William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

Last week the Federal Reserve Board released the minutes of its meetings in 2006. There were discussions of the current economy, numerous credit tightening moves and a consistent belief in the idea that the US and its policy makers could engineer a “soft landing” from our grossly over-heated residential real estate bubble. As we now know, the landing that we had from our real estate bubble was the hardest landing since the “Great Depression”. In the opinion of Smead Capital Management, this is all symptomatic of free market capitalism and the way the economy cleans itself after years of excesses. It is not an indictment of the Fed or any monetary authority in other countries. Here are a few examples of quotes from these meetings in 2006:

March 27-28, 2006—(Ben Bernanke) “Again, I think we are unlikely to see growth being derailed by the housing market, but I do want us to be prepared for some quarter-to-quarter fluctuations,” Bernanke says. He identifies housing as a crucial issue, but adds that he agrees “with most of the commentary that the strong fundamentals support a relatively soft landing in housing.

May 10, 2006—(Ben Bernanke after being warned by Board Member Susan Bies about securitization risks) Bernanke acknowledges the risks, but doesn’t sound overly worried: “So far we are seeing, at worst, an orderly decline in the housing market; but there is still, I think, a lot to be seen as to whether the housing market will decline slowly or more quickly. As I noted last time, some correction in this market is a healthy thing, and our goal should not be to try to prevent that correction but rather to ensure that the correction does not overly influence growth in the rest of the economy.”

Dec. 12, 2006– The meeting that closes out the year sees policymakers showing little rising awareness of the storm coming their way. Indeed, much of the conversation officials have was about employment and inflation. Some of the evidence of rising weakness in housing was seen largely as a correction for past excess, rather than the genesis of the worst financial crisis since the Great Depression.

The US Federal Reserve Board has been trying to smooth out business cycles for almost 100 years. By late 2006, our monetary policy makers were not close to understanding the problems the economy was facing from the meltdown that the residential real estate market was going to create.

Why was our landing so hard and what can be learned as you analyze other massively overheated real estate markets like China? First, everyone believed and got caught up in the mania. From the first-time homebuyer to the investors owning multiple homes to the condo flippers, nearly everyone bought into the idea that real estate only goes up. Second, there was no geographical diversification safety. Florida, Arizona, California and Nevada were the most over-heated, but every state allowed too much debt to get attached to its homes. Third, the banking system got poisoned. Loan losses critically damaged the balance sheet of the major mortgage lending and securitization companies. It was so wide spread that the states of Illinois, Georgia and Washington have ranked in the top five states for the most bank failures even though they didn’t have the worst performing price action. Lastly, the liquidation in the stock market in 2008 and drastic fall in consumer confidence allowed the breaking of the real estate bubble to deeply impair the entire economy.

The chart below shows us where we are in China at the end of 2011 compared to other housing bubbles in the last thirty years:

Source: “Between Errors of Optimism and Pessimism” GMO White Paper September 11 by Edward Chancellor

China’s real estate bubble has had nearly everyone believe in it and has had additional forces driving it. The belief is first driven by movement of Chinese citizens from rural areas to the cities. The popular myth is that 20-30 million people are moving to the cities each year. According to work done by Kynikos Associates, less than a total of 120 million individuals have urbanized into China’s urban centers since 1998. The mythical part is not directional, but magnitudinal. The urbanization levels are closer to 9 million a year, which is a far stretch from the 20-30 million believed.

The real estate bubble has happened all over the country and has spread to every town of over one million people in China. Beijing and Shanghai are the most populated and have seen prices reach the most extreme multiples of household income. A lack of trust in stocks and low interest rates in banks have driven Chinese citizens to invest in what is close by and easier to understand. Private property investments have only been around for ten years and they had only gone one direction in China until last summer.

Most of the housing built in the last ten years in the major cities has been condominium projects. These developments have been funded by the four largest government owned banks in China. These loans are made to special purpose entities formed under the blessing of local municipal government officials. Of these loans made in 2009-2011, the range of estimates of loan losses on these projects runs between 70% (former party official Yin Zhongqing) to 30% (Fitch). Since these loans are equal to $2.5 trillion US dollars, it means that between $750 billion to $1.75 trillion could be written off by the four largest government owned banks in China. This would wipe out the equity of these banks many times over.

Lastly, we believe that when someone finally yells “fire” and there is a rush to sell out of the ownership of multiple condo dwellings, prices will plummet in China. When prices plummet, then consumers in China will back off aggressively. Simultaneously, a huge credit contraction will unfold and China will be faced with a deep recession/depression, in our opinion.

The Chinese version of the Federal Reserve Board has been around for thirty years. The head of China Investment Corporation, Yin Liqan, was interviewed last year by David Faber on CNBC. He said, “Our government (meaning China) over the last 30 years has developed a very much, you know, sophisticated skills to manage the macro economy.” Here are some of the recent quotes of major China experts and policy makers referring to the “soft landing” that they hope to engineer for their economy, even though the price of homes to average household income appear to be twice in China what they were at the top in the US:

The Economist
Is this the soft landing?
Jul 13th 2011, 20:39 by R.A. | WASHINGTON

–THERE has been a fair amount of anxiety over the state of the Chinese economy of late. News of unexpectedly large debt burdens among Chinese local governments generated a wave of concern that recent Chinese growth has been entirely unsustainable. As the government was forced to turn off the credit tap, some supposed, property prices would fall and a hard landing would result.

That seems an unlikely scenario to me. Chinese debt burdens are manageable and its property market dynamics are quite different from those that prevailed in western bubbles markets prior to the crash. That doesn’t mean that all is entirely well in China, however. Many observers have taken some comfort in the latest GDP report from China. Output rose 9.5% year-on-year in the second quarter. That constitutes a moderate slowdown from growth in the previous quarter, and was a little above expectations. It would seem that the government’s efforts to slow credit growth have not precipitated an uncontrollably rapid downturn in activity.

Bloomberg
World Bank Sees Soft Landing for China as Asia Withstands Europe: Economy
Nov 22, 2011

–Bert Hofman, the World Bank’s chief economist for the East Asia and Pacific region, talks about the prospects for China’s economic growth and its implications for the region. The World Bank said China is heading for a soft landing of growth in excess of 8 percent next year, and with most Asian nations has fiscal scope to cushion its economy from an escalation in Europe’s debt crisis. Hofman spoke yesterday in Singapore with Bloomberg’s Haslinda Amin.

Miningmx Reporter
Soft landing in China forecast
Jan 6, 2012

–FOURTH quarter company results should support expectations of a slowdown in minerals demand, some of it seasonal, but for 2012 a soft landing in China would buoy metal shares, said Goldman Sachs in a report published January 3.

Goldman Sachs Global ECS Research team estimated China’s gross domestic product will slow to 8.2% in 2012, a relatively soft landing for the economy, providing sufficient growth to remain supportive of metals.

And if there is some softening in commodity prices, it may be enough for China to launch another stimulus programme rather than risk lower growth, Goldman Sachs said.

At SCM, we believe all the pieces are in place for a “hard landing” in the China real estate markets. By the end of 2012, this bust in real estate will start to affect the major banks in China and severely inhibit policy maker’s ability to stimulate the economy. Credit contraction will follow in 2013, in our opinion. Commodity prices could come down as much as 50% in anticipation of drastically reduce Fixed Asset Investment and energy use in China. In other words, a “soft landing” in China following one of the biggest real estate booms in history is a “Mission Impossible”!

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Some of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date of this missive and do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.

William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

What is required for a whopper of a secular bear market is for most market participants to believe the positive side of the story all the way down. We at Smead Capital Management believe that all the pieces are in place for commodities to suffer a multi-year bear market which will wipe out up to 70% of peak prices on most major commodities. We have shared the graph below before, but we want to make sure everyone sees the potential for a massive reversion to the mean.

Source: Stifel Nicolaus “Interlocking Structural Challenges: Traction, Unity and Rebalancing” July 7, 2011

For commodity prices to revert to the mean in the next ten years and to reach negative rolling ten-year returns requires a massive bear market. Some of the preconditions for a massive bear market in commodities are:

1. Significant over-valuation. Most commodities trade for 3 to 4 times the cost of production.

2. Massive ownership by financial and non-economic owners like Endowments, Foundations, Pension Plans and consultant recommended portfolios.

3. Well identified cheerleaders with great fifty-year arguments (Jim Rogers and Jeremy Grantham).

4. Smart money either short or on the sidelines. Commercial interests have their biggest short positions in CFTC records.

5. Conagra, Cargill and Glencore selling to “bigger fools” at the top. Conagra sold their commodity trading business at the top in 2008, Cargill spun off Mosaic in 2011 and Glencore went public in 2011, both near the top.

We could go on. China is the largest marginal user of commodities in the world at the moment and the largest economy in the world (USA) has been busy teaching itself to use dramatically less of these commodities in the last four years. China’s internal stock market, the Shanghai Composite, the only index which seems to reflect the truth about the immense slowdown occurring in China, made a new low on January 5th at 2148. While China burns, devoted commodity speculators/owners hang their hat on Iran’s effort to flex its muscles in the Straits of Hormuz. Oil is the lynchpin to the commodity markets. It is the biggest single factor in the commodity indexes and has a huge impact in the production and transportation of all the other commodities. Oil and gas production is going wild all over the world and supply is up dramatically everywhere. Oil trades completely uncorrelated to natural gas, even though the process of finding them is deeply intertwined.

We’ve got what we at SCM think is great news for investors around the world. We believe this is Nero’s (Iran’s) last chance to fiddle. In our opinion, the recession/depression coming in China’s economy will break the back of oil prices for decades. Lower oil prices could strip the economic relevance of Iran, Saudi Arabia, Syria and Yemen. The institutional investing crowd will wonder why they got tied up in commodity indexes at their peak of popularity and will spend the next five years moving away from an over-commitment to oil, basic material and heavy industrial stocks. These were nothing more than a back-door play on the commodity boom triggered by the BRIC trade and all of its global synchronization. As we believe that the news will ultimately show that Rome (China) is burning, watch the case on commodities become something that the cheerleaders used to “harp” about.

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Some of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date of this missive and do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.

The information contained in this tv appearance represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. The securities identified and described in this tv appearance do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.

William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

In a recent Bloomberg article, Michael Patterson shared that the relatively new equity division of PIMCO was using the China monetary policy shift to buy basic material, heavy industrial and emerging market stocks. Here is how Bloomberg explained the move by the world’s largest bond fund manager:

“China, which reduced the amount banks must keep in reserve by half a percentage point to 21 percent on Nov. 30, may cut the ratio by as much as three percentage points in the next 12 months, Masha Gordon, the head of emerging markets equity portfolio management at PIMCO, which oversees about $1.35 trillion worldwide, said in an interview. Inflation in the nation may slow to between 3 percent and 4 percent from 5.5 percent in October, she said.

‘We’ve seen the first clear shift from tightening to selective easing on the monetary side in China,’ Gordon said by phone in London yesterday.”

Gordon went further to argue that low PE ratios in those sectors and in emerging market countries make a compelling contrarian case. Here is her argument as quoted by Bloomberg:

“’We started with light positioning in the cyclicals and have been selectively adding to companies in the materials and industrial space where we believe valuations are pricing in extreme distress,’ Gordon said. Some stocks tied to economic growth in developing nations “are very cheap relative to their average earnings power if you take the view that growth in emerging markets on a secular basis isn’t coming to a halt,” she said, without naming any specific companies.

The MSCI Emerging Markets Materials Index trades at about 8.6 times analysts’ profit estimates, or 24 percent lower than the average ratio of 11.4 since Bloomberg began compiling the data in 2006. The MSCI Emerging Markets Industrials Index is valued at a 17 percent discount to its five-year average, the data show. MSCI’s gauge of Chinese industrial stocks trades at 9.4 times profit estimates, down from a historical mean of 16.”

Over the years, we have been very hesitant to buy cyclical companies based on PE ratios. The reason is simple. The best time to buy cyclical stocks is when their industry is hurting and they have little or no earnings. The old adage is “buy cyclical stocks at high PE ratios and sell them at low PE ratios.” We are not big fans of using the Schiller 10-year smoothed earnings for the market as a whole, but for cyclical companies where earnings disappear in downturns, it is a great way to look at the PE ratio. We thought that we would use US companies which have been huge BRIC-trade beneficiaries of the “secular case” on emerging markets to get a feel for where we are at with cyclical stocks in general. Therefore, let’s look at Caterpillar (CAT), Joy Global (JOY), Deere (DE), US Steel (X) and Schlumberger (SLB) on a 10-year smoothed earnings basis and see if they look cheap on the basis of PE ratio. The results are below:

The only stock on this list which looks attractive on a Schiller 10-year smoothed earning basis is US Steel at 7.2 PE. All the others look very expensive relative to the S&P 500 Index.

We believe that buying cyclical stocks and emerging markets under the assumption that secular forces in emerging markets will nullify the cyclical nature of sectors like energy; mining and heavy machinery exposes investors to a great deal of risk and shows a lack of understanding of the history of the markets. Please show me a cab driver or shoeshine boy who doesn’t know that there are secular forces at work in emerging markets.

Over-paying for stocks based on “well-known facts” is not a good way to take advantage of the “current distress”. We believe it would be better to wait for three to five years of poor performance in these stocks, which we expect to see, and until earnings have declined quite a bit before you buy. After all, it is just the first monetary easing move after a year of constant tightening in China. Besides, China could be starting its first real economic contraction as a quasi-capitalist country.

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Some of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date of this missive and do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.

William Smead
Chief Executive Officer
Chief Investment Officer

Printable Version

Dear Fellow Investors:

Mark Hulbert does a great job of explaining how sentiment works in bull and bear markets. He has examined market statistics and investment newsletter writers for the same 31 years that I have been in the investment business. His analysis shows that bull markets climb a wall of worry and that bear markets decline on stubborn bullishness. Investors buy the dips in bear markets and become more committed all the way down. It reminds me of the main characters in the movie, “Dumb and Dumber”. Lloyd Christmas (Played by Jim Carrey) and Harry Dunne (Played by Jeff Daniels) seemed to compound their mistakes in every pursuit they undertook.

What brought this to mind is the price action of the last week in the US stock market. Stocks have rebounded sharply from the lows of Monday, October 3rd. The rebound has been led by Energy and Basic Materials stocks like Apache (APA), Joy Global (JOYG), Freeport McMoran Copper and Gold (FCX), Schlumberger (SLB) and Caterpillar (CAT). These have been the heart and soul of the BRIC trade for the last 5 to 10 years. The theory is that the growth in China and India will cause immense demand for energy and basic materials. This in turn causes Brazil and Russia to prosper by providing China and India with the energy and basic materials they need. They are not in the BRIC acronym, but you can throw Australia and Canada into that mix.

If you read David Barboza’s columns in the New York Times, you’ll see that a major credit crunch in China is causing all hell to break loose in the world of small to medium size businesses. They are the entrepreneurs in China and they have not received loans from the four largest banks in China which are government owned. The Chinese government’s dictated lending spree of the last three years went to communist party officials at the municipal level, who formed special purpose vehicles to develop condo, office building and other infrastructure projects. Instead, a massive underground lending system has developed where risk takers with cash have sought higher interest rates than the government-controlled banks offer. This money was loaned to businessmen and developers who couldn’t get the cheap financing offered by the government. The borrowers wanted these loans to ride the boom. These small to medium-size businesses operate on fairly thin margins and the slowdown in the world economy of the last six months, triggered by supply chain problems in Japan, has put many of them over the edge.

Thousands of Chinese business owners are disappearing and walking away from their business because they can’t meet the demands of the high interest rates and the underground loans they have taken to fund their business. Here is how David Barboza describes the situation in his October 13th piece called, “As China’s Economy Cools, Loan Sharks Come Knocking”:

WENZHOU, China — The 300 employees of Aomi Fluid Equipment here were delighted recently when the owner offered an all-expenses-paid, two-day trip to a mountain resort three hours away.

The owner, Sun Fucai — or Boss Sun, as he’s known — was so insistent that his workers attend that he imposed a $30 fine on any employee who refused the getaway. Nearly everyone went.

Except Boss Sun.

When the employees returned from their holiday, they found that the factory had been stripped of its equipment and that Boss Sun had fled town. “It was entirely empty,” Li Heying, a former Aomi worker, said of the factory. “It was like what happens in wartime.”

The boss, as it turned out, was millions of dollars in debt to loan sharks — underground lenders of the sort that many private businesses in China routinely use because the government-run banks typically lend only to big state-run corporations.

As China’s economy has begun to slow slightly, more and more entrepreneurs are finding themselves in Mr. Sun’s straits — unable to meet debt payments on which interest rates often run as high as 70 percent in this nation’s thriving unregulated, underground loan system. Such illegal lending amounts to about $630 billion a year, or the equivalent of about 10 percent of China’s gross domestic product, according to estimates by the investment bank UBS.”

A major credit crunch for businesses is now occurring in China. Its economy, which was built on its businesses having a significant cost advantage over other competitors around the world, is losing its advantage to inflation. As that advantage dissipated over the last five years, China chose to go on the world’s biggest building spree. In the process, they have made fixed asset investment an unrepeatable 50-70% of the GDP of the second largest economy in the world, depending on whose estimates you use. Real estate transactions and development is estimated to be 74% of municipal revenue.

In other words, if China doesn’t keep on building at the same pace as the last three years, their economy will contract. Therefore, the two-pronged economy of China, exports and infrastructure construction, are both threatened at the same time. Exports are threatened by the underground markets ability to over-leverage small to medium sized businesses and the construction world is over-leveraged on cheap money force-fed into an economy that doesn’t need what is being built. There is nobody to rent the condos and too few citizens who can afford a train ticket.

This brings us back to the US. Most of the US economy’s recovery has been held hostage by incredibly high commodity prices. We have had the worst and deepest recession since 1981 and the deepest depression in construction since the 1930’s. On a per capita basis, home building is at 70-year lows! This means that demand for copper, steel, iron ore, cement, coal and oil are way down from four years ago. We are using the least amount of gasoline since 2000 and the least oil since 1996.

We have been struggling to recover against a back drop that includes record high input prices. At the same time, energy costs and demand for food in China and India have made Americans pay much higher prices for food and other goods. All of these facts stem from the demand coming from China and the faith that has been placed in the idea that their economy is not subject to normal business cycles. David Barboza’s article is proving them wrong:

“That tycoons in a city known for its savvy entrepreneurs are running scared has raised concerns that private business, a vibrant part of China’s economy, may be losing steam — while exposing the high-risk, unregulated financial system on which so many of the nation’s small and medium-size businesses have come to depend.

“There have always been people running away because they couldn’t pay their debts,” said Wang Yuecai, general manager at Wenzhou Yinfeng Investment & Guarantee, which guarantees state bank loans when small businesses are lucky enough to get them. “But recently, the situation here has gotten much worse.”

Last week, Prime Minister Wen Jiabao and a delegation of top officials, including the head of the nation’s central bank, visited Wenzhou, promising to get official banks to lend more to small companies and to crack down on underground lenders that charge high interest rates.

And on Wednesday, China’s state council, or cabinet, announced a series of measures aimed at helping small businesses with tax breaks and new lines of credit.

Beijing no doubt worries that similar problems could surface in other parts of the country.

“This is not just happening in Wenzhou,” said Chang Chun, who teaches at the Shanghai Advanced Institute of Finance. “Some companies borrow from the state banks and then lend into the underground market. Many are doing this type of arbitrage.”

Thanks to research done by Kynikos Associates LP and its founder, Jim Chanos, we believe that many of the premises used to create faith in the idea that China’s economy won’t suffer normal business cycles is unfounded. For example, many China apologists argue that 25-30 million people will move each year to the cities from rural areas and support the added infrastructure. I don’t know how to say, “If they build it, they will come” in Chinese, but that is the theory. Chanos argues that Kynikos research found 8.5 million people migrated in 2009 and a total of 118.7 million since 1998. However, all that movement is predicated on jobs being available in the cities and that is predicated on the building boom continuing along with those entrepreneurial businesses surviving. It sounds so much like the retiree migration that was anticipated in Miami, Phoenix and Las Vegas in 2005 and we all know how that myth worked out.

Michael Pettis has provided us statistics that which show what an unusually large part of the world’s commodities have been used in China in recent years. This was backed up this week by a report which puts China as having 1.9 million metric tons of copper stockpiled at the end of 2010. This is equal to all the copper used each year in America. The credit crunch for small to medium sized manufacturers included them using copper as collateral for loans.

We have argued for three years that commodities are ridiculously over-priced and have argued that China has to have a deep recession/depression if it wants to become a major and sustainable world economic power. We believe this is all unfolding before our eyes, yet US hedge fund, institutional and individual investors are buying every dip in the commodity markets and playing the same risk-on trade that worked in 2009. Hulbert would say that their dogged bullishness is a bad sign for contrarians.

Wenzhou is one of China’s many manufacturing metro areas. Barboza relied on research from Wang Tao, a UBS economist based in Hong Kong. Here is how Tao and Barboza show the current circumstance:

“As long as China’s economy was racing along at an 11 percent growth rate, small companies could hope for enough business to stay a step or two ahead of their underground creditors. But there was little room for error.

Now, businesses here and elsewhere in China are being caught short because the national economy has begun to moderate a bit, to a projected 9 percent rate by year’s end, in response to government-imposed measures to fight inflation and let air out of the real estate bubble.

Ms. Wang, at UBS, said the slowing economy and weakening exports would hurt many small Chinese businesses. Already, according to a recent survey by the city’s small-business council, one in five of Wenzhou’s 360,000 small and medium-size businesses have recently stopped operating because of cash shortages.”

This means that 72,000 businesses have recently been shut down in just one city in China. A major credit crisis and recession/depression is in the offing, in our opinion. Yet US investors continue to pursue the BRIC trade all the way down. This is why the investor behavior reminds me of the movie, “Dumb and Dumber”. We believe the next great bull market in US stocks will not be led by the best performing sectors of the last ten years, because leadership in energy, basic materials and heavy industrial can only come from uninterrupted growth in China. If China can continue its charade, we believe the US economy will continue to suffer. If not, the seeds of US prosperity will be watered and fertilized by lower commodity prices.

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Some of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date of this missive and do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.