Should You Own Underlying Commodities Or Producers?

by: Dr. Stephen Leeb

The question that’s often asked in the world of commodities is: Am I better off owning the underlying commodity, or should I own the producers of the commodity?

A fair amount of market history, especially that from the 1970s, indicates that when commodities are going up, producers of commodities and the underlying commodities themselves tend to alternate. In that situation, in the long run then, it typically doesn’t make much difference where you invest.

The exception here was in 1980, when commodity stocks and particularly gold stocks continued to soar after gold had made a top at the beginning of that year.

So if you were forced to draw a conclusion from these brief bits of history from the ‘70s and early ‘80s, it would probably be that at least for the majority of the bull market you are going to do pretty well no matter what you own.

But in the end, it’s going to be the miners/producers that will likely blow off, and that blow off will probably be a signal for a top.

If that’s the case this time around, then watch out. For we’ve seen nothing even remotely resembling fireworks to date. This is perhaps best illustrated by our first chart, which shows the behavior of junior miners vs. gold, the S&P and the Russell 2000 over the past year.

Clearly, the junior miners have taken a huge licking relative not only to gold but to stocks in general. Indeed, as another line indicates, junior miners have actually underperformed the Russell 2000 Index. The number that really stands out is the huge deviation between the juniors and gold itself – nearly 50 percentage points in a 12-month period. This is simply extraordinary.

Nor are these comparisons confined to just the past year. Again, looking at gold from the beginning of the century until now we find that the metal is up 600 percent (a sevenfold increase), while the index of miners (of gold, silver and other precious metals) is up only fourfold or 300 percent. That’s a difference of 300 percentage points. Again, this is an extraordinary deviation.

The numbers aren’t so extreme when we talk about other metals, but nevertheless those discrepancies are also starting to become more visible.

For example, copper is down about 20 percent from its level at beginning of this year, yet Freeport McMoRan Copper & Gold (NYSE:FCX) – which we still consider to be the best copper stock – is down nearly 35 percent.

Talking more generally, the ETF that tracks the Goldman Sachs commodity index – iShares S&P GSCI Commodity-Indexed Trust (NYSEARCA:GSG) –has fallen less than 1 percent from the beginning of the year.

Yet a broad group of stocks in the commodity arena represented by the SPDR S&P Global Natural Resources ETF (NYSEARCA:GNR) has fallen about 13 percent. In other words, while the divergences may be sharpest for gold, they are becoming pervasive.

And in the case of gold, the divergences are becoming so large that it’s becoming hard to simply rationalize.

Even during the early part of the ‘70s, a period marked by severe economic turbulence up through ’74 - ’75, you did not see these kinds of divergences between miners and metal.

So what’s going on?

There are at least two possibilities.

The first is simply attributable to market action: Clearly a lot of the divergences that have occurred in the past 4-5 years could reflect a lack of liquidity in the marketplace for small cap stocks in general.

But this kind of reasoning doesn’t really hold up when subjected to further scrutiny. Especially as we see that small cap gold stocks have also dramatically underperformed the Russell 2000, the broadest-based index of small cap stocks in general. Gold and especially small cap gold stocks, in other words, have been uniquely affected.

We think – and hope – that a year from now we might be talking about a different kind of divergence, one in favor of stocks or the miners over the metal.

But we have a suspicion that something else could be afoot. And that’s something we’ve talked about many times before: the interrelationships between virtually every resource out there.

As grades go down for practically every critical metal, from copper to silver to gold, it takes increasing amounts of resources to mine these metals. And incidentally, whereas we don’t talk about grades of oil, it’s certainly clear that any growth we can expect to see in the oil patch is very likely to come from non-conventional hydrocarbons – the drilling for which is much more resource-intensive than conventional drilling.

This suggests that we could be seeing the start of what could prove to be a massive squeeze on resources.

We’ve used the following fable before, in our last two books, Game Over and Red Alert, and though we wish we didn’t have to bring it up again, it’s just too relevant to our discussion here:

Imagine a small island isolated from everything else in the world, and this island contains, say, four or five critical resources – each one of which requires all the others in order to be produced. Such a scenario clearly exemplifies that expression about a chain being only as strong as its weakest link – and in this case, big time. Once any resource on the island becomes too scarce to produce or leads to a vicious circle in which scarcities feed on themselves, it is indeed, as the title of my penultimate book says, ‘Game Over.’

How close are we to something like this? Well, going by some reactions I received to my recently released book Red Alert, hardly anyone is paying much attention to it.

But if you look at practically each and every action that China is taking, it appears that they seem to get it – in spades – as reflected in their ongoing, highly focused commitment to accumulate the resources they don’t have sufficient supplies of internally.

And it’s not just China that has an impact on increasing resource shortages and scarcity. In addition to a ‘Red Alert’ regarding China, perhaps we should also have something like an ‘Aussie Alert’ applicable to Australia as well as other resource-rich countries that will be trying their best to keep those resources in the ground for the time being, in anticipation of a future where they will become considerably scarcer and more costly.

As an aside here I want to emphasize once again that I bear absolutely no animosity at all toward China or the Chinese. Indeed, I have great respect for them and think we should be following their example.

For us, among other things, that would mean seriously pursuing (and funding) 21st century versions of the Manhattan Project of World War II, which was devoted to developing an atomic bomb before the Axis powers did – and as such commanded the highest national priority. Such projects today would be devoted to initiatives like figuring out ways to mine resources in the depths of the oceans, or methods for using nano silver to build out solar energy technologies, and many others beyond my ken – but not beyond the ken of the cadre of brilliant minds that we do have in this country.

At the very least we should follow the Chinese in accumulating stockpiles of increasingly scarce materials and resources. It took an oil crisis for us to begin to accumulate a stockpile of oil, and George Bush directed to increase that stockpile beyond the highest level that had been reached before. But where are the stockpiles of rare earth metals…of copper…and of so many critical metals without which our civilization will hit a massive, impenetrable stop sign?

Of course, I realize I can’t change the world. But I can do my best by writing books, speaking out in the media and whenever the occasion arises where I act in an advisory capacity.

Thus we do continue to recommend mining stocks, specifically those we think have great potential and will become extremely valuable because they are the last links to somehow finding the ways to develop and continue to produce the resources that are still there.

On the other hand, our feeling more and more is that investors are probably going to do better owning the actual commodities instead of the miners that produce them. The rising costs to produce these commodities are clearly one sign that mining is increasingly becoming a much more difficult business.

Fortunately, while many of us don’t have access to the commodity pits, there are a number of ETFs that are worth recommending:

  • GSG, for example, we which cited above, faithfully follows the broad-based Goldman Sachs Commodity Index (Pending:GSCI)
  • PowerShares DB Base Metals Fund (NYSEARCA:DBB) follows base metals
  • iPath Dow Jones UBS Copper Subindex Total Return ETN (NYSEARCA:JJC) tracks copper
  • SPDR Gold Trust (NYSEARCA:GLD) tracks gold
  • iShares Silver Trust (NYSEARCA:SLV) follows silver

…and of course, there are others.

But the essential point is that in a commodity based-portfolio, these names should probably represent at least 50 percent of your holdings.

Disclosure: Leeb Group, its officers, directors, shareholders, employees and affiliated entities and/or clients of such affiliated entities may currently maintain direct or indirect ownership positions in financial instruments (i.e., stocks, bonds, options, warrants, etc.) of companies or entities whose underlying exposure is in the companies mentioned in this article.