This past week was particularly hostile towards the Toronto Stock Index and for the fourth time this year, I felt compelled to share my current thoughts and interpretations of the recent market activity.
We continue to have a “tale of two markets” here in Canada. Since our market index is very concentrated in resource stocks and financials, our index has been very heavily influenced by the performance of two sectors. Financials peaked in June of last year with an index weighting north of 30% and at their low point this past July (when I put out my last market update) the sector had fallen by about 30%. Compared to global financials, our financial companies held up very well as many global house-hold names such as Merrill Lynch and Citigroup fell over 75%! Generally speaking, banks all “bottomed” on July 15th and began climbing. As a group, Canadian financials are up over 15% from their bottom although they are still off substantially from their peaks.
As is well known, our resource sector shielded the TSE Index from the global Bear Market reality that was well under way around the world. Resources peaked at a weighting of over 50% in June of this year on the back of a few large companies that dragged the TSE to an all-time high. As I indicated in my last letter, even at their peaks, Canadian energy stocks were being valued using $90 oil but began falling none-the-less even while the price of Oil climbed relentlessly through July to $147. Market commentators competed to see who could throw out the biggest target for oil with $200 per barrel widely regarded as the next stop. The prospects of rampant inflation gripped the global markets and the threat of rising prices against the backdrop of shrinking economic growth (stagflation) really had the markets back on their heels.
Oil has fallen back to earth in the last 2 months and is down almost 30% from that speculative peak but is still trading well above $100 (a level that I suspect will hold). I say “speculative” because it seems pretty clear that the move from $120’s to $147 was parabolic and had to be driven by something more than the forces of supply and demand. There was lots of debate about whether speculators were in the market driving oil to its peak and I think it is pretty clear that the debate is over.
This week’s drubbing on the TSE was due to the falling resource stocks as oil and natural gas prices fell hard largely because Hurricane Gustav did not “bite” as feared. The fall was also fueled by the announcement earlier in the week that a large commodity Hedge Fund was liquidating and winding down which was portrayed in the media as evidence that the commodity bull market is over. The Ospraie Commodity Fund lost 27% in August, bringing its YTD losses close to 40% and the fund managers decided it will give back the $2.8 billion remaining to investors. This sent a chill through the markets as it seemed to indicate that the manager is throwing in the towel on commodity investing and if they are doing such, many other hedge funds and money managers are also likely to do the same. Hence the wholesale liquidation of all commodity stocks this past week. Energy stocks, gold stocks, fertilizer stocks, the baby, the bathwater, everything must go!
Hedge funds such as Ospraie typically charge “2 and 20” meaning they charge a 2% management fee to come to work and they take 20% of all the profits. They don’t share in any losses, charging the flat 2% management fee if losses occur. However, there is almost always a “high water mark” clause that means when the fund posts losses, the fund needs to make the money back before the manager can assess their 20% performance fee. So with the fund down 40% YTD (with all the losses coming in July and August), the fund has to increase by 66% before any performance fees can be collected. I think you see where I am going with this! It is far better (for the managers) to wind down the fund and open a “new and improved” fund shortly thereafter and start collecting performance fees from the lower level. As bad as the recent performance has been, why would the manager walk away from their 2% management fee on the remaining $2.8 billion fund? Because there will be a replacement fund created shortly after this one closes and the manager can make much more money in performance fees from the lower starting point. Every year, about one out of every three hedge funds disappears due to this behavior yet there are record numbers of hedge funds currently in existence as they keep opening new funds after they close losing funds.
Has the world supply of and demand for all things commodities suddenly moved into a surplus over the last 2 months? Certainly the economic slowdown that started in the USA has moved around the world so a correction in commodity prices is somewhat justified. It is also welcomed as it removes the threat of hyperinflation and the higher interest rates required to fight such inflation. But I think all the talk of a bursting commodity bubble and highlighting the behavior of a self-serving commodity hedge fund as proof of such is very misdirected. It is worth noting that the average commodity bull market of modern times has been 18 years in length and the shortest commodity bull market on record was 12 years. This cycle started in 1999-2000 so it is 8-9 years old. With
As bullish as I have been on energy and commodity investing over the last several years, I have not advised any client to have anything close to a 50% weighting in resources. The sector will continue to be a solid investment (after this correction has run its course) but it is just way too volatile for anyone to be close to “market weight” as this week has proven once again. But I am using this correction as an opportunity to slightly increase weightings where appropriate.
So as shocking as it is to watch the TSE drop 7% last week, just remember that the Index is not very representative of your portfolio. And keep in mind that there are many positives to focus on at this juncture. The financials lead us into the mess and they likely will lead us out of it and fingers crossed, it looks like they found their bottom and continue to build strength. Oil has come back to earth so the threat of inflation and higher interest rates is off the front burner. And the C$ is weakening, down 5% YTD after soaring 17% in 2007. Canadian businesses and investors alike will benefit from this softening with higher profits and better returns on Global investments.
All that being said, September and October can be difficult months so expect continued volatility for a bit longer. Traditionally, markets do well from late Fall on and with the USA deciding on a new leader around that time and this should help the market psychology. The Bear Market will be getting old by then, and lower interest rates should start supporting employment and economic growth.