Posts Tagged ‘de-leveraging’

Deleveraging of Australia’s private sector

Thursday, June 3rd, 2010

Back in Significant slowdown for Australia ahead?, we explained how the slowdown in credit growth can suck away aggregate spending in the economy. Today, we will show you credit growth in Australia from January 2000 to April 2010:

Credit Growth (YoY) Australia

As you can see, year-on-year credit growth almost ZERO on November 2009 before bouncing up and then returning down from March 2010 onwards.

As you can see, such a precipitous fall in credit growth should be very painful for the economy. However, the reason why it did not fall into serious recession was due to the crutch of government spending.

If the private sector continues to de-leverage, then the government will have to continue spending in order to prevent the economy from falling into recession. If so, then it means that the budget deficit will have to continue to grow.

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Posted in Economics/Finance, Looking Forward | 3 Comments »

Significant slowdown for Australia ahead?

Sunday, May 30th, 2010

How to buy and invest in physical gold and silver bullion

Recently, we noticed a trend emerging in the Australian economy- retail discretionary spending seems to be falling off significantly. As this news article reported,

But conditions in the retail sector are savage. Consumers are buying less, despite one of the most ferocious discounting wars in history. With the two department store heavyweights, Myer and David Jones, battling it out for customers, the smaller retailers are caught in the crossfire, forced to match the prices or do better.

The latest Australian Bureau of Statistics figures show the household goods sector posted a sharp fall in prices, down 3.6 per cent, making it the second-biggest quarterly fall over the past 11 years. The first-quarter CPI showed particularly large price falls for furniture and furnishing, down 3.8 per cent, and audio visual and computing down 5.9 per cent. The next figures will be even uglier for retailers, whose margins are being cut to ribbons.

Elsewhere, Virgin Blue suffered a big fall in share price as it warned that

… earnings could plunge as much as 75 per cent due to a ”rapid deterioration” in demand from leisure travellers.

It seems that the retail industry is doing it tough. Sectors of the Australian economy related to consumer spending are in pain. Like the US economy, most of the Australian economy are related to consumer spending (say around 60%). Therefore, this trend, if continued, indicates that a major slowdown in the Australian economy is coming. A recession cannot? be ruled out.

The mainstream media will quote mainstream economists and put the blame on rising interest rates, Greek contagion and China? slowdown and so on. Blame will be laid on these “shocks” to the economy that cause consumers to “lose confidence.” That implies that to reverse this trend, consumers will have to be brainwashed to be ‘confident’ in order to spend their way to economic prosperity.

This is an example of voodoo economics for the masses. If this is the correct diagnoses for the ills of the economy, then we have a better idea for an economic ‘stimulus’ package (that will be much far more effective than the Rudd government’s $900 cash splash during the GFC)- distribute $900 worth of Myers/David Jones vouchers (that? will expire in 3 months time) to the masses. We can guarantee that within 3 months, consumers will regain their ‘confidence’ and spend, spend and spend.

Since consumer ‘confidence’ is the wrong diagnosis, then ‘stimulation’ is the wrong cure.? As we wrote in Will governments be forced to exit from ?stimulus??,

In fact, the word ?stimulus? is the most misleading word in economics lexicon because it conveys the idea of a surgeon ?stimulating? a heart into self-sustained beating. In reality, what government interventions did was to put the economy on a crutch.

What is the root of the problem?

Remember, back in Australia?s credit growth is still falling, we wrote that

… for an economy that is addicted to debt, all it needs to tip it into a recession is for credit growth to slow down- no contraction of credit is required. Also, as Professor Steve Keen explained, at this stage of the debt cycle, the aggregate spending in the economy is made up of income plus change in debt.

To understand why, consider this highly simplified hypothetical situation in the economy:

$80 (income) + $20 (change in debt) = $100 (Aggregate spending)

As you can see, of the $100 of economic activity, $20 is the result of an increase in debt. Assuming that next year, the situation looks like this:

$83 (income) + $15 (change in debt) = $98 (Aggregate spending)

Income goes up, but people decide to borrow less. Note that when there’s less borrowing, it does not mean that the total amount of credit in the economy has declined. Instead, it means that credit is still growing, but it is growing at a slower pace.

As you can see from this example, if income remains stagnant and credit growth slows down, the total amount of aggregate spending in the economy will decline, tipping the economy into recession (unless it is the government which increase the spending to fill the gap).

What if next year, everyone decides to stop borrowing (i.e. total credit remains the same)? The equation will look like this:

$83 (income) + $0 (change in debt) = $83 (Aggregate spending)

If aggregate spending falls from $100 to $83, it will be a depression for the economy. What if everyone decides to save, and thus repay their debts? The equation will then be:

$83 (income) + $ -5 (change in debt) = $78 (Aggregate spending)

The situation is worse!

Thus, you can see that for an debt-addicted economy like Australia, if wage growth is constricted, the only way for the economy to grow well (in nominal terms) is for debt to grow at faster and faster rate. Obviously, this is unsustainable because if debt grow faster and faster than wage growth, it will be only a matter of time before the entire economy becomes sub-prime. When that happens, there will be an almighty crash, which in Australia’s case, is likely to result in a currency crisis (see Serious vulnerability in the Australian banking system).

If the government decides to borrow to supplant the private sector’s decline in borrowing in order to maintain economic growth, then the budget deficit will continue to grow. Again, this cannot go on indefinitely because Australia will end up like the PIIGS countries.

One more point, up till now, all these growth are in nominal terms. But what about in real terms?

As we know, it wasn’t long ago that there were media reports of “skills shortage” in Australia. Also, it is clear that Australia requires more “nation building” due to lack of infrastructure. This means that Australia is at the limits of its productive capacity. That means that even if Australia somehow manages to grow in nominal terms, it will be achieved at the expense of higher price inflation. That will attract more interest rate hikes from the RBA. As we wrote two years ago in Why does the central bank (RBA) need to punish the Australian economy with rising interest rates?,

The Australian economy was already running at full steam. Accelerating price inflation is a sign that there are insufficient resources in the economy to allow for all investment projects to succeed and all consumptions to carry on. If this trend is not arrested, the economy will run out of resources, resulting in a crash. Therefore, in order to put the economy back into a sustainable growth path, consumptions and investments have to slow down in order to allow for the economy to catch a breather for the rebuilding of its capital structure. The rebuilding of capital structure is necessary for the economy to replenish its resources for the future so that growth can continue down the track. Unfortunately, this rebuilding itself requires resources now. Therefore, current wasteful consumptions have to be curtailed and mal-investments have to be dismantled to make way for the rebuilding. The curtailment of consumption involves consumers spending less and saving more, while the dismantling of mal-investments involves retrenching workers, liquidating businesses, e.t.c. These involve pain for the people of Australia.

As we all know, the RBA raised interest rates 6 times already and that is the probable reason consumers are de-leveraging (i.e. borrow less and/or repay debts).

To put it simply, a glass ceiling is blocking the Australian economy. If you can feel that the quality of your life is also hitting the glass ceiling, then you know this is the reason.

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Posted in Economics/Finance, Looking Forward | 4 Comments »

Government taking tougher line on debt and bubbles

Tuesday, July 28th, 2009

To be a successful investor, one must be be aware of the sea-changes that are happening in the economy and financial markets. One of the sea-changes is in the line of central bank thinking. As we wrote in How are central bankers going to deal with asset bubbles?, central bankers are now more ready to deal with asset price bubbles than before. Previously, central bankers were targeting price inflation rate with their monetary policy while they stood idly by to let house prices form a bubble. As Glenn Stevens, governor of the RBA said today as reported in this mainstream news article,

Not only would it confirm that there are serious supply-side impediments to producing one of the things that previous generations of Australians have taken for granted, namely affordable shelter, it would also pose elevated risks of problems of over-leverage and asset price deflation down the track.

Please note that we are not endorsing the economic literacy level of that news article. Rather, we are quoting Glenn Stevens to show you what is going on inside his mind. The RBA is also hinting repeatedly that the next move in interest rates is up. Basically, the RBA is telling Australians this: you better wake up from your old ways and get serious about repaying your debts because the party is over.

This line of thinking is in sharp contrast to China’s central bankers, who are allowing a debt bubble to grow (see Is China setting itself up for a credit bust?) and spill over into asset prices (e.g. property and stocks).

The next sea-change is the change in the line of thinking from our dear Prime Minister, Kevin Rudd. He wrote in his essay published a few days ago,

The roots of the crisis lie in the preceding decade of excess. In it the world enjoyed an extraordinary boom… However, as we later learnt, the global boom was built in large part on a three-layered house of cards.

First, in many Western countries the boom was created on a pile of debt held by consumers, corporations and some governments. As the global financier George Soros put it: ?For 25 years [the West] has been consuming more than we have been producing … living beyond our means.”

…

Second, these debts were racked up on the back of sky-rocketing asset prices. In several countries, stock prices and house values soared far above their true long-term worth, creating paper wealth that millions of households used as collateral for their growing debts.

…

This crisis has shown we have reached the limits of a purely debt-fuelled global growth strategy. Not only will the neo-liberal model of the past not provide growth for the future, its after-effects will make recovery more difficult. Mountains of global public and private debt, global imbalances, and a weakened global financial system will drag on global growth for a long time. As the renowned financial columnist Martin Wolf has written: “Those who expect a swift return to the business-as-usual of 2006 are fantasists. A slow and difficult recovery, dominated by de-leveraging and deflationary risks, is the most likely prospect.“

This had been what we were arguing for a few years already (see Aussie household debt not as bad as it seems? on January 2008 and The Bubble Economy in October 2006). Kevin Rudd has finally understood the root cause of the GFC- spendthrift ways financed by rising debt using bubbly asset prices as collaterals. Now, he acknowledges that de-leveraging (repayment of debts) will be the fashion for a long time, in contrast to the past few decades of increasing debts. For many Generation Xs and Ys, the change from profligate to more frugal ways will be alien to them.

Unfortunately, as the mainstream always do, both the RBA and government is one-step behind.

The global economy is like a heart-attack patient on a life-support system. He faced a near-death experience in the second half of last year. Today, his condition has stabilised. But it will be a long time before he will fully recover and be fit enough to run again as in 2007. What the government is doing today is to inject more steroids (targeted stimulus spending financed by public debt) in the hope to see the patient running as soon as possible. The result is a walking zombie on life-support system (massive liquidity injections via ‘printing’ money).

As we wrote in Marc Faber vs Steve Keen in inflation/deflation debate- Part 2: Marc Faber?s view, the government is in danger of painting itself into a corner with no exit strategy (even though they’re talking a lot about it). If the exit strategy fails, we know the result is very high inflation (maybe even hyper-inflation).

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Posted in Looking Forward, Market Observations | No Comments »

When will the next bull market for commodities arrive?

Tuesday, May 12th, 2009

Following from what we wrote at Does the major Chinese economic slowdown signify the end of the commodities boom?, what is our view on the long-term prices of commodities? To understand our view, you will have to follow our explanations below…

No doubt, the global financial markets have experienced a serious bout of price deflation for financial assets and commodities (except US Treasury bonds), especially in the second half of 2008. So far, government stimulus, bailouts, rescues and money printing are minuscule compared to the overwhelming tide of de-leveraging. It has been said that a value of US$33 trillion was wiped out from the global financial markets. So far, government interventions had only forked out at around a few trillions of dollars at most. These numbers are not meant to be accurate, so please do not quote us on that. The point is, compared to the amount of ‘wealth’ lost in the financial asset markets, government injections of money so far are just a small fraction of what was lost. If you include the coming de-leveraging by consumers in the real-economy, then the outlook for the economy and asset prices is even bleaker. Having said that, if governments continue to inject even more money unceasingly, it’s only a matter of time reflation will occur. Indeed, the current rally in commodities and stock prices shows that reflation is working for now.

So, while asset (and commodity) prices are deflating at such unprecedented speed, what will happen to real physical investments in the real economy? Such volatility in prices will make it very difficult for businesses to engage in long-term real capital investments. Using the mining executive as an example in Real economy suffers while financial markets stuff around with prices,

For example, place yourself in the position of a mining company executive today. Commodity prices are falling precipitously over the past few months as the global economy is staring into a possible depression. At the same time, you know that China and India is still going to demand lots of commodities in the very long run in the coming decades. Besides knowing these two basic facts, there will still be great uncertainty in prices as the forces of deflation and inflation battles each other for supremacy, regardless of which forces will eventually win. Will we even be using US dollars to calibrate prices in the future? Who knows? In such an indeterminate environment, it is clear that many more mining projects will have to be shelved. Some have to be abandoned. You may be scratching your head, wondering whether to push forward your project plans.

As we have already seen in various news reports, mining companies are already losing mining, closing down their mines, laying off staffs, cutting production and so on. These will result in lower productive capacity in the long-term. Since the mining business is very capital intensive, it is not easy to ramp up production at a flick of the switch.

Now, let’s turn our eyes at China. As we explained before in Does the major Chinese economic slowdown signify the end of the commodities boom?, a major economic correction for China does not spell the end of Chinese economic growth. Eventually, they will recover and consume resources hungrily again (see Example of a secular trend- commodities and the upcoming rise of a potential superpower).

The question is, when will China recover? Will it happen within our life-time? Some reckon it’s a matter of waiting a couple of years. Others are more sceptical. But let’s assume that a Chinese recovery will happen in a few years time. At the same time, with the long-term productive capacity of mining companies severely impaired by the effects of the credit crunch, what will happen to commodity prices?

Please note that this does NOT mean that commodity prices will surge soon. Rather, this credit crisis is setting the stage for a new commodity bull market from a very low base. The question is, are the current prices near the low base? Or is there more deflation in prices to come?

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Posted in Commodities, Looking Forward | 12 Comments »

Is it time to buy stocks in times of intense fear and volatility? Part 2: Leverage position

Tuesday, October 28th, 2008

Today, we will continue from Is it time to buy stocks in times of intense fear and volatility? Part 1: Introduction. The question was:

Surely, some of these stocks are undervalued by now right? Should you buy now? Even Warren Buffett is buying.

Well, the answer will depend on your personal circumstances. More specifically, it depends on your current level of leverage.

Before we continue, we must stress again that anything on this publication should NOT be considered as personal financial advice. We are approaching the above posed question from a philosophical point of view. Thus, we will be making many assumptions, generalisations and simplifications. The point of this article is to provoke you to think about your investment decisions based on risk-reward probabilities and should not be seen as some kind of economic analysis/prediction. Now, let get back to the gist of the article…

Let’s look at one extreme scenario. Suppose you are currently very highly leveraged. Also, you are not sure what the long-term economic outcome will be. Will the future pan out to be a V, U or L shape recession (see What type of recession is coming?)? But you believe that a V-shape recession is unlikely. Between the U or L shape recession, you are not sure which one will turn out. Now, let’s work out your risk-reward outcomes for each scenario:

  • V-shape recession (unlikely): You will stand to gain immensely when the economy bounces back ‘soon.’
  • U-shape recession (more likely): You will suffer some losses for an extended period of time. But eventually, you will recover and gain.
  • L-shape recession (not so likely but possible): You will lose your entire life-savings, go bankrupt, lose your home and become destitute because of your high leverage (e.g. someone using their mortgaged home as collateral for their stock market investments).

Now, let’s suppose you are at the opposite extreme: complete absence of leverage (i.e. 100% in cash). Let’s look at your risk-reward outcomes:

  • V-shape recession (unlikely): You gain and lose nothing when the economy bounce back ‘soon.’ Relative to the highly leveraged investors, you are very much worse off.
  • U-shape recession (more likely): Compared to the very highly leveraged investors, you are better off during the downturn. Eventually when the economy recovers, you will not be too much worse off than the highly leveraged investors either.
  • L-shape recession (not so likely but possible): You will be way ahead of the highly leveraged investors.

As you look at these two scenarios, it becomes clear that for the very highly leveraged investors, they will sleep much better at night by reducing risk of catastrophic loss through the reduction of potential for gain. That means de-leveraging. For the completely un-leveraged investors (maybe a person who is 100% in cash should not be called an investor?), they increase their prospect for gain (without increasing the prospect of disaster significantly) through increasing their risk of loss. In other words, for the cashed-up investor, the reward outweighs the risks.

In today’s free-falling market conditions, it is clear that the majority of investors are de-leveraging because they want to reduce their risk. Contrarian investors should be approaching the market from the position of extremely low risk seeking towards a gradual and measured increase of risks.

What if you are one of these contrarian investors seeking to increase your risk in the stock market? Which stocks to pick? Keep in tune!

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Posted in Investor Education, Value Investing | 2 Comments »

Unknown unknowns trips up many turkey forecasters

Sunday, October 12th, 2008

As we explained in our previous article, Real economy suffers while financial markets stuff around with prices, the massive deflationary forces from the free market is being (and will continually be) counteracted by government attempts at inflation (see our guide, What is inflation and deflation?). The result will be great volatility in prices, which will undermine business calculations and long-term planning by the free-market.

At the same time, many economic forecasters will have their forecasts and ‘predictions’ completely stuffed up, which will mean that their credibility will be severely undermined. Many of these forecasters simply fail to see that the ground has been shifting as they make their projections. The recent deterioration of the global financial system will cause many of them to back-flip on their views. Those who cling on stubbornly on their previous (and erroneous) positions will have their credibility rubbished by history. Simply put, these forecasters completely failed to see turning points at the economic cycle. We really marvel at the fact that some of these forecasters are paid highly to produce expensive reports that turned out to be wrong. How could they possibly not see such an obvious looming financial disaster? It really takes a special effort to put on the blinkers in order NOT to see it coming. We are so marvelled that we have to write up a guide (Why are the majority so wrong at the same time and in the same ways?) to explain why.

As you will have heard the news by now, Prime Minister Kevin Rudd announced that the Australian government will guarantee all (a change from the $20,000 guarantee last Friday) bank deposits for 3 years. Also, there is other bad news in that announcement as this news report says,

Prime Minister Kevin Rudd has warned that economic growth and job security could be in jeopardy as the global financial crisis entered a “new and dangerous” phase.

As he equated the current financial turmoil to a national security crisis, Mr Rudd today signalled the jobless rate for next year was likely to be higher than originally forecast in the May budget.

…

`So, unemployment is likely to be higher. That’s just levelling with people … It’s likely to be higher than has been projected. We don’t have numbers on that.”

Associate Professor Steve Keen believed that the unemployment rate could reach around ten percent range or more. The economic implication for this is very ugly. As we explained back in March last year (2007) at Can Australia?s deflating property bubble deflate even further?,

In Australia?s case, with her towering levels of debt, any external shock can easily tip her over to a recession, which can lead to further asset (e.g. real estates and stocks) deflation.

…

By now, it should be clear that whatever the external shock is not the issue?the point is that Australia is highly vulnerable.

The global financial crisis is an example of an external shock that we warned back then.

As we further explained in June 2007 at What can tip Australia into a downward property price spiral?,

With the Australian debt levels so high, a recession (with an accompanied increase in unemployment) will result in more distress property sales and further downward pressure on property prices. In such a scenario, what is happening right now in Western and South-Western Sydney can be extended to the rest of Australia.

The Australian economy is very highly leveraged towards the residential property sector. Rising unemployment will exert a downward pressure on property prices (due to the high leverage of the household sector), which along with that will expose the weakness in the Australian banking system (it has been said that mortgages made up of 50% of Australian banks’ loans- you may want to check up on that figure). A major weakening of the banking system will result in a major tightening in credit standards, which can even result in the deflation of credit growth (credit growth is already slowing down significantly in Australia). This will then feedback into the economy as a sharp drop in consumer spending, which along with the ongoing de-leveraging process (see De-leveraging in the real economy- mortgages), will put a major pressure on the retail sector (in addition to the financial sector already under a serious stress). This in turn will feedback into rising unemployment, resulting in another round of vicious cycle.

Now, let’s take a look at some of the economic forecasters and have some humour along the way.

In this news report, Bad day for house sales as jitters spread,

Angie Zigomanis of BIS Shrapnel said people were increasingly worried about their future: “If you don’t think your job is secure then no matter how low mortgage rates go, you are not necessarily going to enter the market.”

Remember BIS Shrapnel? Back then, they were writing forecast reports with erroneous and nonsensical logic (see Can lower interest rates re-inflate the property price bubble? and Another faulty analysis: BIS Shrapnel on house prices). It looks that they are beginning to back-flip on their views.

Let’s take a look at the views of a perennial bull, Craig James senior equities economists of CommSec,

Mr James said the recent report from the International Monetary Fund stressed that the Australian housing market would not experience the same dramatic falls as the US and Britain because of the nation’s strong population growth, fuelled by immigration.

Oh really? Strong immigration will help to keep upward pressure on housing demand in Australian? Well, let us take a read at another news report, Aust rethinks immigration boost as global financial crisis buffets economy,

Australia said on Friday it will re-think a large boost to immigration as the global financial crisis buffets the economy and places a brake against years of strong growth.

Mr James fails to understand that:

  1. Immigration tends to be very cyclical along with the economic cycle.
  2. In the face of rising unemployment and slowing economic growth, new migrants will put additional on the Australian economy. That is the reason for the government re-think on immigration.

It is obvious that extrapolation of current immigration figures into the indefinite future is flawed.

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The ruction in the global financial system will put a spanner in the works of many forecasters. In the months and years to come, we will see the rise and fall of many forecasters as reputations are made and destroyed and credibility gained and lost. The first shall be the last and the last shall be the first.

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Posted in Economics/Finance, Market Observations, Property | 10 Comments »

Interviewing Steve Keen for the upcoming property forum debate

Thursday, September 25th, 2008

In Upcoming forum debate: ?Property 2009: Crash, Boom or Stagnate?!?, we announced that for the upcoming property debate on 15 October 2008, we will be “inviting the various high-profile experts to this debate.”

Today, we would like to announce that Associate Professor of Economics and Finance from the University of Western Sydney, Dr. Steve Keen, will be one of the special guests in this forum debate. For those who have yet to know about him, we have conducted a short interview with him:

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What are you currently doing in your line of work?
Currently, I’m revising a paper on how money is endogenously created by the financial system for the journal Physica A- the journal of interdisciplinary physics, where the so called “econophysics” school has evolved.

Once that’s done, I will start work on my magnum opus “Finance and Economic Breakdown”, a book-length development of Hyman Minsky’s “financial instability hypothesis” which will be published by Edward Elgar Publishers.

So, can you share a bit about your life journey that brings you to what you are currently doing?
I began as a believer in conventional neoclassical economics while doing my undergraduate degree and then had my confidence in this theory shattered by exposure to Lancaster’s “theory of the second best” in my first year at Sydney University. This theory, which shows that a move closer to the neoclassical nirvana of competitive markets everywhere may actually reduce welfare, made me aware of the theory’s fragility and I then embarked on my own learning odessey to work out why.

In the process I started the Political Economy movement at Sydney University.

After my student days I worked as an overseas aid education officer, a computer programmer, computer journalist, conference organiser, and then finally was employed by one of the Accord bodies under the Hawke Government. The way the Accord was hijacked by conventional economists within Treasury and the bureaucracy in general convinced me that I had to return to academia and take this nonsense theory on on its home turf.

That led to the publication of Debunking Economics, which was commercially successful, and made me a prominent member of the non-orthodox fringe of the economics profession.

It has been noted that your viewpoints on economics are very much different from the mainstream economics. In a nutshell, can you explain how and why they are different?
I reject the equilibrium modelling that dominates conventional economic analysis, and since I did mathematics as an undergrad and postgrad student, I knew how to apply nonlinear dynamic modelling methods to economics–basically using Differential Equations and Systems Theory. I also use Hyman Minsky’s “Financial Instability Hypothesis” as my fundamental model, supplemented with lashings of Schumpeter and a unconventional reading of Marx.

What is your stand on the current state of Australia’s debt levels?
We have reached a level of excess that is historically unprecedented–literally twice the level (compared to GDP) that caused the Great Depression. I have zero confidence in our ability to avoid a serious downturn as the great de-leveraging begins.

***********

We will have another special guest for this forum debate. We will reveal who he/she is next week. Keep in tune!

Property 2009: Crash, Boom or Stagnate?!

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Posted in Announcements, Property | 12 Comments »

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.

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