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Markets: Road Block:
New York: August 18, 2008
By John R. Stephenson

Six weeks ago, commodities and commodity-weighted stock indices were near their all-time highs. And then they weren't! The sudden tumble in value has left many of us open-mouthed and stunned. Day after day, commodity-linked stocks close lower, as energy, gold and material prices tumble. Just when we thought we had figured out how to make money in this market, this happens — leaving us wondering what's an honest investor to do ?

For a while it seemed so simple, sell US banks and buy energy and resource stocks. But for now, that has been a losing trade, as investors have fretted about the slowing global economy, rather than the growing crisis in US financials.

While the US economy may be slowing, the rest of the world's major economies seem to be sputtering. Quarterly economic declines in Europe and Japan have focused investors' attention on the possibility of a global recession. And that's bad news for the shares of commodity producing companies whose growth is tied to the fortunes of global, rather than US, growth.

The European Commission said this week that the quarterly economic progress for the 15 countries that use the Euro, slowed for the first time in more than a decade. The European financial services sector has melted-down even faster than it has in the US. In part, this is because the European Central Bank has not been helping out their banks as the US Federal Reserve (the Fed) has. By opening the Fed's discount window and by the swapping of perfumed asset-backed mortgage products for pristine US treasury securities, the US Federal Reserve has bent over backwards to bail out Wall Street banks.

But in their desperate attempt to stem the credit crisis, the Fed is treading on dangerous new ground. The bailouts, while well meaning, have only served to reward those on Wall Street who took huge bets and lost, to gamble again.

So far, the Fed's strategy is working, but for how long? Ultimately, it is the US taxpayer and small business person who is going to be left holding the bag for people like Merrill Lynch's, Stanley O'Neil who pocketed in excess of $150 million, for his tenure at the helm of one of the world's largest financial institutions. Never mind that in the last year alone, he oversaw the evaporation of at least $76.2 billion in shareholder wealth. Asset-backed securities linked to shaky mortgages were just one of the products that Merrill Lynch sold to the detriment of shareholders.

But for now, everyone is buying US financials and selling energy and resource stocks. Why? Because by bailing out the big banks that are too big to fail, the Fed has made an investment in Wall Street banks a no lose proposition. They are cheap today and by absolving them of all responsibility for past transgressions, the Fed has removed most of the risk in investing in these banks.

Figure 1: DXY - The Trade-Weighted US Dollar Is on the Rise!

Source: Bloomberg

With investors focused on the Fed's implicit promise to bail out the big US banks, investing in America doesn't seem to be quite so scary. And that's exactly what global investors are doing — buying the shares of American companies! The US was the first country to slip into recession and investors are reasoning that it will be the first country to recover. That line of thinking is helping to propel the American dollar higher and is wiping out the gains in many commodities (such as gold and oil) that are priced in US dollars. So, America's gain is Canada's and Australia's pain. But is that right?

For now it is, but the jury is still out. For starters, growth in US household net income has gone negative, largely on the back of collapsing house and stock prices. As well, the market for asset-backed securities of all types is severely strained, causing the credit markets to freeze up. With the banking sector and the household sector in the toilet, just how likely is an imminent recovery in America's financial health?

Figure 2: US Household Net Worth Is Now Negative!

Source: RBC Capital Markets

Not very likely! If people are poorer and credit markets are frozen, then the likelihood of consumers leading the US economy higher is starting to look like an uncertain bet. In an economy that is largely dependent on consumer spending (73% of GDP), a weak banking sector that is unwilling or unable to extend credit, coupled with a financially hobbled consumer, is a big problem. Not to mention the cost of all those bailouts of the Citigroups and Merrill Lynches of the world will likely be borne by US taxpayers in one form or another and you have the makings for a pretty sluggish recovery.

In spite of the current zeal, the outlook for the US economy is still decidedly negative, despite a recent uptick in economic performance. Leading the way down is the residential real estate market, which remains a basket case. Housing starts have fallen by over 50% since they peaked in January 2006 and the National Association of Homebuilders' sentiment index touched a record low in July. As well, the number of months of supply of new homes on the market is still double what it was only two years ago.

Figure 3: The Collapsing Value of Asset Backed Securities!

Source: RBC Capital Markets

Already, there are signs that the problems plaguing Wall Street are starting to spread to Main Street USA. The spreading residential real estate woes are starting to impact commercial developments. Hey, if people are losing their homes, it isn't too likely that they will be shopping at the mall under development a mile away. According to the Fed's survey of Senior Banking Loan Officers, banks continue to tighten their consumer lending standards at an alarming rate. In fact, the number of institutions raising their credit card lending standards doubled over the last three months alone.

And that's bad news for the American economy. If people are losing their homes and commercial developers start reneging on their loans en masse, then regional banks will be the next victims in the collapse of the credit bubble that started with Wall Street and is now spreading throughout the broader economy. Defaults on construction and commercial lending, coupled with tighter credit standards is the next tsunami to hit the US economy.

The current weakness in the commodity markets is manna from heaven. Astute investors, such as Warren Buffet, are positively giddy at the prospect of seeing some of their favorite stocks getting so cheap, and I am too.

The stocks of commodity producers have none of the problems facing those of the global banking stocks. Their balance sheets are clean, the demand for their products remains strong but supply continues to struggle.

While the commodity story has been hobbled in recent weeks, it isn't over. The valuations have never been better, the alternatives never looked weaker and global growth, while sluggish, is still trending up, albeit slowly. For those investors willing to start wading back into commodity-linked stocks, the future reward is bright. They offer discounted valuations, solid business models and great fundamentals. Until the risk of financial distress dissipates and a substitute for oil is found, the companies that produce both oil and gold should be attractive investments for investors to consider.

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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