Commodities and Hard Assets - How Safe Are They?
When I piece together what governments, regulators, banks, business, etc., have done, I don't like the picture and I ask myself, "where do you hide?"
Commodities and other "hard assets" have been getting a sales job as safer because they are hard assets. Well, wasn't a house supposed to be a hard assets of sorts? It truly doesn't matter where you are in the market, what is "safe" is going to be what is fairly valued. If you pay too much for an investment it will not be a good investment and it doesn't matter what sector or the classification of asset.
Commodities in the mining sector are commodities that I understand reasonably well and my commodity posts have been mirrored on infomine and I can tear into their financial reports fairly well and see problems or opportunities. I suppose I haven't been writing about them so much lately because I think they have the potential to crash big time as the prices are based on earns which are based on commodities prices in the range of 3-10 times the bottom. The price inflation of commodities doesn't look much different than the price inflation of homes, and earnings are leveraged to these prices. When I read floridabuilder's blogs, well, the concepts and valuations seem so parallel, except commodities work in a global market, not local markets.
I've done a bit of looking at food commodities as well, and more recently being up north has given me the opportunity to pick the brains of a number working in the oil and gas industry. And when I ask questions I do ask good questions to give a better perspective and understanding of how the business operates.
So, today naked capitalism has a post "Commodities: The Big Fall Is Coming." Given my concerns about a crash in commodities, well, it gets my attention.
So, there is no question that commodities have been a great place to be, especially if you are American as it has not only been a booming sector, it has had good protection against the falling US dollar. But what happens if there is a world economic slow down? How much of the increased pricing is sustainable due to the falling US dollar, in other words not really an increase in price for the rest of the world? My sense is that the break even for copper is probably around $2/pound US now. Quite a few analyst when they do their long term forecasts look at the 80c or so bottom and come up with $1 or $1.25 long term forecast. That simply doesn't price in the US dollar decline at all, and that 80c price was probably 2-3 standard deviations below a break even price. The markets constantly under and over shoot where prices ought to be.
At 80c copper the entire industry was being cannibalized, valuable assets being sold for pennies on the dollar compared to how the market is valuing them today. And there would be the just of the problem with valuation. Probably just as pennies on today's dollars was way too low, the today's dollar valuations are probably way too high, maybe up to 3-4 times too high. That would mean that lows were 3-4 times too low. If you were to say that the commodities are only 10-20% too high, it would mean that they got valued down to less than 1/10th of true value, and I tend to think somewhere in the middle is more likely. However, we are looking at multiples, so it isn't a linear middle, but a "exponential middle." Say it was 4c on the dollar compared to today, well, say it was 1/5th the value and ought to have been at 20c, but now it is 5 times over valued at $1. A linear middle would put it at 52c, not 20c, yet because everything gets leveraged, analysing this this stuff with exponents is going to give a more realistic assessment, imho.
I always digress... back to the articles:
"The speculative element in commodity markets has grown sharply; non-commercial trades now constitute more than half of all trading, with hedge funds the biggest movers into the market. And in 2007, global equity funds switched away from financials and real estate into commodities in a big way.
"But that’s about to change. Global growth is declining fast. Recession will ensue and no region or asset class will be immune from its ravages. Contrary to received wisdom, economic decoupling is unlikely."
I have done previous links to Frank Veneroso's stuff, and he's been highly vocal about what's been happening in the economy for years. I think that although it appears he's been wrong for years, the size of the bubble that has been launched is so massive he was simply early to game saying that a correction needed to happen, and when he started the correction would have been manageable and could have been done without the insane things we are seeing in the market today. I had the opportunity to be in a small group discussion with him at the Cambrige Investment conference in January 07 in Vancouver. His example of explaining what happened with hedge funds controling the natural gas market and its fall was very good. Natural gas got up to $12 with the hedge fund speculation and then hit a bottom this past year, 3-4 years after the peak, of under $6. Natural gas has gone up again this year. I'm living up in the NWT and the road to town has had 3 natural gas base camps set up since I arrived in October. Industry activity is increasing the supply again. With hedge funds and speculation the prices swings are so much beyond what they ought to be, and it means enormous increased risk. It isn't that these things can do a 20% hair cut, but they can do a 75% hair cut. I was out of most at about 1/2 to 2/3rds of where they've gone. I simply couldn't see pricing them higher than a P/E of about 8-10 for myself, although I didn't pick on them as bad investments as long as the P/E was under 12. At 12 they could retract, but you could sell without getting completely wiped out and you have time to see problems coming. P/E's of 20 in strong price environments are cliff diving potential investments.
I digress again... The article is giving good information, half of China's metal imports are used for exports. That's an enormous slow down potential, and the way economies are leverage to existing output, that slow down would ripple though the rest of the Asian economy. They have savings and little debt so they recover way faster, but not without going through serious growing pains. The prediction of surplus in commodities is so incredibly likely, and with that commodity prices and the exponential multiples that support them come crashing down.
BTW, Kitco metals is a good source of price and warehouse levels for base metals, but you can only see 5 years of history. Informine gives price data going back 20 years, but I don't think you can find supply data. I think Mike Hewitt of dollardaze has done a few posts where he's put up graphs with longer historical data on the warehouse levels when he's done his posts on commodities. Certainly looking back and seeing how quickly base metal supply can go from tight to massive oversupply leaves me highly cautious.
So, watch the market carefully if "hard assets" are your safety net.