When it comes to commodities, it's not a question of if, but when? The prices of metals, oil, gas, grain and so on have plunged since the U.S. recession started. But the longer they stay low, the more violently they'll rebound when the economy turns. Why? Because low prices beget higher prices.
When commodities are cheap, there's little incentive to throw money at finding new reserves or boosting output from existing sources. But some demand for commodities persists, meaning we chew through current inventory and production. When demand rebounds, we'll likely be in a squeeze, with no way to boost supply fast. The next great bull market in commodities will be here.
That could happen sooner than you think. Sure, the economic headlines are grim. But there are early signs of a turn in fortunes.
Let's start with the obvious: massive stimulus spending. The U.S. stimulus package passed in February is worth $787 billion (all currency in U.S. dollars). It calls for $48 billion in transportation infrastructure spending. China is pledging much of its $586-billion package for infrastructure.
Infrastructure spending will create demand for commodities like copper, steel and zinc. It may not offset the recession-related drop in demand, but that slump is already factored into current prices.
Plus, there are the direct bailouts of automakers and other companies. Central banks in major nations are also keeping interest rates low to fend off deflation. They're essentially printing money.
An abundance of money usually leads to inflation further down the road, and there are few better inflation hedges than commodities. Some investors are already betting on rising prices. U.S. Treasury Inflation-Protected Securities (TIPS) pay interest rates that, in effect, adjust to inflation. In February, the market price of five-year TIPS pointed to a 0.5% annualized drop in consumer prices. By early April, it was factoring in a 1.35% increase.
That's not a big jump, but the point isn't the magnitude, it's the direction. The S&P/TSX materials index also surged in March. Small changes in commodity prices can mean big changes in commodity producers' share prices.
This isn't just wishful thinking based on rosy predictions. Recent prices for copper were 44% higher than their December lows. Zinc was up 24%. Oil has also recovered. China's imports of refined copper doubled in February, year over year. In April, Korea Electric Power Corp. bought a 20% stake in Canadian uranium producer Denison Mines.
If you don't like the risk of investing in one company, consider mutual funds or exchange-traded funds tied to the S&P/TSX composite index. Like Canada's entire economy, it's sensitive to commodity prices. For more concentrated bets, Horizons BetaPro offers exchange-traded notes (ETNs) based on individual commodities like gold. Be careful, though, because many of the notes are leveraged. Other ETNs, such as Elements notes linked to the Rogers International commodity index, are based on commodities futures contracts.
Yes, a turnaround could take time. But if commodity price trends continue, you'll be rewarded for betting on big, solid producers.
Tip Sheet
Value
Harry Winston Diamond Corp.,
Price-earnings ratio, trailing 12 months; 3.8 Diamonds may be a girl's best friend, but they're of the fair-weather variety. When men are flush, diamond prices sparkle. When money's tight, they get cloudy. But Harry Winston, mine operator and retailer to the stars, just got a $150-million (all currency in U.S. dollars) injection from Kinross Gold Corp. That gives Harry a shot in the arm, and at about $5 a share lately, it looks like a bargoon. Keep in mind that in its last fiscal year, Harry Winston earned $1.15 per share. That's a sparkling valuation.
Growth Paladin Labs Inc. Annualized growth in revenue since 2000; 27% Paladin is the company the bear market forgot. Its share price has climbed almost 50% over the past year. Managers and directors also appear to be confident that the firm's pipeline of drugs is solid, because the company recently filed to buy back 10% of its shares. The board doesn't think the recent market share price of about $15 (Canadian) reflects the value of the franchise. At less than 14 times forecast earnings for this year, and judging from the recent surge, the investment prescription looks right.