Archive for September, 2008

What is the meaning of ?oversold?? Part 2: Value perspective

Tuesday, September 16th, 2008

Continuing from our previous article, What is the meaning of ?oversold?? Part 1: Technical analysis perspective, we will explain the meaning of “oversold” from the value-investing perspective.

In Are some Aussie resource stocks oversold?, Pete, our regular reader commented that,

So on one hand, if demand is the same, then they are oversold, but on the other hand, if demand is decreasing, then even though they are currently oversold, the current oversold price may become a nominal price in the near future?
Eg: BHP shares may be worth $40 now, but trade at $35 or so. But due to lack of demand, by December, they may only be ‘worth’ $35. Although by then my guess is that they would be oversold even more to $30, etc.

On that note, when we say the resource stocks might be oversold, is it perhaps a bit like real-estate, where they are in fact not oversold at their current prices, but were in fact ‘over-bought’ in the first place, and are now returning to more normal levels? Perhaps they are still overbought now, just less so?

Before you read on further, please make sure that you understand the concept of value investing in our guide, Value investing for dummies. Particularly, pay attention to the first 4 articles. What follows will assume the pre-requisite understanding of these articles in the guide.

The important things to understand about the mining business is this:

  1. It’s revenue is very much dependent on the price of the commodities it sells (this is a very obvious point).
  2. It’s a price taker in general. In other words, most mining businesses do not have the market power to affect prices. The exception will be BHP and Rio Tinto as they have enough market power to affect the price of iron.
  3. It’s products (e.g. copper, zinc) is relatively very much un-differentiable from those of their competitors unlike the more traditional businesses.
  4. A mining business do not have an theoretical infinite life as some other traditional businesses. That is because ALL mines have a finite amount of the commodity that can be economically extracted. In other words, there is a finite life to every mine/oil/gas field at a specific rate of extraction.

The problem is, the future earnings of a mining company is notoriously difficult to predict. For example, these factors will affect the future earnings:

  1. Commodity prices (that’s obvious point).
  2. Cost of its input (energy is one of the major inputs and that in itself is a commodity whose prices are at the mercy of the markets).
  3. Exchange rate. Since commodity prices are denominated in US dollars, an Australian mining business’s earnings will be dependent on the exchange rate.
  4. The future quantity of the commodities it will produce. Obviously, profits rise when the sale price increases or the quantity of the produce increases. That will depend on the outcome of the development and exploration projects of the mining business.

Within point (1) i.e. the commodity price, there are many factors that will have impact on it:

  1. Underlying demand- this is the real physical demand of the commodity needed by people and nations.
  2. Investment demand or hoarding- This is the second type of demand in which the buyers and sellers do not have interests in the physical commodity. Instead, they trade the commodity in the context of money shuffling.
  3. Physical supply of the commodity- for example, as commodity prices collapses, some mines become uneconomical and close down as a result. This will reduce the supply of commodity produced. Other supply disruptions include strikes, natural disasters and so on. Or there may be new mining projects that start to produce and increase the supply to the market.

Now, let us look at point (1) and (2) that affects the price of commodities. As we explained before in Analysing recent falls in oil prices?real vs investment demand,

Now, let?s go back to oil. What makes up the demand for oil? There are basically two types of demand for oil: (1) The physical demand where the real side of the economy uses for its everyday needs and (2) The investment demand where the financial side of the economy shifts the money here and there from one asset class to the other. We need to ask ourselves the following question: Has the physical demand for oil changed? Will it change in the long run?

In today’s globalised financial system, the investment demand (we like to call it “hoarding” instead) has increasingly significant impact on prices. To complicate the issue, it is very difficult (or impossible, depending on your theoretical inclination) to sift between investment demand and physical demand as the commodity trades are made through complex web of intermediaries and relationships. As we questioned in Price fluctuations and hoarding

In today?s context, does a sudden fall in the price of a commodity (e.g. oil, iron, grain, wheat) mean that its underlying demand has suddenly fallen or its supply has suddenly increased? Obviously, the answer is no.

Let’s say that prices were originally too high because of the artificial demand from investment (or rather, hoarding). Now that the de-leveraging process (see Is the credit crisis the end of the beginning?) is under way, forced liquidation and flight from commodities from these investors/hoarders will send prices down very rapidly. As the change in physical demand/supply of commodities tend to move very much slower (relatively) than the change in investment demand/supply, we believe that this forced selling will tend to cause prices to undershoot (i.e. drop to too low) in the short term.

Now, consider this: as price falls by a lot all of a sudden (due to the sell-off by investors/hoarders), guess what will happen to the physical demand? Obviously, physical demand will increase. To a certain extent, this sell-off will result in a change in the composition of demand (between physical and investment demands). If the miners can increase production in response to increased demand, this will counteract the negative effects of falling prices on profits.

Next, as we mentioned before in Are some Aussie resource stocks oversold?, although commodity prices are falling in US dollars, it has not fallen as much in Aussie dollars.

Another consideration: as investors/hoarders sell commodities indiscriminately, the prices get undershoot. The stock market tends to overreact and price the business as if the prices of commodities will fall even further as rapidly as before. That is, it extrapolates the direction and speed of further commodity price falls too far out. It also tends to ignore the positive counteracting effects on profits as well (e.g. increased physical demand and falling Aussie exchange rate). Now, we will have a second ‘layer’ of price undershooting.

Finally, we will provide a qualifier: it is still possible for commodity prices to fall further in say, 2009 and 2010. But assuming that:

  1. Central bankers will eventually resort to money printing (see Understanding the big picture in the inflation-deflation debate) in the context of…
  2. long-run growth in Chinese and Indian demand (see Are we in a long-term inflationary environment?) and
  3. Physical demand will not collapse as much and as suddenly in the longer term as the short-term prices seem to suggests, …

… we believe that the long-run earnings of some mining businesses may not be as devastating as what their stock prices suggests. If these resource stock prices continue to plunge further, it will come to a point that it will be priced as if there will be a devastating world-wide Greater Deflationary Depression along with perpetual Chinese/Indian anarchy/revolution/chaos.

But having said that, remember that as we said before, all mines/oil/gas fields have a finite life. In the absence of potential new production from future exploration and mining development projects, a mining business will cease after an estimated number of years, after the supply of commodities are being exhausted. The implication is that if the downturn is severe and long enough, some mining businesses may not last long enough to be able to realise the value of the long-term inflationary trend of commodities. On the other hand, a mining business may choose to ‘extend’ the life of its mines by hibernating (e.g. laying off workers, entering maintenance mode and doing nothing) and waking up when commodity prices are more favourable for production.

A warning though: we are not suggesting that you go out and throw all your entire life-savings into any resource stocks now. Not all resource stocks are undervalued right now. And there is still scope for further commodity price deflation in 2009 and 2010. You have to do your homework and look at each company on a case-by-case basis. Even then, after you have decided which stock to buy, you still have to decide at what price you think it is a bargain. Even then, you still have to decide when to buy. And yet even then, this does not mean that stock prices will not fall further.

We will finish this article with an interesting quote on Jimmy Rogers (see Jim Rogers Talks About Latest Investment Activity) for you to think about:

The bull market [in oil] will not end until somebody finds a lot of oil, or unless we have worldwide economic collapse, perpetual economic collapse…

I will tell you I’ve not sold any oil. Even if it goes to $75, I don’t plan to sell any oil.

Do NOT see it as a recommendation for oil or oil stocks (note that Jimmy Rogers has an interest in oil). Rather, see it as window to his line of thinking.

Test for credit default swaps (CDS) begins…

Monday, September 15th, 2008

We are supposed to continue from yesterday’s article, What is the meaning of ?oversold?? Part 1: Technical analysis perspective, today. But the latest news on the financial markets takes precedence over the continuation of yesterday’s article.

As you will probably have heard by now, Lehman Brothers, one of the biggest investment banks in the United States has just gone bankrupt. Its peer, Merrill Lynch was bought over by Bank of America at a fire-sale price. Central bankers all over the world are bracing for vicious reactions from the financial markets. In Australia, the RBA had already injected extra liquidity into the financial system (see Reserve Bank injects extra liquidity). The Federal Reserve is intending to already made preparation for accepting stocks as collaterals for loans, as this news article says,

One of the biggest changes the Fed made was to accept equities as collateral for cash loans at one of its special credit facilities, the first time that the Fed has done so in its nearly 95-year history.

As we said before in Central banks and pawnshops,

Traditionally, the Fed would only accept the highest quality assets, US Treasury bonds, as collaterals. But due to the credit crisis, the Fed (along with other nations? central banks- see Reserve Bank of Australia entering the landlord business) is lowering the standards of collaterals to include top-rated residential and commercial mortgages. The Fed?s most recent statement indicates that they are lowering the standards even more (to auto loan and credit-card bonds). Using the pawnshop example, it?s like the pawnshop lowering the standard of the pawns that it will accept, say from gold jewellery to silver jewellery.

By accepting equities as collaterals, the Fed is lowering their standards even more. The central banks may be preparing and bracing for devastating fallout in the debt and equity market, but the question still remains: will the derivatives markets able to stand in the coming test? As we quoted Satyajit Das in How the CDS global financial time-bomb may explode?,

CDS documentation is highly standardised to facilitate trading. It generally does not exactly match the terms of the underlying risk being hedged. CDS contracts are technically complex in relation to the identity of the entity being hedged, the events that are covered and how the CDS contract is to be settled. This means that the hedge may not provide the protection sought.

This introduces systemic problems to the financial markets that have yet to be tested. Here are the technical difficulties with CDS:

  1. Who problem– As we explained before in Potential global economic black hole: credit default swaps (CDS), CDS is like insurance against default by a specific entity. Let’s call this entity the reference entity. The problem is, modern companies work through a complex web of entities mainly for tax reasons. What if the reference entity in the CDS does not match exactly with the defaulting entity? Furthermore, what if there is a restructuring, merger, de-merger, sale of divisions, break-ups takeover, etc. The definition of the reference entity becomes murky.
  2. What problem– What events constitutes a “credit” event? The common ones are (1) failure to pay, (2) bankruptcy, (3) repudiation or moratorium, (4) restructuring. But sometimes in real life, “credit” event may not be that straightforward. Restructuring may follow further restructuring, followed by even more… Different countries may have different laws regarding the form, definition and handling of bankruptcy that is at odds with local laws, which in turn put the CDS contract into a conundrum of definitions. As we quoted Satyajit Das in Potential global economic black hole: credit default swaps (CDS),

    The buyer of protection is not protected against ?all? defaults. They are only protected against defaults on a specified set of obligations in certain currencies. It is possible that there is a loan default but technical difficulties may make it difficult to trigger the CDS hedging that loan…

    A CDS protection buyer may have to put the reference entity into bankruptcy or Chapter 11 in order to be able to settle the contract.

    Imagine the economic mayhem it will create as companies push and jostle each other into bankruptcy at the slightest excuse to protect their own cash flow!

  3. How problem– How do you get paid the insurance payment in a CDS contract? Should you rely on publicly available information and use it as a basis to get paid? What if the reference entity makes a partial payment and then the news wire reported that it defaulted when it is going to pay the rest later?

By now, you can see how the idea of CDS can be mired into complex legal entanglements. This will have systemic ramifications for the financial markets. We will be holding our breath to see how the drama will unfold in the weeks and months to come.

What is the meaning of “oversold?” Part 1: Technical analysis perspective

Sunday, September 14th, 2008

In our previous article, Are some Aussie resource stocks oversold?, we said that

Thus, if you look at some of the massive falls in some of the smaller resource stocks, it looks that they are being oversold.

Thanks to the comment of one of our reader, Pete, we realise that there are a lot of subtleties and meaning packed in this simple word “oversold.” As such, depending on your perspective of this word, misunderstandings can arise. Therefore, we will give this word a fuller treatment.

For today, we will approach this word from the perspective of technical analysis. In technical analysis, there is a class of indicators called the “momentum indicators.” Examples of this indicator include stochastic, Relative Strength Index (RSI) and so on. Basically, these indicators measure the momentum of price movements. If the momentum is far too much on the upside, then it can be said that the prices are “overbought.” Conversely, if the momentum is far too much on the downside, then they are “oversold.”

The theory behind momentum indicators is that at the either extremes (i.e. oversold or overbought), it is a matter of time before exhaustion sets in and cause prices to reverse. In that sense, these indicators are contrarian in nature because it tells the technical analyst to sell when prices are overbought and buy when they are oversold.

So, when we apply this concept to the Australian dollar, gold, commodity and resource stock prices, many of their momentum indicators indicate that their prices are ‘oversold.’ Therefore, in the days to come, it will not be surprising to see that their prices will stage a counter-trend rally as traders who utilise technical analysis starts buying.

In the next article, we will explain the perspective of “oversold” from the value-investing perspective. It will be a long one.

Are some Aussie resource stocks oversold?

Thursday, September 11th, 2008

Over the past couple of months, we are witnessing price deflation almost all asset class, including commodities. This huge falls in commodity prices is hardly surprising. As we explained back in March 2007 in Warning: gold price can still fall significantly,

When the inevitable liquidity contraction occurs, gold price will fall as well.

18 months had gone past since that article was written. Today, we are witnessing the deflation that we had been waiting for. In this deflation, commodity prices in general are falling. It is in this context of falling commodity prices that many Australian resource stocks are falling, especially the smaller cap ones. Many of them are even falling below their 12 month lows. The market’s logic is that falling commodity prices imply falling revenue and therefore profit will fall.

Is this logic correct?

First, commodities are priced in US dollars and they are falling in terms of US dollars. Next, the Australian dollar is perceived to be a commodity currency and tend to have some correlation with commodity prices. In that context, as commodity price falls, the Australian dollar tends to follow along to a certain degree.  At this time of writing, the Australian dollar is worth of US$0.795. In just 1 ½ months, the Aussie dollar has fallen almost 20%!

Therefore, in terms of Aussie dollar, the fall in commodity prices is not as bad as it looks. However, some costs may rise may rise due to rising price of oil in terms of Aussie dollars. Everything else being equal, a falling Australian dollar is actually good for the bottom line of resource producers.

Thus, if you look at some of the massive falls in some of the smaller resource stocks, it looks that they are being oversold.

How is the US going to repay its national debt?

Wednesday, September 10th, 2008

As we all know, Fannie Mae and Freddie Mac were being nationalised a couple of days ago. The US government has put in $US1 billion of new capital (in the form of preferred shares) and says it might put in up to $US200 billion more. At the same time, it will take over the management of these two companies. Consequently, the stock market all over the world cheered this news in exuberance.

This is a farce.

There is a cost to this nationalisation, which as we said two months ago in How do we all pay for the bailout of Fannie Mae and Freddie Mac?,

The collapse of Freddie Mac and Fannie Mae will result in a colossal deflation. Can the US allow such an unthinkable to happen? If the answer is no, then inflation is the only path out of it, in which the road to hyperinflation hell begins. This is also unthinkable. Which road will the US take? If the US takes the latter route, all of us will be paying for their bailout via inflation.

Now consider the situation of the US government budget as reported in ‘Frannie’ bailout heavy with irony:

According to the US Government’s Accountability Office the national debt stood at $US4.4 trillion early this year. Unless the habit of deficit spending is arrested quickly this figure will double in the next ten years.

Meanwhile, the social security system faces an unfunded liability estimated by the Government Accountability Office at $US6.7 trillion and the unfunded liability of Medicare is $US34 trillion.

If the US government has to bail out more and more blow-ups in the financial system, there is only one way the level of national debt can go: up and up to the sky. It has come to a stage that the word “billion” is not enough to describe the magnitude of the debt- “trillion” has used instead. That level of debt is approximately $150,000 for every man, woman and children in the United States.

Is the US government going to pay all these debt by raising taxes? With rising unemployment, record levels of private debt and wobbly economy, do you think this idea can ever be entertained? If it is politically impossible to raise taxes, what else can be done? Default or print money?

Strangely, the market reacted to this news by bidding up the US dollar.

Upcoming forum debate: “Property 2009: Crash, Boom or Stagnate?!”

Monday, September 8th, 2008

Note: This is an announcement for an event that we are co-hosting with OurFinanceBlogs:

Property has been a popular route to wealth for many Australians for many years. Buying their own home is often the first investment many people make; purchasing another property may well be the second even before shares and other assets.

It has been said that property prices can be less volatile than share prices though not always and it tends to be regarded as a safe haven when other assets are declining in value. Property has the potential to generate capital growth as well as rental income. In addition, there are the tax advantages associated with negative gearing and capital tax concessions.

No wonder property investing is one of the favourite mainstays of investments for Australians.

But there is the dark side of property as well. Over the past 10 years, property prices have been surging faster than the rise in wages. Consequently, the level of debt that comes with this phenomenon has increased significantly for Australians, putting many of them in serious debt situations. As a result, the Australian dream of home ownership has become an elusive hope as housing becomes more and more unaffordable, along with soaring rents.

Without a doubt, this issue is polarising Australia, as there is an increasing perception that some in the community are benefiting from property at the expense of others. Whether this perception is justified or not, it is a making property more and more into a vested emotional issue for the Australian community. Consequently, with the Australian economy at the turning point after 17 years of uninterrupted growth and the global financial system rocked by a credit crisis, we are seeing conflicting forecasts by various experts on the future of Australian property prices.

So, what is the future for Australian property prices?

It is in such a time that clear thinking is urgently required. And so, on the 15th of October 2008, we are inviting members of the Australian online community to a debate on property at ?Property 2009: Crash, Boom or Stagnate?!? We will be inviting the various high-profile experts to this debate. Stay tuned as we reveal who they are!

Property 2009: Crash, Boom or Stagnate?!

Are commodity prices at a longer-term or short-term peak?

Sunday, September 7th, 2008

In just a couple of weeks ago, we mentioned in Will deflation win? that deflation is gaining the upper hand. For those who are following us for a very long time, this development is hardly surprising. You may want to read that article to gain an understanding of what is happening.

Today, we will provide additional commentary from Marc Faber about the current situation. Recently, he was interviewed (you can see that a partial transcript of that interview here). Regarding commodities, he has this to say:

The second half of 2008 of this year would not be favourable for commodity prices… As far as I?m concerned, we peaked out in commodity prices, and later on we will have to see whether it?s a longer-term peak or a short-term peak. But we don?t know yet.

Now, let us put this comment in context. Around a couple of months ago, Marc Faber told his subscribers that commodity prices have peaked and it’s a time to sell commodities. The question is, whether this is a longer-term peak or just a short-term peak. As you can read from our earlier article, Will deflation win?, it is in this context that commodity prices are falling.

At this point in time, you may wonder why there is a feel of uncertainty in Marc Faber as he said, “whether it?s a longer-term peak or a short-term peak. To understand his doubt, let’s turn to our earlier article, China?s slowdown & its implication for Australia,

At this point, we have to ask these crucial questions: (1) Is this Chinese slowdown merely a temporary blip for the sake of the Olympics (i.e. after the Olympics, the break-neck growth will resume again)? (2) Or is it, as we explained in Will China slow down from 2009?, a chance to catch a breather for a while? (3) Or worse still, a pre-cursor to a major economic correction, as we explained in Can China really ?de-couple? from a US recession??

At one extreme, if point (1) is true, we may see a resumption of the up trend in commodity prices in the short-term. If point (2) is true, commodity price may stagnate or drift lower in the short to medium term. If point (3) is true, which is the worst case scenario, we will see a depression in commodity prices at least in the medium term. This worst case scenario can play out as a Greater Depression (that rivals the Great Depression of the 1930s).

But having said that, if point (3) (severe deflation) is to occur, the wild card will be how the governments and people choose to handle it. If they react by repealing the credit-system mechanism (see Understanding the big picture in the inflation-deflation debate for what this means), then the end game will be hyper-inflationary type of Depression (see What if the US fall into hyperinflation?).

Thus, it is in this backdrop of uncertainty that Marc Faber is advising investors to hold their fire and wait and see. Of course, all these has to be viewed in the context of the long term as we describe in Are we in a long-term inflationary environment?.

Do sentiments make the economy or the economy makes the sentiments?

Thursday, September 4th, 2008

Not long ago, we had lunch with one of our friends. Invariable, the conversation turned into the economy. Judging from the quantity of bad news (e.g. sub-prime, credit crisis, inflation, recession threats, oil prices, falling stock prices, etc.) from the media lately, our friend remarked that “I can tell something is wrong with the economy.” Indeed, we believe large segments of the population are thinking the same too. That’s why surveys are reporting falling business and consumer confidence.

Clearly, sentiments are turning for the worse.

In the midst of economic uncertainties, it is very easy to blame the cause of worsening economic conditions on sentiments. Politicians are fond of using this myth (whether deliberately or out of ignorance). For example, Malcolm Turnbull (Australia’s shadow Treasurer) accused Wayne Swan (Australia’s Treasurer) for “talking up” inflation, as if the tongue of Wayne Swan has the power to move economic forces. But is sentiment so powerful that it can move economic mountains? On Tuesday’s ABC 7:30 Report, Malcolm Turnbull stated in an interview that had it not been Wayne Swan’s talk, consumer confidence confidence would not be so low and the RBA would not have to raise interest rates that much.

But do sentiments make the economy or the economy makes the sentiments?

We do not subscribe to the theory that sentiments alone are the root cause of the business cycle. In fact, as we explained in What causes economic booms and busts?, the business cycle has its roots on human decisions and actions. It is not swayed by the cyclical tide of sentiments. But having said that, sentiments can accentuate the effects of the underlying root causes.

This remind us of a story by Marc Faber,

It was autumn, and the Red Indians on the remote reservation asked their new chief if the winter was going to be cold or mild. Since he was a Red Indian chief in a modern society, he couldn?t tell what the weather was going to be. Nevertheless, to be on the safe side, he told his tribe that the winter was indeed going to be cold and that the members of the village should collect wood to be prepared.

But, being a practical leader, after several days he got an idea. He went to the phone booth, called the National Weather Service and asked, ?Is the coming winter going to be cold??

?It looks like this winter is going to be quite cold indeed,? the meteorologist at the weather service responded.

So the chief went back to his people and told them to collect even more wood. A week later, he called the National Weather Service again.

?Is it going to be a very cold winter??

?Yes,? the man at the National Weather Service again replied, ?It?s definitely going to be a very cold winter.?

The chief again went back to his people and ordered them to collect every scrap of wood they could find. Two weeks later, he called the National Weather Service again.

?Are you absolutely sure that the winter is going to be very cold??

?Absolutely,? the man replied.

?It?s going to be one of the coldest winters ever.?

?How can you be so sure?? the chief asked.

The weatherman replied, ?The Red Indians are collecting wood like crazy.?

RBA’s interest rates dilemma

Wednesday, September 3rd, 2008

Yesterday was the first time in several years that the Reserve Bank of Australia (RBA) decided to cut interest rates. As you can read from the mainstream news media, this fall in interest rates is not necessarily good news. For example, Ross Gittins from the Sydney Morning Herald said in Yippee, the bad times are back,

YOU beauty. Interest rates have been cut and happy days are here again. For good measure, we’ve even got petrol prices coming down.

Sorry, don’t be too sure about that. The Reserve Bank has cut its official interest rate only because times are getting tougher.

But our loyal readers should already know about this fact long time ago. Back in July last year (2007), when the talk in the market was still about booming asset prices and inflation, we warned in Should you purchase first home whilst asset price inflation?,

… it is prudent to arrange their finances with the assumption that interest rates are going to be in an upward trend for at least in the medium term. Having said that, it is still possible for interest rates to be cut? when the economy is hit by a threat of recession or depression

While those heavy in debt would welcome RBA’s interest rate relief, there are still many unresolved complications. The most important thing to remember is that Australia’s price inflation problem is still not yet resolved. The RBA is forecasting rising price inflation till the end of the year at least. Normally, no central bank will cut interest rates in the face of rising prices. But this time, they have a bigger worry than rising prices- economic recession. In other words, Australia is facing stagflation (economic stagnation/downturn and rising prices) and the RBA is more worried about the ‘stag’ part of the stagflation. And they are betting that the ‘stag’ part will somehow resolve the ‘flation’ part.

But from what we can see, the RBA’s hands are tied. If they try to prevent the slowdown from turning into a rout by slashing interest rates aggressively, it is very likely that the Aussie dollar will continue its down trend. As we explained before in Falling currency and inflation,

A rapid depreciation of the Aussie dollar will result in rising price inflation for the same reasons stated above.

We do not envy the job of the RBA. It looks like Australia may be moving towards the same path as the US (see Supplying never-ending drugs till stagflation).