Market Commentary for the week of October 18, 2010

Resource economics.

With a steady run-up in natural resources equities the past year, some are concerned that the progression might come to an end.  I am not one.

Although global indebtedness is still a primary concern, consumption of tangible assets moves on unabated, and with that the fundamentals for commodities’ price increases remains.  Clearly, the market’s obsession with natural resources is a two-edged sword.  But sentiment and relative strength indicators are sufficient not to expect a sudden reversal of trend in the near term.

Concomitant with a demand for basic materials is the expectation that price increases (inflation) in those commodities are also likely.  If it doesn’t get out of hand, a rise in prices might be a strong pre-indicator of a pickup in global industrial development.  Besides, we are far from a “hyper-inflationary” environment, as current asset price increases year-over-year hover around 4% across the board.

The intrinsic value of commodities heightens, too, as you move from highly industrialized Western economies towards emerging markets.  Today a “typical” basket of metals, timber, etc. might be more significant to GDP for emerging economies than for those with relatively low/stable demand.  Russia, Brazil, Chile, India, and China are all undergoing a wave of industrialization and modernization programs which require metals, lumber, rubber and energy sources.  Additionally, I have written prolifically about future land use for agriculture and potable, replenishable water supply.

Gold only?

While the market’s current focus seems to fixate upon gold, there are probably more geopolitical and psychological components to that metal’s rise than fundamental, industrial use and its effects.

Commodities are not a zero-sum game.  They are a depleting natural resource whose value can be measured based upon current supply/use and future expectations or alternatives.  Imagine if you will (and this is an extreme hypothetical) if the globe no longer needed fossil fuels.  How severely would production and price decrease?

The question at hand today is “to what degree should an asset allocator be committing to these sectors?”  Based upon improving policies and demand worldwide, it is entirely appropriate to reserve an “overweight” ranking for these equities.  As long as industry prudently manages inventory-versus-demand cycles, upward valuations might persist.

Recall, also, that during the dot.com boom, just a decade or so ago, one couldn’t give an industrial stock away!! Such is the nature of parabolic market continuums that decades elapse during which minor shifts in psychology, expectations, fiscal policy and politics, become tectonic secular themes for our time.

In other words, it is difficult to predict trends but easier to quantify them as we look back with the perspective of time.

Long-term, my thesis is that depleting resources (whose supply today is unquestioned) might provide the science and politics for an elongated trend whose capital gains potential could be significant.

If you simply like to bet on 24 hour trading cycles, please disregard the preceding text.  Mine is not a strategy of uncertainty and malaise, but rather a science of macro potential and cash flow.