July’s Commodities Purge Offers Long-Term Opportunity

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Are we at the end of the commodity bull market or does this battered sector offer an attractive buying opportunity?That’s the question on the minds of everyone trying to navigate one of the most complex and volatile markets we’ve seen in years.

Are we at the end of the commodity bull market or does this battered sector offer an attractive buying opportunity?

That’s the question on the minds of everyone trying to navigate one of the most complex and volatile markets we’ve seen in years. The continuing economic slowdown (particularly at home and in other G-7 countries), combined with more than a year of bleak news from the financial sector, has left investors dazed and desperate.

The liquidity crisis has forced leveraged investors and companies to unload assets across the board to comply with new accounting rules like FAS 157 and FAS 140, and this has created a domino effect as investors panic. An estimated $15 billion was pulled out of U.S. stock funds in July, about four times more than in June. For the first seven months of 2008, those outflows totaled $52.4 billion, an all-time high.

July was also a very tough month for commodities and commodity stocks. The S&P Natural Resources Index fell off 15 percent, the worst monthly sell-off in the sector since August 1998, when the Russian currency crisis triggered the implosion of the hedge fund Long-Term Capital Management. Prices for the underlying commodities also suffered in July, with the Jefferies/CRB Index down 10.1 percent. This was just short of the worst monthly performance for this index since 1970.

The fundamentals for gold have not changed, and with negative real interest rates in the U.S., this is a good time to maintain exposure to gold investments. As you can clearly see from the chart below, July and August generally mark a low time for gold before prices climb with the arrival of the fall buying season, which is another reason to consider gold now.



The world is different from a decade ago. Back then, the world was experiencing a global currency crisis that started in Asia in 1997 and peaked in 1998 with Russia defaulting on its sovereign debt. This was the final blow that doomed Long-Term Capital Management.

China and other emerging economies have massive U.S. dollar surpluses, and these countries are committed to infrastructure spending. This week China’s government announced that it will focus more on sustainable growth than worry about inflation. This is significant.

Last month’s tumble for resources can be traced back to the latest troubles in the financial sector that started more than a year ago with the subprime mortgage collapse and were accelerated by the new accounting rules in late 2007. The intermarket relationship of assets get bundled together with a liquidity event, and the icing on the cake was the March 2008 collapse of the auction-rate securities market, which basically froze $300 billion in retail investor cash. This issue has yet to be resolved, and lawsuits are flying everywhere.

The market is now seeking liquidity in response to the recent moves by Merrill Lynch and others to sell mortgage-related assets at huge losses and the persistent rumors that more Bear Stearns-like failures are yet to come. The regulatory actions in July to stop shorting of 19 financial stocks, including Merrill Lynch (MER), was well-timed. These stocks have rallied 50 percent off their lows, and more importantly for Merrill, it was able to refinance its losses. Had the SEC not stepped in, packs of illegal short-sellers could have crushed Merrill’s stock, just as they did Bear Stearns (BSC).

While energy and resources felt the impact of July’s turmoil, it’s important to keep in mind that this performance did not reflect the sector’s solid fundamentals. Historically, oil dips in July before rallying from August through October, as illustrated in the seasonal chart below.





As the chart above illustrates, in July energy stocks (represented by the S&P 500 Energy Index) moved from two standard deviations above the mean to two standard deviations below the mean in just 20 trading days. We think this extreme pullback offers patient investors a window of opportunity.

Many market pundits have predicted the demise of high crude oil prices after a peak near $150 a barrel, but with numerous energy stocks already trading at levels not seen since crude was under $100, we maintain that much of this forecasted price adjustment is already reflected in energy stock valuations. It appears, based on valuation metrics, that oil stocks are priced as if oil were selling at $70 a barrel.

Moreover, unlike other bull markets where equities traded at challenging valuations, energy and resource stocks are historically cheap. Price-to-earnings ratios are well below the broader market, and these companies have tangible assets that are unaffected by mortgage write-downs.



Looking at crude oil fundamentals, we remain constructive given that despite very high prices for oil, OPEC production has been unable to eclipse peak production levels and spare capacity remains critically low relative to prior decades. Outside the OPEC cartel, countries such as Russia and Mexico have struggled to keep up with demand and are experiencing significant production declines. Meanwhile, costs continue to escalate as marginal supply is typically located in geopolitically sensitive areas or extracted from expensive unconventional resources.

A similar fundamental story holds for the metals and mining sector, where new discoveries and production are not adequate to keep up with strong global demand.



Lehman Brothers published an interesting research piece yesterday on resource sector corrections between mid-2006 and early 2008. During that time, there were five significant corrections in the Dow Jones STOXX Basic Resource Index (SXPP) averaging 22 percent, and these corrections were followed by rallies averaging 29 percent. That trend appears to be holding for last month’s correction as well – after bottoming out on July 23, the SXPP rose 10 percent by month-end.

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