I can see some – albeit very modest – improvement for the US stock market. For one, it appears that the slowdown and problems in other economies, such as the UK (a disaster waiting to happen), Italy, Spain, and Ireland, are even greater than in the US. Also, since numerous emerging stock markets have underperformed the US this year, some money is likely to be repatriated from countries such as India and China, where stock markets are down approximately 40% year-to-date. We should also consider that, as Joachim Fels noted, “Fifty of the 190 or so countries in the world now have inflation running at double-digit rates. Almost all of these are EM economies.” In my opinion, some emerging economies – contrary to expectations – could therefore be hit even harder than the US. So, the good news here is that the “bad news” is even worse in some other countries than in the US (though this may be hard to believe).

The media and some market commentators who were “bullish” until late June have noticed recently that we are in a bear market, because the major indices are down roughly 20% from their peak. This is a remarkable achievement in the annals of forecasting and market timing! How many stocks had to drop by between 50% and 99% before the media and some “bulls” who have continued to talk about another upward wave in stock prices being just around the corner, which would supposedly lift the indices to new highs, finally accepted that we are now in a bear market? Don’t forget that when stock market indices made new highs seven months ago, the media and most advisers were exuberantly optimistic – although most stocks were then already in downtrends. Moreover, sentiment figures (bulls versus bears) among individual investors and investment advisers are now heavily tilted towards the bearish side. Whenever sentiment has been this negative in the past, the odds favoured at least a short term rally. Still, I need to warn our readers that since sentiment remained so extremely optimistic between 2003 and 2007 while the stock market rose, it is possible that sentiment will remain extremely negative for a long time while the market continues to decline.

The third improvement I have noticed is that, from a technical point of view, the market has become “quite” (though not extremely) oversold. But again, I need to warn here that the market would now be oversold in the context of a bull market – not in the context of a bear market, during which the oversold condition could last for a very long time. I suppose that Ambac was already oversold at US$70, and where is the stock now? Moreover, at major turning points, markets can quickly reach oversold or overbought conditions and then work out these conditions without large corrections. Let me explain.

In the summer of 1982, US equities had become extremely depressed; they were no higher than in 1964, and were down in real terms by more than 70% from their 1966 “real” high. The Dow bottomed out at 769 on August 9 and, if I recall correctly, the stock market took off on August 18. By September 22, the Dow had reached 951 (up more than 20% from the August low). The two most overbought conditions I have seen up to that time had occurred at the end of August 1982, and then again on September 22. But, thereafter, the market continued to rise: to 1296 in November 1983, to 2746 at the August 1987 peak, and to the recent high of 14,198 on October 12, 2007.

So, I wish to stress that overbought and oversold conditions must always be put in the context of both the primary trend – up or down – and the phase of the bull or bear market in which they show up. Overbought conditions at the beginning of an uptrend, and oversold conditions at the beginning of a downtrend, are meaningless from a longer-term perspective! If we are indeed in a bear market, which is my view – and has been since the summer of 2007, the current oversold position is relevant only from a very short-term point of view.

The fourth improvement I see is that some previously strong stocks and groups such as US Steel (X), Cleveland-Cliffs (CLF), IBM, and the oil sector, as well as the Nasdaq and some of its leaders such as Research in Motion (RIMM), Apple (AAPL), etc, are beginning to turn down. For the market leaders to collapse is an important precondition for a major low. But again, we need to understand that it will take much longer, and far lower prices, before the very strong stocks and sectors (mostly energy-related and materials) that have so far defied the bear market in financial stocks reach a major low.

Since I fully expect the financial crisis to spread into the real economy, I would sell those sectors and stocks that have so far defied the weakness in financial stocks. Another potentially good piece of news is that the current expansionary monetary policies make the stronger companies in an industry relatively stronger than their weaker competitors, which would then be reflected in strongly diverging stock performances. The weak company stocks could decline so much as to make them, at some point, attractive merger and acquisitions candidates for the financially stronger companies. Industry consolidation would in this scenario accelerate and lead to stronger pricing power (and inflation).

The last potentially good bit of news is that oil and other commodity prices may have reached an intermediate top. Should oil prices decline by, say, 20% to 40%, this fact will certainly be broadcasted by the media – as well as by ignorant cheerleaders and people who still don’t regard commodities as an asset class – as great news for the stock market! A relief rally would likely follow. But wait a minute: why would oil prices and other commodities decline meaningfully? Because of a lack of affordability and a weak economy around the world – not just in the US! This would lead to declining demand for raw materials and likely lower prices. (Supplies are unlikely to increase significantly, but they could be cut as a result of war, civil strife, or concerted action by the producers.) However, a weak economy or economic contraction around the world would be unlikely to be favourable for equities and corporate profits.

I need to make one more comment with respect to oil prices and commodities. It is not a strong US dollar that will lead to declining oil prices, as some commentators argue. What will bring about lower oil prices is a collapse of consumer spending in the US and elsewhere in the world. If US consumption collapses, the US trade and current account deficit will be halved and will lead to a drying up of global liquidity. I have discussed this relationship many times in the past and have clearly shown the relationship between the growth rate in Foreign Official US Dollar Reserves and the US dollar. Declining US consumption will be positive for the US dollar and will certainly bring down commodity prices because of lower demand (at least temporarily). But if you really think that such an outcome will be good for stocks, then dream on!

Finally, since the bull market in commodities began, there has been a body of people who have maintained that commodities are not an asset class. Some have even gone as far as to compare gold to washing machines. But consider the following: my dogs and my books are an asset for me, but maybe not to someone else. My dogs protect my house and my books. My books give me pleasure and – so I hope – some modest knowledge. But my dogs would be a liability to someone else if he lived in a secure condo building. (If there is such a thing as a secure condo building!) Also, my books would be useless to an illiterate person, since he would not be in a position to read them. A high-calibre mathematician is likely to be an asset for James Simons of Renaissance fame, but a huge liability in a rescue mission on Mount Everest. Water may be a huge asset if you are lost in the middle of the desert, but it is not an asset when you are standing in the rain without an umbrella and waiting for a date to arrive. So, the first point to understand is that anything can be an asset for somebody at some time, and not an asset for somebody else at some other time. Normally, cigarettes are not considered to be an asset, but in prisoners’ camps during wars, in wartime in general, and in times of hyperinflation, they are an asset – in fact, they replace cash banknotes.

Now, if someone defines an asset class as something that provides a cash flow, commodities may by this definition not be an asset. However, what if asset markets such as equities, bonds, and cash (T-bills) provide a negative return in real terms (inflation adjusted)? The moment when money loses its purchasing power because real interest rates are negative, and because we need to deal with people like Mr. Bernanke, assets such as raw land, commodities, art and collectibles do become a store of value and, therefore, represent a desirable asset class. All I wish to say is that the term “asset class” is extremely difficult to define, and that at different times and in different situations certain things and certain skills become an asset, whereas on other occasions they are useless. But one thing all my readers should clearly understand: when the last ship leaves the port as the enemy approaches, the captain of that ship will accept one kilogram of gold from you to buy your passage. I doubt that he will accept CDOs, derivative contracts, bonds or, for that matter, stock certificates of Fannie Mae (NYSE:FNM) or Freddie Mac (NYSE:FRE). (Maybe by then the captain won’t even accept US dollars, because their value could decline precipitously during the voyage.) I may add that, in the financial sector, the last ship may be about to leave.

In sum, I believe

“In the next 12 months there will be an unprecedented amount of both domestic and cross-border mergers and acquisitions,” Wilbur Ross, chairman of International Coal Group Inc. (ICO), told Bloomberg News. “U.S. reserves are undervalued relative to those in the rest of the world.”

Ross, the billionaire investor who helped consolidate the U.S. coal and steel industries, considers this the start of a round of mergers that will prove Cleveland-Cliffs prescient in its Alpha bid.

The top eight U.S. coal producers, which are worth more than $50 billion, are possible takeover targets for a country desperate for resources. And compared with China, American coal companies are bargains.

China Shenhua Energy Co., Asia’s biggest coal company is valued at $15.52 for every ton of coal it holds, compared to $2.11 a ton for Peabody Energy Corp. (BTU), and $1.76 for International Coal, Bloomberg reported.

At a point when the U.S. economy is slowing under the weight of a growing financial crisis, and spiking food-and-energy prices, escalating growth in the developing economies around the world has ignited a bull market for coal that analysts believe could last for at least 10 years.

And that’s going to lead to a major shift in the ownership of coal-related assets.

Enter the Red Dragon: China’s Coal Crisis

China, home to 1.3 billion people and the world’s fastest-growing economy, counts upon coal for 80% of its energy needs. Indeed, it’s the world’s largest coal producer, as well as its largest consumer. Coal demand in China jumped nearly 9% last year – meaning the Eastern power now accounts for a full quarter of the world’s annual coal consumption. So it’s no surprise at all that the growing global discrepancy between supply and demand is most acute in China.

Vic Svec, a senior executive at Peabody Energy, the world’s largest private-sector coal producer, referred to China’s ability to influence the price of commodities as a “butterfly effect.” In other words, “demand from Beijing can ripple back to Queensland, Australia, or Gillette, Wyoming,” Svec told The Wall Street Journal.

Svec’s right. Five years ago, China exported 83 million metric tons more coal than it imported. But last year, the nation’s surplus dropped to a meager 2 million metric tons. That means more than 80 million metric tons of coal (about 12% of the internationally traded market)has been taken out of global circulation.

That’s a big reason why the highly coveted low-sulfur coal from the Powder River Basin in Wyoming and Montana has climbed from less than $10 a ton last year, to nearly $15 a ton – a price gain of 50%. And why thermal coal prices at Australia’s Newcastle port, a benchmark for the Asian market, have more than doubled this year.

Ironically, the high prices demand and China helped create, have left the country on on the brink of a potentially disastrous energy shortfall. Overseas coal has simply become too expensive for China to import.

The Asian nation imported just 21.55 million metric tons of coal in the first six months of this year, down 20.4% from the same period last year, according to China’s customs bureau.

Now, the county is suffering through its worst power shortage in decades because of soaring demand and inadequate supplies.

Nearly half of China’s provinces have started to ration electricity. Last month, the government raised electricity tariffs by 5% but prices are still 30% lower than current coal prices would imply, according to BNP Paribas SA (OTC ADR: BNPQY) estimates. And that has forced many smaller energy producers out of business.

The government in Beijing tried to deal with the matter by imposing price controls on electricity that make it impossible for energy suppliers to raise their prices, even as they pay more for natural resources that have skyrocketed in price. But that measure is driving smaller producers out of business.

“Large state-owned power companies have no choice but to keep operating and we have seen strong power generation growth from them so far this year despite the high coal prices,” Daisy Zhang, an analyst with BNP Paribas in Shanghai, told the Financial Times. “But smaller power plants have been shutting down because the more they operate, the more [money] they lose.”

Figures from the China Electricity Council for the first five months of this year show that out of a total of 4,800 power plants, 1,800 suffered net losses over the period. The overwhelming majority of the losers were fueled by coal.

The government has also capped the price of coal but that hasn’t alleviated the pressure energy suppliers either.

“If a coal company wants to raise prices it just issues a notice and that’s it. There’s no way [to refuse] even if you don’t agree,” one coal purchaser with a power plant told the Shanghai Securities News last week.

The newspaper also cited industry officials as saying that coal companies have been refusing to honor contracts, thereby forcing power firms to buy from the spot market, where prices are considerably higher.

While previously around 80% of contracts were honored, the figure has dropped to 60%, the Shanghai Securities News said.

Another problem is the growing number of coal exports. Beijing has capped the price of coal sold in its home market, but global prices continue to rise, which makes exporting coal far more profitable. The difference between domestic and global coal prices was about $54.70 per metric ton in the week ended on July 4, China Business News reported.

China exported 25.49 million metric tons of coal in that time, a 10.2% increase from the year prior. In fact, China’s coal exports soared 83.5% year-over-year in June to 6.99 million metric tons, the highest monthly total since March 2005, even as the nation suffered through a shortage of the fuel that has resulted in blackouts across the country and a multitude of energy providers being shut down.

While many in the industry anticipate Beijing will raise energy tariffs further after the Olympic games, few believe that will be enough. It seems apparent that the solution for China’s coal crisis is to get more coal, and many believe it will through cross-border acquisitions.

China Ready to Pounce on U.S. Coal Suppliers

The total volume of mergers and acquisitions (M&A) dropped by 36% in the first half of 2008, the slowest start since 2005, according to Dealogic. But while deal volume in the United States tumbled 40%, transaction volumes jumped 5% in Asia.

The pickup in Asian transactions is largely attributable to Chinese companies, which announced plans to buy a combined $42 billion in foreign assets. That’s more than five times the amount Chinese companies spent on M&A in 2007, according to Dealogic. It’s also equivalent to the combined volume of all the foreign takeovers by Chinese companies from 2000 to 2006.

Also, while deal volume was down in most every sector, takeovers of energy and mining companies shot up 33% in the first six months of 2008. And that is only a small indication of things to come.

The recent buyout of Alpha Natural Resources Inc. by Cleveland Cliffs Inc. could pave the way for more than $50 billion worth of M&A activity in the U.S. coal industry over the next few years, Bloomberg News reported.

“People will look back on this as the first major U.S. event, not as overpriced,” International Coal’s Ross said.

Another factor to consider is the weakness of the dollar, which makes U.S. assets even more affordable for foreign companies.

Cross border activity represented 40% of the $1.6 trillion in first-half deals and, according to Thomson Financial, “was aided by emerging economies with cash to spend and favorable exchange rates in the U.S.”

Chinese interests have already displayed an aptitude in acquiring resources vital to their growth. This was evidenced earlier this month, when Sinosteel won its hostile bid for Midwest Corp. Ltd., an Australian iron ore producer. Iron ore, the other key ingredient in steel production, has more than doubled in price over the past year.

Also, in February, Aluminum Corp. of China (ADR: ACH) teamed up with Alcoa Inc. (AA) to buy a 12% stake in Rio Tinto PLC (RTP) hoping to thwart an unsolicited takeover from BHP Billiton Ltd. (BHP) that would have give the Australian powerhouse control over a third of the world’s iron ore.

So far, all but one of the 10 unsolicited hostile bids launched by Chinese firms on foreign targets since 2005 have focused on natural resources, according to The New York Times.

“Working on China-related deals two or three years ago, I once gave a presentation to an interest group in which I said Chinese investors did not yet have the appetite for hostile takeovers,” a Chinese lawyer working for an international law firm told China Economic Review. “But I am sure we will see a lot of more of these over the coming months and years. Chinese investors are increasingly sophisticated.”

The attorney went on to say that he was currently working on two commodities-related investments by Chinese firms in Australia – one of which could well end with an aggressive takeover bid.

Source: How Coal Shortages in China Will Spark More Foreign Takeovers of U.S. Assets

Cleveland-Cliffs is paying $10 billion for Alpha Natural Resources, a company that specializes in mining thermal coal used in steel production, the company said on its website. The deal values Alpha at $128.12 per share, a 35% premium to its closing share price on Tuesday.

Alpha shareholders will receive 0.95 Cleveland-Cliffs shares and $22.23 in cash for each share they hold. Alpha shareholders will hold 40% of the resultant company.

“By combining our companies’ complementary operations and management capabilities, we will be well positioned to meet the world’s increasing demand for raw materials,” Joseph Carrabba, Cleveland-Cliffs’ chairman and chief executive officer, said in a statement.

The new company, which will be known as Cliffs Natural Resources, will operate nine iron ore facilities and more than 60 coal mines throughout North America, South America, and Australia. The company’s iron-ore reserves will total one billion tons, while its coal reserves will more than triple to 916 million tons. The annual savings from cost synergies will be at least $200 million by 2010.

Cleveland-Cliffs brought in $2.28 billion in revenue last year, while Alpha took in $1.64 billion. Together, the companies expect to see total revenue of $10 billion by 2009.

“This transaction is a good strategic fit for Cleveland-Cliffs as it gives them a stronger presence in the very tight metallurgical coal market and complements their iron-ore business,” Brian Hicks, co-manager of the $2 billion Global Resources Fund at U.S. Global Investors Inc. (GROW) told Bloomberg News.

Coal and iron ore are the two key ingredients in the production of steel, which is in high demand throughout the developing world.

“Global steel demand growth continues to be led by emerging economies to meet the requirements of expanding industrial sectors and infrastructure growth,” Risaburo Nezu, chairman of the Organization for Economic Cooperation and Development (OECD) steel committee, told Forbes. “Demand in many mature economies has slowed in line with weaker economic activity.”

According to Nezu, steel use continues to grow most rapidly in the so-called “BRIC” economies of Brazil, Russia, India, and China. In 2007, steel use rose:

• 18.6% in Brazil
• 13.5% in Russia
• 11.3% in India
• 13% in China

All told, those four countries found uses for 521 metric tons of steel, with China accounting for 78% of that total.

While the price of U.S. steel-sheet hit a record $1,052 a ton in June, rising from $532 a year earlier, the price of coking coal and iron ore have doubled in the past year as well. As a producer of both products Cliffs Natural Resources will be well positioned to exploit emerging market growth.

Source: Cleveland-Cliffs Taps Into Emerging Market Steel Demand with $10 Billion Buyout of Alpha Natural Resources