Major Markets:
2013 worked out much
better for most major bourses than even optimistic forecasters expected. In
large part that was due to multiple expansion. Traders bid up the value of
each dollar of earnings and the P/E ratio for the market increased.
That generated great
returns last year but don't expect a repeat. Valuations are getting stretched
and, so far, forward guidance by companies has been cautious.
Another 30% gain would
generate a P/E for the SPX well above 30 without a massive increase in bottom
line profits. Companies reporting so far have averaged about 6% YoY profit growth. That won't be enough to underpin
multiple expansion.
The depth of the
2008-2009 crash held back retail investors for years even as markets in New
York were staging one of the best rallies in history. $1.1 trillion flowed
into bond funds as equities were shunned and the trend only started to
reverse six months ago.
Since the middle of 2013
$90 billion has flowed back into equity funds and ETFs, though quite a bit of
that is going to offshore equities. A glance at the charts above for the
Nikkei and Euro Stoxx 50 show those were two of the
favored destinations for those funds. The Nikkei was the biggest gainer among
major world bourses and the Stoxx posted a 30%
return since July.
While there have been
stories about "massive" rotation into equities there is actually
room for a lot more. If markets continue to pull back it might deter retail
investors but there is still plenty of ammunition in bond funds that could be
redirected to Wall St.
Retail investors got
religion thanks to recent daily headlines about new highs on New York
bringing back the greed factor. Continued sector rotation into stocks and
share buybacks by companies could ensure enough demand to generate a modest
return this year even if profit gains are weak.
Anyone with a hint of
contrarianism gets queasy when they see how bullish retail investors in New
York became. Retail sentiment readings and margin levels were at all-time
highs. That almost always ends badly.
NY markets have been
negative since the start of the year and the selling has intensified in the
past few sessions. Worries about China and emerging market countries are the
proximal cause but seasoned traders were looking for a reason to sell.
Economic readings in the
US have been mixed since the taper announcement. A pullback is both justified
and reasonable. Tamping down excessive optimism now reduces the odds of a
much nastier pullback later in the year.
I expect New York to have
a positive year but not an impressive one. An assumption that the US economy
accelerates a bit more this year underpins that. Returns in the 5-10% range
are as much as I would hope for this year unless growth exceeds 3% which
doesn't seem to be in the cards yet.
I expect roughly the same
sort of gains from Euro stocks. They are a lot less undervalued than they
were a few months ago. The Eruo zone has provided
most of the positive surprises in economic readings lately. That could be
enough to generate returns like the US this year even though the region is
still in very rough shape. Returns in Japan will be dependent on how much
stimulus Abe applies. Mild inflation could do wonders for the Japanese economy--as
long as gains get passed along to consumers and they go out and spend.
Traders are currently
fleeing emerging market bourses and currencies so it will be tough for most
of those to put in strong years. China is clearly slowing and the level of shadow
bank debt is scaring markets everywhere. So far a lot of the moves out of EM
countries are repatriation as US yields rise or just reaction to
mismanagement. The countries seeing the biggest hits to their markets and
currencies are those with overriding political and economic issues. I think
the Fed taper is just a convenient excuse, not the reason, for these moves.
The "China Issue":
Debt in China and the
speed its increasing at is a big concern. Debt
levels are not excessive compared to other economies and certainly not
compared to China's ability to generate growth from them. That will change if
Beijing can't rein in debt growth.
The bigger issue is that
there are plenty of while elephant projects driven by local and provincial
governments without the taxing power to pay them off. Some of those will go
under.
The "shadow
banking" sector is dominated by wealth management funds and special
vehicles created to fund projects or companies disguised as more balanced
funds promising returns they probably can't generate. Again, some of those
are going under. About half the funds are heavily regulated but the special
investment vehicles are not.
A couple of prominent
investment vehicles are in trouble. Everyone is waiting to see whether the
banks that sold (but don't control) them or the government will give some
sort of guarantee to unit holders.
This mess exists because
China has only partially liberalized its financial system. Banks can set loan
rates but Beijing caps rates for savings accounts at 3%. This has been great
for the big state-owned banks that have huge loan spreads to work with. Not
so much for consumers who were getting savings rates well below inflation.
That is the main driver for the growth in the shadow banking sector.
A lot of the sector is
similar to money market funds here and probably not in much danger. A lot of
others created to invest in sketchy projects will fail and take investor
money with them. Most of the money in the shadow bank sector does not appear
to be heavily leveraged so in theory even a string of busts should not
create systemic risk.
The bigger danger is
panic either in China or by western traders reacting to it. China as an
economy has massive liquidity and is capable of papering over even large
fiscal disasters. It also has political leadership that likes to make
examples when it wants to get a point across.
I wouldn't discount the
possibility of managers of a blown up fund or two getting thrown in jail or
in front of a firing squad. I'm being literal here. Most Chinese would view
that as natural justice but it could freak out international investors.
The people running China
are smarter than many westerners give them credit for. They are aware of the
dangers of being heavy handed. They still might choose to do something
drastic to cool off excessive speculation in their economy.
A recent example of this
is spikes in overnight interest rates in China's interbank market. Virtually
all western observers assume that market has gone beyond the control of the
People's Bank of China (PBOC). Many commentators based in China, on the other
hand, viewed the spikes as something completely intentional.
Local commentators think
the PBOC intentionally allowed rates to spike to send a message to the banks
to increase liquidity. They also point out that spikes like that are not
uncommon, though they are usually smaller. I don't pretend to have enough
insight to know which side is right but it's true that "China
bears" have been pretty consistently wrong over the years. The transition
to a consumer driven economy will be tricky and is the biggest danger facing
the world economy this year and next. I expect bumps along the way but won't
assume it's going to generate a lasting crash unless things get much more
serious over there.
China's demand for most
commodities, iron ore and copper in particular, were much higher than
forecast at the start of 2013. How much of this is warehousing and how much
is true demand by end users is hard to determine.
Shifting the economy to
consumer demand and services should slow the increase in intensity of metals
demand. That hasn't happened yet but I think we have to assume it will. Note
that we are still talking slower increases rather than absolute decreases in
demand.
The latest banking crisis
will be another test of the skills of China's leaders. They could drop the
ball but until they do I am going to assume this crisis will be managed
successfully. It does highlight again that the biggest dangers in China's
economy are at lower government levels. City and provincial politicians need
to be reined in. That is part of the intent of the latest five year plan but
Beijing may need to do something dramatic to force the issue.
Precious Metals:
2013 was a disaster for
precious metals but there is growing evidence that 2014 will be better. As I
noted above everyone is targeting the $1000-1100 range for gold this year
with similar percentage moves for silver. Silver has a bigger industrial
demand component that could help it in a stronger economy but, generally, it
tracks gold. Comments made about gold below can be assumed to apply to
silver.
Gold appears to be
putting in a double bottom. As this is written the price is sitting right at
the downtrend line defined by price tops through the past year and just below
the high reached in early December. If it can break higher here I would
expect another flurry of short covering trades.
Physical gold demand
absorbed massive selling in the futures and ETF markets last year, albeit at
lower prices. This was particularly impressive when you consider moves by
India's government to choke off gold demand there. China has assumed the
mantle of world's largest gold buyer.
There is no indication
that buying is slowing and the confluence of the Lunar New Year in Asia and a
stock market correction may be goosing demand again.
ETF selling has recently
dried up. I don't know what the true core holding in ETFs is but it's not
zero. The further ETF holdings drop the more likely it is that the remainder
is in the hands of committed longs who won't add to the selling pressure
going forward.
I think 2014 demand out
of China will equal 2013 and it could be higher. The biggest potential upside
surprise is relaxation of import duties and controls by India. I don't see
change there before the May elections. Even then, it depends on who wins.
There is a vast amount of gold smuggling going on in India so we don't know
how much demand has really dropped off. Even with porous borders Indian gold
buying has probably been cut in half so ending the restriction would be huge.
I assume central bank
buying of gold remains stable. I ignore China in that equation since Beijing
is not telling us how much it's buying. Many assume China has doubled or
tripled its gold reserves. I wouldn't be surprised by an announcement like
that but the market would be. When China makes its intentions clear a bunch
of new gold bulls will be created.
I don't think China will
create a gold standard. I do think it will back its currency with gold
reserves as several other major economies do. Gold standards handcuff
politicians when it comes to monetary policy (that's the whole point). I
don't see Chinese leadership putting up with the restrictions.
The combination of
balance and probably buying pressure returning to physical markets,
skittishness about equities and a continued large short position should be
positive. I'm looking at $1400 as a target for this year. That could be
raised if things really go our way early in the year. Silver would follow
along.
Platinum and palladium
have more supply constraints and production is concentrated in unstable
countries. Platinum has gained as both a jewelry metal but the auto sector is
still the big user. In that sense PGMs are pro-cyclical with demand tracking
auto sales.
South Africa has ongoing
issues with power generation and labor strife. Most of the deposits there are
also inherently expensive to mine as they tend to be both relatively narrow
and flat lying. There are still huge PGM deposits in South Africa but few
want to tackle the problems that come with mining there.
One positive for South
Africa is that the Rand is one of those EM currencies getting hit right now.
If the Rand continues to fall it will help the bottom line for miners. I like
PGMs in general but I am still looking for a project I
really like in a low risk political jurisdiction.
Base Metals:
If we do see a slight
increase in growth across the major economic blocks this year it will be a
positive for base metals. That doesn't mean they will fly higher though.
Several metals and bulk materials are expected to enter or remain in supply
surplus this year.
In some cases they are
finely balanced and could stabilize under better conditions. The capital
intensive projects required by iron ore and coal are still very tough to
finance. Some of the expected supply growth in those sub-sectors is still in
doubt. Based on its most recent budget, China plans to reduce infrastructure
spending in some areas, notably railroads. Private side demand may not be
enough to counteract those cuts so I am cautious about iron ore this year.
Above and below are
one-year charts for copper, zinc and nickel. All three ended the year at
lower prices though zinc came very close to even at year end. I expect similar performances this year.
Copper had the price
decline I expected last year. Several copper mine startups did not have the
intended effect on copper inventories. Indeed, there was a large decline in
warehouse stocks in the second half of 2013 and copper inventories are now on
the low side of their five year range.
One important point about
warehouse inventories should be made. In the past few years there has been
rapid growth in unregistered warehouse stocks and third party warehouses not
counted by the LME. Owners could be end users or investment banks or hedge
funds holding metal for gains or as hedges. The exact nature of the holdings
is impossible to gauge which makes base metal forecasting a lot trickier.
The LME is forcing
changes to make it easier for end users to take delivery of metals but
inventories are still murky. There has been a lot of strange goings on in the
metal space during the past couple of years. There is potential for surprises
as the market is (hopefully) brought back to a more transparent state. I
think the odds are surprises would be of the upside variety.
2014 should be a surplus
year for copper though it now looks like it will be a small one. China is the
800 lb gorilla when it comes to metals but both the
US and EU are significant copper end users. If both
areas tack on an additional half percent growth copper could end the year
close to balanced.
I still think we will see
another price decline but it may be smaller than I expected. The red metal
could end the year near $3 which would be supportive of copper producers and
new projects alike.
Nickel has attracted some
attention recently due to a ban on the export of raw concentrate by
Indonesia. Indonesia is one of the world's biggest producers. Nickel is
produced by a large number of local companies using simple laterite mining.
The local miners that
dominate Indonesia's nickel production can't afford to build smelters and
Indonesia's grid doesn't have the power to supply them. I think there may be
some compromises on the export ban. Even if there are not the Philippines
could ramp up production from its similar locally-run operations. Nickel
inventories are still rising. I would be hesitant about chasing nickel
stories unless they have superior grade. I am not expecting a lot of movement
from the nickel price.
Zinc was the best
performer among major base metals and that could be repeated this year. The
Brunswick mine ended production last year and the Century mine in Australia
should be closing next year. Century is the third largest zinc mine and its
closure will take almost half a million tonnes of
production a year offline.
There are mines in
development but none of Century's scale. Zinc's main end uses are in larger
scale construction and automotive sectors. It goes without saying that
Chinese growth will be the main determinant of demand but zinc is mainly a
supply story for now.
LME inventories have
dropped by 300,000 tonnes but are still high by
historic standards. There should be anticipatory buying closer to yearend
that will generate price gains for zinc but it looks like 2015 will be the
pivotal year.
The Juniors:
2014 started with the
Santa Claus rally we hoped for but it's been cut short by the correction in
major markets. The US Dollar and Treasures are getting fear buying though the
Dollar isn't trading as well as many expected. That's in part because the
Euro and Yen are getting their share (more than, really) of safe haven buying
too.
The Christmas rally
lifted the Venture index through its 200 day moving average for the first
time in almost three years. Nine months of trading flat is the main reason
that was possible but it's still a positive sign. December created a double
bottom, also a strong technical signal if it holds.
The recent rally carried
the index above the resistance level it topped out at three times in 2013.
It's tough for microcaps to advance when the big indices are getting
pummeled. We'll have to see a bottom to the current correction before we know
if this is just another head fake. I think it isn't this
time.
That won't be proven
until the Venture manages a higher low and rallies to a new high above 987.
That would make it a triple bottom and bring the index to its highest level
since last April's gold crash.
All that happening
presumes two things; that New York is just correcting not crashing and that
gold can clear the $1280 level and start hitting buy stops. If these events
unfold, which could take a month or two, then I think the Venture could post
a 30%+ gain this year.
I mentioned that figure
to some of you at the Cambridge conference. Most people were startled at how
positive I was. That surprised me in turn because 30% doesn't seem that
optimistic a number.
We're talking about a
sector that is off by two thirds over the space of three years. A 30% gain
barely starts the process of rallying back. We can rally that much
just with an end to selling pressure and gains from a small subsector of
stocks. 30% is just "the good guys" doing better, not a tide that
lifts all boats.
That looks achievable to
me if the market can get past the taper panic and gold trades a bit higher.
It wouldn't be a banner year but there would be gains to he had in select
names. I'll take that for a start.
Newsletter writers Keith
Schaefer, Eric Coffin and Lawrence Roulston are
bringing the management teams of their 2014 Top Picks to this year's
Subscriber Investment Summit at the Downtown Toronto Hilton on Saturday March
1, the day before the PDAC begins. Hear them speak and talk with them
directly. Register NOW for FREE--only 200 people can attend and the last two
events have sold out. http://toronto-sis-2014.eventbrite.ca
Predictions for 2014. From the HRA Journal: Issue 208-209 (Part ii)
