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Markets: REFCO and Rocks
New York: October 24, 2005
By John R. Stephenson

It's been a pretty tough couple of weeks for commodities and the companies that produce them. Adding to the sell-off is undoubtedly the REFCO effect. REFCO, a major commodities and futures broker, hid half a billion dollars in losses in a hedge fund company controlled by the former CEO. Adding to the woes at REFCO, the company had just gone public in August, raising the question — was going public just a scheme to hide the losses in the first place? Probably. But this is not the first time that REFCO has landed in hot water. The most memorable? In 1978, Hilary Rodman Clinton turned a $1,000 investment in cattle futures into a $100,000 windfall in a few months. The upshot? The largest fine in the history of the Chicago Mercantile Exchange — $250,000.

All across the board, commodities and the producers of commodities have been sliding. The only exception, ironically, has been feeder cattle futures. But because of the nature of the settlement mechanism on futures exchanges, the pain of the REFCO meltdown will likely be limited to the shareholders and bankers who helped perpetuate a massive fraud on the investing public. While there may have been some forced liquidation of futures positions with various REFCO clients, the long-term implications are probably limited to reduced confidence in the system. The commodities sell-off may be related to the REFCO debacle and fears about subsequent unwinding of positions, but is most likely part of a broader trend in the market.

The news from the economy of late has been anything but reassuring. A twelve percent jump in the energy prices in September resulted in a 1.2 percent jump in the consumer price index ("CPI"), the largest monthly increase since March of 1980. This follows on the heels of dismal consumer confidence numbers and a Federal Reserve (U.S. central bank) that seems hell bent on steadily raising interest rates to choke off liquidity in the system and to slow down the housing bubble. Also, Avian Flu moved from the middle of the newspaper to the front page in the last few weeks (see: "Bird Flu Blues?" — Money Focus 10-17-05). With the short-term interest rate about to rise above that of long-term rates (an inverted yield curve) over the next couple of years, can an economic slowdown in the U.S. be far away? Maybe not.

That, at least, seems to be the view of the overall stock market. With oil above $60 a barrel and no end in sight, the stock market seems to be signaling that higher energy prices will eventually translate into slower economic growth and lower future stock prices. The betting goes like this: if the U.S. economy were to slow, then this would be bad for the Chinese economy sending it for a tumble and taking with it the stocks of commodity producers — especially the metals and mining companies which are levered to an economic expansion, particularly in China. Across the board, the metals and mining companies have taken it on the chin as worries about energy-induced inflation have continued to wreck havoc on commodities and the stocks of commodity producers. Hedge funds, and other market participants, seem to be taking the view that they should be buying commodity producers if the prospects for global economic expansion look promising and selling them if the world economy looks a little shaky.

Nowhere has the market pounding been more severe than in the stocks of the metals and mining companies. Companies such as Phelps Dodge (P/E = 6.5 times), Rio Tinto (P/E = 9.0 times) and INCO (P/E = 11.0 times) have been crushed with the growing chorus of sell orders from the street. While the group is up some 11 percent this year, their earnings have been soaring much faster than the price of their equities. The result? These companies are extremely cheap when viewed through the lense of price earnings ratio (the price multiple that investors will pay for current earnings). Not only that, but the market is paying significantly less for these earnings than they were one or even two years ago.

Figure 1: Phelps Dodge Price Chart - 1995 to Today

Source: PC Quote

While the market may be saying that earnings for these companies have peaked, this seems like a stretch to us. With earnings skyrocketing for these companies, it seems like the time to be buying rather than selling the producers of metals and other commodities. Not only that, but these companies are extremely healthy from a financial perspective.

While inflation may be ramping and growth may be slowing, the broader economic picture is not nearly as dismal as the stock market may have been signaling. Corporate earnings are enormous and overall economic growth throughout the world is still strong. While higher oil and gas prices may start to slow the economy and keep the consumer out of the malls, the one area that is likely to remain strong and historically has not been correlated with the economy is the stocks of commodity producers which have zigged when the market zagged. The pullback in commodities and particularly the metals and mining stocks might be an ideal entry point for investors who are looking to outperform the broader stock market. Earnings are phenomenal, growth is still strong and the mining and metals companies are cheap on a historical basis. What more could you want?

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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