Liquid Gold

There Is No Commodity Bubble Yet

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What's going on in the stock market these days? Are we in a commodity bubble or not? Discussion on commodity trading these days is rampant. I think folks want us to be in a bubble, so we can move on and rally some more in other sectors. I don't blame them a bit for wishing, but the fundamentals don't support their desires--at least for now.

At issue is supply and demand. We're using more than we're producing in most of the commodities so that makes the price rise. It's simple economics. Yes, there'll be dips and rallies within those individual resources; gold, oil, grains, natural gas, and coal can all rise and fall with the news of the day, but the underlying trend remains upward and will probably continue for a few years.

Read Saturday's "Options Report" in the Wall Street Journal by Geoffrey Rogow. The near-term options on USO show a put-call ratio of 1.82. The Materials Select Sector SPDR Fund has a put-call ratio of 2.57. If the options traders can be trusted, a bubble from the energy and materials stocks is safe from bursting soon.

Note the insider buying list where Chesapeake Energy (CHK) CEO A.McClendon purchased millions of dollars of his own stock at an average cost exceeding $54.00 per share. Because CHK has been one of my biggest gainers over this decade, I'm buying, too, Mr. McClendon. I'm also loading up on another natural gas producer, El Paso (EP).

Gold is rising today. It's often at its lowest point in the second quarter before moving higher through the first quarter of the following year. I'm a buyer of gold mining stocks. The jewelry association today announced big gold purchases because they felt the metal was downright cheap at current prices. I continue to like GG, GFI, NEM, EGO, and AUY, but I think most of the gold mining stocks will move upward on momentum alone.

All the best to you healthcare and financial supporters out there, but your time has yet to arrive. I'll join your bandwagon in 2011 or 2012.

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Fannie Who?

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Fannie Mae has been a bastion in the finance world for many new and moving up homeowners. Until the subprime crisis, I'd have called the stock a bedrock in any portfolio.

Fast forward from high praise to current conditions. My message is to run, run, run from this and most of the financial stocks. Sure value players are probably casting gleeful eyes at Fannie now that the price has dropped precipitiously. But waiting for the rise in value stocks in the financial markets today will be like watching grass grow in September; it will be a slow, ardious process.

Currently several analysts have a sell rating on the stock. There is a big reason for all of this and they have even more insight into the numbers than many of us.

My suggestion is to wait. Watch the economy post this phoney stimulus mess and then evaluate Fannie very closely. She may show some life in 2009 or 2010, but I'd let the stock rise closer to 30-32 range to see if it can hold. I'd be afraid to tie up good money in hopes that it might go up, because it could sit for ages with all the headwinds the economy is facing.

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Defense is spelled with three R's

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Read, research, and be ready are the three defenses I use in an upside down market. Sure, you think, but what do you read and who do you believe? Good questions, but stay with me because I have answers.

Most folks go for the standard staples when a market declines to preserve capital, but a few plan for the day a market recovers. I suspect that we've been in a secular bear market since 2000 or 2001. Secualr markets are different from others in that they are longer term and generally last between eight and twenty years. Now cyclical markets, on the other hand,are usually correlated with shorter-term fluctuations of the economic cycle.

The last secular bear market we experienced occurred between 1966 and 1982, a period in which the Dow Jones Industrial Average declined at a per year rate of -1.5%. Have you noticed that the Dow has gone nowhere in nominal terms and the S & P has yet to sustain its former height since 2000?

One of the defining trends of a secular market is its inflation background. During the secular bear market of 1966 to 1982 inflation increased over 6.5% per year. Since 2000 inflation has risen over 3% per year and with oil prices rising, that number is surely headed higher. With continued oil inflation and food inflation it will be much harder for the market to make much upside progress. That means that our returns in most sectors will probably stink.

During the 1970's stagflation helped keep stocks (I wasn't paying much attention to bonds) in a secular bear market and it kept gold and commodities in a secular bull market. Those trends ended in 1980 with a huge thud and by 1982 a huge secular bull market had risen from the ashes and continued through the 1980's and 1990's. This ended with the Asian financial crisis, the tech bubble and later bust, the deflation worry, and the rise of the emerging economies, particularly the BRIC nations which seems to be bringing us back to another uptrend in commodities.

Now here's where research comes in. The piece of the puzzle I have long ignored and don't pay any attention to is the bond yield curve. I learned from several bond, financial, and gold company web sites that in an environment of rising inflation, short term interest rates usually rise more than long-term rates, which makes the yield curve flatter than usual.

During the secular bear market of 1966-1982, the mean spread between the 10-year and three month Treasury yield was just under one per cent. During the bull market that followed the spread was double or two per cent. Since 2000 the spread has averaged 1.5% and we could see that average drop closer to the 1970's average if inflation rises. That, in turn, would support a secular bull in gold and commodities. Gold performs better when the yield curve is flat than when it is steep.

How long it is going to take to send this secular bear back to the woods is open for debate. I don't know the answer to that, but my research tells me that when the bull returns the sectors with the brightest outlook include tech, consumer discretionary, materials, and industrials.

For now I'm sticking with the commodity plays in both the US and emerging makets. It's possible to still buy natural gas producers and gold miners without breaking the bank. But I'm keeping my eye on the prize of an eventual bottom and am positioning myself to take advantage of the upcoming secular bull. It may be in two years or four, but I'm adding dollars to the trendy four sectors I listed above.

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Some Thoughts on Lufkin

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LUFK is a stock to watch with a bright future. It has traded this year between 51 and 85 and is currently in the high 70's. The p/e is 16.

Lufkin manufactures oil field pumping units and power transmission products. It also was involved in production of highway trailers, but is exiting this business this year. The mainstay is the oil field supply and the growth portion is the power transmission.

I have been watching the company for months and waiting for a pullback. I think we'll see one shortly when oil pulls back after the Saudi's increase oil production by 500,000 barrels next month. The market tends to punish good companies when sector rotation occurs so I'm looking to pick up this good growth stock closer to 70 and enjoy its eventual rise to 95.

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