Click here to read part one of Have the markets bottomed?

The energy sector, along with the oil price, has undergone a meaningful correction. It is our view that oil prices will make a final low sometime within the next six months. It will be at this point that we envisage buying opportunities to once again emerge in the sector.

The recent result from BHP Billiton (NYSE: BHP, Stock Forum), which we cover in Monday’s report, reaffirms our belief in the stronger for longer commodity cycle. Despite the cloud of uncertainty over the ability of China’s economic growth momentum to maintain upward pressure on commodity prices, we put more weight on the comments of Marius Kloppers, BHP’s CEO. Kloppers made two key points after announcing the company’s profit result this week.

Firstly, he highlighted the fact that in the event that China’s underlying growth slows to around 8% (which is probable in our view), significant future demand remains in place for natural resources to continue the rollout of key infrastructure. He highlighted that the Chinese economy is much larger today than five years ago. For this reason, China’s (and India’s) demand in volume for natural resources has risen significantly.

Below is a chart showing the strength of this past growth in China and India. Clearly, at these levels a modest slowdown in the future would still result in robust growth for the raw materials fuelling the economies.

As we have highlighted on so many occasions, China’s economic growth is not totally dependent on exports. A large part of its economic growth is now oriented towards internal development and rolling out of infrastructure, and domestic consumption. With $1.5 trillion in reserves, nothing will deter China’s centrally planned leadership from altering course, and more importantly, they now have the cash to pay for the next 20 years of infrastructure development.

We don’t see China backing away from the path that they are currently on, and for this reason we continue to believe that commodity prices (and commodity-related stocks) will do well relative to the market over the medium term, despite the recent correction. BHP management share the view that China’s internal development of its economy will mean that demand for commodities remains high for many more years yet.

Below is the now-familiar CRB Commodity Index. After finding support in the region of the March lows, the index has staged a solid rebound this week.

In the weeks ahead, we will be looking for a break above the 423 region to signal a revival of upward momentum. Such a move would return focus to the all-time high of July at 474 and an eventual continuation of the long-term upward trend. If we are right about the demand coming from China, then this all-time high is living on borrowed time.

The other key point highlighted by Mr. Kloppers is that ongoing supply of commodities remains an issue. While BHP itself is managing to ramp up its production response within the resources sector, other industry participants as a whole are struggling to generate a meaningful supply response to higher prices. BHP believes that the commodity supply response over the next five years is currently being overestimated and that it is the supply part of the equation that all the forecasters are getting wrong.

BHP believes the credit crisis is having a negative impact on smaller resource stocks that are unable to source capital for new projects. This is another factor that will restrict future supply. Although time will tell, we are firmly in BHP’s camp on this point and believe that the current negative sentiment surrounding demand for commodities is way overdone.

In summary, we acknowledge that market conditions for investors globally are extremely challenging. The ongoing volatility in 2008 has put every investor to the test. We believe that while the bear has not yet released its grip on the markets, an end is now in sight and that we have witnessed the worst that markets have to offer. Having said that, we recommend caution be exercised and we could potentially see further deterioration in key equity market indices over the near term in light of the latest money-supply deflation.

We continue to back our key macroeconomic themes and remain overweight in key sectors discussed above. But be prepared for further volatility; we could easily encounter a very choppy period over the next six to eight weeks as stock markets grapple with the latest concerns with respect to the U.S. banking sector, fears of a global slowdown, a rising U.S. dollar, and a fall in the M3 money supply.

Lastly, this time will pass for the stock market. It always does, in our experience, even in 1929 where the structure of the world economy, and more importantly, the monetary policies of the central banks were very different.

In terms of the outlook for the stock market, the technical picture shows a rebound from the July low of 10,827 which is encouraging, but we continue to recommend that gains be viewed with caution while the price remains below the 12,000 region.

While below here, we cannot rule out the risk of a slip below 11,125 to retest 10,827. Considerable support lies below here in the region of 10,700. This includes the 50% retracement of the 2002 to 2007 rally, at 10,697. However, if the fall gathers momentum, probes below 10,000 are not out of the question.

On the topside, a sustained break above 12,000 will ameliorate near-term downside risks, although considerable resistance exists between here and 12,750.

In time, after a period of consolidation in the 12,000 to 12,750 zone, we believe that there is potential for a revival of the longer-term upward trend.

Such optimism though is likely to be a few months away yet. Until then, we encourage members to keep the faith.

Whilst many sectors of the market are likely to remain challenged (i.e., the banks, retailers, property companies), we see increasing out-performance in many of the defensives. As mentioned in Monday’s buy recommendation of Glaxo (NYSE: GSK, Stock Forum), we are already seeing this in the pharma sector. We expect growing risk aversion to increase the out-performance of other defensives such as health care, telcos, and tobacco. The mining sector is also traditionally very defensive, and with China set to purr along well after the medal table is finalized, we have every expectation of an ongoing re-rating here.

(We encourage members to check out Monday’s blog for further commentary on the outlook for commodities and the Asian giants whom we believe will continue to propel the boom.)

On a final note we are also encouraged that it is now dawning on the world’s central bankers that deflation, not inflation, is the enemy. Gold, the immovable store of wealth, is the best barometer to inform us of who is winning the battle. Deflation has the upper hand right now, but we think inflation will win out, and gold will move considerably higher in the years to come.

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