"Rogers, Wien See U.S. Commodity Producers' Shares as Overvalued," a Bloomberg News headline declared. "Jim Rogers and Byron Wien are still bullish on commodities after their biggest weekly decline in 15 years," the news story explained, "Yet they view the shares of U.S. raw- material producers as overvalued."
Your New York editor would not rush to disagree with either Rogers or Wien, but he would add one important qualification:
Some commodity shares are more overvalued (or less undervalued) than others. That's because the supply/demand factors influencing the price of crude oil, for example, are not identical to those influencing the price of soybeans.
Jim Rogers, the hugely successful former hedge fund manager, is a full-time fan of physical commodities, but only a part-time fan of resource stocks. In fact, he created his own commodity index in the late 1990s (along with a fund that mirrors the index). So when he says, "Don't buy the stocks. Buy the stuff itself," he is both offering honest investment insight AND "talking his book."
But that doesn't mean we should not heed his advice. Rogers correctly notes that "costs are going through the roof" for many commodity producers, thereby reducing the profits they would be earning from the soaring prices of their products. As faithful Rude readers may recall, we anticipated and examined this phenomenon in the column of September 16, 2005 entitled, "What's an Ouroboros?"
"For more than four years," we noted, "most natural resource companies have been enjoying brisk demand for their products...and rising prices. Unfortunately, rising commodity prices are causing production costs to increase sharply for the commodity companies themselves, thereby eating into their profits. We should not be surprised, therefore, if profit growth at many resource companies begins to slow down, or grinds to a halt completely."
As anticipated, steel makers, copper minors, gold miners, fertilizer producers, chemical companies and many other types of commodity-based companies are all suffering from a toxic combination of high energy prices and mounting labor costs. Therefore, profit growth at many resource companies is, in fact, grinding to a halt. Based on Wall Street's consensus forecast, the profits at basic materials companies in the S&P 500 will fall 8% in the first quarter of 2006, compared to a 9% increase for the rest of the S&P 500 companies.
Phelps Dodge, DuPont and Alcoa number among the many resource companies that have reported disappointing earnings due to rising costs. The "cost of goods sold" at Phelps Dodge, the world's biggest publicly traded copper producer jumped $1 billion last, as energy costs jumped more than 23%. Alcoa suffered a similar fate, which lead to a surprising drop in first-quarter profits. "Entering 2005," CEO Alain Belda explained, "we anticipated significant pressures from rising input, energy costs and other cost inflation, but actual increases were even higher."
The cost side of the profit and loss statement, however, is not what worries us most. It is the revenue side. The prospect of falling commodity prices poses a much more serious threat to profitability than the prospect of rising production costs, especially if the most buoyant commodity markets, like crude oil and platinum, deserve their recent savage declines. If, as many seasoned commodity traders believe, "artificial demand" has been boosting the prices of many commodities, then the current washout in the commodity sector may signal something more serious than a mere "correction."
"Billions of dollars of long-only index-fund money is pouring into these markets," observed commodity-trader, Richard Morrow, in the February 3rd edition of the Rude Awakening, "And that's throwing the traditional fundamental influences all out of whack. These markets are just too small to handle an influx of money this large...I can tell you this; if the money-flow into these markets stops, there's going to be some great opportunities on the short side."
Immediately after Morrow's Delphic warning, the commodity markets tanked. Likewise, the stocks of most commodity- producing companies. But maybe the high-flying resource stocks deserved their whuppin'. Certainly, they had enjoyed a spectacular run over the last few years – a run that may have become a bit too spectacular over the last few weeks.
Even though the Goldman Sachs Commodity Index (GSCI) topped out last September, for example, the ETF of resource stocks (NYSE: IGE) that mirrors the weightings of the GSCI continued soaring into late January. In other words, resource stocks continued climbing, even though the prices of the underlying resources did not. The ferocious 11% drop in the price of IGE so far this month, therefore, is not entirely unwarranted.
But before panicking in the face of these wicked declines, we should take a peak inside the commodity indices to see what's up and what's down. For example, the energy complex has been dropping sharply, while the grains have barely budged. In the month of February alone, crude oil has fallen 14%, while unleaded gasoline has tumbled 20%. But the prices of corn, wheat and soybeans have registered very slight declines. And many of the agriculture-based stocks have actually GAINED ground. Corn Products International (NYSE: CPO), Archer-Daniels (NYSE: ADM) and Agrium (NYSE:AGU), to name three such companies, have all advanced in February...and for the year-to-date.
This divergence between the energy complex and the grains may contain the kernel of an opportunity: sell what's been frothy to buy what's less frothy. The ag. Sector, which has been about as frothy as a week-old glass of champagne, suggests itself as one possibility.
As the nearby chart illustrates, ag. commodities have been conspicuous laggards throughout the resource bull market of the last few years. Perhaps their day will soon arrive. We based this conjecture on no greater wisdom or authority than the mere idea that markets tend to be mean-reverting. Thus, as the chart also suggests, energy prices are rolling over at the same time that ag. prices are turning up. Hence a possible mean-reversion has already begun. The fact that the agricultural sector has been trailing far behind the energy sector does not automatically imply that the energy sector is a "sell" or that agricultural sector is a buy, but it does raise that possibility.
So rather than "sell the stocks and buy the stuff," as Rogers suggests, maybe it would be better to sell some of the stocks and some of the stuff, and buy OTHER stocks and OTHER stuff...like the stocks of agriculture-based companies.
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