Monday, October 26, 2009

Metal Mining edge

For all the angst about the collapsing U.S. dollar in the past few months, the greenback is now trading essentially at the same level it did before the financial crisis imploded capital markets and sent economies worldwide into recession. Although many financial institutions are far from sound, investors have taken apocalyptical risk out of the equation and have shifted back to their usual modus operandi of maximizing relative returns on capital. However, faith in the store of value represented in the international reserve currency is highly strained, and capital flows show the lost confidence could send the dollar spiralling further. This fear is currently driving commodity markets and the gold sector. The question for equity investors is how best to play this bet against the greenback?

Currency and commodity exchange traded funds are direct investments that small investors can now trade. There are funds, too, that specialize in markets of commodity strength – which would include Canadian equities – or non-dollar denominated markets, especially Euro-zone. Emerging markets, too, are a magnet for capital wary of the declining U.S. currency. Even the stocks of multinational U.S. corporations, like Coca-Cola Co. (KO-N) and Caterpillar Inc. (CAT-N), that derive much or most of their earnings from foreign markets are considered dollar-hedging investments.

In this monetary environment Canadian investors are again sitting in a sweet spot thanks to the heavy commodity bias of our market. The mining sector is outperforming the broad TSX market by 26 per cent since mid-summer and is not yet showing signs of relinquishing its leadership role. Gold stocks are comparatively unspectacular – up by no better than the 11 per cent that the S&P/TSX Composite Index has advanced over the period. However, “black gold” producers – the energy sector – are showing some relative strength, outperforming the market by 7 per cent. Investors should start to look at the relative movement of these sector plays on the falling U.S. dollar, which fell another five per cent against a basket of currencies represented in the U.S. Dollar Index (DXY-I) over the past three months. In times of dollar instability there are appreciable but varying effects on the stocks of the producers of both hard commodities and oil.

During the last Stock Trends Bearish trend of the U.S. Dollar Index from the summer of 2006 to the trembling of the financial crisis two year later metal mining stocks were largely in a strong bullish trend. Gold stocks, though, were in a flat trend throughout the period. So, too, with energy stocks – although they rallied strongly when crude oil prices peaked and put a stranglehold on global economic growth. Investors can learn from the last stint of dollar devaluation: commodity inflation can be largely benign until it hits energy prices. The current market stock market performances of these sectors suggest a similar scenario. Investors can continue to weight in the bullish mining sector, but beware the return of triple digit crude oil prices.

While the relationship of gold and oil is typically a commodity focal point of investors worried about currency fluctuations, metal mining stocks are also showing the relative value of other commodity hard assets, like copper and iron ore. Generally, these industrial-use commodities do not have the allure of traditional stores of value found in precious metals, and move cyclically with the global economy. Certainly, the strength of the mining sector is a strong vote of confidence in the economic recovery likely in place. But investors are also responding to dollar weakness by bidding up these assets even further. Mining stocks will continue to attract investment flows while the greenback remains in a bearish trend.

The relative performance of metal mining stocks versus energy stocks took an about face at the end of last year in the pit of the financial crisis. This shows that investors started to favour these industrial commodities over the bleaker energy fundamentals. In fact, mining stocks have performed much better than gold stocks since the March stock market bottom. Charts of the price movement of the S&P/TSX Mining Index versus the price movement of the S&P/TSX Energy Index show just how favourably investors have fared in hard commodities relative to investors weighted in another dollar denominated commodity – crude oil. When compared on the same basis, investors in gold stocks have not benefited as well during this period of dollar weakness.

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