Boiling Frog Syndrome

Boiling Frog Syndrome

Ted Butler of www.investmentrarities.com summed the current situation up best.

People do not appreciate the current economic events, because every day there is more and more bad news. We start to tune out of it after a couple of banks go under. It starts to feel normal (or common). People also just do not like to hear bad news. It's a bit like hearing terrible war stories from Iraq or Afghanistan. We do no truly appreciate the true seriousness of events over time, only if it personally affects us.

If you put a frog into a pot of cold water and increase the heat gradually to a boil, he won’t jump out.

The heat is on the world economy and now is the time to wake up. Don't wait for the water to reach boiling point. Major banks and insurance companies which go back to the mid 1800s do not suddenly go bankrupt for no good reason.

(Ted's boiling frog explanation was originally in relation to a retail shortage in the silver market. I have yet to find time to discuss the opportunity in silver on my blog, but right now there is a 10 week wait to take delivery of any silver in Australia. There is a worldwide shortage, yet the price of silver is still low because of market manipulation by a couple of US Banks. More to come on this subject..)

To avoid the boiling frog syndrome you must have i) an open mind, ii) change your context and iii) take action.


Last week in Review:

U.K. Trillion Dollar Bailout

Last Wednesday 8 October 2008, the UK government announced a £400bn bank rescue package to help increase bank capital and sure up loan guarantees.

The chart below puts some perspective on the bailout plan:

Six central banks cut rates

Also on Wednesday, six central banks cut interest rates by half a percentage point (following Australia 1.0 percentage cut on Tuesday). The US official interest rates are now 1.5%, and the European Central Bank (ECB) has its rate at 3.75%.

"Free-Fall" Friday

Sharemarkets continued to fall dramatically last week, with many stock exchanging closing at one point due to indexes falling by over 10% (Indonesia and Japan). The worst falls by far came on Friday.

- Australian ASX down 8.2% (down 16.2% for the week!)
- Japan's NIKKEI down 9.62%
- UK FTSE down 8.85%
- German DAX down 7%
- US Dow Jones down almost 10% at start of trade, but ended up closing 1.5% lower.

The Australian Sharemarket has now fallen 42.5 percent since its peak on 1 November 2007 in about 243 days. This bear market is officially worse then most previous bear markets.

Prime Minister Rudd Guarantees bank Deposits

Political pressure came to be, with the Australian Prime Minister would guarantee all bank deposits in Australia for the next 3 years. This is estimated to cover about A$700 billion. The government also doubled to $8 billion the funds available to improve liquidity in residential mortgage-backed securities.


Main discussion point today: Shake up for world Industries

Automotive

The US car industry, in particular, has been in dire straits for a number of years. The only reason General Motors (GM) and Ford have not gone into insolvency is because the US Congress keeps throwing tens of billions of dollars at them. A couple of weeks ago $24 billion was thrown.

The US Government is not prepared to see GM and Ford collapse. They are bigger then many countries in terms of annual revenue and employment.

Ford currently has a market cap of US$4.55 billion. Ford lost US$12.6 billion in 2006, and US$2.7 billion in 2007. In the 2nd Qtr 2008 it lost $8.7 billion! (in only 3 months).

GMs share price is now at the levels of 1956, with a market capitalisation of US$2.77 billion. GM lost US$38.7 billion in 2007, and US$15.5 billion in the 2nd Qtr 2008! (in only 3 months).

Companies which are loosing tens of billions of dollars every year should not be kept in business. New car sales in the United States are now at their lowest level in 15 years. The US Government and taxpayers have always subsidised the auto industry, but the cost of doing so today is for its very survival. If they were allowed to fail, many hundreds of thousands of workers would loose their jobs world wide (think of component manufacturers and indirect jobs). I suspect the main reason for keeping GM and Ford alive is all about confidence. In the early 1930s, Ford laid off 10,000s of workers, which helped fuel further unease in the outlook for US economy.

They represent manufacturing and economic activity. With millions of American's foreclosing on their homes over the last few years, no one is looking for a new car. People go back to basics and if the 2nd hand car works, why replace it?

Talk on the street is that Ford and GM proposed a merger recently. Current talk is GM is now exploring a merger with Chrysler and Ford is apparently seeking to offload its majority stake in Mazda.

Where ever this goes next, one thing is almost certain and that is consolidation in the automotive sector. There has been too much competition. The car manufacturers have been absorbing rising steel prices, aluminium prices, wage prices etc. As a consequence, they have been unable to pass these costs onto the consumer in full and their profit margins are squeezed. So they have been left caught building increasingly expensive cars, that no one is prepared to buy.

Consolidation across other industries

There will be more consolidation across all other areas of industry. The longer the credit squeeze goes on, the more depsrite companies will be to merge with one another, or face bankruptcy. Right now it is basically impossible for companies to raise equity, to raise debt, or even sell assets to raise cash.

Airlines

The best example of consolidation will be in the Airline industry. We are all familiar with the $1 special sale fare's JetStar and Tiger Airways etc has every few months. Competition is fierce, yet airlines are operating in an environment where fuel has been hurting growth and profits. Air Italia is going under. The low-cost carrier model isn't sustainable. Only the major airlines which consolidate will survive a major global downturn. Many have gone under in the last few years, and this happened in economic good times.

Commodities:

As discussed previously, commodities have had a rough time in the last couple of weeks. Deflation is hitting both hard commodities (metals and energy) and soft commodities (agriculture).

Hard Commodities

In Australia, we should particularly see consolidation in the resources sector. Many high-cost producers and explorers will go out of business. Companies will need to preserve capital, which means less exploration. Those who have plans to start producing 3 or 5 years down the road will find it difficult to get into production. The best near development assets will have to team up (joint ventures) with cashed-up majors or sell equity to overseas investors to get their project into first production. Only the very low cost producers will manage to bring in sustainable cashflows to keep their business going.

Right now the market is factoring in that many resource companies will fail. However, some of the better companies are falling just as hard as the bad ones. Several companies I have come across have a market capitalisation less then the cash they have in the bank (AED, BRM and CFE for example). Maybe the market is factoring in that the Australian Dollar will be worth less in the future :) ?

It was only less than 10 years ago, that many large resource companies went insolvent and closed down their mines. Zinifex (now OZ Minerals) is essentially a repackaged Pasminco. Ironically now that zinc and lead prices are becoming low again, and many mines are being closed and placed on care and maintenance.

Commodities work on boom and bust. This sector works on over confidence or no confidence. You don't want to be holding a commodity stock during a bust. Right now the market is factoring in that the US led global slow down will severely affect demand coming out of China.

Soft Commodities

Soft commodities should fare much better then hard commodities in times of economic depression. Our spending habits change from buying luxury goods (new cars, plasma's etc) to the very basics. At the end of the day people still need to eat, and if it takes 100% of our disposable income to buy food, people will do it (which is exactly what has been happening already in some countries).

However, the global liquidity freeze will affect farmer's world wide. Banks will be less willing to lend debt to farmers for a wide variety of reasons. Many farmers are already in heavy debt, and have less capacity to repay debt in the future. There is always the uncertainty of drought, flood and other forms of crop failure. Farmers have also been absorbing a large slice of the inflation pie in recent years. Rising fertiliser and fuel costs have not been offset by rising food prices. Farmers are still price takers, with many receiving the same prices for potatoes or milk then what they did 10 years ago. They know exactly what inflation is (on costs of production), and they know exactly what deflation is (the price they receive). On top of this, the 2 major supermarkets in Australia are squeezing the farmers (and food manufacturers) out of the market because of their market power. Lastly, rural Australia is already being hit hard by an aging population. There are not enough young people coming through to replace those looking for retirement in the next 10 years. All this factors will mean there will be fewer farmers, less domestically grown food, higher prices, and more food imports to Australia. Couple this with international factors, such as a population the size of Australia moving from rural to urban landscapes in China each year, and a major push for biofuels, and its easy to comprehend that food prices world wide will inflate dramatically in the coming decade.

Investing in a backyard vegie garden might become widely popular again, or be prepared to pay a greater amount of your disposable income on the basics.


The next post will be on Household Debt and why Australia may end up in a worse situation than the US within the next couple of years.

- Scott