Strange Days

Is the bull market in commodities a financial "Jim
Morrison?" Is it a sensation that flames out as suddenly as
it first burst onto the scene? Or is the bull market in
commodities more likely to be a "Jerry Garcia" – a slightly
mellower and longer-lasting phenomenon?

A "Garcia" bull market – like the Grateful Dead lead
singer, himself – would still offer plenty of mind-altering
ups, but might also spend a little time in rehab along the

So if the bull market in commodities is more "Jerry" than
"Lizard King," courageous investors might want to consider
adding a few resource stocks to their portfolios.

In 1966, a leather-clad James Douglas Morrison burst onto
the world stage as the voice and persona behind the mildly
scandalous, "Light My Fire," the most famous song ever
released by Morrison’s band, "The Doors." During the next
five years, Morrison wowed the rock music world with a
frenetic combination of groundbreaking "acid-rock" music,
indecent on-stage antics and over-the-top offstage
indulgences. In short, he both created and epitomized the
stereotypical rock-star lifestyle. Doors fans loved
it…But poor Jim couldn’t keep the party going. In the
summer of 1971, Morrison was laid to rest at Père Lachaise
Cemetery in Paris, after dying in a bathtub of an apparent
heart attack. He was 27.

In 1998, James Rogers launched the Rogers International
Commodity Index. During the next few years, as its value
more than tripled, the index became something of an
investment sensation (despite the fact that Rogers, as far
as we know, did not engage in any Morrison-style excesses).
Not only did the Rogers Index triple since 1998, but it did
so while the S&P 500 produced a cumulative return of only

Most resource stock indices had been producing similarly
astonishing results…until recently. Since the middle of
March, the Rogers Index has slipped more than 10%, while
the Goldman Sachs Natural Resource Index has dropped a
similar amount.

In the context of the last six years, the recent sell-off
doesn’t seem like much. But in the context of the last six
months, the sell-off feels like the beginning of the end.
Accordingly, CNBC’s daily broadcasts have not lacked for
experts proclaiming the death of $50 oil and celebrating
the seeming death of the entire commodity bull market.

The bull market in commodities may, indeed, be dead – just
as CNBC’s expert celebrants assert – but we are not yet
prepared to RSVP to the wake. Rather, we eagerly await its
revival. (For full disclosure, it was only last year that
we finally conceded that Jim Morrison was, in fact, dead.)

Over the last couple of days, as we examined one beaten-
down resource stock after another, we were struck by two
conflicting observations. First, most of the stock price
charts we viewed looked horrible. Second, most of the
valuation measures we examined looked downright gorgeous.
We encountered stock after stock that had tumbled 20% to
30% from its March highs, and that now traded for five or
six times earnings. A few offered hefty dividend yields to

And so we wondered, should the prudent investor be dumping
resource stocks selling for 6 times earnings to put their
money to work elsewhere, presumably in some sort of
"consumer staple" stock selling for 19 times earnings or a
"tech stock" selling for 29 times earnings or an Internet
stock selling for 99 times earnings?

We suspect not. On the other hand, we are very familiar
with the argument that "deep cyclical" stocks like mining
companies should be purchased when their PEs are above 100
and sold when they are about 4. That’s because,
traditionally, cyclical stocks carried very high PE ratios
at the beginning of a new economic cycle, before any
earnings growth had materialized. By contrast, by the time
these companies were reporting big profits, the cycle was
already drawing to a close. Therefore, the "E" would be
going away.

We appreciate this logic, but consider it less relevant
today than in prior economic cycles. In the past, the "deep
cyclical" phenomenon we just described resulted from the
boom/bust rhythms of the U.S. economy, before such extremes
were forever banned by Alan Greenspan and the FOMC. But
today’s cycles lack the drama of past episodes. Our "Great
Depressions," for example, have become "growth recessions."
And even though we are not convinced that depressions have
become extinct, we would not want to base an investment
strategy on awaiting the next one.

Then too, global economic trends were rarely as influential
over commodity price trends as they are today. In the
modern global economy, large foreign economies might grow,
even while the U.S. economy slows. In which case, commodity
prices might slip, but they need not collapse…at least
not necessarily.

Therefore, the seller of Phelps Dodge at 6 times earnings
must believe that the entire global economy is slowing to
such an extent that this copper producer’s robust earnings
will soon disappear. We are not so downbeat. Perhaps the
U.S. economy is pulling back a bit, but somebody is still
buying copper. The Phelps share price may have tumbled 20%
from its recent high, but the copper price slipped only 5%
over the same one-month span.

The chart above depicts the price and estimated PE ratio of
the Goldman Sachs Resource Stock Index – a group of
resource stocks like ExxonMobil and Louisiana-Pacific. For
more than a year, the PE of the index steadily declined,
even while its price rose. That’s because earnings were
increasing much faster than the price of the index.
Recently however, the PE has dropped sharply because the
index price has dropped. As a result, the index sells for
less than 12 times estimated earnings – a multi-year low.

We readily admit that most of the stock price charts of
resource companies look like "death" right now. So maybe
May 18, 2005 is not the optimal date to establish new
positions in resource stocks. On the other hand, the PE
ratios of resource stocks are as low as they have been at
any time in the last three years. So maybe May 18 is not
the worst day to buy a stock or two.

The commodity bull market might be in rehab, but we suspect
it will be touring again very soon.

Did You Notice…?
By Eric J. Fry

It might seem impossible for us Americans to become rich by
buying houses from one another, but that doesn’t mean we
can’t try. The chart below, courtesy of BCA Research,
depicts the remarkable rise of real estate financing in the
U.S., as a percentage of total loans. Now, for the first
time ever, lending to purchase real estate comprises more
than half of all lending in the U.S.

If all this borrowing were devoted to investing in
commercial property, one could make the case that the loans
were finding their way into productive assets. But this
does not seem to be the case. Instead, the loans are
finding their way into the nation’s discretionary spending
budgets. Increasingly, homeowners are cashing out their
home equity to fund the consumption that incomes alone
can’t quite seem to support. As consumption continues to
rise, therefore, mortgage debt continues to pile up on the
balance sheets of American households.

"Even at today’s very low interest rates," Northern Trust
economist Paul Kasriel points out, "mortgages are eating up
the biggest proportion of income since the early ’90s. In
the fourth quarter, mortgage payments were equivalent to
10.12% of disposable income, the highest reading since the
first quarter of 1992 (and of course in many mortgage-
paying households, the share will be much higher – a fact
that is lost in highly aggregated national numbers). Here’s
the stunning difference between now and 1992. Back then,
the interest rate on a conventional mortgage was 8.5%.
Today, it’s just under 6%.

"In addition," Kasriel continues, "the market value of
residential real estate is at a record high in relation to
after-tax income. Again on a nationwide basis, the market
value of real estate is close to 200% of disposable income
now. That ratio’s previous high was in the late ’80s, when
it climbed close to 160%. A ratio close to 200% cannot last
more than a few months. It is the equivalent of Nasdaq
trading over 5000."

Unlike Kasriel, we have no confidence that this record-high
ratio "cannot last," we only know that is SHOULD NOT last.

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