It’s Groundhog Day As 2007 Draws To A Close

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This story was first published two days ago in the form of an email sent to registered FNArena readers.

By Rudi Filapek-Vandyck, editor FNArena

There’s a theory going around in the market that resources stocks should commence the new year on a high as many institutional fund managers have gone underweight the sector during the past few weeks to safeguard the investment gains made earlier in the year.

These institutional investors are expected to return from their holiday sometime in January and conclude their money is best directed towards buying resources stocks, which should almost guarantee a bumper start for the sector into the new year.

The problem with this theory is that it only tells you half the story. Yes, many institutional investors have scaled back their exposure to cyclical companies, and to resources stocks in particular, and the metals and mining sector may well have a positive start into the new calendar year, but it is yet to be determined whether the likes of Merrill Lynch, Deutsche Bank and Credit Suisse will decide to go Overweight resources again immediately or shortly after the Christmas Break.

The odds seem in favour they won’t as it is their current assessment that the risk for some serious mayhem for resources stocks next year due to weak economic data from the US and Europe is simply too high. The big wholesalers are therefore happy to wait on the sidelines and see what develops first. It is their view that chances are high they will be able to step into the market and buy the likes of BHP Billiton ((BHP)), Woodside Petroleum ((WPL)) and Newcrest Mining ((NCM)) at lower prices than what they are trading at today – all they have to do is be patient.

Why the big instos in the market are so cautious was this week shown by economists at Morgan Stanley who predicted on Monday (US time) the world’s largest economy is poised to go through a “mild recession” next year with business investment and personal consumption expected to slump on the back of a severe downturn in the US housing sector and continuous problems in global debt and credit markets.

It is for the same reason that several of the large international money managers have adopted a cautious stance towards Asian equity markets: if a positive scenario unfolds next year these markets -even at today’s unusually high valuation multiples- are likely to offer some of the highest investment returns available. However, if anything less than such a positive scenario unfolds, chances are high we could see some serious damage to Asian share prices and this is a risk most large fund managers find too high to be dealing with under the given circumstances.

But it’s not only the risk of a recession in the US -mild or not- that is preventing large investors from moving Overweight resources stocks. Most will tell you next year will be the turning point when inventories are about to rise, more supply will start catching up and spot and contract prices will ultimately trend down.

Current consensus price forecasts anticipate a lower average price next year for all six publicly traded major base metals, a slightly higher crude oil price only and with bulk commodities about to make one last significant jump.

What this means, in essence, is that market expectations for base materials over the next twelve months are pretty much the same as at the end of last year. As it happens, I just went through a pile of research reports which took me whole the way back to the end of 2005, and guess what? Same situation.

We know now that market expectations on both occasions were too conservative. In fact, I still vividly remember the general scepsis in 2004 so it is probably a fair statement to make that securities analysts and professional investors in general have been underestimating the market developments for resources since early 2004, when the upturn in the current Super Cycle started.

So it’s Groundhog Day all over again as 2007 is about to end and make way for 2008.

There are a few things that stand out this time around though. One is that expectations for steel, iron ore and coal are still on the rise. Most experts will safely assume a big jump in bulk commodities’ contract prices for next year, likely to be followed by a minor price increase for 2009, before prices start weakening. However, the trend in expectations is up. A few months ago these same experts would have told you: one last small price rise and that would be it.

This week the team of resources specialists at Merrill Lynch revised their expectations for three more years of sizeable price rises for contract iron ore and a roll over in year four. The key question for investors is, of course, what if Merrill Lynch has shown the new trend for iron ore price expectations? If plausible, then consider the team’s view that this stronger for longer scenario is not yet reflected in today’s share prices.

The same principle applies to coal (in various products) with Merrill Lynch joining other experts in projecting continuous price rises for the three years to come.

It is more difficult to pinpoint a clear trend when we turn to the base metals. There is a whole army of specialists who is ready to nominate aluminium as the prime candidate for a positive surprise in 2008, but it appears that for every bull in the market there’s at least one bear elsewhere who puts the metal at the end of his list of preferred metals for the new year.

The bull case for aluminium centres around the premise that Chinese smelters will face increasing pressure from rising power costs and further government restrictions. If this would reduce their output this would be a positive for aluminium. A second factor seems to be anticipated reduced bauxite exports from Indonesia. This would be bullish for alumina (alumina is treated bauxite used to produce aluminium metal).

What seems to be clear however is that lead is likely to have taken over the role of nickel during the first half of 2007: after a meteoric price rise since the middle of the year, most experts agree the only way for lead seems to be down, down, down – this process is arguably already taking place.

Most experts will also tell you that copper is their preferred metal for the coming year with the likes of GSJB Were projecting the price of copper will remain above US$3 per pound this year. Again, not everyone agrees.

In this week’s sector update, the team at Merrill Lynch acknowledges its view on the red metal has been way off the mark throughout the past twelve months, but the experts refuse to change their view that the copper market is heavily manipulated by traders.

While the first few weeks of 2008 may show continued weakness, most bullish experts are projecting a price recovery closer to February on anticipated renewed Chinese buying.

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