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Markets: Not Yet
New York: April 24, 2006
By John R. Stephenson

Hardly a day goes by when a Wall Street pundit or major newspaper doesn't declare the commodity bull market over. The analogies they make are simple: that this is the tech boom all over again. For a brief fleeting moment last week, this looked like sage advice as silver plunged some 14 percent on Thursday taking with it some of the base metals. But, by Friday, silver had bounced back with its largest one-day gain in 11 years. By the end of the week, gold, zinc, nickel and copper had roared back and crude oil hit new highs closing at $75.17/barrel. So is it over yet? For our money — not yet.

A combination of geopolitical tensions, low inflation, struggling supply and strong demand from a growing world economy has created a perfect storm for commodities that is taking them to dizzying heights. In spite of strong crude oil inventories, the threat of a nuclear-fueled conflict with Iran, plus Nigeria continuing to simmer in the background, has helped to keep crude oil on the front pages of the newspapers for the time being. Gold has been another strong performer of late since it is widely viewed as an inflation hedge (rising energy prices) and a safe refuge in times of trouble.

Strong growth from all four corners of the globe is supporting the prices for base metals such as zinc, nickel and copper. Last week, the International Monetary Fund boosted its growth forecasts for the global economy to an impressive 4.9 per cent for 2006. If their forecast turns out to be accurate, it would be the first time in 30 years that the world's economy has expanded at a 4 per cent or greater rate for four consecutive years. Leading the charge in surging economic growth are the usual suspects — China and India — whose rapid industrialization has sent commodities on an upward trajectory.

But according to the press and many Wall Street analysts, the good times are about to end. They reason that surging commodity prices, particularly energy, will cause widespread inflation, which will dramatically slow economic growth. This in turn will lead to a sell-off in commodities as strong global economic growth has helped to keep commodity prices in nosebleed territory.

Figure 1: IMPACT OF DOUBLING CRUDE OIL PRICES ON CORE CPI

Unfortunately, the higher inflation argument just doesn't hold water. For starters, Figure 1 illustrates that the effect of higher oil prices on the developed economies has been declining since 1980. For consumers, oil and gasoline purchases over time have become a smaller and smaller proportion of the basket of goods and services that they buy. Not only that but the rise in global trade has helped to keep inflation at bay. With our shores awash in low cost imports, a dramatic rise in inflation is unlikely to follow.

In countries such as Canada, where commodities, particularly oil & gas, are king, the calls for a market top continue to grow ever louder. For the pundits, the reasoning is simple. There is lots of speculative activity (mainly from hedge funds) in commodities coupled with strong price increases (crude oil is up 39% in the past year and 8 percent this past week alone) suggesting that things will get a lot worse before they get better. Not only that, but this is the same story we have seen once before, when shares of technology shares surged year after year. But are they right?

Figure 2: Toronto Stock Exchange - The Most Commodity Intensive Index

Source: CIBC WM


Figure 3: Earning Have Kept Pace With Valuations

Source: CIBC WM

It would appear from the above charts that the pundits are wrong. While there is no doubt that there has been a rise in speculative activity surrounding major commodities this is not like the last time . The reason? Earnings have been surging whereas valuations (stock prices) have been struggling to keep up. In the technology boom, earnings were slim to non-existent, yet technology shares continued to surge. Today, the situation is just the opposite.

With commodities hot and likely to get hotter, fast and faster money is sure to continue to follow. With fast money comes fast decisions and situations like we witnessed in silver (silver fell $3.00/ounce in a few hours) last week are sure to follow. As well, a lot of money has been made in commodities, which further exasperates the concerns that perhaps we are nearing a top. But all that flies in the face of the facts.

For our money, commodities and the shares of commodity producers, particularly those with operations in geopolitically stable regions of the world, are still the way to go. Unless you believe that China's frenetic urban growth is a passing fad and that millions of Chinese will shortly be heading back to life on the farm, the commodity story for base metals and energy is still strong. Global growth is poised to head higher, not lower, in the year to come and inflation, while still a potential spoiler, is just not as big a worry as it once was. While things may soften and sell-offs will occur, the story for commodities and commodity producers is one of higher prices not lower prices, at least not yet.

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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