Charting the Boom, Bust and Recovery of the Commodities Cycle

Investors can’t seem to figure it out. Is a lower oil price good for the economy, or is it bad for the economy?

It’s a no-brainer. Of course it’s good for the economy. No one wants to spend more for something if they can possibly get the same thing for less.

The awkward part is that the energy companies are such a big part of the stock indices. So when the Exxon Mobil [NYSE:XOM] share price falls, it tends to take the market down with it. For your information, Exxon has a market cap of US$387 billion.

You can see the drag effect of oil stocks on the US S&P 500 index below:

Source: Google Finance
Click to enlarge

The red line is the S&P 500, the blue line is the Exxon Mobil share price. You can see how the market struggles to hold up in the face of weaker oil stocks.

The closest analogy I can think of is a swimmer being dragged under by weights. The weights aren’t heavy enough to make them sink, but it requires more effort to stay above water.

But remarkably — for the US market anyway — the major indices are still near record highs. The US market soared to a record closing high last week.

And even after a rotten few days, the S&P 500 is still only 1% or so below that record closing high.

If only we could say the same thing about the Aussie market.

While others see destruction…

While the US market continues to clock up new record highs, the Australian market is stuck in a downward spiralling commodities death trap.

OK, that’s an exaggeration. Things are bad, but they’re not that bad.

It does go to show you that, for all the prosperity in Australia and the high standard of living, Australia remains a commodities economy.

Attempts to turn Sydney into the financial capital of south east Asia have failed miserably. As long as Sydney remains an eight or nine hour flight from Singapore and Hong Kong, it will never become a key financial hub.

Global financial jetsetters like to jetset, but even they balk at the idea of another long flight after a 13-hour flight from London.

So, a commodities economy it is, and a commodities economy it probably always will be.

If that’s the case, and if commodities prices are set to plunge further, doesn’t that mean the Aussie stock market faces years of falling prices?

It’s easy to think that. And I’m not about to tell you that the market won’t or can’t fall. But just as generally falling technology prices haven’t put Microsoft [NASDAQ:MSFT] or Apple [NASDAQ:AAPL] out of business, you shouldn’t expect the Aussie resources economy to collapse either.

Nor should you expect stocks to go into a terminal decline just because iron ore and crude oil falls in price by half.

The simple reality is that what you’re seeing now in the commodities markets is the natural follow on from a booming market. You’ve probably heard of the term. It’s a ‘bust’.

You know, like the subprime bust and the dot-com bust.

This is what happens. And it’s painful.

And even though the housing market and the internet may seem a world away from iron ore, copper and crude oil, the market fundamentals are the same.

A boom occurs when there is a change in the demand for a product or service. We don’t need to go one step back to examine the reason for the change. All we need to know is that something happens in the market to cause the change.

The demand for a product or service starts to explode. It’s a positive feedback loop. It gains momentum — again, the reasons don’t matter.

This filters throughout the market. Entrepreneurs and businessmen and women notice that something is happening. They see the demand. They see the money flowing into the tills (metaphorically speaking). So they decide they want a piece of the action.

They invest in creating similar products. They try to improve on each other…anything to get a competitive advantage. It becomes a trend or a fad…everyone wants one of these things. It becomes a talking point at parties and barbeques — ‘Do you have one?’, ‘Have you done it yet?’, ‘I can’t believe you’re not doing this.’

You know, the usual stuff that surrounds a hyped event.

But then, something changes. Again, it doesn’t matter what the change is, only that the market dynamics change.

The boom ends. There is over-capacity. Businesses that planned for continual 20% growth per year, now see that the market is only growing b 5% per year. All that stock in the warehouse, all that new machinery that will lay idle, the workforce that the business will need to cut by half.

This is the inevitable bust. It happens all the time. It’s not new.

It’s curtains for the entire industry, right?

Not so fast. In some cases that may be true. A boom can lead to a long term decline that eventually ends in collapse. Camera film, and a company like Eastman Kodak [OTCMKTS:EKDKQ] is a pretty good example.

But it’s not true for all companies or sectors that go through a boom. Microsoft and Apple both went through and survived the dot-com boom.

They were durable businesses.

Even the US homebuilders that soared during the subprime boom didn’t completely collapse. Yes, they’re still below their peaks, but they have mostly recovered from their lows.

I’m talking about companies like KB Home [NYSE:KBH], PulteGroup [NYSE:PHM], and Lennar Corporation [NYSE:LEN]:

Source: Google Finance
Click to enlarge

This is the boom and bust cycle in action. It can take a long time to play out.

Stocks like BHP Billiton [ASX:BHP] and Rio Tinto [ASX:RIO] are going through this now. Both stocks went through a tremendous boom during the early to mid 2000s. Since then, their share price action has largely mirrored that of the US homebuilders.

That’s not surprising. Both benefited from the same circumstances — cheap money. Americans could borrow cheaply to build big homes and consume lots of things. China benefited from this by selling lots of things to the US.

The cheap money that flowed into China created a demand for resources. China spent its wealth on building infrastructure and developing an affluent middle class.

China will continue to do this. But it won’t be at the double-digit growth rates of the past. China will still become the world’s biggest economy within the decade. But it will be at a growth rate of 5% or 6%.

But China will still need iron ore and crude oil. It’s not as though a cheap alternative to steel will appear tomorrow. And as nice as it would be for solar or wind power to take over from fossil fuels, it’s just not going to happen.

Not within the next 20 years anyway.

Is it the end for the commodities sector?

So, everyone hates commodities at the moment. That’s understandable. But is it the end for the commodities sector? No, of course not.

The market is doing right now what it does during every bust. It’s looking for equilibrium. Investors need to figure out what kind of revenues and profits they can expect from the likes of BHP and Rio.

They need to work out the new growth rates, the new margins, and which commodities will grow fastest in the years ahead, and which will grow slower.

Until that happens you’ll continue to see volatility. You may even see commodity stocks fall further until collectively and independently, investors figure things out.

But the idea that this is the end of the resources sector is just preposterous. The Aussie resources sector remains what it always has been — an excellent avenue for investors to bet on speculative growth.

Commodity prices may fall, but regardless, if you back the resource stock that discovers a new bumper resource, you can expect the company’s stock price to skyrocket.

It’s high risk, but while others see destruction among resources stocks, I see the opposite. I see opportunity. For a clue of how the future will shape up for resources (and it may seem an odd comparison), just look at the NASDAQ index.

That paints a perfect picture of the boom, bust and recovery cycle. Contrary to the mainstream view, now is the perfect time to speculate on Aussie resource stocks.



Editor’s Note: This article was originally published in yesterday’s Port Phillip Insider, the free daily eletter written by Publisher Kris Sayce to subscribers of Port Phillip Publishing’s premium investment advisories.

From the Port Phillip Publishing Library

Special Report: When Kris Sayce released the latest issue of his new investment letter, we all got a shock. In it he doesn’t recommend a high risk play. In fact, by his standards you might even say it’s ‘boring’. But according to Kris it’s ‘the single best stock on the Australian stock market…and it could pay out year after year after year.’

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