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Markets: Free Fall
New York: October 27, 2008
By John R. Stephenson

Every day the roller coaster ride continues with banks being nationalized left, right and center. Yesterday's winners have turned into losers and fast! U.S. Treasuries are up and just about everything else is down — sharply! Most commodities and commodity stocks are down anywhere from 50 to 70% from the peak this past summer, as the de-leveraging of the world's financial sector continues. The pain is real, it is universal and unfortunately it will persist for a while longer as the global margin call continues. The latest victim has been the emerging markets who, up until recently, were all too content to sit this one out — at least until the traders started to sell.

China 's economic growth rate has slowed to a paltry 9 percent annual rate and India has seen its growth trajectory slow from 9 percent to 7.5 percent. Emerging market growth, while still leaps and bounds ahead of the growth rates of the Western world, is definitely slowing. India has some 300 million urban consumers who, like the rest of us, are starting to reign in their spending. Just a few short months ago, the Indian middle-class was on a roll with rising incomes and the highest consumer confidence levels in Asia . But now, the global financial crisis has taken its toll and that's bad news!

Markets have reacted by declaring that the bull market in commodities is dead. Further exacerbating the situation is the fact that many of the global hedge fund players have been forced to sell their commodity stocks as well as the commodities themselves as part of this forced liquidation. Managed commodities represent a tiny fraction of the global investment dollars, so when traders start selling it's like yelling fire in a crowded theatre.

Figure 1: Managed Commodity Funds are a Small Market

Peak oil has become weak oil, as traders have sold all but the kitchen sink by betting that a massive global recession would kill demand for commodities. Base metals have been hit hard with zinc the first to cave, followed by nickel and now copper falling sharply as the massacre has continued. The China bull appears to have become the China bear and everyone has an opinion on the global financial meltdown. All around us there is chaos, the only real question remaining is does that equal opportunity?

For most people, pain and misery is all they see, but Hollywood sees opportunity and is rushing to capitalize on the stock market sell off. A sequel to the movie Wall Street is in the works and will star Michael Douglas. NBC's Law & Order is developing its popular television series around financial themes. McDonalds Corp. and other fast food eateries have seen sales soar, as consumers have started to crave bargain eating with the stock market and economy in a free fall.

The signs of an eventual rebound are all around us. Mine closings and oilfield shut-ins have accelerated at an alarming rate which will eventually result in slowing the supply of oil, natural gas and base metals. Capital budgets for all kinds of commodity producers are being slashed, further curtailing supply. With less supply on the market and demand still strong, prices will eventually rebound. But it still will take time and investors will have to adopt a more cautious approach.

In volatile markets, it is always smart to be cautious, but for my money, the commodity bull market is not dead — it is only on sale. Unless you believe that the entire global economy goes into a major depression, then over the next couple of years you are going to witness an unbelievable buying opportunity in utilities and commodities. In its haste to meet the margin calls the market has been throwing the baby out with the bathwater. The crown jewels of the global energy and base metals business have been trashed in spite of the fact that they are still hugely profitable, having strong balance sheets and good cash flows and they operate for the most part in geopolitically secure parts of the world.

One of the reasons why commodity prices soared so rapidly was that it was a relatively safe way for investors to play the emerging markets story. Rather than get directly involved with understanding the ins and outs of each unique emerging market, commodities allowed investors to play the unfolding growth story from the comfort of their own backyards. And that will be the case once again, once the hot money investors have been flushed out of the system.

Already, valuations are looking incredibly attractive for not only the commodities themselves, but also for the stocks of the companies that produce these commodities. Now is the time to start slowly building a position in the great growth story of the next century — the emerging markets.

In the 1987 stock market crash, the emerging market debt problems figured prominently. This time round, the situation is totally reversed. The emerging markets are the ones that are solvent and it is the U.S. and European investment and commercial banks with their tremendous leverage that have put us on this out of control roller coaster ride. It is their growth, not ours, that will be the eventual solution to what ails us.

Right now, emerging markets are looking ridiculously cheap. Malaysia , Thailand and Singapore all have trade surpluses and low inflation rates and yet their currencies have been pounded. The real risk is in U.S. treasuries rather than the stocks of commodity producers or emerging market funds. Once the world has to absorb the trillions of dollars in debt that the U.S. will have to issue, things will start to reverse once more.

Money will pour out of the U.S. dollar and gold will have its day in the sun. A weaker U.S. dollar will benefit the other commodities as well, since all of them are priced in U.S. dollars. Energy stocks will soar as demand remains strong and supply continues to struggle.

Another area that offers promise for investors is in the pipeline and utility sectors. These have been hard hit as investors have dumped everything they could get their hands on in a flight to the perceived safety of U.S. treasuries. Utilities are regulated businesses that sell electricity to a wide range of commercial, industrial and residential consumers - a boring, but stable business. Pipeline companies are also highly regulated and yet they operate a relatively straight forward business — they ship natural gas and oil to other businesses.

Times are tough and investors should be cautious, but things have rarely been so inexpensive. For those with the stomach for a little volatility, the worst is likely over and it would be prudent to start to pick away at some of the greatest bargains around - the great commodity stocks and the shares of emerging market funds.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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