Wednesday, September 26, 2012

"Sometimes buying early on the way down looks like being wrong, but it isn't." --Seth Klarman

THE RALLY FOR COMMODITY SHARES IS FAR FROM OVER (September 26, 2012): Based upon the mainstream financial media and from the flood of emails from subscribers who want to sell their commodity shares and related cyclical assets as soon as possible, it's clear that there is far too much bearishness toward risk assets. Almost everyone is convinced that since the stock market's post-QE3 announcement rally lasted less than 24 hours, it must be hopeless for stocks and commodities going forward. During the past several trading days, investors have once again been eagerly buying U.S. Treasuries. They have been selling the euro, the currencies of commodity countries, and especially cyclical shares. Even though prices are higher now than they were from May through early September, most investors have demonstrated a similar level of fear and want to reduce risk.

The irony is that the only assets which most investors are retaining are defensive shares, bonds, and precisely those assets which have mostly begun multi-year bear markets. They are selling commodity shares and other cyclicals which are the most likely to soon surpass their respective peaks from September 14, 2012 to challenge their levels from February-March 2012. The least popular subsectors, such as coal mining shares (KOL), rare-earth extraction (REMX), and steel manufacturing (SLX), will likely enjoy the greatest percentage gains; I purchased more of all of the above in early September and would consider buying more into additional weakness. Unlike the shares of many defensive equities which doubled from their lows of July 2009, most commodity shares during the past several months retested three-year bottoms and are thus fundamentally undervalued. Probably even more importantly, as underperforming hedge-fund managers and momentum players desperately seek out assets which are likely to gain significantly in percentage terms, they will eventually realize that their best hope lies in assets which can rally another 30% or 40% and still remain below their 52-week highs.

Here's a question which has bedeviled many analysts: why have stocks and especially cyclical equities retreated during the past several trading days? If you go to any of the web sites which track the likelihood of President Obama succeeding with his re-election bid, you will discover that the chance of an Obama victory has soared during the past four months from 55% to 80%, with much of that increase occurring during the past 1-1/2 weeks. While some of this is due to the stock-market recovery, much of it can be attributed to the recent "47%" video incident combined with the poor campaign which Mitt Romney and his team have waged. Regardless of the reasons, the financial markets are already almost fully pricing in the certainty of another four years with a Democratic U.S. President--along with a likely continuation of a Republican majority in the House of Representatives and a narrow Democratic margin in the Senate.

Thus, when nearly all other financial analysts are obsessed with which investments will perform best if either Obama or Romney wins, it is more important to ask how the financial markets will behave in anticipation of a continuation of the status quo. Gridlock has its disadvantages, but it does tend to lead to less wasteful spending overall as very little legislation is enacted. There will have to be some form of federal tax compromise to avoid the fiscal cliff, but this probably won't be worked out until the first quarter of 2013. Some investors have fresh memories of the dramatic stock-market slump during November 2 through November 20, 2008, and are incorrectly expecting a repeat--just as most investors foolishly expected 2012 to be similar to 2011, and therefore weren't sufficiently invested in the stock market near its lowest levels of the past several months when they should have been aggressively buying the most undervalued and oversold equities including the shares of commodity producers.

Many cyclical equities are still trading below their respective 200-day moving averages, and in many cases have retreated all the way back to their 50-day moving averages. Sentiment remains firmly negative toward energy, mining, and agricultural shares. Therefore, we are almost certain to enjoy significantly higher prices for the shares of commodity producers and other cyclical equities during the next several months.

Disclosure: From May through early September I had progressively accumulated substantial long positions in funds of commodity producers near their lows. My largest positions are GDXJ, VFWPX, KOL, XME, EWZ, REMX, SLX, RERGX, RSX, VGPMX, TNRPX, TRIEX, FCG, TAN, GDX, and NLR, in that order, with by far my greatest concentration in GDXJ.