Wednesday, May 24, 2006

Commodities - Which way? (updated)

The recent direction of the stock markets seem fairly clear, and for anyone who's got any doubts, these two (one, two) recent postings by Barry Ritholtz over at The Big Picture should help clarify things. The market, overall, seems poised to continue moving down - or at best - sideways. Yet, as always, even in soft markets, some stocks - or groups thereof - will continue to make gains.

The largest seemingly identifiable group that is likely to continue significantly differentiating itself from the broader market is commodities - mainly minerals, and oil & gas.

The only question is - which way?

Goldman Sachs analysts Arjun Murti and Brian Singer surprised the markets in March 2005 by calling for $100/barrel oil. While it may have been headline surprise, it was only a reiteration of similar calls for continued oil prices at increasingly elevated levels. More recently, pundits on both sides have pointed to a myriad of evidence supporting both higher and lower prices - pointing to things like increased demand from rapidly industrializing China and India, and potential for disruption from Iran, etc. - and on the other side - speculators keeping the price high. Seemingly authoritative sources on both sides make compelling arguments for both directions.

Other commodities too, had well known prognosticators on both sides of the fence point to imbalances. A recent letter from investment guru Bill Miller of Legg Mason suggests that the boom is more likely to be nearing the end, than in the middle of a tear. Superinvestor Warren Buffett also suggested in verbal comments (use browser tool to search for "commodities" within the article) made at the 2006 annual weekend conflab in Omaha, that commodities were subject to some speculative excesses although the comments were somewhat vague in nature.

Surveying the scene, it's possible to become utterly confused as to which way commodities might move. Investment guru and commodities expert Jim Rogers (co-founder of the Quantum Fund with billionaire George Soros) says that while commodities may in the midst of a "big correction" lasting anywhere from three months to two years, that this is a secular (commodities) bull market with another 15 years to run, "because supply and demand are so out of whack".

One can never be certain of course, and it's difficult to see exactly who's right: well-known conservative investors (i.e. Miller, Buffett, etc.), or other renowned experts like Rogers.

Me, I just keep thinking China and India growing economically at 7-10% a year, with their two and a half billion citizens. That, my friends, is a lot of demand. Are prices out of whack? Frankly, I don't know, but I very much doubt we are in the seventh inning in this particular game.

On the other hand, it's important to remember that even favorable long-term investment winds can't rescue an investor if he/she paid a wild price for their asset. Just ask anyone in the "NASDAQ 5000" club.

N.B. 7:22AM PST May 25 Update:

One thing I personally would NOT do, is to invest directly in the underlying commodity index, as seems so popular these days, by the roll-out of various commodity-indexed ETFs. As CIBC World Markets chief economist Jeffrey Rubin pointed out in some market commentary, the stocks of commodity companies typically lag the leading indicator (the spot price, usually) in a commodity rally for a long period of time.

Both the imputed price of the underlying commodity is much lower (in 2005, Mr. Rubin said most oil companies had a value which imputed oil in the high $20s or low $30s per barrel, for instance). The longer the rally goes on, the more the stock price begins to close the gap, AND begins to experience multiple (i.e. PE ratio) expansion.

This suggests that the best way to invest in a commodity bull market, is in the early phases invest directly in the commodities themselves, and later, through stocks. I personally feel that we're into the second part of that investment thesis, and the best days of the first portion are already behind us.


The Confused Capitalist

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