This new focus on growth is most evident in the copper market, where China has come back as a major buyer of the metal.  The dynamics of the copper market actually looks better right now than it has in over 20 years!  LME (London Metals Exchange) inventories have dropped back down to under 350,000 tonnes and Shanghai inventories have also fallen.   But, more importantly, Cancelled Warrants (product that is designated to be released from inventory) on the LME have risen to over 96,000 tonnes, equal to almost 30% of total inventories.  The last time that anything close to this much copper was removed from warehouses was in 1989.  After that happened, copper prices rose by over 50% in the following six months.  While we don’t necessarily think that copper prices are about to rise another 50%, they are clearly on the verge of breaking through the psychologically important US$4 per pound level, close to a multi-year high.  Copper company stocks are still mired in the 2011 downturn when most investors thought copper prices were headed back down to the US$2.50-3.00 range.  But stronger demand from emerging economies, more strength in the US housing market and a restriction of supplies from strikes and mine output deficiencies have all combined to push prices higher.  Copper and economic bears beware; copper has often been referred to as the ‘metal with a PhD’ for its ability to forecast future economic conditions.  The signals we are now getting from the copper market for overall global economic growth should not be ignored!

Underlying the better economic and stock market data we have been seeing lately is the Bloomberg Financial Conditions Index (FCI).  This is a composite of monetary and lending conditions including the availablility of credit and money supply.  The historical data shows that stronger numbers on the FCI are a pre-condition for stronger economic growth and better stock markets.  While the chart below shows how the FCI crashed and then recovered along with the stock market in late 2008, the more recent activity in this indicator is interesting as well.  After dropping in the second quarter of 2010, after the initial onset of the Greek financial crisis, the index dropped again in mid-2011 as the Euro-crisis spread.  However, the action of central banks across the world to reduce interest rates and provide more credit to troubled lenders has caused this indicator to turn upward again in late 2011.  The stage now seems set for better economic conditions and, consequently, better stock markets in 2012.

Financial Conditions Index Improving

While economic and market risks will never go away, cooler heads appear to be prevailing in early 2012 and investors are beginning to realize that the global economy is not headed for another recession in the near term and that stocks are more under-valued compared to bonds than they have been in over 30 years.  Company profits continue to grow, albeit at a somewhat slower pace than the past few years, and companies are sitting on substantial cash balances that they are starting to deploy in stock buybacks, corporate takeover activity and organic expansion.

Our indicators for the stock market are ‘slightly overbought’ in the short-term, meaning that it wouldn’t surprise us to see a short-term, shallow pull back in stock prices.  But stocks in a rising market can remain overbought for longer periods of time (as occurred in 2009-10) so, despite taking some profits in a few cyclical stocks where we have seen enormous upward moves in the past four months (i.e. some coal, uranium and iron ore stocks), we remain over-weighted in stocks.  Our favourite sectors remain the basic materials (where we have moved back to a slight overweight in gold stocks), energy, industrials and technology.  The Canadian oil stocks are simply not reflecting the strong commodity price as well as the benefits of substantial reserves and a stable political system.  The energy service (drilling) stocks are as cheap as we have seen them in over 20 years while the companies continue to see robust industry conditions.  Copper stocks look set to break out to the upside and the auto sector in North America has clearly gone through a significant and successful restructuring which is not yet reflected in the stocks.  Technology companies are generating substantial free cash flow and are also positioned exceptionally well for growth outside of North America.  U.S. large cap stocks in particular look like tremendous value at current levels, particularly with interest rates forecast to stay low through this year and next and economic data starting to improve again.

Europe will continue to be a slight headwind for global growth but we are not expecting robust economic conditions anyways, just a return to moderate growth.  Moreover, German economic data is much stronger than the rest of Europe, and Germany remains the key to the financial and economic future of the Eurozone. In our view, this remains a highly opportunistic time to be establishing long-term positions in the stocks of the larger companies that will continue to benefit from global economic growth.

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