Burst Bubble? Commodities' Long-Term Story Remains Intact

All kidding aside, the last two days have been absolutely brutal for the commodities side of our portfolio and Wednesday, the energy stocks also got whacked. And I don’t know about you folks but I haven’t reached that zen, Buffett-like state where falling prices don’t faze me. They faze me. A lot. In my experience, the periods in which my self-doubts peak are honestly the times I should have been buying. Even in the short time since this website/blog has been up (since 01/2007), the market has already tested me many times and I can’t profess to have bought every time at that bottom. I have regretted it every time.

“Should I have sold Agnico-Eagle? (AEM)” I knew that at $80, it was a bit ahead of itself and if I had held it for over a year, I would have sold it earlier at $72, $75. Doing quick math, taking profits at $80 and paying 30% tax was roughly equivalent to holding to $70 and selling with a 15% tax rate but now it’s at $68. “Should I have sold Chesapeake Energy? (CHK)” It’s at the low-end of my fair value estimate and I’ve held that stock long enough for favorable capital-gains treatment. Am I getting greedy?

“Did I make a mistake on SK Telecom (SKM)?” The damn thing is below $20 but I can’t find any news that justifies the pounding it’s taking and then you have the Korean Won going parabolic in the last month. So yes, I have my doubts. Every day, I question my theses, analysis, picks, etc. Especially on a day like yesterday.

That said, I just can’t buy into this commodities “bubble” story for the following reasons:

Have the central banks stopped pumping money into the financial systems? No, nor has the Fed given any serious indication of tackling inflation. The Fed is the only thing propping up the markets It strikes me that the Fed cannot raise rates until the market signals a sustained 'all clear.' Otherwise what was the point of all this if the markets are just going to tank again the moment you raise rates? Even a 3/4 point cut (off a 3% base — that’s a huge 25% move) can’t buoy the markets for longer than a day. So I don’t see how the new Goldilocks scenario plays out — that is, the Fed cuts rates, the economy responds after a brief recession & then the Fed raises rates again once we’re in the clear. It all comes back to housing and credit — this will be years in the unwinding. Housing does not bottom in a V — it bottoms in an L. People still can’t afford housing and wages aren’t going up so that means prices will continue to fall.

Did we discover any giant oil fields in the last week that I didn’t hear about? The long-term supply and demand picture is still overwhelmingly in favor of higher prices. Many people consider supply as the weekly inventory reports. I refer to supply as reserves in the ground. I don’t care if it’s in Cushing or some tanker or floating bitumen in Canada as long as there’s visibility that we’ll have access to energy when needed. The peak for production still remains the summer of 2005, despite record high prices.

Domestic natural gas production is still running to stand still — more wells drilled just to maintain production. Imports from Canada are dropping and apparently, the rest of the world values natural gas more than the US. Despite the drop in agricultural commodities, the FT reports on record high rice prices in Asia. Some of this year’s harvest disappointed and I’m not sure if the issues that have led to countries like Vietnam imposing export restrictions have been resolved in the last week or so.

Obviously, we are in a corrective phase of the commodities bull run but I think any characterization of the run in hard assets as a bubble is absurd. We know what bubbles look like — they leave indices like the NASDAQ or the Nikkei ravaged years/decades after the fact, they devastate whole industries and professions like realtors & Wall Street financiers, they transform thriving municipalities into ghost towns and retirement accounts into part-time work well into your 70’s — basically an awful lot like what’s happening today in real estate and Wall Street. Just study previous oil busts — we are obviously nowhere near that phase with commodities.

If you are a nimble trader, I’m sure there is a lot of money to be made in this correction as well as the run back up. I can’t handle trading so I remain committed to my discipline of long-term investing.

I don’t know where the story goes next from here. Maybe, some of the commodities will drop another 20% from here. And I’ll cringe every step of the way. But I know where this story must end — with higher inflation, strained energy supplies and a burgeoning emerging rest of the world who won’t continue to foot the bill for Americans living large. The long-term fundamentals dictate that any major corrections remain buying opportunities for long-term investors.

I have been a believer in commodity exposure since way back, but I always repeat my belief in having MODERATE exposure.

My thoughts about my commodity exposure is not that I am “going long commodities,” but that I am adding in a little zig to my stock market zag (to be clear, I do have long exposure - I just don’t view it as a “bet on commodities”).

There is plenty of research that compellingly argues for 20%, give or take, in commodities and some readers subscribe to that line of thinking, but I have never been comfortable with a number anywhere close to that.

In buying gold, I hope I am buying a little something what will go up if there is an external event that crushes the market so in a way the price does not matter. No matter where gold is today or where it was yesterday if there is a terror attack tomorrow, I think gold would go up.

Another aspect about small commodity exposure versus large is how levered you are to one theme. If you were 20% yesterday you really need to decide what you think the March 19 and 20 sell-off mean and whether or not you need to do anything about it. With a 3 or 4 or 5% weighting the consequences for being wrong are much less which makes managing a portfolio much easier.

At least that’s the way I see it.

Here are some questions investors should ask today regarding Gold and other PM’s ( Precious metals ) :

* Why should Federal Reserve Notes reverse their slide since 2001 when the Fed uses every opportunity to crank up the electronic printing press?

* Both the Fed and the ECB have been lamenting a worrisome inflation outlook for some time now. Have they enacted a single (tightening) step since? (I am talking action, not empty words.)

* Can you see any structural improvement in the triple US deficits?

* Do you think commodity prices in general will descend again in a world where some 3 billion Asians will have evolved from paupers to car-buying consumers soon?

* Did you come across any news that South Africa has yet found a way to solve its energy crisis that severely cut PM output?

* Do you have a clear picture on the physical PM demand in the Eastern hemisphere?

* How many of the last 100 persons you spoke to have actually invested in gold/silver yet?

* Do you think the banking crisis is over or will we see more failures?

* Oil hit $100 before correcting to $88 earlier this year and nobody forecasted the end of the 7-year uptrend. Why are MSM so quick to call the death of the PM bull market, now in its 8th year too?

* Relating to gold’s 11% drop this week: Did capital markets stabilize by 11% in the last 4 days?

* Can you name another asset class that is a store of value in itself and not somebody else’s obligation.

* Did gold ever lose its value in the last 3,000 years?

* Global gold production may actually fall this year below 2,500 tons while demand hovers around 5,000 tons. Is this good or bad for prices?

* Short positions in COMEX gold and silver have kept rising through the latest record advances. Who are those “investors” that can afford to short such markets without running into serious margin calls?

* Assuming you hold bullion: Have you sold any of it or are you keeping it in the vaults despite the recent hammering?
Assuming you do not hold bullion: At what price will you allocate 3% to 10% of your assets into PM’s?

* When do you think that other investors will raise their asset allocations in favor of PM’s?

* Have you discovered another inflation-proof asset recently?

Just some food for thought...

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