. At the end of April we learned that February gas consumption by industrial users fell 10% month-on-month to 520 Bcf. February's industrial use was the lowest in the last nine years. By far. Previously, the lowest February usage was 560 Bcf, in 2006. The average for the last eight years was 615 Bcf. This year we're 15% below average. None of that is good news. And yet the gas price rallied 40%. This wasn't a seasonal effect. Typically the gas price is flat in April and May as the winter heating season winds down and the summer cooling season has yet to crank up. So why has the gas price been rising? Speculation. Technical analysts have been screaming for months that gas is oversold after plunging from $13 last June. People started thinking that other people would soon start buying. When the price did show a little bit of life, everyone jumped in. Driving gas up 40%. Regardless of the poor fundamentals. This "do what everyone else is going to do" mentality drives markets. The Federal Energy Regulatory Commission recently found that speculation in natural gas futures was a major factor in driving gas prices to $13 last June. As the Commission noted in its report, "None of the market fundamentals were extreme enough to explain why spot Henry Hub prices reached $13.31/MMBtu by July 3." The real explanation was "large pools of capital [that] flowed into various financial instruments that essentially turn commodities like natural gas into investment vehicles." How big are these pools of capital? The Commission estimates that during the first 10 months of 2008, physical gas traded on the U.S. Intercontinental Exchange was about 1,200 Bcf per month. This gas was actually bought and delivered for use. The other part of the market is financial trading. Gas that is bought for solely for investment purposes and never actually delivered or used. "Financial gas" trading averaged about 40,000 Bcf per month. The financial market was 34 times the size of the physical market! Here's the real evidence of the "speculation effect". Last October, the financial crisis hit. Investors no longer had cash on hand to play the gas market. By December, financial gas trading fell to 20,000 Bcf per month. A 50% decrease in two months! This shows just how much capital had flowed into natural gas when the sector was hot during the first nine months of 2008. These buyers were buying natural gas not because they felt it was undervalued. But simply because they saw it going up and wanted to ride the momentum. Speculation at its best. This isn't just happening in natural gas. Any exchange-traded commodity can be used by investors as a funnel for pools of capital. OPEC said this month they believe large amounts of "hot money" have moved into the oil market recently. In the OPEC Monthly Oil Report, the group writes, "In the oil market, prices have remained above $50/b due more to market sentiment than fundamentals. Considerable risks remain as oil market fundamentals are far from balanced due to the persistent contraction in demand and growing supply overhang" (emphasis mine). The same thing is happening to oil today that happened to gas a year ago. Oil prices had a small rise, probably because of OPEC production cuts at the beginning of this year. Investors saw oil moving up and jumped in to ride the wave. They weren't buying because they believed $40 or $50 was a good price for oil. The price was irrelevant. They were buying the trend. And the trend was up. This "momentum buying" has taken oil close to $60 over the last few weeks. "One Night Stand" Pricing I want to be clear here. I'm not claiming that speculators are a destructive force in the market. Or that speculation should be curbed (as some regulators have called for). The great thing about free markets is that they are free. Free to be as irrational as buyers choose. If someone wants to pay $60 or $80 or $200 for a barrel of oil, that's their business. If you want to speculate, jump on the wave and ride it. But the danger for investors is confusing speculation with fundamentals. A number of analysts have recently pointed to the rising oil price as evidence that world industrial growth is recovering. But the oil price can only be used an indicator of industrial growth if the oil price is based on fundamentals. That is, buying by people who are actually using oil. Or users who need to hedge their forward oil requirements to ensure a reasonable price. Buying by investors looking to ride a "trend in motion" tells us nothing about real oil demand or the world economy. The real meaning of the oil price gets smeared out by speculation. As investors, we need to recognize when markets are sending us useful signals. And when we are getting "false positives" due to speculation. We can"t just assume that the "market will get it right." We've seen too many examples recently where the market got it wrong. Commodity producers too are realizing that market signals aren't as reliable as they used to be. And it's changing the way those producers do business. The iron ore market is a perfect example. Iron producers are currently locked in their "negotiation season". Producers and sellers are coming together to set iron ore prices for the coming year. Traditionally, these prices are set on long-term contracts. This "benchmark" system locks in prices for the coming year. There's a small amount of flexibility for market conditions. But generally once the negotiations are done, the price is set for the year. Buyers and sellers forge a long-term relationship. But this year will likely be different. Negotiations have stalled over the past few weeks. The biggest problem is that buyers are asking for a term price below the current spot price. Usually the spot price is taken as a general guide to the state of the market. Long-term prices are set more or less in line with spot. But buyers no longer trust the spot price. Spot prices have become increasingly volatile over the last few years due to factors like speculation. Buyers doubt that spot prices accurately reflect the state of the market. So they don't want to lock in a long-term price based on spot. They would rather have a flexible pricing system where price is continuously determined and re-determined based on what is actually going on with supply and demand. Long-term relationships are out. Buyers want "one night stand" pricing, the kind that changes quickly if conditions change. Iron ore producers are mixed on the idea of flexible pricing. Groups like Rio Tinto still believe that spot prices are a good indicator for term pricing. As Rio said this week, "Some customers have suggested a benchmark price for this year below current spot levels, which is not acceptable to us." BHP Billiton is a little more progressive. The company's president of iron ore operations said at meetings this week that "the changed market dynamics" make obsolete a system whereby pricing is locked in for 12 months." Brazil's Vale agrees, saying, "The market circumstances are determining that this [long-term pricing] is not the only system possible and we are prepared for alternatives if our clients should desire." This is an important change in mentality. One that could spill over into other commodities markets that use term pricing. Coal, for example. Buyers and sellers are both realizing that commodity price volatility is a fact of life. And spot prices may get distorted by non-fundamental factors. They are trusting the market less and less. Investors would be wise to do the same. China Compacts its Cost Structure China has become "ground zero" for the base metals markets over the last few months. Record Chinese imports of copper and zinc have been one of the only bright spots for these metals recently. It appears that China has been nearly single-handedly responsible for driving base metals prices higher in 2009. As we've discussed in the past, some of this demand was due to stockpiling. This is "apparent demand". Stockpiled metal might sit in storage for some time before its used to make industrial or consumer goods. Stockpiling is therefore a temporary source of demand. Sooner or later, stockpiles grow to desired levels. Then the owners stop buying. But there are encouraging signs of "real demand" for base metals in China. Chinese production of automobiles was up 17.6% year-on-year in April. The Chinese government is offering rebates on new automobile purchases to stimulate demand. This appears to be working. Auto sales were up 25% year-on-year in April. Sales were over one million units in both March and April. China's first two-month, "plus-one million" period ever. China is also trying to stimulate demand for new appliances in rural communities, although this campaign doesn't appear to have had much effect on demand yet. The pick-up in Chinese domestic demand is positive for base metal demand. Chinese domestic base metal prices have been running 10 to 20% above London Metal Exchange prices. Sellers around the world have been sending metal to China to capture these higher prices. Which has helped lift global prices for most of the base metals. Why are Chinese prices running at premium to the rest of the world? As mentioned above, stockpiling of base metals by the Chinese government has helped drive up prices. The government is attempting to support its domestic metals producers. And the Chinese base metals industry needs higher prices than the current global average to survive. ... To read the rest of this article, click on the hyperlink below: http://www.piercepoints.com/print_letter.php?newsletter=2009_05_15_Pierce_Points.html May 15, 2009 Copyright ©2009-2010 Resource Publishers Inc. Note: To subscribe to Pierce Points please click here: www.piercepoints.com Pierce Points
mailing address: 321gold Ltd |
