Gartman calls for end to Commodity Boom

Continuing from where I left off yesterday, I have had some some additional thoughts overnite about the natural resource / energy stocks. My thinking was reinforced this morning (Wednesday, August 6) by comments from Dennis Gartman on CNBC. He came on and unequivocally said the bull market in commodities is over. Now, he is a trader, and he did not frame that comment with a period of time. Later he suggested that it was over for the near term (which might be 6 months to two years for all I know). During the show, Gartman suggested that oil would not top $145 a barrel anytime soon. This is not so different from my thinking. I have been watching the commodity charts and they all look the same, and it is not good for commodities. BHP does a nice job of representing the general natural resource trend, as it has a little of everything, including coal, gold, copper and iron.

Notice that the stock price broke below the Moving Average about July 1. About the same time, red flags occurred on the MACD and Stochastic trends. Investools analysis suggests that three red flags are a strong sell signal. Other technical analysis suggests that when previous support (the moving average) becomes resistance, it is a further indication the trend has changed (see the bounces off the MA on July 14 and again on about July 21). Because all the commodity charts show this pattern, it may indeed be over, as intuitively we may feel that way (notice gas prices have dropped the past 2 weeks).

The second MA test is interesting for its timing. It was on July 23 that the financials broke out to the upside after Fannie and Freddie were rescued by the Feds. We have also looked in the recent past at how Commodities and Financials are countertrend of each other right now. So, the breakdown in commodities in July has supported the surge in Financials and the broader stock market (aided by Fed support for the banks, of course). No suprise here, because commodities are a surrogate for a weak dollar, and anything that helps the dollar hurts commodity prices denominated in US dollars.

How long will this last? Yesterday I suggested that the Chinese Olympics may be the signal of the top for the near / intermediate term for natural resource stocks (for the next several months). So much talk has been about the huge infrastructure buildout in China, and how China was rushing to get ready for the Olympics. As the Olympics begin, everyone will take a collective breath and know that the big buildout is done. Traders will respond accordingly using this as a signal.

Probably more important than this symbolism is the fact that the European and Asian economies are cooling off, most likely in response to decreased consumer demand in North America. Because much of consumer demand has been financed by loose credit in our banking system, it may not reignite until housing and banks have bottomed. Again, it is likely that won't happen before mid-2009.

What is a reasonable strategy until that time? I would suggest it is similar to the strategy followed until now, which is to invest in high dividend stocks and funds. This play has hurt me some the past year, as Value stocks really were out of favor. Some of that was due to the focus on international and commodity stocks, which don't issue dividends. The rest was the fact that much of the high dividend stock world comes from out-of-favor sectors, like banks, insurance, REITs and consumer products.

But, eventually this high dividend strategy will prove correct. All dogs have their day. So, it is best to stick with the strategy knowing it will eventually pay off. As long as we stay diversified with our high dividend investments, we won't be hurt by individual company failures (ala Bear Stearns). DHG is my favorite high dividend stock fund right now. Not because of recent performance, but because it has a solid strategy and continues to make its dividend payments without reduction. DHG has become much more of a commodity / natural resource play the past 6 months. When it first was introduced, there was quite a bit of financial exposure for the high dividend bank stocks. But the management team moved away from financials late last year and avoided most of the carnage early this year. To demonstrate the degree to which DHG now reflects the trend in commodities, see the attached chart comparing DHG (red line) to BHP (blue line) over the past 6 months. So, if commodities do bounce back, DHG will go with that trend. But if commodities continue to lag the market, DHG will be able to offer high dividends to offset the decline in commodity stocks.

This is a Pretty Crazy Market

This is a pretty crazy market, but then it has been since last summer. I have been working hard just to stay even with my portfolio. With your fresh funds from the sideline to bring in gradually, you should do very well over time.

Regarding the Fed / JP Morgan / Bear Stearns situation, I suspect there will be more of those down the road. Lehman may be one, Washington Mutual might be another. Even Fannie Mae and Freddie Mac may go that route. This is really the only way for the Fed to get the market restarted. It is a variation on a theme that has been recommended by many financial market experts.

The basic idea that is being implemented is that when a financial company like Carlyle Capital (failed on Wednesday) and Bear Stearns (almost failed Thursday), which are both loaded with mortgage and commercial securities that are below AAA (subprime, Alt A or other), freeze up and have their loans called back, the Fed will orchestrate an asset rescue. With Carlyle, the Fed just let that private banking company fail. Carlyle had to turn over its loan portfolio, which was collateralized by its value, to the banks to whom it owed short-term money. It had a 30:1 leverage ratio, so it was bound to fail in this environment. Carlyle, like many private banks and hedge funds, had played the "carry trade" game, which is to borrow high quality paper short term at lower rates, and then lend long term, for poorer rated debt at higher rates, and earn the spread between the two.

If the borrowing is at 4% and the lending is at 6%, then the spread is 2%. 2% does not impress wealthy clients. So, the private bank or hedge fund borrows 30 times its capital short term from bigger banks and now it can show a leveraged return of 60%, which does impress those clients. This works as long as the short term money stays cheap and the banks continue to renew the loans. But if the merry-go-round ever stops and the bigger banks refuse to renew the short term, low rate lending, then the game is over.

Bear Stearns is a much larger publicly traded banking company that the Fed did not want to see fail because of the negative psychology it would create in the Market. Apparently, the Fed approached JP Morgan Thursday night and asked it to rescue Bear. Bear had margin calls on Thursday it could not cover (just as Carlysle did on Tuesday). The Fed said it would guarantee all the loan securities that Bear sold to JPM, and it would loan JPM funds from its new TAF program to pay for those loans that were acquired. This is a way for the Fed to help Bear without a tax payer "bail-out", without violating the requirement that the Fed only accept AAA rated paper as collateral for loans under the TAF program. JP Morgan will carry the lower rated paper on its books, but it will be "insured" by the Fed. Bear will still have some equity value (it has not been wiped out but was cut in half today) and has another 28 days to try and get itself straightened out. The public is supposed to be reassu red by all of this.

But instead today, the public saw through the entire situation and showed concern that this was the first of many bank failures that must be rescued by the Fed. There are much bigger banks in trouble (Citi, BAC, WM, Wachovia, Fannie, Freddie), so the concern is "where will it all stop"? It is a legitimate concern / question. I personally feel that the Fed's moves will eventually clear the deck on the worst of the problems. Once those problems are in the open and secured by Fed guarantees to the more sound banks, it should free up the better loan securities to begin trading at something near normal prices. If the banks start trading those securities again, they will be able to gradually mark up their books and improve their capital ratios and move away from the brink of failure.

But there is a slim chance that the Fed will not be able to stop the snowball. If that happens, there will be general carnage in the banking industry and in the economy. We will have a depression (or the modern day equivalent).

Because all of this is creating so much uncertainty in the banks, I shorted several on Thursday and Friday (C, BAC and WM) to protect some of my long positions. I will take the shorts off when it looks like this gets resolved convincingly.

The high yield CEs like BDJ, VVR or DHG do have exposure to the financial stocks. Those are normally the source of higher dividends than the market average. There are also REITs in these high yield funds, along with pharma, industrial and energy stocks. As I have been suggesting, I think high yield CEs are a decent risk because of the diversity and the dividends. All the banks will not go bust with the current Fed strategy. They will be consolidated by the Fed, the weaker to the stronger. There will be winners and losers. So, the diverse CE's will have their share of each as well and will eventually prosper.

I agree that Oil and Gold must be near short term highs. They can't go to the moon, at least without a breather. What will turn them around is some success in the financial markets with clearing up the problems that are undermining the economy and the dollar. I agree that a pullback to at least $900 is likely for gold and to $90 for oil, and maybe 10-20% less for each. But we are in a long term bull for commodities, so any pullback would be a buying oppty, though it will probably not feel like it at that time.

The Canroys should be going along for the ride right now. Chesapeake is setting new highs and it is very similar in its business mix (oil and gas) to the Canroys, except it does not issue much of a dividend. If the tax situation in Canada does not get resolved, the Canroys may eventually look like Chesapeake by converting from LLCs to incorporations. They will reinvest their profits in additional production to minimize taxes. They can do so by increasing amoritization and depreciation with the new production investments.

Market Strategy - May 2007 Checkpoint

I am still sticking with my original forecast for 2007, though the timing has changed a little. I always disclaim any timing calls because there is no way even the most educated, smart people get this right every year. There are just too many variables, especially now that we are in a world economy. But my general thesis is based on history repeating in some ways. Value is value, so that remains constant and is the basis for all other decisions. I had suggested that the first half of the year (through the summer) would see declines, followed by a rally at the end of the year into 2008 leading up to the elections. The year before presidential elections is almost always good for the stock market.

When the market corrected by 6% on Feb. 27, I thought I had this call nailed. But then the market came roaring back to new alltime highs on the Dow 30 the past month. I still think this summer will be weak and the decline could start any day. However there is a big BUT and that is global liquidity (many years of good profits in raw materials) and the China expansion prior to the Beijing Olympics. Our economy is now global and what worked in the past for American markets, is now influenced by global markets. So, maybe the Melt-Up continues. Here are the arguments for both directions, up and down:

1. The market is neither cheap nor expensive at around a P/E of 16 for the Dow and around 20 for the S&P (which has smaller cap companies). This makes direction difficult to choose. It is why my own portfolio is somewhere in the middle with about 67% equity and 33% cash and almost no bonds, since it is possible interest rates will go up from here as the dollar devalues (to attract money back to the dollar, the Fed can raise interest rates). Of the equity portion of the portfolio, most is in "value" or low P/E stocks like Health Care/Pharma (now historically cheap), Energy or Basic Materials. You know I am heavily in the CanRoy oil trusts both for their value and their large dividends. The big dividends provide the income and diversity that bonds would otherwise provide. Dividends provide a cushion against a potential market downturn.

While attractive from a fundamental, world growth, point of view, materials stocks like FCX and BHP have become more expensive on an absolute historical basis. But, their profits are growing almost as fast as their stock price, keeping relative value almost constant. The potential demand from China and Asia for infrastructure development has the potential to dwarf anything the world has ever seen. Materials companies with operations in that part of the world (both FCX and BHP have big operations in Australia and/or Indonesia) will benefit for years to come. That is unless the China economy were suddenly to come to a halt or collapse. This is possible over the next 12 months as the big push for the 2008 Olympics in Beijing comes to a close. There is a lot of risk in the China economy right now as it is growing at historically unsustainable rates (for a national economy) of over 10% a year for the past 5 years. It makes sense that once the artificial, government led push for the Olympics is done, that the Chinese market will cool off, and maybe cool off the entire world economy.

2. Other than the Olympics thesis, it is not possible to know for sure what might change the current global synchronized economic expansion. Various war scenarios are speculative, they may but probably won't happen. There really is no precedence for this global economy. There was a 20 year period before World War 1 that saw global peace and prosperity with lots of free trade. And again in the 1950s, during the reconstruction after World War 2, there was a 20 year period of the same (Korea in the 50s notwithstanding). But during those periods, there was no internet or global communications. It was also before the era of global air freight and the fast movement of goods and people around the world. So, the expansionary period since the last big recession from 1990-1992 is exceptional. The current environment that favors industrial goods and basic materials is also without precedent (the construction of industrial infrastructure in the USA took 100 years and America is only 20% the size of China by population). High demand and short supply for raw goods could continue for another decade or more, until global infrastructure development slows, or materials production facilities dramatically increase supply.

3. We are now officially in a bull market from the lows in 2003. We did not know this for sure until earlier this year when the Dow went past 11,700 surpassing the previous high from 2000 (the S&P500 has not yet confirmed with a new all-time high, but is only about 2% away at 1510). Bull markets tend to have 5 distinct segments: up for several months to a year, then a 10-15% correction; up for another several months, then another 10-15% correction, and then a final up move which can have a big "melt-up" at the end before it collapses from its own prosperity and exuberance. This was the pattern from 1992 into 2000.

It could again be the pattern, with the correction last summer of 10%, now followed by the up leg which may be "melting up" right now. Note that the every day public investor like you or me is typically the last to get into a bull market (even though we all probably have mutual funds investing on our behalf all along the way). People who follow such data professionally say that the public is still on the sideline and never got back into the market after the 2001-2002 collapse. Until that money comes in, the market can't make a true bull market top. By definition, tops in stocks or in stock markets happen when everyone who ever will buy has already bought. Then, there is no one left to buy at a higher price, so all that can be done is to sell, driving the market lower (into a bear market).

The way we can know a major market turn as average people without access to industry data that shows this action conclusively, is to watch major magazines and newspapers. When the media headlines start talking about a New Era and featuring great riches earned (or lost), we know we have either a market top or bottom. You may have noticed a year ago that all the talk was about how EVERYONE was making money flipping real estate. That was the sign that the top had been reached in that market. Same thing was true in 2000 with all the talk of the Internet changing the world and creating a new era and people day-trading tech stocks that had no earnings.

So, if in the next few months, everyone gets in, then that will spell the top of the market. Since that time is hard to see until it has passed, it is probably good to have one foot in and one foot out of the pool. At this stage of the cycle, investments should be defensive (lower P/E and non-cyclical necessities of life) with a lot of dividends to provide a foundation for the stock should there be a correction.

4. The dollar continues to weaken against world currencies. Fewer nations are using the dollar as a benchmark. Japan still does, but says it may not in the future. China is gradually moving away from the dollar as its standard, slow enough not to hurt its export economy. As the world moves to other currency standards (or "baskets of currencies"), and the US goverment continues to run big deficits, the dollar MUST continue to devalue. This will move the price of all world raw goods, especially precious goods like gold and silver, higher in dollar terms, even if the prices stay constant in other currencies. Gold, then, is a good hedge against devaluation, as are energy plays like the Canroys or the other Materials stocks like BHP or FCX. In fact, the first quarter's supposed "earning surprises" to the upside were mostly a result of currency translation by the big multi-national companies issuing those earnings reports. When the dollar goes down against the Euro, then all profits from Europe earned in that currency will appreciate by the amount of the decrease in the dollar. The dollar decreased by about 8% in Q1. That was about the same as the "earnings increase" reported on average. So, on a weighted basis, profits in real dollar terms may have only increased by 2-3%, not the 8% reported. This will eventually catch up as year over year comparisons do not benefit from currency translations in the future (if the dollar stops sinking).

If you are looking for an idea, other than precious metals / gold (VGPMX) or the CanRoys I recommended in January that you bought, I am now buying and recommending BDJ and DHG. BDJ is a twist on "Dogs of the Dow" investing. It buys the highest dividend Dow 30 stocks and does so with borrowed money which leverages the return. It also uses a Covered Call options strategy to further enhance payouts. Covered Calls are a good defensive strategy and easier to execute on large cap Dow stocks when working with big money in a fund like this (options fees are high compared to the available returns on these big name stocks for average investors). The return is currently around 8.3% with a monthly payment. The payment has been steady for a couple years at a little over 10 cents a share per month. Share price is right around $15. If the Dow goes up, so will the price of BDJ, as its portfolio appreciates. But it is a closed-end fund, so underlying value (NAV) and the market price can be and usually are different. Make sure you don't buy at a premium to NAV. It is a small discount right now, so a good time to buy.

Another closed end that I have started buying is DHG with a dividend return around 7.8%. This is more of a commercial paper (short term loans to companies with high interest rates) and a high dividend fund specializing in deep value stocks (including some CanRoys). It is run by Dan Dreman's fund company. Dreman is a renowned value investor. This one is brand new and so has had a pretty spastic market price as a closed-end can, even though the NAV has hardly changed at all.

Both the above benefit from a lot of diversity. It is unlikely either will get hammered in a market selloff on NAV (market price MIGHT get hurt, but would quickly rebound. The payout probably won't change, so the yield would provide some drag on the selloff: as price goes lower, the dividend yield goes higher if payout is constant). As long as high yielding investments are in tax deferred accounts, there is no tax impact from the payments and they will continue to compound if reinvested in the CE funds.

www.etfconnect.com is a good place to research closed end funds and see the history of discount versus premiums