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Discovery Investing: The Commodity Cycle

Michael Berry
0 Comments|October 23, 2006

Bear market for gold still to come, but base metals are simply taking a breather.



Bear market for gold still to come, but base metals are simply taking a breather.

You keep asking. I keep telling. We are not at the bottom yet on gold or the hard commodities for that matter. Gold sentiment has not yet turned bearish. It is that simple. You must sense total despair in any market before you can expect to see renewed and sustainable strength. Gold has been selling down, and making lower highs and lower lows. In June I said that we might see lower gold prices. Recently I suggested that gold might find support at $550 per ounce and then $480. This is a good-news, bad-news scenario. On the bad-news side, the psychology of speculative markets almost always overwhelms the fundamentals and can for a very long time.

The psychology of this equity market, in the run-up to the November elections, is sunny indeed. Oil prices are down significantly. The Saudis are, evidently, lining up with Washington. Gasoline prices have fallen dramatically: the surest route to the consumer's (and voter's) heart. The Fed is suggesting that inflation and economic expectations are "anchored" and growth, while slowing, is controllable. This means that the Fed might cut interest rates in the future. Low interest rates are good for the economy and rate cuts are even better.

Despite dire predictions of a hard landing in the housing industry, homebuilder share prices are not currently predicting that eventuality.

Most important was the reaction of gold to the assumed nuclear test of North Korea. There was no reaction! It was a "dead cat bounce." The US dollar has been stronger in the past few weeks. Lower oil and a stronger dollar are formidable barriers for gold's ascension. The markets are happily complacent. The Dow is at new highs and gold is not on the investment menu. Most gold stocks are trading at significant discounts to the fair value based upon the price of gold - according to a note from BMO Nesbit Monday morning. On the good-news side of the equation the fundamentals of the gold market seem to be very positive. This holds, according to Ted Butler, in both the gold and silver market. However the sentiment for gold is not yet negative in spite of quite a significant drubbing (20%) since May 12 when the metal crested at $721.

Those levels were clearly too high and reflected intense speculation.

We could see this environment for another six months to a year. Gary Shilling has often commented that markets can be obstreperous for longer than we have patience.

One might ask why we did not recommend put options in May at the peak. That is a very good question that hindsight allows us to ask. The answer goes to the oldest investment force in the world. God has wired our brains to buy at the top and sell at the bottom. Only a select very few individuals can reverse this primordial force.

So here we are five months to the day from Gold's top. What now? Clearly we are not at the bottom yet. Once the sentiment turns sour on gold we will have our powerful buy signal. In the meantime take a trip to Mars - and be sure to reduce your leverage. That might take another six to 12 months and a much lower price for gold. The golden tree is shaking and only the true believers will stay the course. That too is human nature.

What of base metals? All I have heard over the past few weeks is that the commodity cycle is finished. Not so fast. Alcoa Aluminum (NYSE: AA, BullBoards) may be a case in point. The company's shares have been trounced this year (-10%) but aluminum markets (like zinc, nickel and copper) are "tight." Alcoa is seeing 20% demand growth from China each year. It is also a strong cash generator as are most of the other legacy commodity companies. It is true that North American demand will be weak but China continues to more than fill that demand gap. Alcoa has been executing beautifully contrary to its share price decline. It has closed high-cost plants and opened plants in Iceland and Brazil. Alcoa missed its earnings and revenues this quarter, but I suspect that is due to the rising cost of Alumina. I do not see the demise of the commodity cycle at this time in stories such as Alcoa.

Yesterday zinc supplies were so tight that zinc prices hit a multi year high at $1.82 per pound. Copper continues to tread water. One must remember that one year ago copper traded for $1.50 and five years ago copper traded at $.68 per pound. Copper could trade to $2.00 or $1.50 per pound and still be in a major bull cycle. The reason, of course is that supply is severely limited. By 2007 / 2008 most of the cheap copper will be gone.

Keep your powder dry: the metals are simply taking a breather.

Michael Berry has been a portfolio manager for both Heartland Advisors and Kemper Scudder, where he successfully managed small and mid-cap value portfolios. He was a professor of investments at the Colgate Darden Graduate School of Business Administration at the University of Virginia and has also held the Wheat First Endowed Chair at James Madison University. Dr. Berry is now a proponent of what he calls "discovery investing."


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