Safehaven | Commodities Stocks - Trouble or Opportunity?

May 14, 2005

Commodities Stocks - Trouble or Opportunity?
by Bruce Zaro

In his 2003 book, Adventure Capitalist, famed investor Jim Rogers reiterated his prediction of a long and profitable run for commodity-based investments. That turned out to be a bold call, as commodity prices, as measured by the Commodity Research Bureau Index (CRB) had been flat to down over the previous 10 years and had barely stirred in over 20 years. Looking back to 2003, this index was far below its long-term trend of lower peaks, rendering the index essentially stagnant since 1985. This, of course, roughly corresponds to the wringing out of inflation pressure in the US and around the globe over that period.

While world financial markets adjusted to this new inflation quashing mentality with euphoria, Rogers spells out the downside (and his opinion of current opportunity) from that long period of under-investment. The bullish case, he says, is based on simple economics: little investment in raw-materials capacity over the past 10 to 15 years plus growing demand - especially from big emerging Asian economies, such as India and China - has resulted in higher prices. Indeed, the pricing of certain commodities can be particularly telling in taking the pulse of global economies, most notably copper, steel and semiconductors. Among the industrial sectors that hold additional clues are trucking and transport, machinery, chemicals and forest products. As sector trend watchers, it's no surprise that our individually managed portfolios are over-weighted by many names in this area. Recently, however, we have been taking profits and tightening up our stop loss points on these. Indeed, some of the best performing market sectors of 2004 and first quarter of 2005 have been Steel (up 90% in 2004), Transports (up 30% over the same period), Chemicals (up 22%) and, of course, Oil and Oil Services, up 35% each in '04 followed by advances of 21% and 12%, respectively, in the first quarter of 2005.

But where does that put trend-watching basic materials investors now? What should their strategy be? Is this a good time to initiate positions if one has missed the ride of the last 5 quarters? Are Jim Rogers's predictions in danger of fizzing out?

Truckers:
The trend line of Truckers index started its current uptrend in October 2000, with the market still dealing with the reality of a March 5100 NASDAQ print. Yet something was stirring in the truckers. Since the start of the up trend it has never really come close to violating the support line. But recent action is cause for concern. A 420 top in March has been followed by a triple bottom break at 364, a lower top and another break at 348. Certainly, on the way up this can be seen as confirming an economy recovery as far as the shipping companies are concerned. But what's the next move? Stay tuned. The first buyer signal off the bottom was a recent breakout at $368. Now, a pullback could present attractive risk/reward potential with the second possible buy signal coming at $376. Such buyers, however, should keep in mind that the support line is well below at 292.

Dorsey Wright & Associates DJ Trucking Index:

Steel:
This index doubled as it became fashionable to quote "China will need the equivalent of all the steel in New York City every year for 20 years". Someone forgot to add that China might actually become a net exporter along the way, as is the case possibly now. Recent steel industry figures show demand staying steady, but supply and inventory increasing. Well, this chart had been confirming the China/Manhattan to the moon theory until recently. Now, however, it's threatening to violate its support line at 184, taking it back to its October 2004 low. The recent breach of the trend line at 180 is not to be taken lightly, in our opinion as it was a trend line that had been intact since May of 2004 while the index doubled. We can comfortably say steel stocks likely have some work to do before resuming their uptrend (resistance line now overhead at 240), let alone the prospects for a new Manhattan in China every year. We urge caution here and think this is a group best left to aggressive bottom fishers.

SIG Steel Producers Index (STQ):

Coal:
Accounting for more than a third of the electricity produced worldwide, coal has certainly participated in Rogers' commodity theme. The Coal Producers Index rose 3-1/2 fold from late 2002 till March of 2005 - from 100 to 348. While it has since broken a bearish triangle and took out a number of support levels, this sector ended up bouncing from near the bottom of its expected 10 week trading range. The break at 304, if accompanied by a subsequent pullback sets up a very bullish scenario with a spread triple top break at 316. While any entries will need to be monitored closely, very good risk/reward potential seems to be shaping up in this group.

Dorsey Wright & Associates Equal Dollar Coal Index:

Most of the aforementioned indices are in deep pullbacks as investors sort out their next moves. It's typical that the market's best performing sectors tend to have sharp, short downdrafts that are followed by a resumption of up, up and away. This remains a possibility in many of the base materials sectors, but would be less likely in sectors whose trends have more decisively changed from positive to negative (and violated trend lines), like Steel. Similar patterns can be seen in Chemicals and Copper. As a general strategy, we typically like to see buy signals off the bottom before we would start to re-enter some of these sectors. We further suggest paying close attention sector relative strength as it can be an early signal of a change in trend.

If Jim Rogers is correct and this trend has a long way to go, then the recent weakness may just be a blip on the radar. Our confidence would increase in this call, however, if and when we observe the supply of buyers returning to these areas, and the supply of sellers drying up. We will see this happening plainly as new columns of buyers (X's) on our point and figure charts.

Please feel free to contact us for further discussion on favored stocks within these sectors.

Bruce Zaro
Chief Technical Strategist
Delta Global Advisors, Inc.
877-746-4228
bzaro@deltaequity.com

Over his 20-year investment career, Mr. Zaro has become a highly-regarded technical analyst who runs private client portfolios at Delta Global. For the last 3 years, he served as Managing Director of Granite Wealth Management outside of Boston and spent nearly 15 years prior as a Vice President at Gage Wiley & Co. His current firm is full-service, but specializes in providing international market access as well as alternative investment strategies.