Commodities Investing

By: Scott Wright | Fri, Feb 1, 2008
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The financial markets are always exhilarating. And as a student of the markets, I've learned over the years that their dynamics leave no room for boredom. Whether bull, bear, or monotonous grind in either direction, there is always something new and exciting going on.

Astute investors and speculators are able to make money no matter what direction the markets are moving. But for the average investor, it is usually live by the bull and die by the bear. And for those investors positioned to grow their capital in headline stock indices, in flat or down-trending markets there is wailing and gnashing of teeth.

The simple fact is the majority of investors lack the time, knowledge, and/or discipline to capitalize on volatility or understand the machinations of playing the downside of a market. It is indeed normality for investors to only know how to bet to the upside by going long in stocks or funds that focus on the general markets (S&P 500, Dow, NASDAQ, Russell, etc...). So when the general markets retreat or face headwinds, what's an investor to do?

Unfortunately many investors get caught in the trap where they are willing to sacrifice their capital and ride out a prevailing downward trend. Even active stock traders can fall prey to this trap. I call it the "my-short-term-trade-just-turned-into-a-long-term-trade" syndrome.

This is very dangerous though due to the nature of supercycles, or Long Valuation Waves (LVWs). And LVWs tend to last a very long time. Historically a full cycle spans an average of 34 years, 17 years each of secular bull and bear markets. So if you are caught in the bear side of an LVW you may have a long ride in the wrong direction. This is detrimental not only to wealth building but simple preservation of capital.

The good news is regardless of where we are in an LVW bull markets can still be found, even in the stock markets. And for those investors who aren't willing to allow their capital to dissipate in grinding general markets exacerbated by an eroding dollar, it is just a matter of knowing where to look.

One sector that runs in supercycles of its own, historically inverse to the cycles of the general stock markets, is the commodities sector. With the recent stock valuation peak hitting its apex in 2000 ending a 17-year run that witnessed the greatest bull market in history, this places us still in the first half of a receding LVW. And in this receding LVW commodities have not let investors down.

Now you may be wondering where in the heck this receding LVW has been considering the stock bull in recent years. But before I explain it is important to note that valuation contractions can occur in two fashions. Either stock prices fall until earnings are high enough to lower valuations, a bear market. Or they grind sideways slowly allowing earnings to rise, which also serves to lower valuations.

The stock bull in the last several years has sure allowed folks to forget about the prevailing secular trend. With the S&P 500 rising 101% from October 2002 to its October 2007 top, it has indeed been easy to forget. But when referencing secular trends, we need to go a little further back than the 2002 lows.

It's a known fact that the latest valuation peak occurred in glorious fashion in early 2000. If you were invested in stocks from the early 1980s to this 2000 peak, you'd have seen spectacular gains. But if you measure stocks from 2000 through today, it's quite a different story.

When the bubble burst in 2000 we entered into an LVW cycle that at worst will see the general stocks run their course as a deadly bear market and at best be a monotonous sideways grind. And we know we are within this new cycle because valuations have indeed been contracting since 2000, going from 44x earnings to 19x in the flagship S&P 500. Interestingly over this span of time, almost 8 years, the S&P 500 is actually down 11% through this past week.

I encourage you to read up on LVWs via the extensive research my business partner Adam Hamilton has performed in his series of essays on this topic. Ultimately even in sideways general markets investors will lose money, if for no other reason than inflation eroding their valuable capital. Prudent investors who want to grow their capital need to search out the sectors that are historically and fundamentally strong in times like these.

And among hot LVW-contraction sectors, none has been hotter than commodities. Now when it comes to commodities investing unfortunately many investors still put up blinders or shudder in fear at the perceived complexities of investing in this arena.

It has long been thought that only highly-sophisticated traders or adrenaline-junkie speculators were able to invest in commodities. While this may have been true for some commodities in times past, the 21st century commodities bull has changed the entire face of commodities investing.

Now as an investor new to the commodities game or just starting to dabble, you may be asking why you should go through the trouble of learning about this sector. Well how about some proof positive as to why it would be worth your time. Have a look at the performances of these indices/commodities from March 24, 2000 (the S&P 500 reached its apex that day and can be used as a starting point for the LVW contraction period) through January 30, 2008.

Looking at these numbers it is apparent where the smart money has been in the last eight years. And many of these gains, especially for the hard commodities (commodities with a finite resource, drilled or mined), are well off their highs due to some sizeable pullbacks in the last couple years. So I believe it is safe to say it is absolutely worthwhile to invest some time into researching commodities.

And it is not too late to jump aboard the commodities train. Similar to the secular nature of the general-market LVWs, commodities bulls also run in massive secular supercycles. Commodities experienced their bear market in the 1980s and 1990s when stocks were thriving. And now that they are on the bullish side of the supercycle it is likely that we are not even to the halfway point of what is shaping up to be the greatest commodities bull ever seen.

The long-term fundamentals of most commodities are rock-solid. The world's population and infrastructure is growing at a rapid pace and will continue to require massive quantities of natural resources to meet growing demand. And Asia's growth in particular has only just begun.

So for investors looking to tap into the commodities markets, it is simply a matter of knowing how and where to invest. And the good news is not only is commodities investing now easy, but it is available to everyone. There are numerous vehicles now available that allow the average investor to trade virtually any commodity of his choice. Whether it be through futures, ETFs, ETNs, funds, or individual stocks, the options are limitless.

A large factor that has enabled investors to better participate in these vehicles is the evolution of the internet. With the click of a mouse trades can now be executed instantly and cheaply. Anybody can now open online brokerage accounts in minutes and actively trade the markets. And yes, even the futures markets.

There are a number of brokers that have enabled real-time online futures trading. Now trading in the futures markets is a little scary for most folks, and should still only be attempted by those that can dedicate a little time to learning the intricacies of these markets. But for those investors who can get a grasp on futures trading, fortunes can be won.

One of my favorite online futures brokers is Lind-Waldock. LW is one of the world's largest commodity futures brokers and it offers a sophisticated online system that gives you access to every major futures market worldwide. I believe it only requires $5,000 of initial funding to open an account. And if you want to learn the futures game without putting down real money right away, LW gives you the ability to trade in a simulated account.

If futures aren't your cup of tea, investors also have access to the rapidly-growing world of Exchange-Traded Funds (ETFs). ETFs combine the best of both worlds of open-ended mutual funds and stocks. They provide investors with partial ownership in an underlying index, asset, or basket of securities. And the beautiful thing is ETFs can be traded like stocks. Some are even optionable.

According to ETF powerhouse Barclays Bank, which operates iShares, the total capital in U.S. ETFs has grown from about $15b in 2000 to over $250b in 2006. Over these seven years the growth rates have accelerated each year with 60% growth in 2006. I would expect to see a similar growth rate in 2007.

As far as commodities go there are a myriad of opportunities on the ETF front. There are now dozens of commodities-centric ETFs to choose from. For instance if you are interested in base metals exposure have a look at PowerShares' ETF that tracks the Deutsche Bank Liquid Commodity Index (LCI) focused on industrial metals (DBB-AMEX). DBB has strong exposure to copper, zinc, and aluminum.

There are also new and exciting agricultural ETFs. Another of PowerShares' ETFs (DBA-AMEX) is designed to track the Deutsche Bank LCI composed of such liquid commodities futures contracts as corn, wheat, soy beans, and sugar.

You can also find ETFs that mirror such specific commodities as oil, natural gas, gold, and silver. And there are a number of broader ETFs that track such commodities baskets as a gold miner's index, the energy complex, coal, and precious metals. And of course we can't forget the ETFs that focus on such exotic commodities as timber, water, and nuclear energy.

Even broader is a brand new ETF that tracks the Continuous Commodity Index (GCC-AMEX). At Zeal we have written extensively about the CCI. If you haven't been a believer in the commodities bull, one look at a CCI chart will change your mind.

And one of the most popular commodities ETFs is the StreetTracks Gold Shares ETF (GLD-AMEX). GLD is backed by physical gold and tracks the price of gold on the open market (each share is priced as one-tenth an ounce of gold). This ETF has had immeasurable positive impact on this gold bull. Not only does its physical gold storage now rank it among the top ten central banks in the world, but it has allowed investors who would not normally buy gold to hedge their portfolios and participate in gold's bull via the stock market.

Ultimately ETFs prove to be magnificent investment vehicles, even for commodities investors. They are not subject to expiration, redemption, or individual company risk and can be bought with the click of a mouse. Another of the investment vehicles on the exchange-traded front that has piqued my interest are the new Exchange-Traded Notes (ETNs).

Barclays Bank recently broke ground on ETNs and they offer commodities investors some interesting options. From what I can tell ETNs are different from ETFs in that instead of fractional ownership of an underlying asset they are debt securities that have a maturity. So in effect you are loaning your money to Barclays in the form of notes to invest and track the prices of various assets.

As an example one of Barclays' new ETNs provides exposure to copper (JJC-NYSE). JJC is designed to mirror the performance of copper and is composed of copper futures traded on the NYMEX. But unlike ETFs, JJC is not backed by the physical asset but the creditworthiness of Barclays. The same goes for a group of new ETNs managed by ELEMENTS. Its ETNs are quite interesting as they track the returns of the sub-groups of the famous Rogers International Commodity Index (RICI).

There are other differences between ETFs and ETNs, especially on the tax and tracking fronts, but I believe ETNs offer stock traders an excellent resource to easily invest in commodities as long as they are aware of the credit risk. Other ETNs currently available track such commodities as nickel, livestock, and grains.

Another good vehicle for commodities investment is mutual funds. Since this commodities bull was born, there have been a number of mutual funds that have hit the markets with wide-ranging focuses in the natural-resources sectors. But since funds don't have the same ease of entry and exit as stocks and futures, they are more for the less-active investors who want to ride the secular commodities trend. Some of the larger funds we direct folks to are managed by U.S. Global Investors and Tocqueville Asset Management.

And finally the world is a commodities investor's oyster with individual company stocks. Individual stocks can offer highly leveraged rewards when the commodity a company explores for, produces, sells, or transports is on the rise. Just look at the gold stocks and energy stocks measured by their headline indices' performances above.

There is of course a risk versus reward trade-off for individual stocks. When you are invested in the stock of a public company you are always subject to management risk. No matter how good the product is or how much it is selling for on the open markets, if operations or the balance sheet are poorly managed then the stock can tank.

But well-managed and well-researched stocks offer the opportunity for legendary gains. And there is so much to choose from on the commodities front. There are hundreds of metals stocks that range from the conglomerates that touch all the bases to companies that focus on one specific metal. There are also hundreds of energy stocks with the same range of focus as the metals stocks.

There are even opportunities in individual stocks with the soft commodities. Softs are those commodities that are renewable, i.e. can be grown or bred. While futures and ETFs provide easy access to directly trade the softs, the producers aren't typically publicly traded like in the hards.

But though farmer John can't be traded in the public markets, there are many individual stocks that can profit in direct correlation with the growing demand and appreciation of the soft commodities. From equipment to agricultural chemicals there are many stocks to choose from.

Also benefitting from the commodities boom are the alternate energy stocks. There are indeed publicly-traded companies that focus on solar power, wind power, and "clean" fuels. And though there is a place for bio-fuel and ethanol, the ultimate clean fuel is uranium. Surprisingly there are hundreds of uranium stocks ranging from the highly-speculative junior explorers to the utility companies that operate nuclear reactors.

Ultimately investors now possess a wide range of vehicles to use to invest in the 21st century commodities bull. But a key component to commodities investing is knowledge. Knowledge allows you to understand the big picture and gives you the ability to analyze today's and tomorrow's markets. And knowledge is practically applied with the help of proven trading tools and timeless trading principles.

This is why I believe information is a priceless commodity in its own right. At Zeal we are students of the markets and scrupulously research and analyze the commodities markets to grow our own knowledge and make profitable trading decisions. And we share this knowledge via information-packed newsletters.

If you are short on the time and resources to learn and understand the commodities markets, then Zeal can be of service. We publish an acclaimed monthly newsletter and an action-packed weekly newsletter. Both are chock-full of research, analysis, and high-probability-for-success trade recommendations that will help you stay on top of these exciting commodities markets. Subscribe today to receive your first issue!

The bottom line is we are in a period of valuation reckoning in the general markets. Are you willing to allow your precious capital to wither away in a secular stock bear? The good news is investors have options to not only hedge against down-trending or sideways markets but to greatly profit. Commodities are hot and are still early on in their secular bull markets.

And though there will be flows and ebbs even in the up-trending commodities bulls, global fundamentals remain solid and commodities should continue to outperform the general markets. At Zeal we currently favor the precious-metals sector due to their stocks' inclination to follow gold regardless of the general stock markets. But we always keep our eyes open for all opportunities that may abound.

 


 

Scott Wright

Author: Scott Wright

Scott Wright
Zeal LLC.com

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