Bonfire of the Commodities

By Justice Litle

The commodity bull market may be on the ropes…but it is
not down for the count.

It’s true, of course, that the commodity markets have been
taking a few body blows recently.  Crude oil, which
recently reached a new all-time high above $58 a barrel,
subsequently tumbled $8 over the next few trading days.
Many other commodities have endured similarly harsh
treatment from investors during the last few weeks. But
this commodity-sector washout seemed to reach an important
selling climax last Friday as numerous resource stocks
spiked lower on very heavy volume. The 6.8 million-share
downside day in XLB (an ETF representing basic materials
stocks) was almost quadruple the stock’s average daily
volume.

Happily, most commodities and resource stocks have bounced
a bit this week. But still, anxieties remain. And still,
prudent investors must ask themselves whether the 3-year
old commodity bull market has exhausted itself, or whether
it is merely taking a well-deserved rest. We favor the
latter interpretation, knowing full well that we entering a
period of heightened volatility.

The commodity market’s worst enemy at the moment seems to
be sheer momentum. Commodity prices have been slipping
recently and resource stocks have been falling. We don’t
get any "warm fuzzies" from this sort of market action, but
we do realize that sell-offs create investment
opportunities. So let’s examine the current case for
commodities and resource stocks.

With a little perspective – and the conviction born of a
long-term outlook – it’s clear we should be scouting for
opportunity, rather than fleeing for the exits. The
commodity bull market relies primarily upon two powerful
secular trends, both of which remain very much intact:
Strong global demand for natural resources and feeble
global demand for U.S. dollars. These two trends are very
different from the trends that depressed commodity prices
throughout the 1980s and 90s.

From 1982 to 2000, many resource companies struggled just
to keep their lights on. The big commodity bull market of
the 1970s prompted a frenzy of over-investment in the
resource sector. Inevitably, commodity supplies began to
swamp demand, thereby depressing prices. At the same time,
former Federal Reserve Chairman, Paul Volcker, hiked
interest rates to break the back of inflation. The
combination of rising rates and overcapacity in the
resource sector proved a toxic cocktail for commodity
prices. The sector swooned for the next two decades.

But the very same libation behaved as a kind of magical
elixir on the stock and bond markets. Stocks and bonds
benefited from a long, prosperous period of disinflation,
characterized by falling interest rates and expanding P/E
multiples. The "goldilocks" economy of the 1990s – not too
hot, not too cold – allowed equities to flourish. With
American stock markets taking center stage, steady inflows
of foreign capital bolstered the U.S. dollar. The political
combination of a Democratic president and a Republican
Congress was an added bonus, as political gridlock produced
a kind of benign neglect of the economy.

Paper assets prospered, while hard assets languished.

But the new millennium has seen a complete reversal of
fortunes for stocks and commodities, thanks to a complete
reversal of underlying trends: commodities have become
relatively scarce and the dollar has become relatively
weak. In other words, the most important secular trends
influencing the commodity markets have reversed
themselves…to the detriment of paper assets and the
benefit of "stuff."

Therefore, the U.S. equity markets look ready to begin
wandering around in the very same financial wilderness from
which the commodity markets finally emerged about three
years ago. As the U.S. stock market weakens, the dollar is
also likely to weaken. And if one believes, as we do, that
America’s balance sheet will continue to deteriorate, the
dollar’s downward slide becomes even more certain.

A weak dollar is very bad news for buyers of Bordeaux wines
and BMWs, but it’s very good news for investors in
commodities.

The second force behind the long-term commodity bull, and
arguably the more powerful of the two, is global demand. As
China and India grow, their long-term demand will dwarf
current levels. Jeff Rubin and Peter Buchanan of CIBC World
Markets note that China’s present-day level of crude oil
demand is merely an eighth of South Korea’s. The two
analysts further note that India saw a 5% increase in
demand last year, and that "oil demand in the rest of
developing Asia is growing at the fastest rate of any
region in the world." As this robust demand collides with
dwindling supplies of commodities…things will get REALLY
interesting for commodity bulls.

An old saw says that "the best cure for low prices is low
prices" – a phenomenon that the commodity markets
illustrate continuously. The very low commodity prices of
the 1980s and 90s, for example, encouraged demand while
discouraging investment in new supplies. Eventually,
therefore, supplies became so lean that growing demand
drove prices higher. Global demand for commodities remains
very strong today. Yet most large resource companies are
still hesitant to investment heavily in new supplies. The
painful memory of the 1980s and 90s is still too fresh.

Years from now, these large companies will forget all about
bear markets. They will lose their inhibitions about
investing billions of dollars on exploration. And
eventually, their exploration successes might – we
emphasize, MIGHT – produce the next cycle of over-capacity
and falling commodity prices.

But these cycles unfold over very long periods of time. The
commodity bear market that started in 1982 lasted nearly 20
years, before finally ending in about 2001 or 2002.

If we assume that a new bull market is now underway, it is
only about three or four years old. In other words, this
boxer still has a lot of fight left in him…and we think
he is likely to score a decisive knockout over the next few
years.

Did You Notice…?
By Eric J. Fry

"I doubt the market can do anything on the upside without
IBM," options pro Jay Shartsis remarked last Friday, while
examining Big Blue’s stock price chart on his computer
screen. "This thing hasn’t been able to bounce even half a
buck…The volume in the stock is huge, which could be a
climactic event, but I’m not convinced…I’m telling my
clients to sell naked calls on the stock."

As it turns out, selling naked calls on IBM has been a
brilliant move…The tech stock icon has continued its
sickening slide. And since the big bellwether continues to
fall, its relevance as a market leader becomes an ever-more
frightening prospect. Is it really true, we wondered, that
"the market can’t do anything on the upside without IBM?"

Unfortunately, Jay’s assertion seems to have history on its
side.

For example, as the first chart below illustrates, IBM
shares "gapped down" $10 on April 6, 2002, then continued
to drop for several months thereafter, leading the entire
stock market lower. Over the ensuing six months, as the
second chart shows, the Nasdaq Composite tumbled more than
40%.

And the Markets…