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Markets: What Lies Ahead?
New York: January 03, 2006
By John R. Stephenson

What does the investing future hold in store? Who knows? But certainly this past year has given us something to think about. In 2005, the Dow Jones Industrial Average was up a meager 0.3% and the NASDAQ a paltry 2.5%. During 2005, the broad U.S. stock market indices languished, Japanese equities soared, energy stocks rallied and mining stocks exploded. Copper and natural gas prices rallied 61% and oil leaped 45%. Housing was hot, while interest rates remained tepid. Emerging markets were strong, domestic markets remained weak. Large caps languished while small and mid caps sizzled. That was 2005.

Surging markets overseas created strong demand for commodities while hurting the fortunes of local manufacturers. China and India were hot and became the reason for just about everything as their economies continued to surge. Economists warned of a potential slowing in the U.S. because interest rates in the short-term looked as if they would soon be higher than those in the long-term (an inverted yield curve).

With economists and the stock market (a leading economic indicator) in the U.S. forecasting slower growth in years to come, future returns from the stock market will be modest. If markets slip sideways, then investors will need to look toward dividend income and away from capital gains.

But while markets weaken at home, ample evidence suggests that overseas markets may be strengthening. With Japanese equities on the prowl and the FTSE Index hitting a four-year high, the investment spotlight seems to be shining away from the U.S. and towards overseas markets.

Just what are some of the other themes that are likely to dominate in the years to come? For my money, we are likely to see more of the same. One reason? Emerging markets such as China and India have a huge advantage in world trade — their costs are lower. Not only is labor cheaper, but social costs are largely non-existent.

Increasingly, the world is experiencing freer trade at a time when we in the West are experiencing an aging demographic. With more and more people entering retirement, the promises we have been making (e.g. Medicare, Social Security) are increasingly costly to honor. This is especially true when you consider that it costs approximately six times as much to look after a retiree (medical costs) than it does to care for an infant.

Figure 1: The Percentage of Working People to Retirees

The upshot? It makes less and less sense to try and compete with China and India on manufactured or service items that have a large labor component. As well, the money that we are pouring into social programs is money that could be used for savings and investment in our own industries — further weakening our competitive position. Investors should avoid industries where we are competing with countries with cheaper costs. We have all witnessed what two retirees for every one worker has done for the American car industry.

While the future might be bleak for North American manufacturers, it looks positively buoyant for commodity producers such as energy and mining companies. The reason? Strong demand from Asia is likely to persist.

If economic growth continues to sprint in Asia, then demand will remain elevated for commodities of all stripes. With China recording a 9.8% growth rate in 2005 and with 25 million people making their way from rural China to the coastal cities each and every year, China will be demanding copper, steel and energy for years to come.

While demand might slow in Europe and North America, China and India are likely to keep on demanding commodities. With few sources of world supply and limited internal capability to produce copper, nickel and energy, these hungry consumers will have no choice but to buy these commodities wherever they can. Ultimately, this is good news for the investors in commodity-oriented companies.

But in spite of these reasons for optimism, commodity-oriented companies still don't trade like rock stars. In fact, they are investment laggards. Viewed as cyclical names with low quality earnings. Premium names such as Exxon Mobil (10x), Phelps Dodge (7.5x), Conoco Phillips (6x) and BHP Billiton (11.6x) are trading on a price/earnings basis well below that of the overall market. The earnings quality of these companies is excellent, meaning that a substantial gap exists between what these companies are actually doing and how the market is rewarding them. The upshot? This is a gap that can be exploited by investors looking to outperform the market.

Around the world, the control of the commodity agenda has been gaining steam. China and India remain active on the acquisition trail, trying to snag energy companies to secure future reserves. In Russia, the Putin government has been exerting increasing control over the country's biggest export — energy. With Gazprom (Russia's largest natural gas company) cutting off exports to the Ukraine over a pricing dispute, the global energy chess board is likely to get more interesting before it gets less so.

All of this is good news for North American energy companies that stand to benefit from strong global demand for their product. Unfortunately, the news is not so good for companies that consume these commodities. With sky-high natural gas prices, chemical companies and merchant energy companies (think Calpine Corp.) will likely be squealing in the months to come.

For savvy investors, 2006 will likely be a banner year. Commodities and the producers of commodities will likely do well as demand remains strong, valuations remain low and supply remains short. Not only that, but overseas stock markets, where growth remains strong, should outperform investment growth at home. Another good bet? Consider beefing-up your portfolio by picking up a few good dividend-paying stocks.

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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