REPEAT Rudi's View: A Change In Trend

(This story was originally published on 13th April, 2011. It has been repeated to make it available to non-paying subscribers at FNArena and to readers elsewhere).

By Rudi Filapek-Vandyck, Editor FNArena

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Last week, Louis, who's an active trader and investor in the share market, called up his stockbroker with the directive to buy a million shares in a micro-cap stock he had kept on his radar for quite a while.

Later that day, when he looked up the share price, Louis could hardly believe his eyes. That little gem he thought he had discovered was up by close to 16% on the day.

He made another phone call to buy some more. To his great delight, by the close of trade that day the stock had soared more than 22%.

That evening he opened an expensive bottle of red he had kept aside for special occasions. Sitting on his balcony, watching the sun set, he muttered to himself: "I am a genius, yes, indeed, I am".

The next day Louis called his stockbroker and told him he wanted to secure the profits made. "I want to sell half of my stock", he said. The response from the stockbroker was not exactly what he expected.

"I don't think I can do that, Sir. You've been the only one buying."

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The (fictitious) story above is only funny if you're not Louis who finds himself between a rock and a hard place. To be honest, I myself ended up in a similar situation many moons ago. My position wasn't as extreme as Louis', but a large gain on paper nevertheless disappeared completely after I waited too long and hadn't noticed market volumes had dried up in the meantime. That was one good experience to draw many valuable lessons from.

In more recent times, I have been using the above tale to illustrate how financial investors and short term traders have become "the market" when it comes to commodities, including agricultural products and precious metals. It is not possible to get exact data, but what is a fact beyond doubt is that financial investors have grown to become an ever larger force in every commodity market available. This is why base metals can move in unison for an extended period, regardless of differences in underlying market dynamics. And this is why correlations between US equities, copper and AUD/USD have held such extreme high levels since 2007.

This is also why we all should feel sorry for those on the payroll of stockbrokerages and investment bankers expected to project commodity prices a long time out into the future. Predicting price forecasts is no longer a matter of mapping demand and supply, it is also about trying to guess how much money will flow in and out. Not that many market watchers tend to pay much attention to these details. Most of them enjoy poking fun at those "lousy analysts" who are constantly behind the facts, while taking constant guidance from price development itself.

"Oil is at US$120 because of strong demand from emerging countries, a weaker USD and the threat of supply disruptions among key producers in North Africa and the Middle East."

Well, in a sense, yes. But the price of oil is above anything else at elevated levels because financial investors and market traders believe it will go higher still, so they can make a profit on their positions.

Where these commentators go wrong is by drawing reverse conclusions such as "the price of oil is showing us the recovery in the US remains in good shape". Yeah, right.

Gold and silver might have been around for more than two thousand years, and we all eat pork, rice and grains on a regular basis, the world around, but when it comes to viewing these markets in terms of financial size, they are all tiny and midgets.

It really doesn't take that much to move up the price of a small tradable asset. All you need is to invite investors in and give them a good story. (A big congrats to Marius Kloppers who clearly did understand this principle).

Apart from the awakening of a new middle class in emerging countries, the increasing popularity of commodities as a trading and an investment tool, as well as monetary liquidity the world around have over the years past all delivered a strong and marked contribution to price developments for natural resources, energy and agri-products. Yet, all we ever read and hear about is "China" and "the recovery in the US".

I do understand why there is a taboo in acknowledging that financial investors now hold a large command over price developments in these small markets. Authorities are watching too and new customers want to hear about the fundamental story, not that they themselves have become part of that same story.

How does one determine the value of commodities? Interesting question. If it was purely a market determined by suppliers and end users, this question would be much easier to answer. Under circumstances wherein demand exceeds supply it's pretty much up to what the next guy wants to pay for it, and for how long. This is why market sentiment has become so important. Bullish investors easily ignore short term negatives and hiccups and there's nothing that sooths the bullish mind as do rising prices.

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Commentary from technical market analysts suggests commodity markets have simply run into headwinds because "market sentiment" had once again jumped up too high. This suggests that once the "weak longs" have been taken out, it'll be business us usual.

A number of recent observations and developments seem to suggest otherwise.

Firstly, let's take note from an observation made by Citi analysts returning from the recent CESCO Copper Conference in Santiago de Chile:

"Feedback from the CESCO Copper Conference was that the physical copper market was quiet in Q1 2011, after an active quarter in Q4 2010. The consensus view is that there seems to be plenty of copper in China at present; however, the material is largely held by speculators and merchants, with Chinese consumers light on stock. Chinese consumers have been waiting for a major price pullback, but such an episode has so far failed to eventuate. The price weakness associated with the earthquake in mid-March provided consumers with one of the few opportunities to take on material in the past five months."

Let's put this quote, and its importance in context. At a time when, and I quote, "the physical copper market was quiet" and end users in China remained on the sidelines, the price of copper surged to an all-time high above US$10,000/tonne.

Makes sense?

Only if you read all of the above first.

Analysts at JP Morgan returned from the same conference with an equally interesting observation: "It was interesting to see the ardent bulls finally become cognizant of the real demand destruction happening now from high outright and relative copper prices".

The latter issue might well become increasingly important in the months ahead. Here's what Citi analysts had to say on this issue: "Substitution remains a major concern among copper producers. Citi’s estimates are for a loss of more than 500kt in 2011 as a result of current high prices."

The most important changes, in my view, have come from those sector analysts I mentioned earlier, who are believed to be behind the curve into eternity. Behind the daily market commentary and newspaper headlines one major change has now taken place, and only few have genuinely taken note.

Forward looking price projections are no longer automatically on the rise. Economic growth forecasts are being lowered. In both cases, changes to date are benign, but they mark a change in trend nevertheless.

Analysts at Bank of America Merrill Lynch were according my observation the first to update their commodity price forecasts, on March 24th, in a report that -against the trend- contained cuts to previous forecasts for metals, including for copper. (Everybody is bullish on copper).

Since then, others have started following BA-ML's example. Today, analysts at UBS added another twist to the commodities story. They cut earnings forecasts for Rio Tinto ((RIO)) post this year. I cannot even remember how long it has been that anyone actually cut forecasts for Rio or for BHP Billiton ((BHP)). I do note that on recently updated forecasts by Citi analysts in London, Rio Tinto is expected to see earnings per share decline in 2012 (yup, I had to rub my eyes and check three times too).

UBS analysts were quick in pointing out both RIO and BHP are still trading on benign looking PE ratios (especially RIO), but we all know how it goes with commodity companies: their share prices tend to go down when commodity prices do, regardless of whether they are cheaply priced or not.

Back in 2008, I was the last man standing when everyone was convinced oil prices would rise to US$200/bbl by year end, and in August that year I predicted the most severe correction for commodities in modern history. On both occasions, the insight that investors had become a leading factor in these markets played an important role when I made both predictions. I am by no means suggesting anything similar this time around, but the easy, straightforward uptrend seems to be coming to an end and it is anyone's guess how exactly the next weeks and months will play out.

My feeling is we are heading towards lower prices. Exactly how much lower will be determined by as yet unknown factors such as Fed actions, liquidity, the US recovery, the global slowdown and post Japan earthquake interruptions. Not to forget movements in the US dollar and crude oil.

(To those who attended my presentations in Melbourne last month: it all starts making sense now, doesn't it?)

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