Economics: Dancing on the Edge
New York: October 01, 2007
By John R. Stephenson

The dollar touched new lows as oil reached $84 a barrel. Interest rates have started to ratchet up, even though the Fed cut the overnight rate. Existing condos for sale have risen by 35% since January of this year to 661,000, or 12 months of supply. Over 500,000 homes are in the process of foreclosure and yet the stock market chugs higher. So, what's an honest investor to do?

Panic. But after that, the approach should be the same as we've been advocating all along. Lever your investments towards the things that are working. Investments tied to the emerging economies in Asia and large multi-nationals that get 50% or more of their earnings from abroad are where the action is.

The last three times the Fed (U.S. central bank) started to ease on the interest rate front, the yields on the bond market fell by 20 basis points or more. This time they rose by 20 basis points. What does it all mean? It means that the bond market is worried about inflation. Great!

Recently, the inventory of existing homes for sale rose to over 4.5 million, which is more than double the supply at the beginning of 2005. Now inventories stand at 10 months of supply, with no let up in sight. Look for things to get worse before they get better in the housing market. That's bad news for stocks levered to the U.S. consumer.

But across the pond, things are going gangbusters. The Asian economies continue at a furious clip and Europe is turning in some pretty fair performances. Commodities are on a tear and will continue to outperform since they are at the forefront of the rapid industrialization that we are witnessing in Asia.

But somehow the strength in the commodities hasn't translated into quite the same strength in the stocks of commodity producers. Newmont Mining, a gold producer, is trading at the level it traded at a year ago, even though gold has been on a tear. The reason? Newmont is struggling to replace production.

Increasingly, this is a common theme being played out. Margins are great on existing projects, but to replace the current production, producers are being forced to look at increasingly remote areas of the world — areas of the world with huge geopolitical risk.

Take the Congo, for instance. That's where the current activity in the copper industry is going on. Producers have been flocking to the Congo on the backs of huge discoveries of copper. But behind the scenes, there is a nasty civil war raging on and producers still face the prospect of exorbitant taxation, or worse, expropriation.

The oil industry, desperate to replenish its reserve life (current production divided by proved and probable reserves) lunged headfirst into Nigeria, Russia and Venezuela during the 1980's on the prospect of discovering and controlling these prolific basins. Today, ConocoPhillips and ExxonMobil are picking up stakes and exiting countries such as Venezuela as punitive royalties have taken their toll. So much for extending their badly beleaguered reserve lives.

BHP Billiton Limited, one of the best-managed mining companies in the world, took it on the chin as commodities slid over the last few months. Everywhere you look, commodity producers seem to be struggling with a similar theme — how to keep production flat. Not an easy feat when, increasingly, the sources of supply are unstable regimes that are likely to leave producers flat on their backs once the schools have been built and the roads constructed.

While stock prices may have increased for commodity producers, P/E ratios haven't. The market still believes that these are stocks with risk and that eventually, the commodity bull market will end, sending these stocks torpedoing to the ocean floor. Really?

Perhaps. But don't bet on it. The world of today is a different world than it was twenty years ago when commodities were on a tear. Growth is global and sustainable and commodity-producing stocks are precious. Sure, political risk is an issue. But in the S&P 500, there are only two large capitalization mining stocks represented. There's just no way that the supply of commodity-producing stocks will keep pace with rising commodity prices. Talk about scarcity.

Figure 1: DBA - A Food Commodity ETF Has Been on a Tear!

Another way to augment your exposure to commodities, while lowering your investment risk, is to invest in one of the many commodity-linked ETFs. You participate in the upside of the commodity, without worrying about operational issues, taxation levels and general corporate malfeasance. Throw in a few good U.S. multinationals whose earnings are largely from abroad and you have the makings of a pretty good investment portfolio.