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Rinse Cycle
by David Coffin and Eric Coffin

By putting US $534 billion of sub-prime mortgages and CDOs on either downgrade or review, S&P is finally getting to the magnitude of the bad debt issue in the US. Had they let auditors do their year-end jobs without this, the music would be much louder down the road.

We’ll put aside the irony of bond rating groups with very central culpability in this mess having the ability to call any shots aside for the time being. We hope the rating agencies have galactic sized liability insurance. We’re pretty sure they will need it.

For the rest of 2008, we expect to see a tug of war in the market between optimistic bulls and bears who fear the entire credit sector is about to collapse. Both sides have some merit to their arguments.

We come down somewhere in the middle. We expect to see a lot more write downs and melt downs so we remain cautious about the market. Notwithstanding the addition of two companies to the Journal list, we think a trading stance that includes harvesting of profits when offered is a good idea.

We continue to be worried about credit markets but we are definitely not in the doom and gloom camp. The knock-on effects of credit tightening are well known and dangerous, but so far the casualties have largely been foolish lenders and borrowers. There are A LOT of both, so the effects could still be severe but there was some good news with the bad this month.

The obvious positive spin for the month of January is the hyperactive Fed. Bernanke embarked on one of the fastest rate cutting campaigns on record. He’s been castigated by many for bowing to the orders of Wall St. We don’t think that is what’s going on here. The Fed got behind the curve and was shocked at how quickly the credit market deterioration accelerated.

Cutting 125 basis points also clearly did wonders for equity markets that were in full crash mode when the first emergency rate cut was made. We were hoping to be able to point to January 21 as at least a short term capitulation day. We not sure it can be called that since the Fed really didn’t give US markets a chance to sell off.

Back to back rate cuts made for heavy program trading and the best week the S&P has had for many years. That doesn’t automatically mean the bad stuff is all over with. We suspect a lot of that pent up selling is on hold but not forgotten. The bears are still stalking the canyons of Manhattan and are likely to pounce at the first sign of weakness. In the meantime, the cascade of liquidity has cleaned up the markets and reinvigorated the bulls.

For all of the fear in the market the economic numbers are still best described as “mixed”. Q4 growth came in at 0.6% which was not unexpected given earlier consumer spending and employment numbers. The January labor report was more shocking, with 17,000 jobs lost, though a respected private survey (the ADP Survey) estimated a 150,000 job gain. Construction sector and housing numbers went from awful to more awful, but the ISM survey for January showed mild expansion in manufacturing, something predicted by exactly no one.

All in all, numbers continue to be confusing and contradictory. The US economy is clearly stalling out, but things are not yet as bad as many fear. We think most of the potential write offs referenced in the first paragraph will arrive. The question is where, when and what the market reaction is. A hundred hedge funds writing off $3 billion each might not scare the market very much while a major investment house writing off $30 billion would terrify it. Only time will tell which version we get.

The problem is still lack of information and that won’t change soon. On the bright side, it looks like Wall St’s ADD personality is already dampening the impact of bad news. Swiss Bank UBS reported a $14 billion subprime write off last week, twice analyst estimates, and lost only a couple of percent.

Traders are getting bored of the endless bad news from the financials and starting to assume its all priced in. We’re not willing to make that assumption ourselves but its wise to remember the markets are efficient discounting mechanisms. The market will bottom before the write offs end, not after.

Bernanke is fighting off credit contraction. He also cut quickly and deeply enough to have steepened the yield curve. This increases spreads for banks, helping them earn their way out of their mistakes. Monocline bond insurers and derivatives are still huge issues. Neither has had much direct market impact yet but either one could flatten the financial sector. There are too many risks around for any of us to be complacent. Trading smart and taking profits should continue to be central strategies. No “all clear” yet for the markets but no panic either. If we thought you should just sell everything we’d say so. We haven’t come to that yet.

Its (still) the Supply, Stupid.

We’ve spoken at a lot of venues in the past couple of months. One thing we’ve noticed is extreme bearishness on the part of almost all analysts other than us. We’ve warned of selling in the base metals too, but we are thinking in terms of 10% drops, if that. Part of our relative bullishness is simply recognition that many base and industrial metals have already seen big price drops. We see no reason why there should be yet larger ones in their future.

The second reason for our view is that the supply side of the market simply isn’t keeping up for a wide variety of reasons. The problem is acute enough that supply disruptions can keep prices stable or even move them higher, even in the midst of a shaky market backdrop.

This month brought multiple evidences of those difficulties, as problems both natural and man-made added to the woes of producers.

Winter weather in China is playing havoc with road, rail and power infrastructure. A number of China’s largest base metal smelters have cut back production or shut down completely. This is obviously a temporary issue but the scale of the cutbacks means the predicted base metal surpluses will have to be cut back yet again.

Monsoon rains in Australia that just won’t go away have flooded a number of the countries’ largest coal operations and several large iron ore mines as well. BHP has declared force majeure on deliveries.

Heavy rains in South Africa crippled the local utility, ESKOM. ESKOM has cut back power to the country's biggest users - miners - by 10-20%. The hoists and ventilation systems for South Africa’s deep mines require full power. A number of mines will have to be shut for safety reasons if 100% grid power cannot be assured. ESKOM has stated the only real solution is more power plants.

Barrick Gold has signed a long term tire (yes, tire) purchase agreement with Yokohama Tires of Japan. The 10 year deal includes a $35 million loan by Barrick to help fund expansions of Yokohama’s plants for producing large off road tires

China’s biggest aluminum producer spends billions on a minority stake in RTZ to help block a potential merger with BHP.
A cynic would argue these are all “temporary” issues. Stuff happens. But as we have noted for years “stuff happens” the most when capacity is strained. The fact these issues are news reinforces our view that the fun’s not over yet. There are bumps in the road and our short term cautions remain, but metals haven’t lost their luster.

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