Tuesday, January 4, 2011

Secular Bull Markets Don't Guarantee Short Term Success

It's Tuesday and the wife is positively giddy as she watches Glee on television. That same giddiness and glee is also present in the commodities space of the stock market. The trend is up, the trade has worked, and the story is intact. Investors/speculators continue to pile into any and all real asset plays as an inflation hedge, a dollar hedge, and a participation in emerging markets. I've done so myself. But I worry.

"What the commodity markets are telling us is that we're living in a finite world, in which the rapid growth of emerging economies is placing pressure on limited supplies of raw materials, pushing up their prices. In other words, commodities are in a real, secular bull market, not a bubble." The forgoing quote is a sentiment that I encounter daily in articles, newsletters, and analysis. I don't disagree, but that does not mean that a nasty correction cannot happen in spite of the commodity shortages.

An example. The aggregate industry in the U.S. is a wonderful, regionalized monopoly. Supply is limited by the inability of operators to easily obtain permits for new quarries, mines, and facilities. The scarcity is real. Until 2008 the share prices of all aggregate companies marched steadily upward based upon their ability to raise prices, even in the face of declining volumes, due to limited supplies. It was a secular bull market in rock. Then as the real estate recession moved from residential real estate development to commercial development to road building, the price increases no longer stuck well enough to offset the huge volume declines. Share prices declined. I was on the right side of that trade and did well.

The aggregate business is still a good one, if your balance sheet is conservatively financed, and the permitting of new projects hasn't become any easier, but the share price declines show that shortages can become oversupply rapidly. That oversupply can affect the conservatively financed and the aggressive companies alike [MLM and VMC, respectively]. Commodities, and commodity companies, face the the same dilemma as the rock suppliers.

Should China experience a "hard landing", commodity volumes will drop drastically, prices will be slashed, and share prices will no longer enjoy a positive trend. Inflation and a weak dollar won't be able to compensate for a stalled China. Emerging markets are going to emerge and use huge amounts of raw materials, but their progress doesn't have to be in a straight line. Raw materials are in a secular bull market, but they aren't immune to dislocations caused by retrenching markets.

If China were to stall, the secular bull market in commodities goes into neutral for several years. I don't have an opinion on China's ability to manage their economy, but I do have an opinion on how my raw material/commodity investments are structured. If China craters, I only want to own companies with pristine balance sheets that can easily survive until the emerging markets bounce back. I don't own "junior" miners, rare earth hopefuls, and leveraged operations that are taking on large, debt funded, expansions to supply China.

I don't have the conviction to sell materials stocks short, like I did the aggregate operators, but that could change! In the meantime I hope the China led recovery continues, and should it not, that my conservative materials positions perform well enough to get me to a prosperous resumption of the secular bull in commodities.

Glee's over so I can quit typing.

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