Commodities: A Wise Long Term Investment

Today, our neighbors to the north are celebrating the birthday of Queen Victoria, the most commemorated and longest-reigning British monarch. Frankly, if President Obama manages to get our nation through the current economic crisis successfully in the few years allotted to him, celebrating his birthday from then on would be the least honor we could bestow upon him. No matter how much he wanted the job, being promoted to ship's captain in the midst of a typhoon is one tough assignment.

Of course, many people will find the coming months tough, including investors, who will likely find that any recovery is a double-edged sword. You see, we've noticed a very strong correlation between changes in raw commodity prices and changes in corporate profits, dating back at least a generation. And that relationship implies both opportunities and pitfalls ahead.

For instance, the current stock market rally seems to be anticipating a surge in corporate profits. Right now, the S&P sells for roughly 20X annualized first quarter profits (S&P / (Q1 profits) * 4 = 20). That's far too high. So either the S&P has gotten too far ahead of itself, or corporate profits will likely surge forward in coming months.

At the same time, commodity prices are rallying as well. In fact, the gains in oil prices since the recent bottom far exceed the gains in stock prices. Ditto for many other commodities. If corporate profits are about to go on a tear, we can expect commodity prices will march in step. Unfortunately, such a move would make stock prices self-limiting on the upside.

Here's why...

THE COMMODITY TAX

A bull market in commodity prices would surely lead to slower economic activity. As we clearly saw in 2008, rising prices for commodities (especially oil and gas) act as a punitive tax on the American consumer. We use the word “punitive” because, unlike government taxes which can pay for programs and services that benefit everyone or be used to retire taxpayer debt, higher commodity prices only benefit producers. In the case of oil it is the Middle Eastern countries that reap the bulk of the rewards, for other commodities beneficiaries include nations such as Brazil, Canada, and even Australia.

(Incidentally, because the future looks so bright for commodities, we recommend these resource-rich nations as some of the best places to invest. If you can tolerate a high degree of political uncertainty, you can add Russia to this mix.)

In other words, to whatever extent the economy recovers, it will be accompanied by higher commodity prices. The two factors are wedded.

In passing, we must admit that even we have been surprised by the gains in oil. News from the oil industry has been horrendous, from our point of view. Days-to-cover (oil inventories divided by daily demand) has climbed to the highest level in 15 years. And U.S. demand remains subdued indeed close to decade lows. As far as we can see, the only reason oil prices remain over $50 must be due to rising consumption in China and India. Nonetheless, oil prices are not only hanging in but rising faster than stocks. This positive leverage may have something to do with China – and just their outright need for commodities but also their need to protect their assets.

CHINA'S EFFECT ON COMMODITY PRICES

Let's consider China's response to the massive amount of money that has been poured into the U.S. economy, by both stimulus spending and the Federal Reserve's money creation efforts. So far, these efforts have not resulted in higher inflation, but they likely will in time. Consequently, yesterday's newspaper reports that China has started putting more of their huge money reserves (which they get from selling products abroad) into commodities rather than U.S. Treasury bonds.

We cannot be surprised. Creating massive amounts of U.S. dollars lowers the perceived value of our currency. China naturally feels nervous about holding all its reserves in an asset whose value is destined to drop sharply, at least in their view, so it wants to diversify into more tangible assets. In similar vein, China recently reported adding to its gold reserves.

China's increased buying of commodities naturally helps support commodity prices. In fact, we think it's one reason two of our picks, Mosaic (MOS) and Potash Corp (POT) have done so well recently. They are the two largest fertilizer companies in the world, and big producers of the potassium-based fertilizers known as “potash.”

If there's one thing China needs, even more than energy, it is fertilizer. The country has an enormous population to feed, and requires stockpiles of potash to get through any economic turmoil. We strongly suspect that fertilizer stocks are gaining ground because of Chinese efforts to accumulate fertilizers, and it is a trend which should continue for some time.

So that gives us two good reasons why commodity prices will rise. First, they will rise alongside any gains in the stock market and corporate profits. Second, commodities will increasingly be seen as a hedge against a falling U.S. dollar. This double kicker is the likely reason critical commodities have been rising even faster than financial assets.

Our general advice is that, to the extent the current rally continues, you will likely profit from commodity-related investments. The only thing that could short-circuit commodity gains would be further declines in economic growth. Any improvement in the economy will only push commodities higher. So stick with commodities, including oil and gold.

As for the market in general, the downside still outweighs the upside at this point. We still could see a retest of the recent low. However, we are heartened by the fact that the government seems determined to do whatever it takes to avoid a real depression. Given the choice, we would rather face the consequences of monetary stimulation than deflation.

With that in mind, if the market does move lower, we would probably see the Federal Reserve buying large amounts of Treasury bonds. Treasury bonds have been under pressure as a consequence of the monetary stimulation taking place. That won't change, especially with the Chinese buying commodities (which reduces demand for Treasury bonds). So the government will need to step in and buy bonds if it has any hope of keeping mortgage rates low and engineering a recovery in the housing market. (Of course, this can become another vicious circle which leads to inflation.)

Longer-term, we expect the stock market will remain stuck in a trading range. The Dow will have a hard time getting past 10,000 anytime soon, which gives us a maximum upside of 20% from here. (Short-term, we doubt it will get that far.) The bottom of the trading will probably be around 5,000. Those boundaries may remain in place for a very long time.

Short-term, too, the downside outweighs the upside. Given the negative signals from our indicators, we think the recent rally has been extremely speculative and could soon run out of steam.

Bottom line: the way to make money in the long-term trading range will be to invest in commodity-related investments.