Trader’s Narrative

Way back at the end of April 2008 I mentioned that I was skeptical about the ability of Canadian fertilizer giant, Potash (POT) to be able to continue the heady pace it had kept for the past few years. I compared the stock rise of Potash to Nortel during the tech bubble and said:

The problem is that right now it is priced for utter perfection. And if the world is one thing, it is imperfect. For one, there is no reasonable logic to its valuation.

I also brought up several key metrics which made the valuation of Potash simply unsustainable. Of course this was only a small part of the much larger commodity bull run which has since, also imploded along with the equity markets. At the start of June 2008, just before oil ramped up to $145, I pointed out that the chart for crude oil had all the markings of a bubble. Now oil is trading at ~$78 a barrel - down 46%.

Nevertheless, when I wrote my thoughts on Potash, I received insulting comments - which always confirms my position. If someone has to rely on emotional outbursts to defend their trade position, there is something obviously wrong. Here is what happened:

The other fertilizer companies which I mentioned have fallen even more than Potash. Agrium (AGU) -55% and Mosaic (MOS) -70%.

The market got spooked today because of the release of the Fed minutes (April 30th meeting) showed a hawkish bent. First, I don’t think the market fell because of that. I’ve been cautious for a while now due to a number of technical and sentiment indicators.

But the reluctance of the Fed to continue cutting may not be a bad thing. For one, take a look at the comparison between the Fed Funds rate and the 3 month Treasury bill rate:

It is like the reunion of two lovers (this is as romantic as a trading blog can get). These two financial metrics usually go hand in hand but for far too long there has been a historic dislocation between them. I first pointed this out last summer: Fed should cut rates immediately.

The fact that now we are seeing the bond market and the Fed Funds rate return to their normal behavior bodes well. Especially considering the financial turmoil we’ve endured so far. Believe it or not, at one point they were 133 basis points apart!

And now we are down to just 14 basis points.

I know this is a very simplistic way of looking at an incredibly complex matter but what can I say? I like simple things. I prefer to allow the market’s voice, through the 3 month T-Bill rate, show me where the interest rate should be. I definitely think they do a much better job than a committee of economists harrumphing around an oak table.

I would have preferred the Fed to have taken the rate below, even if just a smattering, the bond market set rate. But I doubt that will happen. We can just settle for the fact that instead of the previous pattern of running away from the Fed, the bond market is now heading towards it in what seems an inevitable reunion or perhaps, even
a crossing.

After almost two years of estrangement, that calls for a celebration.

Yes, this is about #2. At least the chemical equivalent. So let’s get the jokes out of the way first…

Whenever one stock grows enough to represent an inordinately large percentage of the index it belongs to, you know there is some major dislocation going on. And it is about to be corrected.

Right now that would be Potash (POT) the fertilizer company from Saskatchewan, Canada. Potash is now the 2nd largest company on the Toronto Stock Exchange, at $60 billion capitalization. The largest is RIM (RIMM), which along with Potash has been the engine that has propelled the Canadian indexes higher in 2007 and so far in 2008, almost unassailable.

From the bottom of the bear market in early 2003 to recent times, Potash stock has given the lucky few to have ridden it loyally higher, a “20 bagger”:

The problem is that right now it is priced for utter perfection. And if the world is one thing, it is imperfect. For one, there is no reasonable logic to its valuation. We have more than ample reserves of yet to be mined. In fact, according to the International Fertilizer Association (who should know) at the current rate of use, we have enough proven reserves to last us another 300 years.

And strangely enough, inflation adjusted potash prices have continuously and consistently fallen over time. It is only in 2007 that we’ve seen an exception to this with KCI (potassium chloride) prices tripling. This is a response to a similar rise in the price of sulfur and natural gas (raw materials) for potash.

To bring back some perspective to this, consider a research note from Merrill Lynch saying that if we add the capitalization of the 3 large fertilizer companies: Potash, Mosaic (MOS) and Agrium (AGU) we have a value larger than the sum of the value of all potash ever mined and sold in modern history!

During the tech bubble of 2000 many Canadians remember how the TSX index was pulled higher by Nortel (NT) to levels it wouldn’t have attained by its own accord. But Potash’s (POT) meteoric rise makes Nortel’s look pathetic in comparison.

If you were lucky enough (or smart enough) to buy Nortel at the 1998 October bottom - around $75/share - and repeat the miracle of perfect timing again to sell at the top: August 2000 at around $830/share, you would only be boasting a 10 to 11 “bagger”.

If you have been fortunate enough to be long Potash, the good times may be over. Time again to look for what most are ignoring.

Darn, I meant to post this yesterday but, ran out of time. Now it won’t seem as brilliant but what the heck…

After the recent panic selling, the relationship between stocks and bonds got out of whack in a major way. Basically, relative to each other, stocks were very cheap and bonds very dear.

This usually happens when investors and traders panic - they flee to the “safety” of bonds, pushing their prices up. But what we saw in the recent rout was monumental. We’re talking several standard deviations.

So to answer Keith’s question whether bonds are a sell, I’d say yes, although equally important: stocks are a buy.

After today’s gap down, we have an island reversal (see chart below). I was going to write yesterday that it looks bonds spiked up to 122.81 in an exhaustion gap. After the fact, this seems obvious. Nevertheless, according to Japanese candlestick patterns, it is still bearish.

The last time I hollered that stocks were a buy and bonds a sell was at the start of December (see chart above). It was a bad call on the stocks side, but good for the bonds, since they tumbled to almost 113.

Bond prices (30 year US government) have not been this high since the summer of 2003 (high of 121.67) and the summer of 2005 (high of 119.72). So prices poke their head just above resistance (taking out a lot of stops) and then headed back down.