Imagine if today you had not turned on the TV, or satellite radio to listen to CNBC. You would have seen 94% of the people go to work, get stuck in traffic jams, and eat their regular meals. You would have turned on the lights at home-the air conditioner was probably running all day anyway. You would be looking forward to a shower/bath. You may even have walked the mall to pick up something small. In other words, the basics in life continued on pretty much as usual. In foreign markets the same would hold true.

As you know, the market headlines have been much more exciting, with dramatic volatile swings suggesting the world has changed between 5% and 50%, depending on which stocks you look at.

In other words, the micro Main Street has mostly carried on, especially around the world. The flashier Wall Street that we all monitor is arguing for something very different. In some cases, micro and macro have coincided, as would be true for the extended Anglo-Saxon banking world that financed too many houses. In some cases micro simply refuses to confirm the market weakness, which would be true of the makers of artificial knees, or the makers of fertilizers.

The Macro does need attention, because fixed income spreads confirm that lending markets have seized up. Between global central banks, and reluctant politicians, we still expect enough liquidity to come to the system. We expect to see an acceleration of intervention in the weeks and immediate months ahead. However, it is fair that failure to intervene poses still further risks to financial markets, and ultimately to Main Street too. For this reason, it makes sense to maintain sufficient liquidity in personal and business circumstances to ride out the storm. I suspect having insured deposits or similar for one year should be enough. Two years may be more appropriate for very risk adverse investors or companies that have longer development/sales cycles. That should allow challenges to flush through the system, get worse if necessary and then get better again.

Higher potential return assets have been under unrelenting selling pressure, as banks/brokers/hedge funds that owned them scramble for liquidity. Emerging markets? Sell, sell, and keep on selling. This, despite the fact that many of them are priced near trough valuations of the past and have much stronger fundamentals, much lower bad loan risk, are likely to have trending down but positive economic growth next year, and have above average long-term growth potential based on young populations that are being enabled to be more productive.

Aforementioned fertilizer companies are similarly suffering massive sell-down, even though corn inventories remain near record lows and grain prices continue to support global farmers paying more for potash next year than this. Energy service companies that have reasonably firm order books for several years from financially strong clients are indiscriminately being dumped in the market. Most impacted are resources within emerging markets.

Perhaps the draconian view will be right and a global meltdown is underway. We doubt it, because against the all-black we think there is still some white, which is why we argue for grey. Given where valuations are, that is all that we must argue for to justify buying resource equities at these prices.

Liquidity

This is the most pressing problem. There are two parts to this-who needs the cash, and is there any cash to be had? Clearly the biggest need is in the Anglo-banking sector that financed physical property with not enough margin, so now the classic lending killer of borrowing short to lend long has caught them. If you were told your house needed to be sold within 24 hours, you may not expect to receive a fair and reasonable price. Under normal circumstances, depending on asset, given 1-5 years these assets are likely to cover the lending value, but it does take time. This is what the TARP program was designed to achieve, time. Over time a natural buyer may come in to the neighborhood. Similarly in markets, gradual changes allow sellers to seek out buyers. But it appears that hedge funds et al have been told to sell within 24 hours. Many companies have cash and would be willing buyers, but board meetings need to be called. Many competitors have cash, but that requires two boards, advisors, and government review. Foreign national funds have record cash, but that takes even more time. Ratios of money market funds to equity market cap suggest investors have cash consistent with past bear market lows, but they want time to convince themselves of the resilience of business models. It seems only reasonable that holders of assets that are now selling under some real or perceived time pressure are not getting full and fair value, just as if the house needed to be sold within 24 hours. Even without going into extensive discounted cash flow valuation, this is why we believe investors with time are being granted an above average opportunity.

Demand

Demand is a function of trend line growth and inventory cycles. Global population has been advancing by one USA (say 350 million people per UN data) every five years for the past several decades. By the end of 2020, forecasts call for a need to feed another 1 billion people. Plus we have incremental demand from youthful emerging economies that are empowering higher output with access to more productive tools, technology, and education. This trend line growth strongly suggests that high quality productive resource assets in a resource-constrained world will indeed be worth more in the years ahead. Nonetheless, the values of productive assets can time out for an extended period if suppliers facilitate a multi-year overbuild. The housing construction industry for several years overbuilt relative to household formation, and now must wait for the trend line to catch up by under-building relative to household formation (this fix is already underway). The oil price acceleration in the 1970's brought on an over build as a new 8 million barrels per day came on from Mexico, the North Sea, and Alaska. Today there simply is no equivalent. Electricity is still under built in most of the world as growing demand leaves markets with little extra margin. China and India still have massive needs and plans to build out railway systems and highways. Normal trend line demand can flatten as it did in Japan for lack of population growth, or as it did for Motorola flip-phones as technology shocks came along. Neither appears in play for resources since there is scant evidence of new technology (though the world will try) of oil being replaced, or iron ore, or fertilizer. The slope of the demand will likely come down given deleveraging. However, nearer term is the impact of the liquidity crunch on inventory cycles. One way to improve liquidity is to reduce inventories. This has been under way in a number of industries and has compounded the view of demand falling off. Unlike normal trend demand, inventory destocking can only go so far. Hurricane Ike has brought gas pump line-ups to Atlanta. The strike by Potash has tightened global potash inventories to very low levels. China has been destocking copper, but will need to step back into markets soon enough. Global inventories of metallurgical coal and thermal coal remain tight too. If we were heading into a global slowdown with massive inventories, then careful would be the watchword. Our models just don't show it.

Supply

If it is so easy to find, permit, and produce a bunch, even with $100 oil, then why is Exxon spending more money returning capital via buybacks and dividends than putting back in the ground? If it was so easy to bring on more production, then why is BHP trying to take out its competitor rather than build anew. If China has the ability to source growing internal demand, then why is it putting export tariffs on so many materials? If gold at $900 seems like a fancy price, then why is production declining? The 1980's and 1990's period of under-earning cost of capital forced marginal producers out and rationalized industries, in many cases, effectively to only a handful of suppliers. Mother Nature is not revealing cheap/easy/new solutions to growing demand. Trained people are still not easy to get. Now, with a global liquidity crunch, companies will be even more reluctant to put money into the ground.
This last point bears repeating, because it sets up the next inevitable spike in commodities, even if it is a couple years out. The catchword in the 1970's was to produce all you can to capture a price seen as unsustainably high. The 1980's was about bankers demanding maximum production to maintain the lowest cost in a low price environment. It took until the late 1990's for resource industries to be in a position to do the logical-produce only based on the customers' ability to pay, with inventories being the best indicator. To quote a September Morgan Stanley report on fertilizers, these are still cyclical industries, but paradigm shifts are taking place in terms of peak, trough, and duration. We are bullish on the world's ability to find and produce more resources over time, but we adamantly maintain that it is not getting cheaper or easier. The few company managers that were getting more comfortable with overzealous expansion dreams will now need to face boards of directors that read the recent headlines too. Start-ups will find it very difficult to get financing. Supply in a number of industries like natural gas will loosen up for a bit. Onshore drilling may not be as much fun as hoped. However, for most industries it remains a matter of it just ain't that easy. This is why we believe resource providers including OPEC will be happy to slow down if demand slows down. If you disagree, feel free to approach a bank for a loan to go drill a hole in the Gulf of Mexico, or in Nigeria, or Siberia, or Saudi Arabia, or Venezuela. Lost amongst the most recent market turbulence were studies coming out of Canada's tar sands that new production sources would need $100+ to earn a decent return on capital. We still think $90-$125 will become the new range with brief periods above and below based on circumstance over the next several years. This should keep many of the service industries like offshore completion near sold-out in the immediate years ahead.

Valuations

The recent selloff of resource share prices, begs us to conclude that the business models are at risk. The primary risks would be a sharp drop-off in demand, a sharp acceleration in competition, compounded perhaps by balance sheet leverage. Balance sheets are in good shape, especially for the companies we have emphasized. Free cash generation is strong. Supply is coming on with reasonable discipline. Demand may see destocking, but this leads to more of an air-pocket than a sustained crash and burn. Then why are shares gapping down so rapidly? The resource sector has demonstrated above average prospects and the potential for above average returns. Hedge funds have wanted to be long some of this too. Many of the stocks that investors have good reason to own for the long-term are precisely the ones that are being hit most in the short-term. This is why we suspect that short-term money got too long late spring, and is now being forced to wind down positions. We are hopeful that further flushing will be measured in weeks no months. Of course not all resource companies will come through this without a ding, but we believe the super-cyclical treatment of global resource leaders with assets that are virtually impossible to replace are gapping down to silly levels. In the summer some stocks were getting closer to fully valuing sustained good times, now we believe that many are simply over-discounting the future. Gazprom, the world's largest hydro-carbon company with almost no net debt through next year traded down to 3x P/E. Several Brazilian companies, including Petrobras who has quasi monopoly access to one of the world's most prospective basins has been inundated with emerging market liquidation. U.S. based master limited partnerships have seen interest rate differentials blow out to yield 8-12% and offer what appears to be meaningful dividend growth. Companies that provide carbon fibre today for electrodes and wind farm blades for tomorrow are at flea market pricing. The list goes on. The market is giving us a chance to focus on higher quality assets with strong free cash generation.

Where does this leave the Mackenzie Resource Funds?

As managers we must apologize for dragging investors through this volatility. Better would have been to be a short-term trader, have had all cash three months ago, and be gobbling up today's bargains. While we were diligently spending the summer focusing on the micro of the companies we have interest in, a big macro typhoon sideswiped us. All we can ask, is that you consider that the market is not always right, that the fundamental long-term story still has enough white to it, that the correct shade is more grey, rendering today's all black assessment excessive. We are very encouraged how solid the investor base continues to be in our funds. While new money is not pouring into the funds, some appears to be dollar cost averaging into these lows. The above discussion was not meant to be exhaustive. For instance, consider the opportunity for growth as America moves to invest in more energy independence. While we understand the market rotating through various sub-sectors, to us it is not clear that U.S. consumer staples or financials should be more defensive than resources that are exposed to global activity. You may want to make sure you have staying power cash on the side, and hold no more than can withstand the volatility in the interim. Barring total global economic collapse, our research suggests the investments in the Fund are worth more than the quote today, and will be worth substantially more over the next five years.

Looking forward to providing more detail on the quarter, and with thanks for your patience,

Fred Sturm and Team