Archive for May, 2009
The world economy is in longterm trouble because we are running out of oil as well as other key commodities, says longtime investment newsletter writer Stephen Leeb. Moreover, there is no easy fix, he says, because most of the proposed approaches to renewable energy, also depend on scarce minerals — and on water, the most vital commodity of all. Therefore it may be harder than some people think, to build enough windmills, solar panels, or nuclear plants to replace the fossil energy we now use while maintaining our standard of living, he says. America’s best response would be a careful study to map out the most feasible combination of solutions, probably in consultation with other countries. Otherwise if we try one solution, other countries may do something that makes our approach impossible.
Meanwhile, Leeb says, the individual investor would be wise to concentrate on precious metals and commodity based stocks (he does name names). Essentially Leeb seems to believe: now that billions of Asians have joined the world’s capitalist economy, manufacturers compete fiercely. Therefore manufacturers’ profit margins get squeezed, and scarce natural resources are the thing to own. On this we could not agree more.
The book is strongest where it explains just how hard it will be to adapt to the end of the Oil Age. For instance, he quotes Caltech scientist Mark Jacobson’s estimate that the US could take care of the bulk of its energy needs with 700,000 windmills. However, Leeb asks, where on earth would we get the steel to build them? Interested readers will remember that iron ore prices skyrocketed along with oil during last year’s commodity price boom.
Similarly, because it is expensive to refine silicon so that it can be used in solar panels, First Solar (FSLR) has captured the imagination of many investors. FSLR uses thin film instead of silicon, and thin film’s active ingredient is cadmium telluride. This compound is cheaper than to make than refined pure silicon, at least in small amounts. Again the problem comes when trying to scale up production. Chemists classify tellurium as a “rare earth” element and while the earth might contain enough of it for our current uses, Mr. Leeb thinks that tellurium supplies could become run short if we began relying heavily on FSLR’s technology.
One more example should drive the author’s point home. Leeb notes that Australia has decided against building any new nuclear power plants. Have the Crocodile Dundees gone soft? Far from it. Drought prone Australia simply doesn’t have the water needed for the big cooling towers that nuclear plants employ to diffuse their huge outputs of waste heat. Normally nuclear plants are built near a large water supply, but Australia needs every drop of water it can get for drinking and agriculture.
Leeb also thinks defense stocks will continue to do well, because America will need to police unstable regions of the world that produce commodities. We are less sure of his argument here. We don’t think the US can afford the kind of military it has over the long term, and are reminded of how Russia had to retrench defense spending after its economic crisis in 1998. But if fiscal and trade deficits precipitate a dollar crisis as Leeb predicts, we think the Pentagon will come in for budget cuts.
The military uses about 40% of all stated federal expenditures as detailed in the annual budget, but in fact, the military spends about twice the budget’s stated dollar figure. To fully measure defense spending we must also account for the “supplemental” appropriations that fund the wars in Iraq and Afghanistan, plus the “black” portions of defense expenditures that are not fully disclosed, as longtime defense analyst and China expert Chalmers Johnson points out here.
We also disagree with the way Leeb dismisses energy efficiency as merely “buying time.” We understand that if you drive a gasoline powered car that gets 40 mpg instead of 20 you will still be out of luck when the price of oil soars even higher than it did in 2008 –or if as Leeb predicts, the government eventually rations or even bans the sale of gasoline for use in private automobiles. Yet, if you agree with Leeb about the difficulty of developing renewable energy on a large enough scale, you want to use less energy for everything you do. In Leeb’s scenario, you would want an electric car that would need less solar electricity to stay charged, a car that would also need fewer batteries that contain exotic minerals. In other words, you want a car that weighs less than a thousand pounds and has a low drag coefficient, according to physicist and McArthur “genius award” recipient Amory Lovins. That way your car will get where it is going with less energy, no matter what kind of energy you use. When he began developing his prototype efficient “hypercar,” Lovins started by asking a question that ought to have been obvious to everyone else: how can we change a situation where we burn up the gasoline needed to transport 4,000 pounds of car — and a 150 pound person?
Energy efficiency provides even more dramatic gains in well insulated buildings. In a housing project in Darmstadt, Germany (not exactly a warm weather city) the buildings are so well insulated, they stay warm throughout the winter without any furnace whatsoever; the sun, body heat, and appliances do the trick. It’s true, these homes have less area per person than many Americans would prefer, but, we think we have proved our point: energy efficiency is going to count big time in the future no matter how we chose to produce energy.
We think Leeb gets back on target when he talks about economic growth and inflation. Leeb’s longterm scenario for the economy is that it veers from commodities driven inflation, to steep recession and back. In his view high commodity prices tax the economy and slow down growth. Commodity prices crash along with the economy. But then mineral exploration projects get put on hold, and so when the economy turns up, commodity prices soar even higher than they did during the previous recovery, because such projects have a long lead time to restart and so we are caught short of supply once more. That prediction seems to be dead on; many oil companies are cutting back exploration and production expenditures in response to oil price decreases, at least for now. It’s hard to know just how prescient Leeb was regarding the current economic meltdown: the book was due to come out in late 2008, and then he admits to updating it on a crash basis after Lehman Brothers (LEH) collapsed. On the other hand Leeb seems to have held fairly accurate views for some time, having penned books such as The Oil Factor and The Coming Economic Collapse.
Now for Leeb’s key stock picks (we didn’t quite include all of them), which are about what you would expect given the arguments he makes. He made these picks based on company quality and sector strategy given his economic scenario; he obviously did not know what the stock prices and valuations would be when the book actually reached stores.
He notes that both in periods of extreme inflation, or in deflation, gold has tended to do well, and so he thinks that gold will be important for all investors. He recommends Street Tracks Gold Trust (GLD) as the easy way hold bullion. For gold miners, he notes that investors can choose GDX as an ETF to get general exposure to the sector, one could also use Fidelity’s Select Gold Fund (FSGAX) or the Tocqueville Gold Fund (TGLDX) if you want exposure to the smaller speculative picks that can also do well if gold soars as high as he expects . Among individual gold miners he picks American Barrick (ABX) as the conservative choice, along with Agnico-Eagle (AEM) and Kinross Gold (KGC). The latter two are mid size producers with properties that can expand their output in the future, but as Leeb notes, Kinross does have political risk since many of its projects are in Russia. For silver he suggests SLV, the silver bullion ETF, and industry leader Pan American Silver (PAAS). On the energy side he eschews the oil majors, because they are no longer able to increase production. Instead he goes for oil drillers such as industry leader Schlumberger (SLB) as well as Baker Hughes (BHI), Halliburton (HAL), National Oilwell Varco (NOV) and Transocean (RIG). Their technology will be in demand, he thinks, as the majors and some of OPEC’s national oil companies scramble to replace or work over existing oil fields. He aslo likes Canadian Oil Sands Trust (COSWF) for its long lived reserves and uranium producer Cameco (CCJ)In a like vein, he likes Fluor (FLR), the engineering and construction firm, because they help build energy installations. His all round defensive stock is Berkshire Hathaway (BRK/B) not only because of Warren Buffett’s record but also because of its strong re-insurance franchise. He notes that consumer staples stocks, which are normally thought of as “defensive” did badly during the inflationary 1970s and advises investors to stay away from them. Water stocks he likes include French water infrastructure builder Veoila (VE) and ITT, which has a water engineering division along with its defense business. Finally, if you agree with Leeb about defense stocks, he likes Lockheed (LMT) and Raytheon (RTN).
On the whole we think that in turbulent times like these investors should consider most of Leeb’s ideas carefully. As he points out, the conventional wisdom of putting something like 60% of your money in diversified stock funds and the balance in fixed income did not work out during the inflationary 1970s. We also think that (with the possible exception of defense) he is pointing out sectors that actually have a chance to preserve investors’ purchasing power in the years ahead, if bought at sensible valuations.
Disclosure: we own GLD in our personal accounts and look to buy AEM on pullbacks. We have no connection with Leeb or his newsletter and this article should not be construed as a recommendation for his products.
We were rather intrigued with the following quote from Bridgewater Research, via John Mauldin’s weekly newsletter. We definitely think they are on the right track.
“Normally, labor markets lag the economy because incremental spending transactions are financed via debt, stimulated by interest rate cuts. But as long as credit remains frozen, spending will require income, and income comes from jobs. And debt service payments are made out of income. Therefore, in a deleveraging environment job growth becomes an important leading, causal indicator of demand and other economic conditions.
“… The bounce in the economy and the stabilization in markets reflect government actions that are big enough to impact near-term growth rates, but are not sufficiently directed at the root problem of excessive indebtedness to produce permanent healing. The deterioration in employment markets will continue because companies’ profit margins are so deeply damaged that a little bounce in growth won’t do much to alter their need to cut costs. This deterioration in labor markets will undermine demand and continue to pressure loan losses, which will keep the pressure on the banks and elevate the cost of capital for tentative borrowers, inhibiting credit expansion.”
So Bridgewater (and Mauldin too) are right to say that anyone who is telling you that recovery is near because employment lags, has it backwards. Bridgewater also has it right about weak profit margins; as this chart says, profits for the S&P 500 are down 90% year over year (h/t ritholtz.com).
If we understand Bridgewater’s thinking, they are telling us that employment lags during a “normal” recession that happens when the Fed tightens to head off inflation. The recovery from such a recession begins when the Fed gets around to cutting rates after it has accomplished its objective. We assume they are saying, that hiring would lag interest rate moves (and the economic recovery generated thereby) in such a scenario. And Bridgewater is saying, correctly, that this is a very different kind of recession, a recession caused by an overabundance of debt and the need for deleveraging in the private sector. In this recession, layoffs are actually helping to drive the recession forward rather than the other way about. Furthermore, interest rates are already at rock bottom and the low rates are failing to stimulate the real economy, because no one dares borrow, assuming the banks would be willing to lend in the first place.
We just feel at pains to make two obvious missing points. First, employment always lags the cycle because of normal business behavior. After all, when recovery starts, the first thing companies do to meet new demand is to ask existing workers to put in more hours. Only when employers are convinced that the rebound is for real, will they start new hiring. So… employment should usually lag changes in GDP, all other things being equal, no matter what the cause of a recession is.
The other point we would like to make is that the home mortgage interest rate reset problem has not gone away, and we can expect resets to force foreclosures on an ongoing basis for borrowers who can’t refinance. This in turn will continue to dump more distressed inventory on the market, provide more pressure on the banks, and keep housing starts depressed. We won’t really be finished with the bulk of mortgage resets moving through the system until 2012. And let’s not think about how brutal those reset rates could be, if the Treasury is forced to pay higher rates to place all the debt it will be issuing….
In this kind of environment we are left to scratch our heads when we wonder what can turn things around. The stimulus program should help some, and it is important to remember that it has not kicked in yet; only $100 billion or so has even been allocated. In addition we know that when consumer durables such as automobiles get old or wear out, people eventually have to replace them. The Calculated Risk blog claims that current rates of auto production would only suffice to replace the current US fleet in 27 years. Surely production will have to rebound from this level, right?
Most likely, but not so fast. After all, in our country, passenger vehicles outnumber licensed drivers. In a recession that is likely to be deep and prolonged, with people changing their spending habits, is it possible that the car population might actually drop in absolute terms as people scrap “extra” vehicles and don’t replace them? Or, less dramatically, could we see the ratio of cars to people drop as more families make new teenage drivers share an existing family car or pay for their own vehicle? We think both scenarios are possible. We like the idea of consumers returning to their senses, but we think we are just beginning to understand how that will look. Other than unpleasant for the economy, that is.
Chrysler’s former senior creditors have complained bitterly about the value they are to receive in the current bankruptcy settlement proposals. There has been lots of talk about what is “legal” under Bankruptcy Code Section 363, which allows for asset sales by debtors facing bankruptcy. Some lenders have also groused about how the government has “unfairly taken” property from bondholders. Our view, given our previous experience in junk bond portfolio management: while pre-existing lenders have every right to make their case in the press, they protest too much.
We know full well that in most cases senior creditors have a high priority claim on bankrupt companies’ assets, but (you knew there was a “but,” coming, didn’t you) senior creditors also know that in the ordinary course of Chapter 11 bankruptcy they get bumped down the line if a new party lends new money to keep the company going while it restructures. Usually that money takes the the form of debtor-in-posession (DIP) financing, which the government in fact provided. DIP financing immediately becomes senior to the claims of ALL existing lenders, according to well established precedent. Which makes sense because, a company goes bankrupt if it can’t repay its existing lenders. Why would a new lender step into the same position as the existing lenders?
Back in the 1990s when an over leveraged company with a good business model went bankrupt, it immediately lined up DIP financing to keep itself functioning while it restructured under court protection from creditors. Now DIP financing is harder to come by, as the banking system is weak and fromer key non-bank DIP lenders like GE Capital have also pulled back from the business. We can’t know if Chrysler would have gotten private DIP financing in the Nineties, but they failed to find it this time.
Therefore, the government (us taxpayers!) found it necessary to provide Chrysler’s DIP financing. This is an extraordinary situation, a loan by the taxpayers made to save a shaky company in a highly competitve industry. No one should be surprised that the government, which negotiates from a position of legal strength as a DIP lender, is trying to exact the terms it wants from the now more junior lenders.
Moreover when the old lenders cry foul they are asking to bailed out of some outlandish stupidity. These lenders financed the leveraged purchase of Chrysler from Daimler-Benz by the Cerberus private equity firm, a deal that helped signal the market top. Back in the heyday of LBOs, in the Eighties, investors knew that the purpose of an LBO was to unlock value from a non-cyclical company with stable cash flow. LBO deal makers targeted companies that could service a heavy debt load even during recessions. Leveraging up a cyclical company has always been thought imprudent, and leveraging up Chrysler, of all companies, really took the cake. The lead banks knew this deal was the industrial equivalent of a NINJA mortgage (no income, no job, no asset verification) and after originating the loans they hoped to sell these loans to others rather than keep them on their own books. But in the summer of 2007 the music stopped, and their bridge loans became non-salable, “pier” loans, as in, bridges to nowhere. Should they be spared a hit for this stupidity? Not in a capitalist system they shouldn’t. And that goes for all of Chrysler’s lenders, whether they’ve accepted TARP funds or not.
If the private lenders think the government is getting “too much,” or being too generous to the unions, they should remember this. The pre-existing lenders had their chance to put more money into Chrysler. They could have created their own senior DIP facility to keep Chrysler going, but they chose not to. So Chrysler went bankrupt, the government is playing a large role in Chrysler’s rescue, and the private lenders are shocked, shocked, that they don’t control the situation.
The original lead bank lenders might well have been right to let Chrysler go. By chipping in more they’d have risked throwing good money after bad, in a deal they’d never wanted to own for more than 90 minutes. But when a white knight saves the day by bringing gold, he makes the rules.
The market exploded upward today as buyers, worried about missing the rally, came in strong today. After a gap up this morning, and only a minor pullback at lunch, the market surged upward during the afternoon, led by of all groups, the financials to close at the highest level since mid January. We’re now positive on the year.
Much as I was worried about several weeks ago, as the market has slowly churned higher the past week or so, seems as if money of the sideline got real nervous that we may not actually get a pullback to make their buys. So when in doubt, chase. The Dow closed up 214 while the SPX added nearly 30 points to close at 907.24. Nearly everything was strong today including all the energy related sector including solar, Semis and Ag. But the star of the day was the financials with the BKX tacking on a whopping 15% today. The reason was that the small uptick in housing stats led many to believe that the banks are now out of trouble. Good luck. Guess these are the same banks who had to connive and use every trick in the book just a week ago to show any earnings. Even the report leaked that WFC would have to raise additional capital could not dent the enthusiasm. The top performers were JPM, WFC and AXP, up anywhere from 10-24%. Just amazing.
In other markets, gold barely finished on the positive side after being up big early in the day and silver finished in the red after being up early. The dollar was down just slightly.
I’m enclosing two charts tonight, the 5min showing the break to the upside today and the 60min SPX showing we’re not quite out of the woods yet.