Commodities prices have been falling, causing some investors to question whether it is finally time to pull out of what was once the one area of relative stability in a turbulent market. Analysts warn, however, that it is too early to make the call and holding onto commodities will pay off in the long term because peak prices have not yet been achieved. Rising inflation and materials costs point to a spike in value and experts say there is no need to worry about getting caught unawares by a burst bubble, because a sudden drop is unlikely. For more on this continue reading the following article from Money Morning.
If you’re like me, you’ve been invested in mining companies or oil producers the last couple of months because you expected a return to the strong commodity prices of early 2011.
But if that’s the case, like me, you’re hurting. Commodity prices are well below the high levels we saw in early May – in fact, they’ve dropped more than the rest of the market.
The temptation to sell out before things get worse is very strong.
But don’t do it …
The preconditions for strong commodity prices are still in place. And at present levels, a number of commodity and energy-producing shares are stone-cold bargains.
Let me tell you why …
Don’t Be Fooled by the Price Declines
Against a backdrop of strong commodity prices, these companies had an excellent 2010.
I’m sure you were surprised to see that these same companies didn’t do all that well in the first few months of the New Year – even though oil, gold, silver and copper prices were climbing and rare earth prices were going though the roof. The market seems to have believed that these strong commodity prices were actually peak commodity prices – and that producers wouldn’t get much benefit from those peaks because they would receive the high revenue for only a short period.
Then when commodities prices dropped from their peaks – oil by about 20%, silver by about 35%, but gold by only 8%, even at the bottom – share prices of commodity producers fell even more. The investor sentiment was very clear: Commodity producers hadn’t benefited all that much from peak prices, and now that prices were likely headed down, producers were looking at a stretch in which they would be much less profitable.
But here’s what I want you to know: This bearish theory on commodity producers becomes flawed if, in fact, we have not yet seen the peaks that commodities will actually achieve. If that’s the case, the benefit to producers from high prices would become much greater, as we would expect the prices to rise further and the high-price period to last longer.
And I would argue that this is precisely where we are today.
Monetary authorities around the world are still pursuing loose policies with very low interest rates. Chinese Premier Wen Jiabao recently declared that China had conquered inflation. However, since inflation is currently running at 5.5%, while the People’s Bank of China deposit rate is only 3%, giving a minus 2.5% real return to depositors, one can only assume that he has been channeling U.S. Federal Reserve Chairman Ben S. Bernanke.
A Recipe for Strong Commodity Prices
All around the world, only the tiniest steps have been taken against inflation, yet inflation itself is rising quite rapidly, far more rapidly than interest rates are being increased. In the U.S. economy, consumer-price inflation in the last 12 months was 3.6% and producer price inflation 7.2%, yet interest rates are still zero. Not only is monetary policy extremely loose, it is getting looser, with U.S. Treasury bond yields declining in the last few weeks and the Federal Funds target rate of 0.00% to 0.25% falling further and further behind the inflation rate.
Since real interest rates worldwide are negative, hedge funds and other investors are actually being paid to invest in commodities. And those commodities can be expected to track inflation in the long run, with some upward pressure due to rising demand in high-population emerging markets. Thus with both fundamental and funds flow factors supporting commodity prices, they will inevitably end their current pause and rise further – which means it’s a virtual certainty that we’ll see strong commodity prices once again.
And don’t worry about getting nicked by this "bubble," either: You will have plenty of warning before that bubble bursts.
At the earliest, this bubble in commodities prices will burst only when the first decisive steps are taken to raise interest rates – particularly here in the U.S. market.
That’s not likely to happen yet. In fact, at last week’s press conference, Fed Chairman Bernanke defined the "extended period" for which rates would be held at zero as "at least" two to three meetings of the policymaking Federal Open Market Committee (FOMC). In other words, we won’t see even the smallest rate increase before October. And we actually probably won’t see one before December.
That would not make me buy shares in general, because Bernanke’s policies are damaging the U.S. economy and keeping unemployment higher than it needs to be. Nor would they make me buy bonds – rising inflation and huge deficits seem certain to cause cracks to appear in the bond market at some point soon.
But commodities remain an excellent bet. And given that strong commodity prices are coming, commodity-producing companies (which have been knocked down further than commodity prices themselves) seem an even better one.
This article was republished with permission from Money Morning.