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Markets: The Rally Stalls
New York: February 13, 2006
By John R. Stephenson

For investors in commodities and commodity stocks, this last week was tough. Prices for oil, natural gas and gold were all off during the week. With weaker commodity prices, the momentum players in the market decided to get out while the getting was good and in doing so, the shares of commodity producers tumbled. For many, this was long overdue. To the vast majority of market participants the logic was simple — commodities are cyclical. Tumbling prices are the surest sign that it is time to head for the exits. But is that right? Should investors be dumping their oil, gold and base metals stocks in favor of biotech shares?

Maybe. The logic, according to the pundits, is straightforward. The U.S. consumer is the growth engine of the world economy. With a negative personal savings rate, rising interest costs and a housing bubble ready to burst on its shores, isn't the U.S. consumer ready to collapse? If so, spending will dry up, reducing the demand for cheap Chinese imports and hence stalling the boom in commodities.

Sounds simple enough. But this logic assumes one thing — that the U.S. consumer is still the driver of the world economy. Over the last year, global economic growth was up over 5% with the economies of the developing world outperforming those at home for the first time.

In the past, the economies of the developing world weren't nearly so strong. Currency crises seemed to be the order of the day. With few, if any, products to export, their economies were vulnerable to changing economic winds from the developed world.

Today, things are different. China and India have an emerging middle class. Their currencies are stronger and what's more, they have massive foreign exchange holdings in their treasuries, which stand ready to back their currency in the event of a decline. For Americans, growth at home has been the result of borrowing, rather than savings and investment. For the most part, American economic growth has been dependent on absorbing the excess savings of developing nations.

No doubt, much, if not all, of the incremental demand for commodities is coming from Asia — namely China. With demand growth for copper and nickel essentially flat throughout the developed world, the incremental demand increase is coming from China. Nickel, which is used in the production of stainless steel and copper with its commercial applications, are in short supply as China rapidly industrializes.

The supply and demand balance for copper is amongst the worst of all the commodities. Chile, which is the source country for much of the world's copper supply, has been rocked with earthquakes and a reduction in the grades of copper from the producing mines. Smelter difficulties in India and Thailand have further reduced global supply to the point that copper stocks have been reduced to just 21/2 weeks of physical supply. Yet the stock of Phelps Dodge, a global commodity powerhouse, was hit hard last week.

To many investors, China and India are still marginal players on the world economic stage. While growth rates have remained impressive, some have refused to believe in the sustainability of this growth. Yet in spite of the pessimism, the numbers indicate a different story. Growth in China has been strong for quite a while — averaging between 5 and 12 percent annually since 1979.

A massive slowdown in the U.S. would no doubt be bad news for the Chinese economy. But, what the pundits fail to consider, is that China's growth, while impressive at 9% plus a year, would have to take quite a tumble before the struggling world commodity supply would catch up with demand. Not only that, but China's economic base continues to grow substantially each and every year. Will it end? Maybe. But I wouldn't bet on it.

So far, the stock market seems to be saying that they expect the stocks of commodity producers to head lower. Multiples on these stocks are still well below the averages of the broader markets and yet the fundamentals (supply and demand) appear favorable. When everyone is convinced that this is a winning trade, then it probably would be time to take your bets off the table.

By any comparison, the stocks of commodity producers appear cheap. This at a time when demand for commodities worldwide is strong and supply across the globe continues to struggle. At the height of the last commodity bull market (12/30/1980), energy companies represented some 30% of the S&P 500 index. Today, commodity stocks in aggregate only represent 9.5% of the S&P 500. With pessimism abounding, this hardly seems like the time for commodity investors to cash in their chips.

With a fire sale in commodity producers occurring, now might be a good time to increase your exposure rather than rein it in. But more than just that, the lesson of the last several years seems to be that global investing is here to stay. With developing countries adding as much as they are taking from the global economy, perhaps investors should start to broadly diversify their holdings.

Markets, such as Japan's, have swung from laggard to leader. Not only that but good value exists in much of Europe. Price earnings ratios for the broad European indices average 15.3 times versus some 17.6 times globally. As well, dividend yields across Europe average 2.7 percent versus a global average of 2.1 percent.

Investors looking to outperform this year should consider investments a little further afield. Emerging markets, European stocks and commodity producers all look attractive especially if you believe that the world is becoming more interdependent rather than less. A safe and easy way to participate in global economic growth is through buying exchange traded funds ("ETFs") which track stock market indices around the globe. With over $400 billion in assets globally, ETFs offer all the advantages of mutual funds (diversification) with the ease and simplicity of buying and selling stocks.

While pullbacks in the market may cause us to question, isn't now the time to be jumping on the bandwagon rather than off?


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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