The Commodities Bull
Is Just Getting Started

By Charles Delvalle – Investors Daily Edge

“In 2000 it was the Federal Reserve's rate hikes that finally burst the dot-com bubble.  Six years later, history may be repeating itself, this time in commodities.”

- Fortune.com

Early last year, commodities were scorching hot.

It seemed that the entire world had their eyes on them.  People were buying up gas producers, miners, and even bulk transporters.  It didn’t matter what commodities people were buying into, because they all were hot.  And they kept on getting hotter.

After all, China was growing at a nine-percent annual clip, India was a close second, and the rest of Asia was growing at five percent.  Even Japan was showing signs of coming out of its decade-long economic funk, and Europe was beginning to expand.

This unprecedented global growth put a serious strain on natural resource reserves and production, something that couldn’t be fixed at the drop of a hat.  It would take years before these issues were resolved.  And that helped fuel even more buying.  Stocks such as BHP Billiton and Phelps Dodge saw their trading volume double from the prior year.

It then became obvious that what started as an underground following had finally made its way to the radar screens of hedge fund managers and investment professionals.  Barclay’s estimates that by the end of the year, more than $110 billion in commodity investments will be sitting in pension funds and money manager accounts around the country.

In March and April, commodities started hitting the front pages of the Wall Street Journal, Fortune, CNN, Reuters, and Bloomberg.

And then in May the market came crashing down.

Did I know it would happen?  Yes.  Did I know the severity of the correction?  I had an idea (no one can ever truly know the future, although I’m sure Nostradamus would beg to differ).  Would I call what happened to the commodities market a bubble?  Not even close.  And here’s why.

A few years ago when I first began studying the market, I heard a random analyst or two talking about the tech bubble.  Though I had heard the term “bubble” uttered many times, I didn’t have a clear understanding of what a bubble actually was. 

So I looked to Investopedia.com, which characterizes a bubble as “A theory that security prices rise above their true value and will continue to do so until prices go into freefall and the bubble bursts.”  According to this definition, prices have to become much more expensive than the company could possibly be worth for a bubble to start forming.

But how do you know a company’s worth?  That’s the hard part.  If you ask 10 analysts to put a price tag on Budweiser the company (not the beer), you’ll probably come up with 10 different valuations.  (Of course if you put the beer in front of them, you’ll have 10 drunken analysts).

Since I was looking for a more practical way to determine whether a stock was cheap or expensive, I turned to the Price-to-Earnings (P/E) ratio.  This ratio tells you how much you have to pay today to get one dollar of current earnings.

So I jotted down the P/E ratios of various commodity sector stocks to determine whether they were in a bubble market.  To get an accurate reading, I compared current commodity sector prices against the stock market bubble that reached its zenith in 2000.

According to USA Today, the S&P 500 carried a P/E ratio of 27 when it peaked in 2000.  The Dow had a P/E of 29.  And the NASDAQ (where the bubble really inflated) had a P/E of 246!  In other words, in the NASDAQ’s heyday, you were paying an average of 246 bucks to get one dollar in return!

Now that’s pricey.  I could certainly see how that would be a bubble.

But hey, in the Oil and Gas sector, all you have to pay is 10 bucks to get a dollar back.  You pay $13 in the Iron and Steel sector and just $12 in Metals and Mining to get your dollar back.  That’s much less expensive.  In fact, it’s so inexpensive that our resident value analyst, Andrew Gordon, still considers commodities an undervalued investment group!

The truth is that commodity companies went from being dirt cheap and ignored to being cheap with somewhat more notice.  Clearly, these stocks never entered a point where their price far exceeded their true value (except for a handful of hot mining stocks).  In other words, commodities never hit the bubble stage. 

In fact, the best may be yet to come.  According to Bloomberg, “Global commodity supplies, which are three to five years behind demand, may test record lows in 2007, Morgan Stanley wrote in a report today.  ‘The next leg upward in the commodities cycle’ will happen in the next six to 12 months, it said...‘The best-ever fundamentals for the sector remain fully in place…We believe that we may not yet have seen the highs for commodity prices and therefore the commodities supercycle is just pausing for breath.’''

I couldn’t agree more.  After all, has anything changed with the fundamentals driving the commodities market?  China didn’t stop growing.  Neither did Asia.  Europe is growing faster, and so is South America.  Supply still isn’t keeping up with demand and reserves never stopped declining.

The only reason why commodity prices slowed down is because there was a fear that a U.S. recession would dampen demand and let supply flood the market.  But regardless of what the U.S is doing, the rest of the world will continue to expand.  China is on track to build the equivalent of two New York Cities every year for the next 20 years.  Just imagine how much copper, zinc, silver, lumber, coal, and energy it will take to feed those massive expansions.

And even if the U.S. slowed Chinese imports, China has more than $1 trillion in currency reserves!  And they are willing to spend some of that money to ensure growth well into the future.  This virtually guarantees continued demand in the commodities market for a long time.

The next time you see Fortune or any other publication proclaim that we are in a commodities bubble, just remember what a bubble really is before you start believing it.

Good Investing,
Charles