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Markets: Is it Over?
New York: November 07, 2005
By John R. Stephenson

For a while now, it's been a pretty good bet to buy the stocks of commodity producers. The ride for investors has been stellar. But lately, things are different. In the mainstream press and on Wall Street, people are asking the question — is it over? With nickel prices trending down and oil cooling off, investors and pundits of all stripes have declared the death of the commodity bull. The rationale cited for the start of a commodity bear market — a massive economic slowdown in the U.S. and China.

The theory, according to some, is simple. The driver behind the phenomenal growth in the demand (and hence price) for commodities is China, a country which is churning out a boatload of low-cost manufactured goods. The American consumer, always on the lookout for a bargain, has lapped up all the Chinese-made household products he/she could stuff in an SUV. This massive spending by the American consumer has sent our current account (exports minus imports) spiraling downward while the Chinese economy has leapt skyward, as China industrializes at a truly staggering pace to meet this insatiable demand. The problem? Growth in America may be starting to slow which might tank the Chinese economy while at the same time torpedoing the commodity story.

Figure 1: The U.S. Continues to Borrow and Spend

Source: FrontPoint Partners

No doubt about it, Americans love to spend and with the consumer representing some seventy plus percent of the economy, everything hinges on that consumption. China, on the other hand, has been the major driver of the commodity bull market (particularly for metals) as they are in need of everything. China has been all too happy to manufacture the goods that we have been demanding. So much so, that China's seventh largest trading partner isn't even a country, it's a corporation — Wal-Mart. But according to the pundits, the consumption binge is about to end taking the Chinese economy and commodity prices down the drain along with it. The reason? The U.S. consumer is starting to battle a huge economic headwind in the form of persistently high energy prices. Not only that, but consumer confidence is weak, the U.S. personal savings rate is negative, house prices seem to be slowing and the Fed (U.S. central bank) has been raising interest rates at a steady clip.

Figure 2: China: The Commodity King

Source: Frontpoint Partners

To be sure, some commodity prices have taken a tumble. Nickel is down sharply. In the last several years, Chinese nickel consumption has been rising by more than 25 percent a year. Aluminum and the stocks of the producers of the metal, Alcoa and Alcan, have been trading like an Internet stock in 2002. But copper, a metal in short supply, is humming along just fine and crude oil, although somewhat humbled, is still hovering above $60 a barrel. So what gives?

Metals, it would appear, are not created equally. Aluminum is made from electricity and alumina — the second most plentiful metal in the world's crust. With the Chinese subsidizing aluminum production as well as the cost of electricity, is it any wonder that the stocks of Alcan and Alcoa (the two largest producers of aluminum in the world) have taken a tumble? Nickel is used in the production of stainless steel, which is used to produce sinks and other basic household appliances — making nickel more sensitive to retail consumption trends. But copper production is much harder to expand than aluminum and nickel and is used in primarily industrial applications making it a hot property indeed.

So while certain metals may be cooling off, other commodities are going strong. Oil and natural gas, the two most important commodities, are showing no let-up in price. And no wonder, in cities such as Beijing some 33,000 cars are added every month. As a non-renewable resource which has witnessed some twenty years of under-investment in the industry, the scramble is on to find more oil and natural gas. Demand for crude oil from a surging China and India and strong growth from everywhere else around the world threatens to overtake available supply. The demand for oil has increased in 87 out of the last 100 years, making it extremely likely that strong demand will continue for some time. Not only that, but most of the demand growth over the last twenty years was met by non-OPEC producing countries which are now at maximum production. Future supply growth will have to come from OPEC countries which are getting short on spare capacity.

Figure 3: Oil Supply Gorwth Will Have to Come From the OPEC World

Source: BMO Nesbitt Burns

But if demand is strong and supply is tight, why are we experiencing a pullback in the prices of energy stocks? In part, the explanation seems to be that overly bullish calls about the price of the sector caused fund managers to buy the sector in September to show sector exposure before the quarter end. October showed some early profit taking, making the stocks more volatile (risky) than the underlying commodity. But oil prices in the future (futures prices) are higher than current prices, meaning the pros in the market still feel that we are likely to experience higher commodity prices than lower commodity prices. Not only that, but, by any measure, the price of commodity producers is cheap relative to the broader market (trading at 14 times trailing earnings). Benchmark companies such as Exxon Mobil are trading at a mere 10.4 times earnings.

Energy stocks across the board are trading below their historic norms (on a P/E basis). But it isn't just energy stocks in which investors are treading lightly. Copper producers such as Phelps Dodge, a world leader with zero debt on the balance sheet, is trading for a mere 7 times earnings. The lesson? These stocks represent an incredible bargain at this level.

How about China and America? What if a slowdown occurred in the U.S. — would that lead to a meltdown in China? Possibly, but it is unlikely. For starters, we are not talking about static positions. China is not only a significant exporter to the U.S., but it is a growing exporter, meaning that not only is the absolute volume of trade increasing but also its share of the total U.S. trade is increasing. While a slowdown in the U.S. economy looks increasingly likely, particularly as the winter heating season approaches, the magnitude of the slowdown would have to be massive indeed to slow the overall growth in demand for the scarcest of commodities.

But, as the aluminum story has shown, the greatest determinant of commodity prices and the value of the stocks that provide them is supply and demand. Once that balance changes from tight supply in the face of strong demand to plentiful supply in the face of strong demand, the party is over. While nickel and aluminum may struggle for a while, the prospects look good for copper sales as well as for oil and natural gas. The upshot? Investors should consider buying the stocks of energy and copper producers on these pullbacks as the fundamentals for these commodities remain intact. Not only that, but on a historic as well as a relative measure, these stocks are a steal.

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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