The Forgotten Few

By James J Puplava CFP, October 29, 2003

At a time when the price of most stocks are soaring and valuations border on the ridiculous, very few bargains exist in the market. What drives the price of most equities these days is momentum. It has become a game of money chasing money. The Fed has done its job to keep hot air flowing into asset bubbles and keep them from deflating. If there is talk about deflation it is asset deflation they are referring to. Central bankers are most worried about the value of paper assets declining from junk bonds to small cap stocks, to stocks and bonds in general. Very little has been accomplished within the real economy.

Judging from the value of markets around the globe and especially here in the U.S., you can say that monetary policy has been effective in resurrecting old bubbles (stocks) and creating new ones to take their place (mortgages, bonds, and real estate). The NASDAQ is up nearly 45% this year and still has no earnings. The companies that are doing well this year are those companies that are either losing money, have no earnings, or are experiencing balance sheet problems. In a momentum driven market things such as real earnings, dividends, price-earnings ratios have no place. Investment decisions aren't based on research, industry fundamentals, or sound investment principles. Instead, in a frothy speculative market such as we now have today what other investors are doing, what they are buying, and what the general mood of investors is becomes more important.

The basic decision to buy is predicated on the fact that others are buying the same thing. No one wants to be left out, so resources are deployed and asset prices get inflated. While everyone in the financial industry may be worried about asset deflation what we are actually seeing is asset inflation. When professional investors or amateurs are willing to pay 30, 50, 100 or more times earnings we're talking about a casino, not an investment market. The best thing many of these highly speculative stocks have going for them is that they have no earnings. If they did investors would realize just how expensive many of these companies are and the fact that they are being ransomed at a fool's price. Even the companies that are actually making a profit may not have real profits if one takes into consideration all the variables such as stock options, inflated pension plan earnings, or write-offs which routinely get dismissed or are left out in most earnings releases. As already mentioned, this market trades on momentum and not fundamentals. How else can P/E multiples of 30, 40, or a 100 be justified?

The Fundamentals

While the momentum crowd chases one sector after the next, rotating in and out of stocks like a roulette player changing from red to black, there is another story that is being ignored by investors and the market. What I'm referring to here is the fundamentals of the commodity markets and the companies that produce them. Today ConocoPhilips reported earnings of $1.3 billion this quarter. Profits were bolstered by higher energy prices. Thanks to a merger sales revenues rose from $14.7 billion to $26.5 billion this quarter. Profits from refining rose from $57 million to $485 million as refinery margins improved. Cost savings from the merger last year are now starting to pay off. Unprofitable assets have been jettisoned and debt has been paid down further increasing the profit picture going forward.

Newmont Mining, the world's largest mining company, reported profits that jumped five-fold this quarter. Net income rose from $20.8 million in Q3 of last year to $114.4 million. Sales rose 25% and average selling prices gained 16%. The company increased its quarterly dividend 20% from $0.04 to $0.05. The company said that it expects full year gold sales to be at the high end of its forecasts.

Phelps Dodge reported a loss that was less than expected as record high copper prices helped the company on the road to profitability. The company boosted production 4.8% and is benefiting from copper prices that are at a three-year high. The losses this quarter were due to assets set aside for environmental reserves and litigation. Next quarter the company plans on returning to profitability. Copper prices this year have soared 31%. The company plans to boost production this year by 2.2 billion pounds as a result of high demand coming from China. China is consuming 16% more copper this year than last year due to increased auto production and construction. Personal income has increased 9% for the average Chinese this year. Increased income has led to increased consumption for homes, autos, and other consumer goods.

Northrop Grumman reported profits that rose 59%. The world's largest builder of warships saw profits rise as governments increased spending on military satellites and missile defense systems. The company recently bought out TRW which is helping it gain a foothold in the growing space and satellite business.

Earnings reports such as these companies reported today are not unusual in the hard asset sector. Most of this year's earnings for the S&P 500 have come from the energy sector. Profits are on the rise for most commodity producers as the surfeit of money and liquidity created by central banks is starting to spill over into the commodity sector. Up until a few years ago all we saw was paper asset inflation. Now inflation is starting to spill over into the commodity sector driven by currency debasement and strong demand coming from emerging markets, especially China. China's voracious appetite for commodities from oil and gas, copper, lead and zinc, to grains and beef, is driving demand for natural resources of all varieties. It isn't just China that is driving the price of raw materials up this year.

Here in the U.S. oil imports hit a new monthly high in September averaging 10.36 million barrels per day, up 18% from a year ago. Total imports of energy represent 66% of the U.S. market in September. Year-to-date imports have accounted for 62% of all energy consumption this year. Weather experts are forecasting cooler temperatures this winter which will add further to energy demand this year. Energy analysts point out that strong commodity prices are more than off-setting rising exploration and development costs. These strong industry fundamentals are leading to massive amounts of cash flow for E&P companies. While industry fundamentals continue to improve the price of most energy companies are still trading at historically low levels. The two major critical factors driving investment returns for the industry are commodity prices and exploration and development costs. As reserves become harder to find and as production declines continue, a floor has been created underneath energy prices. Revenues from higher prices should continue to outpace costs which mean higher profits and cash flow for the industry.

While the demand fundamentals for the hard asset sector continue to improve, the price of most securities in this sector remain undervalued and inexpensive. The momentum crowd continues to chase and bid up the prices of companies with no earnings, declining profits or deteriorating balance sheets; the prices of most natural resource companies from energy, metals, water, and food remain depressed. Investors have simply ignored the sector preferring instead to chase hot tips, rumors, or the current fad of the day. In its latest power and velocity ratings report Lowry's Investor Services lists a group of companies it calls its "Forgotten Fifty," a group of stocks and sectors completely ignored by the market. The list includes energy, food, drugs, defense, and consumer product companies. A group of companies that all have real earnings are experiencing rising real profits as opposed to pro forma profits and whose shares remain depressed. Many of these companies are selling at PE multiples of 6-8, pay 3-4% in dividends and are realizing 15-30% returns on equity. They still remain cheap and stand in sharp contrast to the hot air that unpins the prices of most momentum stocks whose price performance depends on a steady stream of idiots willing to pay even higher prices in the hopes that more idiots will follow their lead. At some point the momentum crowd will wake up to find that the emperor has no clothes. They will then be looking for a wide exit gate when none exists. I also suspect that there will be the need to find something tangible to land on as the value of paper deflates.

Today's Market

Back at the casino, stocks rose for the third straight day as Boeing, Northrop Grumman, ConocoPhilips, and Newmont Mining reported higher than expected profits. So far this quarter profits for 352 of the S&P 500 companies have risen 20.8 percent according to Thomson Financial. That is the fastest pace since the second quarter of 2000. Revenues have risen 7.5% this quarter. Trailing earnings for the past four quarters according to GAAP is $37.77. At today's close of 1048.11 on the S&P 500, the Index is trading at 28 times earnings.

Analysts now expect a strong year-end rally based on the Fed policy of providing strong liquidity for the markets. With the Fed money presses operating at full throttle, speculators have plenty of money to throw around with most of it going into financial speculation. The U.S. may have lost its position as the world's premier manufacturer of goods but it has gained in stature as the world's largest producer of credit, asset bubbles and paper. We may produce less goods and services in this country but we are creating plenty of paper assets in which to trade to take their place.

In today's market volume levels declined to 1.51 billion on the NYSE and 1.95 billion on the Nasdaq. Market breadth was positive by 20-12 on the Big Board and by 19-12 on the Nasdaq. The VIX fell to a new record low today at 16.43, down .39. The VXN is also at a new record low falling .28 to 24.72. I can’tremember when there was this much complacency in the markets. There is absolutely no fear on the part of investors. In one sense they have become fearless.

Just like a casino bets are made between the casino and players with the gamblers looking like winners. But we all know that in the end the house usually walks away with the chips, not the gamblers.

Charts courtesy of: StockCharts.com

James Puplava

© 2003 James Puplava

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