I found myself exposed to life's excesses and contrasts on a recent whirlwind business trip to the United States.
It started with the book I had bought to read during the flight, The Devil wears Prada by Lauren Weisberger - quite entertaining, but also a shocking display of mindless waste.
Back home again, and it was the contrast of excessive consumer spending and debt versus the necessity of creating an economy conducive to growth and investors that struck me as I passed the informal settlements on my way from the airport back to Cape Town. It does not seem as if the recent interest rate hikes have fazed the South African consumer too much, but these measures take time to make an impact.
Bubbles and market excesses can fool us into believing they will go on forever. In financial markets, a stock market bubble is a term applied to a self-perpetuating rise or boom in the share prices of stocks of a particular industry. The term may be used with certainty only in retrospect, after share prices have crashed.
A bubble occurs when speculators note the fast increase in value and decide to buy in anticipation of further rises, rather than because the shares are undervalued.
Many companies thus become grossly overvalued. When the bubble "bursts", the share prices fall dramatically and many companies go out of business.
These market phases are usually characterised by:
- New anecdotes which revolve around the theme that things are "different this time" and that the crazy valuations are justified. "China is going to be the powerhouse and will just keep growing at its current high rates and will need huge amounts of commodities," would be one such justification that springs to mind;
- There is usually an abundance of capital to invest (such as we have seen, for example, as a result of the impact of the higher oil price on certain economies);
- There is usually a high level of speculation. At present, there is evidence of increased speculation in the commodity market, with an extremely active secondary (for example, futures) market;
- The environment is usually exuberant (evidenced by the low volatility that we have witnessed);
- It is torture if you are not invested in that area of the market. It just keeps going up, retreating a little now and then before resuming its climb, often causing investors to throw their valuations and caution to the wind and buy in; and
- A focus on top line (revenue) rather than on the classic business model of, for example, cost, cash flow and the ongoing value proposition to the customer. A lot of the dot.coms failed because of poor cash flow and value-proposition issues, and the current resource boom relies heavily on the Chinese continuing to accept the current commodity prices as the best value proposition for their needs.
I must add here that the resource companies are not only showing good profits, but many analysts continue to predict that future earnings may be better than the market expects.
I want to make it clear that I am not making a simple comparison between commodity companies and the tech companies that fell apart in the dot.com bubble of the late 1990s.
Commodity companies are generally not run by extremely young and inexperienced managers with expensive tastes that characterised the dot.com managers of the 1990s.
The larger commodity companies are managed by experienced professionals. Commodity companies also produce something real - not the promise of millions of hits on a website in return for a perfect 100 p:e (price to earnings ratio).
The problem with the commodity sector revolves around what investors are willing to pay for the prospect of commodity demand from China and, more importantly, the certainty with which they approach the sustainability of this trend in what has proved to be a cyclical industry.
Another problem is that because the bulk of investing in commodities is no longer taking place in the real asset but in some financial version of the asset, it is easier for a financial bubble to form, adding fuel to the secondary market.
Major global pension funds are contemplating, if not already implementing, greater exposure to commodities.
Cracks in the argument for the continuation of the super-cycle are:
- The US housing bubble (which is showing an annual decline in house prices for the first time in over a decade) can lead to a slower demand for commodities from the US.
The counter-argument is that the US is already becoming less important as a consumer of commodities in today's economy.
- China may continue to act sensibly and slow its amplified growth path, thus curbing demand from this region.
- Commodity producers may finally increase supply, which should lower prices.
- The currencies of "commodity countries", such as Australia, South Africa and Canada, have shown some stability after the commodity-led strength of the past few years but, of course, the rand has sung to its own tune and has shown such short-term weakness as was last seen in 2001 and 1998. This has helped to keep firm the share prices of local commodity companies, while many have declined in sterling and US dollar terms in recent months.
In the meantime, the weaker oil price has led to some relief on the expectations for inflation, with volatility levels and bond yields coming down.
We are still in a phase where the market is recovering quickly, when the bad news is overtaken with relief, but there are definitely some warning signs for those investors who want to start positioning their portfolio differently.
One thing we do know is that if this is going to unravel, it will not be pleasant as far as resource share prices are concerned.
Fortunately, we have other sectors to pick from our portfolios.
- Anet Ahern is the chief executive of Sanlam Multi Manager International