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Markets: Investor Speak
New York: February 27, 2006
By John R. Stephenson

What exactly are investors saying? According to the stock market, quite a lot. The general sentiment amongst investors is one of caution. Investors are fretting over Iraq, Nigeria and the strength of the U.S. housing market. The result? Investors are uncertain as to how sustainable the current global economic recovery is. But with global investment powerhouses such as Credit Suisse calling for strong global economic growth this year (4.8% growth), is the pessimism overdone? For our money, it is.

Investors seem to be dismissing the strength of the global economy — particularly the overseas market. The logic appears to be that a slowdown in America is bad for the global economy. While that has been true in the past, many economists now believe that much of the heavy lifting of global economic growth will happen in Europe, Japan and China. In fact, research from Credit Suisse shows that just 15% of global economic growth is expected to come from the U.S. this year.

Figure 1: Global Economic Growth Broadens

The problem seems to be that investors of all stripes can't see the forest for the trees. Over the last five years, a subtle shift has been occurring. The world has moved away from a U.S. centric world to a much more balanced world, a world where Europe and Asia are playing an increasing role.

For many, the Achilles heel of global economic and commodity growth is China. China, they say, is headed for a slowdown. Really? Growth is up 9.9% and since 1979 the Chinese economy has grown between 5 and 12% a year. But while economic growth in China has been very strong this year, the export growth to the U.S. has been falling. What this suggests is that growth in China is being maintained not by the U.S. consumer as many maintain, but increasingly by domestic demand.

But in spite of this robust economic outlook, investors across the globe are fretting. This worrying has translated into a less than robust market for stocks — particularly those linked to Europe, Japan and China. Instead of placing their bets on stocks levered to the parts of the world where strong economic growth is anticipated, investors would rather bid up the prices of domestic utilities, gold and bonds.

The global mining sector is a case in point. Lately, investors have hammered it. Fears that the commodity bull might become a commodity bear have been behind the recent slide in the valuations of mining companies. Today, these stocks appear to be discounting a 17 percent slide in industrial metals prices. But all of this flies in the face of strong economic growth from China (currently 9.5% growth) and a reserve life index for mining companies that is on average two-and-a-half times their 2006E P/Es (versus 1x for oil companies). Not only that, but mining companies offer a stronger pure play on Chinese growth (China accounts for 8% of global oil demand but nearly a third of iron ore or coal demand) and in many cases, global supply is coming from just a handful of global players. Mining firms that produce copper, iron ore, platinum and zinc should be likely winners in the years to come.

Energy is the one exception to the global commodity story that investors seem focused on with many professional investors over-weighting their portfolios toward energy. But in spite of this enthusiasm, oil companies are still trading (on a P/E basis) well below their historic norms.

Gold is an investor favorite, but it's hard to know why. In spite of a rising U.S. dollar, muted inflation expectations and slowing central bank purchases, gold has been climbing in value. Is there really that much jewelry demand in India? Doubtful. The only thing that is clear is that gold pricing, at least for now, has become divorced from its fundamentals.

Stranger still is investor interest in utilities. With interest rates globally rising rather than falling, utilities, the most bond-like of all equities, are set for weaker performance. On a historic basis, utilities have under performed the market 89% of the time when interest rates have been rallying. As well, surging oil and natural gas prices, which allowed electric utilities to increase their rates for power, are likely to slow in the years to come. Utilities, which are the most sensitive of all sectors to rising interest rates and have the lowest leverage to improving economic conditions, should be investment laggards rather than leaders.

With strong economic growth coming from all corners of the globe, savvy investors should have a portfolio that represents that growth. Exposure to China, Japan and Europe should figure prominently in investors' portfolios. One simple way for investors to get this exposure is through country ETFs (exchange traded funds) that carry lower costs than mutual funds with the benefits of diversification.

As well, commodities such as zinc and copper and the producers of these commodities are leveraged to the surging growth in China. With its rapid industrial growth, China will continue to be the catalyst of industrial metals prices for the foreseeable future. Energy stocks should continue to perform as a cocktail of surging demand, struggling supply and geopolitical risks underpin strong oil and natural gas prices. One safe way for investors to play the energy theme is to buy shares in the oil & gas drillers and service companies which offer strong leverage to the energy bull market.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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