Great Investment Articles

May 22, 2006

The other big event last week was a heavy dose of profit-taking in the commodity pits. The CRB index lost a little over 6%, while $56.20 was whacked off the head of the gold price. Most commodity stocks naturally lost ground as well.

The financial media, which hasn’t been bullish on commodities or gold since the 1980s, naturally started screaming that another bubble was bursting. But before you panic and sell your commodity and gold shares to the many eager traders around the world who are looking for a bargain, let’s take a moment to consider soberly whether this so-called “bubble” even existed in the first place.

Bubbles, properly speaking, are strong price gains that by their nature undermine the fundamentals that caused prices to rise in the first place. For example, in the late 1990s, the bull market in technology stocks led to a massive boom in capital spending. The result of this capital spending was too much capacity in the technology industry, which then led to a sharp fall in earnings, and finally a steep drop in share prices.

The current bull market in commodities bears no resemblance to the tech boom, for the simple reason that few people today believe actually the commodity bull is taking place. Hence, very little in commodities is overvalued.

Consider, for instance, that during the tech boom, leading stocks like Cisco and Microsoft were selling for 70 to 80 times earnings – while many others sported P/Es well into triple digits. Compare this to the P/E ratios of leading commodity stocks in today’s worlds. (examples all under p/e of 10)

I think you’ll agree that commodity stocks today look downright cheap by any historical standards. Indeed we challenge you to find any stock in the energy or metal patch which is not selling close to a historically low P/E today!

The other sign that technology was in a bubble in the late 1990s was that tech companies were using their high stock multiples as currency. By issuing or selling shares like crazy, companies were able to buy other companies or raise funds for capital expenditures. Consequently, the number of outstanding shares expanded rapidly for many tech companies.

In today’s commodities bull, almost the opposite is true. Most resource companies today are using their substantial profits to buy back their own shares and reduce the number outstanding. And who can blame them with their stock prices so cheap.

The trouble is that Wall Street does not believe there is a bull market in commodities. It is valuing these companies as if commodity prices are about to fall back to where they were before the bull began. And herein lies a serious problem.

You see, as long as Wall Street ignores the supply/demand pressures on commodities, and stubbornly insists that the price of nickel, copper and other commodities will soon collapse, it will continue to undervalue the companies that produce them. As long as everyone expects oil to fall back to $38, no one will be willing to finance alternative energy.

As long as this situation continues, resource companies will not issue more shares in order to raise funds to build more production capacity. And the result will be no relief for the supply/demand pressure that’s driving commodity prices higher.

We’ll know the commodities boom is nearing its end when we see huge amounts of investment money flowing into overvalued resource companies, driving up P/Es and causing excess production capacity to be built. Typically, it is that excess capacity, brought about by overly optimistic forecasts, that results in a glut on the market and falling prices.

But today, when resource companies remain at low multiples and are buying their own shares, we can be pretty sure the end is a long ways away.

That’s not to say last week’s sell-off in commodities will be erased this week. It may take a few weeks or even a month or so for prices to bottom and reverse. But we are fairly sure that this bull is far from over.