A banker’s warning

Zoomer | June 3rd, 2008

The TSX hit a new all-time high last month, topping 15,000 before investors decided the air up there was too thin and retreated. Still, considering what’s been happening in the rest of the world, that’s was tremendous, if short-lived, accomplishment. But let’s keep things in perspective.

For starters, the TSX has become pretty much a one-trick pony. Just as at one time the Index was driven by Nortel, now it’s being driven by commodities. Except for a few lonely stars like Research in Motion, our natural resources are the only thing keeping the TSX above water.

Until recently, the Composite Index rested on twin pillars, financials being the other. But the fallout from the subprime mess in the U.S. has taken its toll on our banking and insurance stocks, leaving the S&P/TSX Capped Financials Index in the hole year-to-date. Financial stocks will recover but it will take time to fully restore confidence and cautious investors will want to be sure there are no more skeletons in the closet before plunging back in. Meantime, we need to ask ourselves what will happen to the TSX if the commodities sector goes into reverse.

We were warned about exactly that possibility recently by TD Bank CEO Ed Clark. Mr. Clark was always highly respected but his prescience in protecting his bank from the turbulent subprime waters has elevated his status to something approaching iconic. To paraphrase the old E.F. Hutton ad, when Ed Clark speaks, people listen.

Mr. Clark’s words should have sent a chill down the spine of every TSX investor. He was quoted in The Globe and Mail as saying that commodity prices are too high and that TD is basing its loan standards in Western Canada on the assumption those prices will be “dramatically lower” at some point.

There are lots of economists and money managers who disagree. In fact, the same article in The Globe also quoted John Kinsey of Caldwell Securities as saying politely that Mr. Clark is way off base and that when it comes to commodities “We are in a new era that we haven’t seen before.”

I get very nervous whenever I read some variation of the words: “This time it’s different.” Over the quarter-century I’ve been in this business, I have heard them more times than I care to remember. Sometimes they are disguised in an academic-sounding term like “new paradigm” but it always comes back to the same thing.

Granted, Mr. Clark is only doing what bankers should do — being cautious. Many of his American counterparts undoubtedly wish that they had exercised the same degree of prudence in recent years. But as investors, we should also apply a measure of caution. History has taught us that whenever prices look like they will keep rising forever, a crash inevitably follows. It was only about 20 years ago when the value of Tokyo real estate was estimated to exceed the value of all the property in the United States! We all know what happened.

I don’t want to suggest that the commodities boom is going to end overnight. In fact, it will probably continue for some time and there is still money to be made. But to assume it will last forever is folly.

Consider, for example, the price of gasoline. In Toronto, where I live, it is about $1.28 a litre. It’s higher in most other parts of Canada, except Alberta. I know anecdotally that the relentless price increases are beginning to affect not only driving habits but car purchase decisions. One of my children’s families no longer drives a car, relying on bikes and public transit to get around. Another traded down from a gas-guzzling van to a smaller, more fuel-efficient sedan.

All of this raises the question: where is the tipping point? At what price does gasoline consumption go into decline? When that happens, inventories will start to rise. And when that happens, the price of oil will go into reverse, at least for a while.

The pull-back may not be “dramatic”, to use Mr. Clark’s term. Rising demand from China, India, etc. should put a cushion under any decline. But even a retreat to US$100 a barrel — which not long ago was an unthinkable price — would represent about a 25 per cent drop from current levels. Think about what effect that would have on energy stocks.

Oil isn’t the only commodity that could be vulnerable. Have you noticed the reports lately that suggest some politicians are rethinking their unqualified support of ethanol? The only thing that worries our leaders more than fuel rage is food rage among voters. The media is increasingly pointing at the diversion of corn supplies to ethanol production as a contributing factor to rising world food prices. The corn farmers adamantly deny this and why not — they’ve never had it so good. But public opinion on ethanol appears to be shifting and, as it does, so does the political will to push ahead.

What does all this have to do with the TSX? Simply this: if the commitment to ethanol weakens here in Canada, and especially in the U.S., the price of grains will probably start to decline. That in turn will reduce demand for one of our great commodity success stories, potash. Producers like Potash Corporation of Saskatchewan have been able to push up their prices by hundreds of dollars a tonne because the demand is strong and farmers can afford to pay. If the cycle changes, so will the fortunes of the fertilizer stocks.

As I said, none of this will happen overnight — assuming it happens at all. These scenarios take months, sometimes years to play out. But I think the odds are good that we will see a weakening in commodity prices over the next couple of years and that will inevitably be reflected in the TSX. Hopefully, by then the financials and some other downtrodden sectors will take up the slack.

Mr. Clark spoke from a banker’s perspective. But investors who ignore his message do so at their own risk.

Portions of this article originally appeared in the Internet Wealth Builder, a weekly e-mail newsletter that provides timely financial advice from some of Canada’s top money experts. For more information about becoming an Internet Wealth Builder member, click here.