You may find it hard to resist going whole-hog into the market these days, especially as we are likely to get a very strong third quarter. By some estimates, growth could be 4%. It could even reach 6%.
However, all the growth we'll see will be the result of unsustainable factors such as inventory accumulation, car production increases (due to the “cash for clunkers” program), etc. With this in mind, you must resist the urge to increase your weighting in stocks.
Long-term, we still face substantial headwinds. But our feeling is, if the market bubble does pop, it will likely be the last pop.
It's true that irrational markets can rise, and in doing so attract more irrationality. But in the end there will be some event, some realization, that higher earnings (the ultimate motivator of stock prices) will not show up. We're not smart enough to know exactly when the catalyst for this realization will arise, but we do have a handle on why future earnings will not measure up by the first quarter of 2010, or perhaps as early as the fourth quarter of 2009. We also believe the issues with earnings will be serious enough to derail today's historically strong market rally.
Looking at stock market commentary, we continue to be amazed that no one mentions commodities. Bloomberg, Barron’s, and other major media invariably deal with commodities and stocks in separate columns and articles. Never do they discuss commodities and stocks together, in the context of their interrelationship. We think this is a serious mistake, for nothing matters more to the outlook for stock prices than commodities these days. And there's no asset group more important for you to own on a long-term basis than commodity plays.
Just to remind you, the commodity plays we continue to recommend are Transocean (RIG), Nabors (NBR), Mosaic (MOS), Fluor (FLR), Petrobras (PBR), Potash (POT), National Oilwell Varco (NOV), Chevron (CVX), and FPL Group (FPL) – the latter two being our most heavily weighted.
In addition to commodities, which are used to make things, we also like one in particular, the one that functions as currency, and that’s gold...
SLOW GROWTH AND HIGHER PRICES ARE IN STORE
Over the past 45 years, there has been an interesting relationship between growth and commodities, in which the average change in commodity prices has roughly equaled the average change in GDP. In the short term, a rising GDP tends to lead to higher commodity prices. In the longer term, when GDP rises sharply, commodity prices tend to stay flat or fall. And when commodity prices rise quickly, GDP tends to struggle.
The 1970s were a notable time when we had soaring commodity prices which short-circuited GDP gains. We had a massive recession between 1973 and 1975 on the heels of OPEC's engineering a massive hike in oil prices.
Commodity prices then moderated, but began rising again in the late 1970s. It took a stalwart Fed Chairman, Paul Volcker, to finally halt commodity prices by raising interest rates dramatically, which reduced GDP and allowed more commodity supplies to come on stream. He set the stage for low to negative commodity price growth and a very strong market throughout the 1980s and 1990s.
The 2000s, however, have told a different story. Stocks have dramatically underperformed their long-term average. In fact, the years from 1997 to 2007 may have been the worst ever in real terms. During that period, commodities soared. GDP growth, which until recently looked to be on a strong trajectory, faltered. The last time we saw both the 6-year growth in GDP and the 3-quarter growth in GDP above their averages at the same time was back in 2000. In other words, it's almost been a decade since we've seen above average GDP growth, both short and long-term, simultaneously. (In fact, it's been four years since we've had even short-term GDP growth above average.)
During this long period of slow GDP growth, commodity prices have surged. By the 2nd quarter of 2008, they had risen nearly 185% over a 6-year period. That's a bigger gain than we saw in 1973-4.
Bear in mind that this past decade has not been marked by commodity shortfalls due to political events, as we had in the 1970s. Commodity prices have risen purely as a result of growth – but not growth within the U.S.
As for the most recent 3-quarter period, even assuming growth of 6% during the 3rd quarter of this year (admittedly a reach), the 3-quarter growth rate will still be negative. Yet commodity prices for the same period will have risen 16%. It's unheard of for commodity price growth to be a standard deviation above the mean in the context of negative economic growth! Plus, 6-year commodity price growth is close to 75%, which is off the charts and almost unbelievable given the weakness of the U.S. economy and that of the entire developed world!
Our point is that the U.S. has become a non-player in the commodity dynamic. The real players are the emerging markets, which continue to grow like crazy. Indonesia, for instance, will likely grow at an annual rate of 5-6% for the next 6 quarters. China and India will grow even faster. The emerging nations have become more important factors than the developed nations. Nearly 100% of world growth over the next 6-8 quarters will likely come from the emerging markets. And as the emerging markets become bigger and bigger players, their need for commodities will become even greater.
This is bad news for the U.S.
High commodity prices caused growth in the U.S. to be subdued during the 2000s. Now, with the emerging markets growing larger and driving commodity prices higher, U.S. growth will be even more restrained.
Also holding down U.S. growth for some time will be the very tired U.S. consumer, who accounted for over 100% of U.S. growth during the 2000s.
It's not a pretty picture. Nonetheless, it is clear that, for the next 10 years or more, money will be made by those who invest in the hard stuff – commodities – and the emerging markets.
Keep your eye on this big picture...
WHO'S THE GREATEST FOOL?
As we said above, stocks could rise a little, but we are caught in a “greater fool” market. Irrational markets can always become a little more irrational. In such a market, many people can foolishly buy overvalued stocks and sell them at even more overvalued prices, on the theory that there's always a “greater fool” to buy them. Of course, the danger is that you could turn out to be the greatest fool of all, and be left holding too many shares when the bubble pops.
We don't want you to be caught in that trap. We want you to look back on this period and be glad someone warned you in time.
Everything tells us that we are headed for major trouble in the stock market, and that our economy is far from being out of the woods. You are better off being selective and focusing very strongly in commodity and emerging market plays.