Charlie's Verdict

I am currently empanelled on a jury. Of course I can't speak about the case I am on, or about any of its details. Due to the apparent inefficiencies of the criminal justice system, my fellow jurors and I spend an inordinate amount of time locked in the windowless jury room. During this downtime, we chat about all sorts of subjects. When we finally get past the Ford vs. Holden debate, we get into some more broadly interesting areas.

Without discussing my jury's composition in any detail, as I don't want to compromise their anonymity, it's fair to say the 12 people represent a broad cross-section of Australian society. It actually gives me faith in the jury system that such a random sample of socio-economic backgrounds have been brought together on this jury: a slice of middle Australia. They are all very decent people.

About two days into the trial I was forced to reveal I was a stockbroker, and that I drive neither a Ford nor a Holden! After the initial shock, and numerous jibes about being a "fat cat", my fellow jurors started firing equity market questions at me, and these people were far better informed than I ever expected.

The majority of the jurors hold Australian shares directly, and all hold more equity market exposure indirectly via compulsory superannuation. Many hold Telstra, and, unfortunately, as their largest individual holding. We have spent hours going through the pros and cons of Telstra as a medium-term investment, and I think I persuaded the group that selling Telstra shares now was pointless as they have already taken most of the investing pain. I actually encouraged them to buy more shares via T3 to bring down their average cost, and be exposed to a finally fully privatised Telstra.

It is worth remembering that many Australians are in the same position. They are watching the longest rally in Australian equities ever yet their largest holding, which was sold to them by the Government and supposed to be defensive, has fallen by 50%. Perhaps the wealth effect of the equity market rally is a little less than we all think out in suburbia.

I have been stunned by how keen some of my fellow jurors were to borrow money and invest in the equity market. They all asked whether this was a good time to do this and, specifically into resource shares, which were "hot".

They all claimed they didn't have enough exposure to the resource sector, and only a couple owned BHP Billiton directly. They felt they were missing the resource boat, and that the upside was limitless. I had to explain to them there's a huge difference between buying BHP Billiton for your super fund and leveraging into already highly leveraged second-tier resource stocks,

Leverage works both ways

They were taken aback when I said it would be a terrible decision to borrow money now and buy, low-quality, highly leveraged resource stocks. Very few of them realised that they had already missed making between 200% and 1200% in individual resource stocks over the past four years.

They were all familiar with oil’s price rise, but did not know gold was 250% off its lows, copper 600% off its lows, and zinc 500% off its lows, or that the prices of underling commodities and listed resource stocks were now being driven by speculators, day-traders and non-traditional players.

I told these people that there is nothing wrong with buying mega-cap, diversified, low-cost, high-grade, long mine life, strong balance sheet, huge cash generation, well-managed, organic growth companies such as BHP Billiton, Rio Tinto and Woodside Petroleum through the pending trading correction. Conversely, buying high-cost, low-grade, short mine life single commodity stocks right now is highly dangerous because they are vulnerable to an underlying base metal price correction.

I tried to explain the paradox that our highest quality resource stocks were now our cheapest, and our lowest quality were the most expensive. I used all my favourite lines, ranging from "in a strong enough wind even turkeys can fly", "what the wise investor does at the beginning, the fool does at the end", to the most appropriate of all from the great Jimmy Goldsmith '” "when you see a bandwagon it's too late".

I was trying to get through to them, as I am trying to get through to you, that there is rampant speculation in the leveraged metal space right now, and I see not just a "bandwagon", I see a whole procession!

I see the words "new paradigm", "super cycle", and "commodities boom" used with gay abandon, yet mostly by people who never believed in commodities or resource stocks until today. I see commodity strategy written by people who I doubt have ever visited a mine! I see a competition between global brokers, who have completely missed the cycle, to now see who can have the highest commodity price forecasts and resource stock earnings forecasts. I see "super bears" now morphing into bulls, and it is impossible to find a "sell" recommendation. There is nothing surer than that a trading correction is coming to teach of these people who are now blowing with the wind a quick and hard lesson in economics and investing.

"Denial" to "belief"

Basically since January 1 the "denial" that we wrote about for three years regarding the resource sector has started to be priced out. The risk/reward pendulum has swung to risk in relation to low-quality, single commodity, short duration resource stocks, while the high-quality, diversified commodity, long duration resource stocks are value, but clearly no longer compelling value.

The "glass half-full" argument, that the resource sector isn't reflecting spot commodity prices, is simply rubbish. Have a look today: the spot base metal prices retreated on Friday night on the London Metals Exchange, and there was a race for the trading exit in our most leveraged metal stocks today. These stocks are just reflecting spot commodity prices; the trading market prices off them every day. There are clearly now people who every day need to see a rising commodity price to justify what they are holding, and that just tells me there needs to be a cleanout. Perhaps the cleanout has started.

Do not misunderstand me; I am only calling for a trading correction in base metals and base metal stocks. I remain an unflinching bull on oil, gold, iron ore, and coal. However, I believe when the trading correction comes it will be violent, and will shock those newcomers to the metals sector.

Nobody has been more bullish, earlier, or more outspoken on commodities over the past three years than me. People who have followed my strategy have done brilliantly, but please listen to me now when I are trying to tell you to lock in some profits in the metals sector, and rotate to the highest-quality, longest mine life, lowest-cost, long-duration resource stocks. Now is not the time to increase leverage, as other brokers are attempting to tell you; now is the time to reduce leverage, increase quality, increase organic growth, and increase duration.

I remain a long-term believer in the underlying drivers of the commodity cycle. However, I believe speculators have taken control of the sector, and I am happy to take a more cautious short-term stance. I can still see BHP Billiton trading to $50 over the next five years, even if copper comes back to $2.50 a pound. BHP will be digging copper out of the ground for 50¢ a pound, expanding production by 40%, and they don't need the current spot price of around $4 a pound to be maintained to have a huge profit margin and be printing money.

So I again say to you what I have said to my fellow jurors: now is not the time to add leverage. Interest rates are rising, and inflationary pressures are everywhere. Risks are clearly rising globally, yet the Australian equity market is pricing very little "risk". The four mega-cap resource stocks I recommend accumulating through the pending corrective phase are BHP Billiton, Rio Tinto, Woodside Petroleum and Wesfarmers.

The "metals" sector today by market capitalisation has grown to $50 billion and stocks such as Oxiana and Zinifex have filled the market cap gap left by Western Mining. I suspect investors/traders are now "capitalising" spot commodity prices in the base metals sector. They may prove correct, but I suspect in the short term they will prove too enthusiastic. If you want to remain fully invested in the mid-cap space, I recommend you rotate to the oil, gold, junior iron ore, and coal sectors, where spot prices are clearly not reflected in current share prices. (Roc Oil Company, Hardman Resources, Karoon Gas Australia, Oil Search, Tap Oil, St Barbara Limited, Avoca Resources, Gindalbie Metals, Straits Resources, and Excel Coal Limited, etc)

Anyway, it's a bit annoying being away from the coalface while there's such heavy trading volatility, yet I have to do my civic responsibility, and I am learning by listing to the economic views of my fellow jurors.

Investing requires absolute discipline. It's not about momentum or riding a bandwagon. Actually, that's wrong '” it is about riding the momentum bandwagon, but you must remember to get off the bandwagon before it heads over the cliff!

It's been a very lonely place writing cautious strategy over the past month, and it doesn't come naturally to me. But greed had taken over, and fear was only about the fear of missing further upside.

The big bad wolf

My strategy is based on the view that inflationary pressures are underestimated. The commodity prices we see today must have second-round inflationary ramifications, as manufacturers attempt to recoup rising input prices. All inflationary readings globally are starting to surprise on the upside, and that's telling you the interest rate debate is going to get louder and louder. Bond yields are rising globally to reflect rising inflationary risks, and the "Goldilocks" scenario, of inflation-free global growth, is going to prove just that, a "fairytale". Unfortunately, that "fairytale" is the one currently priced into markets.

I continue to urge you to make sure your investment house is made of brick (pricing power, barriers to entry, high return on equity), as the "big bad inflation wolf" is starting to huff and puff. Treasurer Peter Costello threw the wolf a bone the other day, and now it's only a matter of just how high the Reserve Bank will have to take cash rates over the next 24 months. That could take the Australian dollar well above US80¢, and that's another issue domestic investors will have to deal with.

The risk adjustment phase has started in Australian equities, and by adjustment I mean some equity risk premium will actually be priced back in. Remember, 75% of the Australian equity market remains industrial. The inflationary, oil, and interest rate headwinds we are seeing are not broadly positive for 75% of the benchmark index.

I simply can't see how we aren't in for a corrective phase in Australian equities, and hopefully you are positioned to take advantage of cheaper share prices as they emerge over the next few months. I actually believe the supposedly "defensive" banking sector will lead the correction; particularly once the sector goes broadly ex-dividend in a few weeks. The banking sector has never been more expensive, or had a lower comparative yield to bank bills in the past six years. Bond and bill yields have moved to six-year highs to reflect inflationary risks. If we have banks and resources correcting simultaneously (50% of the index), you could easily see 400 points wiped off the ASX200 from the all-time high reached last week. That's a trading correction.

Be prudent, be patient, and be disciplined. Wait for some risk to be priced back in. And please send me some decent sandwiches!