Friday was a fresh record close for the TSX composite. Ending the day at 14,984, the broad market composite has now breached the previous peak marked last October and January. To be bullish from here one needs to believe that stock markets have now fully discounted world recession and credit crunch fears and have at last launched into the next bull market expansion in stocks.
Maybe they will. I wish I could believe this. My belief of course is irrelevant, only time will tell; but critical thought prompts us to look deeper than just the record close headline, and so we should look closely at underlying sectors for insight on present strength.
As I have noted in the past, the TSX 60 Index is overwhelmingly driven by the movement of its three main sectors Financials (29.45%), Energy (29.11%), and Materials (18.73%). The 60 largest cap Canadian companies that comprise the TSX 60 are the most relevant benchmark for our investible market, and in total the above three sectors account for more than 77% of the TSX 60 market cap. These sectors have undoubtedly been the patrons of our strong Canadian market gains since 2003, so their fate from here will be strongly indicative of our future market action.
When we break these main sectors down, we find that the all time high on the TSX this month has been heavily driven once again by energy and materials prices. Financials have continued to lag and have so far not yet broken out in a new up trend. And here is the rub, the higher energy and material prices go the worse it is for the rest of the economy including the profitability of the energy and materials companies themselves as their costs balloon and their production slips.
With oil nearing $130 a barrel, energy prices are scaring all but the most aggressive traders. Many that have been professional oil traders for the past 30 and 40 years are shaking their heads and warning that prices at present levels have gone too far too fast. Traders are estimating that anywhere from $10 to $70 of the present price is based on pure momentum speculation that prices will go higher still. See Oil Prices: Wall Street's game. This type of action brings concerns of a “bubble” forming.
Even in the US, if one strips out Exxon, Chevron and ConocoPhillips, profits at US companies are at their worst level in a decade. Without the profits from oil producers in the past 2 quarters, profits in the other S&P 500 companies tumbled about 30%. With data suggesting on-going economic weakness in the US and many other countries around the world, more earnings downgrades seem likely over the months ahead. See Oil Producers Mask Decade’s Worst S&P 500 Profit Drop.
At some point in this economic down cycle, demand slack will ultimately dent commodity prices. At the same time, the US 10-year Treasury yield having been negative in real terms for many months is now about equal to CPI. Negative real yields were another leg in support of the recent commodity price boom, positive real yields will also help shift capital out of commodities. The trouble is that historically commodity price corrections (even within secular bull trends) have been sudden and dramatic. History offers us our warning here, we must govern our animal spirits accordingly.
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Danielle,
I agree with much of what you're saying.
However,…you knew there was a 'however', right? 😉
“And here is the rub, the higher energy and material prices go the worse …including the profitability of the energy and materials companies themselves as their costs balloon and their production slips.”
I must disagree with this statement. I understand the rationale but historically during a secular commodity cycle it is not accurate. You have a point that this is true with the big traditional oil companies at present like Exxon etc… but that is only because agreements inked with some countries hand over a much greater share of the profit to those governments at oil prices so far above what big oil predicted when they signed those agreements. In fact, this is precisely why big oil was fighting the oil price all the way up and insisting that it would come down. Essentially, management bet wrong in a big way on these deals. I don't consider those companies well managed and their assets are overpriced since they are in politically risky areas, but they are the exception.
For the most part commodity producers will benefit greatly from rising material and energy prices for their products despite input costs rising. Why? Well, management is part of it – Suncor will continue to thrive for example based on their cost model. However, much more importantly historical precedent tells me that, in a secular commodity cycle, companies, even those like Valero (refining) which had astronomical rising input costs benefit strongly for one reason. During this cycle it is they who have pricing power under stronger demand conditions. They not only pass on price increases, they take advantage of it to increase margins. This is exactly what Valero did over the past 6 years.
It is exactly what occurred in the supermarket and meat producer arena in the 70s and will occur going forward. Companies like Smithfield et al will at some point profit handsomely after being in a bear market for 25 years because they will have pricing power just like Valero did.
With respect to materials companies like mining, costs have risen but they have risen much, much less than the selling price of many commodities. For example, gold has quadrupled in price but input costs certainly have not quadrupled. Keep in mind also that we have not even seen the driver of the second upleg yet (inflation expectations). As Donald Coxe and Felix Zulauf are fond of saying – You do not, in general, buy mining companies in a commodity cycle for the profit they generate. Rather you buy them for what their in ground assets will be worth in the future. Suncor can be considered in the same way. These companies have been cash cows, but once inflation expectations set in then you will see a re-pricing and PEs will go from 15-20 to 50+ at some point. Simultaneously, one would expect a rout in the bond market. Of course, de-leveraging during a credit bubble burst puts everything at risk. This is not to say that commodities which may have gotten ahead of themselves like oil in the short term could not correct sharply- chances are they will correct sharply.
“At some point in this economic down cycle, demand slack will ultimately dent commodity prices.”
Yes, this is logical. However, it has been Asian consumers who have largely set the prices of commodity prices, so it is important to consider whether 10% year over year grow (exponential) reduced to 5% yoy is worth timing. If Asia still uses more materials than they did last year and supplies of copper, for example, are not keeping apace then….
All bets are off if massive de-leveraging increases which I suspect there is a strong chance of. Credit derivatives losses have not even been priced in. Off setting this at the moment, inflation expectations seem to be rising and import product inflation was just reported at 23.9% yoy in the U.S. Once the cost of meat rises in the supermarkets, look out, history tells us that food and fuel will then propel not just prices, but expectations of prices. Consumers hoard, companies throw JIT out the window and real demand increases and the financial markets undergo a massive downward revaluation in bonds and upwards revaluation in commodity equities.
If you can time it all, more power to you.
-Sonny in NYC