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Commodity Investing Shell Shocked
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Markets: What About Commodities?
New York: April 18, 2005
By John R. Stephenson

For most of us, commodities belong in cowboy country. It's just not something that most of think about as part of our diversified investment portfolio. For most of us, commodities just don't figure. We obsess about real estate, we wonder if the Fed is going to raise interest rates and wreak havoc on our bond portfolio or we worry about returns to our tech portfolio. Yet when we hear anybody mention commodities, we shrug our shoulders and wonder what all the fuss is about. But for many investors, commodity investing could add some much needed oomph to an otherwise lackluster portfolio.

But, by ignoring commodities, we are potentially risking our financial health. The reason? Commodities rock when the stock market rolls. Commodity returns are largely uncorrelated with the returns of the broad market. In other words, commodities tend to soar when the stock market falters and sink when stocks rally. So given the sharp sell-off of the stock market over the last few days, doesn't it make sense to at least take a look at commodities?

For starters, what are commodities? Commodities are real things: orange juice, sugar, cocoa, rubber, oil, natural gas, pork bellies, steel, lead, copper and coal are all commodities. They are used in our morning breakfast and in the products that we buy. They are tangible things that tend to follow a very cyclical pricing pattern. Today, commodities are hot and likely to stay that way for some time. The reason? Supply and demand are out of balance and regardless of what happens in the economy or the stock market, too much demand and too little supply are good for commodity prices.

Commodities are all around you in your everyday life. Whether it is on a trip through the grocery store or a drive around town - you are surrounded by commodities. Commodities are the essentials of life and a well developed system of production and price management through the futures markets has evolved to regulate prices and to ensure that producers can produce and end-users can get their hands on the necessary commodities at the right price and in time.

Yet commodities get no respect. We happily pony up money to invest in Nortel or Enron shares yet when it comes to commodity investing most of us are at a loss. But the world of commodities is hardly bush league. In fact, the market for natural resources is the largest non-financial market on this planet and the daily volume of the 35 most active commodities traded worldwide is some $2.2 trillion. Not bad, for something no one has ever heard of!

But why is this so? For starters, commodity investing is the same as futures investing. Futures contracts trade on organized exchanges, just like stocks. But, futures contracts specify the quantity of a particular commodity, the month of delivery and the location of delivery for that same commodity. In other words, it's a little bit tricky. All this and the ability to use a whole lot of leverage make it difficult for most individual investors to participate in the Futures markets.

Not convinced that commodity investing makes sense? Consider the alternatives. Stocks are overpriced on a historic basis (the one hundred year P/E average for the S&P 500 is 14 times) and technology stocks are still in nosebleed territory. Bonds hardly seem to do the trick with interest rates hitting multiple decade lows, the likely direction of rates is up which is never good for bonds. Not to mention the fact that Fannie Mae and Freddie Mac the two "government sponsored" home mortgage agencies are sitting on top of $7.3 trillion in home mortgages and are scandals in the making. If either of these entities goes down, don't expect Uncle Sam to give you a bailout on this one. How about real estate? One possible place to park your money there is a massive speculative bubble that is developing along the coasts of the United States. At some point, this bubble, like all others, will pop and could result in a net loss of wealth on the order of $2 to $3 trillion.

Figure 1: The Stock Market Has Seen Many Booms and Busts

On the other hand, there are commodities that are experiencing resurgence after decades of neglect. What's the principal driver of the current bull market in commodities? China. With 1.3 billion people, China is now the fastest growing economy in the world growing by 9 percent a year during 2003 and 2004. As the country rapidly industrializes, there will be increasing demands for commodities of all sorts to fuel the expansion. Not only that, but the Asian and Russian crisis of 1997 and 1998 led to the liquidation of the remaining commodity inventories at fire-sale prices, setting the stage for the current supply imbalance in commodities.

But what's the big deal? Why is this not a short-term phenomenon? Well, it takes time for the cycle to reverse and for demand to balance supply. It takes six to seven years from the discovery of gold in the ground until a mine is productive. It takes four to five years to grow a coffee tree. Oil was discovered in the North Sea in 1969, yet that oil didn't reach the market until 1977. Commodity production takes time to reach the market. Rapidly increasing demand and tepid supply growth have resulted in the current supply/demand imbalance.

Today, the stage is set for an extended run of strong commodity returns. During the 1980's and 1990's, investors shunned commodity producers in favor of Internet companies that promised to deliver spectacular new products to an information-starved world. The result? We have entered the new millennium with an under-investment in productive capacity for commodities and an over-investment in under-utilized fiber optic cable and now defunct companies.

With the recent run in oil prices, commodities are starting to take center stage. Hardly a day goes by without at least some reference to surging oil prices and the affect of higher prices on the global economy. But what's a savvy investor to do? How to play the commodity market without having to open a futures account? One way, without the pitfalls of futures investing, is to consider purchasing a mutual fund specializing in commodities. Some examples include the PIMCO Commodity RealReturn Strategy, the Oppenheimer Real Asset and the Merrill Lynch Real Investment Fund.

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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