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May 25, 2007

Natural Resources: Here We Are!
by Chuck DiFalco

My undergraduate years filled my life with continuous drudgery, interrupted by the occasional classic situation. One such case was orchestrated by R. L. Jennings. This University of Virginia professor taught a structural engineering class. Upon entering the room of 100 or so chatty students, he would announce, in a deep monotone: "Here we are." That was our signal to be quiet. By the end of the semester, as soon as he entered the classroom, we students would all chant in unison: "Here we are!" He had us trained well.

For so many years, natural resource stocks suffered as commodity prices dropped and under investment persisted. The 1980 high in gold to the 1998 low in oil destroyed these sector plays. Dealing with the future has no closed form solution, no absolute certainty, particularly with regard to human affairs. Predicting the future is messy, not well defined, but not totally impossible either. Clearly, the cycle had to turn like it always does. Some investors wanted to know, are we there yet? Well, here we are! We natural resource bulls are enjoying a secular up market. I did not move up to what is now my target 50%-60% allocation during the rolling lows (buying opportunities) in these equities from 1998 to 2002. Secular cycles last 10 to 20 years. With so many years left in this cycle, I know I'm not too late.

There are fundamental factors behind the natural resource sector. Its secular bear market late last century led to chronic under investment in supply producing projects. Exploration and development take years to execute. On the other side, the newly capitalist economies of Asia, with their increasingly wealthy 3 billion (with a "b") consumers, are part of a decades long story. All the hype about Hubbert's Peak distracts from the truth that there will not be any more cheap raw materials. There are those naysayers who conclude that soon the commodity bubble will pop. I don't buy it. Bouncing off such a low base, with demand continually outstripping supply, we're a long way from a mania.

Indeed, monetary factors augment the fundamental factors. Extreme exporting nations continue to debase their currencies in a beggar-thy-neighbor competitive devaluation. Extreme importing nations are caught in an inflate or collapse spiral. They create money out of thin air, beyond the increase in productive capacity of their economies. While monetary inflation helps commodities in general -- in effect, it takes more and more paper money to buy the same amount of raw materials -- precious metals by far get the biggest boost from monetary inflation. Gold and silver are real money, while paper and electronic currency are not. If you don't consider that as truth, students of the global markets like me will be on the other side of your trade.

The category of applied physics known as "statics" can be dry. Professor Jennings, however, sometimes made it fun without even trying. "To the right of the beam, there is no beam," he would say. "The forces acting on it there are zero." I can't invest money I don't have. The most obvious form of such money for small investors like me is the fraction of future paychecks going into 401k/403b plans. Presently, I'm dollar cost averaging into an energy equity fund. While not every employee has this option, I have it, and I'm using it.

Also, I have some money recently raised from selling other investments -- i.e. anything with mortgage bonds in it. I'm sitting on in, getting a decent money market return. I'm using my only advantage as a small investor. DO NOTHING! When it comes to my portfolio, I have no boss to report to. I don't need to produce results every quarter. I can afford to wait for a nice big dip. I drool at the prospects of a 2007 recession (which I think will be small compared to the next one in a few years, but that's another article), which could drag down, for example, oil stocks. Of course, if the recession results from increased hostilities in the Middle East, oil stocks will go up -- messy in multiple senses of the word. I would put some money to work if a classic economic downturn lies directly ahead of us. This "double dipping" would accelerate my natural resource investments compared to a fixed piece of every paycheck. I don't need hit the shorter term "cyclical" low exactly. The secular bull will erase my mistakes and make me look smart as the chart rises jaggedly higher over the years.

Please note that I am not optimistic about commodities and natural resource stocks. Optimism has nothing to do with it. In the markets, optimists lose money, pessimists don't make money, and realists profit from the other two groups. There is always a decades long bull market in something. Right now it's precious metals, energy, base metals, agricultural products, and the companies that produce, process, and deliver them. If you're wanting to double your money in an S&P 500 index fund from the high in 2000, you'll be waiting a very long time. You've already spent 7 years just to stay even. I act on what's there, not what I want to be there.

Also, I'll try not to fall into the specialization trap. "Falling in love" with stocks and/or sectors is a common way that small investors lose money. Getting too specialized in natural resources could lead to some wild rides. Maybe the whole natural resources sector will drag up the timber subsector. I suspect, however, that the boom/bust housing cycle could make timber stocks highly volatile. If only 2% of my portfolio is in timber stocks, a 50% drop won't make me lose sleep. However, a 20% allocation whose value gets chopped in half would. Although I can't be right all the time with every transaction, objectivity helps me manage risk.

Similarly, I'm not trying to convince anybody to take the plunge. I don't want folks to have an epiphany. Too many small investors get "into" a theme -- "Oh wow, natural resource stocks, commodities, buy buy buy buy." The psychology of addiction overwhelms good judgment. They go all in. Then comes a shorter duration cyclical downturn. The account balance goes down. Oil stocks, gold, corn, base metals all drop simultaneously during a downturn or recession. For example, gold staggered lower for two full years during the inflationary 1970s. The "hooked" investors either (1) panic, or (2) get burned out. Then they sell sell sell sell. Calm, patient, incremental investors like me will be on the other end of the transaction of those one-track-mind speculators. If the market puts something good on sale, I'll buy it. Even "Mad" Jim Cramer talks about taking a pot of money (NOT the whole enchilada) and putting it to work in portions. For example, if an IRA rollover cashes me out, I don't immediately move all of it out of a money market fund. Cutting it into fourths works for me.

My college experience came to a well-defined end. This secular bull market in natural resources will also end. Unlike college, pomp and circumstance won't mark its culmination. When my long-lost college friends are seeking me out to get tips on energy stocks, I'll know it's time to think about an exit from my natural resource investments, and put that money to work in the next secular bull market.

Chuck DiFalco

Living in League City, Texas, Chuck DiFalco is a software engineer by day, and an unconventional thinker and writer by night. He can be reached at cdifalco@houston.rr.com.

Copyright © 2004-2007 by Charles Joseph DiFalco. All rights reserved.

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