A Commodities Bubble Is Forming: The Correct Action Is to Buy
Our founder has an appreciation for what he calls "simple complexity" when making investing and trading decisions. We have considered where commodities are going and have come to the conclusion that we are still at the point where it is acceptable to invest into the bubble.
Regardless of how you individually feel about bubbles, they are part of human nature. They do not just take place in financial markets, but even on the elementary school playground. Anyone who was a parent of an elementary school child or was in elementary school in the late 1990s remembers the Pokemon craze: At one point the value of one of the cards in the original 150 card set was $2500. Having not understood bubbles at that time (and based on the tech bubble, adults certainly didn't either), we have one of those cards lying somewhere around our childhood room instead of $2500 in cash.
The one person who seems to understand how to deal with bubbles is George Soros, who has made the point that it's completely okay to invest into a bubble if you do it at the outset and do not get excessively greedy.
We look at the commodities sector today and see plenty of potential for a bubble to form. Bubbles tend to have a common thread amongst themselves. A legitimate investment thesis exists initially and begins to get attention. As the thesis receives more and more attention, money flows in further validating the thesis. As more and more money goes into the forming bubble, more and more attention is bestowed on the thesis as the returns generated for early investors incite envy in those not yet invested. The increased valuations generate new supply - in the tech bubble it was the IPOs whose valuations defied logic, in commodities it will be new mines becoming operational.
In the most economic point we will discuss in this analysis, this new supply begins to absorb the demand, fueling the bubble to the point that valuations begin to drop. As they drop, some of the new entrants go down as their enterprise is only economic at the bubble level valuations. As the first domino falls, the risk involved begins to get re-evaluated and the bubble deflates, typically in dramatic fashion.
In commodities, we have a very straightforward thesis that has been present for a couple of years. The rise of China, India, Brazil, Russia, and other emerging markets means more than 2 billion people will join the middle class in the next thirty years, and these countries will require commodities as their development progresses.
A completely valid argument and a very bullish one for commodities when you consider how inelastic the supply is of commodities. A mine is not going to be developed or a well is not going to be drilled unless the price of the commodity makes it economic, so the demand from these countries will inevitably create a supply/demand deficit.
This deficit will push up commodity prices and bring new supply into production. Now here is where we often hear the point that oil was once $150/barrel so the bubble already occurred. Here are our counterpoints: The financial crisis made financing for new mine development almost impossible with the tough credit conditions and volatile commodity prices (oil was at $30/gold under $800), so we can effectively reset the clock in our opinion.
The time (in some cases 10-15 years) it takes to bring new mines into production tells us that we should look at companies with low cost production and imminent production or existing producers with very competitive cost structures that will profit from the rise in commodity prices.
The commodity groups we would look at specifically are copper, silver, iron ore, steel, and rare earths. We would also chooses stocks over ETFs or commodities futures for all of these groups.
A model basket to represent this commodity thesis would be: Freeport McMoran (FCX), Silver Wheaton (SLW), Rio Tinto (RIO), US Steel (X), Molycorp (MCP). But as always, do your own work in determining a basket of stocks to represent this commodities thesis.
Our decision to include steel may surprise some since it is not a mining product, but it plays into a second stage of the development thesis that this commodity bubble is predicated on. As more development occurs, there will be more scrap steel which will pressure the demand for iron ore, but that will not change the demand for steel, just the composition of the supply inputs for steel mills.
There are risks that come with investing the "2 billion people enter the middle class" commodities thesis. The first risk above all else is that China has political instability as that would in all likelihood cause quite a hiccup to economic growth. The second risk is a double dip recession generated from a sovereign debt contagion spreading across the Western world instead of remaining on the fringes of the EU.
We think this is an optimal opportunity to enter into the commodity space because many of the stocks in the space are exhibiting relative strength and are near their 52 week highs. As momentum and relative strength traders, we find this incredibly positive as it shows that money is flowing into the space and the investment thesis behind the commodities boom is getting recognition as the bubble begins to inflate.
If we are wrong, as relative strength traders we would not advise taking an overall loss on the basket in excess of 12-15% depending on risk tolerance. It is cheaper to take the hit to our ego of admitting we are wrong than to compound the original mistake.
