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Commodity Bull Run Not Over


Ethanol may have been myth, but sector is real.

"This is when they return to their rightful owners," an ace in this business told me once when I was cutting my teeth trading my first few odd lots. I cannot help but think about him as I connect a few dots on charts and overlay them against rather unchanged supply versus demand data underneath on many commodities markets and related equities.

The noise all around an underlying shift often turns out to be just that. Now that commodities are no longer the subject of cable TV specials and have lost some eye-room for their quotes in blinking boxes -- appropriately called "the bugs"-- perhaps a secular story can quietly trump noisy sound-bites once again.

A few other things have disappeared as it turns out. According to one of my commodity research firms, at least 16 ethanol plants were in the process of bankruptcy this month. One of them, Alternative Energy Sources, could not raise money for an ethanol plant in Iowa. Even more telling, it had to shut down operations of its consulting business that apparently ran out of projects to help management of other ethanol producers. The entire firm shut down.

Thankfully I will not have to pay on this bet I offered two years ago on Minyanville: "I'll wear a Cornhusker hat to a Longhorn rally if we look back 3-5 years and say ethanol was a tremendous investment opportunity." It was as polite an answer as I could give to a question I had received about Pacific Ethanol (PEIX) which was trading around $20 at the time. Now it's on the non-green side of $2 a share.

Through it all, I was a secular bull on grains' demand outstripping supply. I began buying before the ethanol myth was a factor, and will be after it has finished bankrupting late arriving longs. Below is the December '08 corn contract. The circle at the top of this graph coincided with news of this shut down.

Click to enlarge

Corn is one of 19 contracts that make up the DJ-AIG Commodity Index. I wanted to answer a few questions about what makes up that index at present time.

The violent retreat over the past month of many of these components has sent the index to an interesting spot. As I Buzzed about earlier this week, if I'm right about a multi-year secular uptrend driven by fundamentals, you don't get too many technical setups of this kind along the way. And when, not if, I'm wrong with trades I choose to be taken out with tight stops while maintaining a basket of core longs. My trading diary is quite clear about the fact that the key to a secular shift is surviving to see it happen. So I trade all the technical indicators away in a heartbeat for one set of strict sell disciplines based solely on my P&L, instead.

Click to enlarge

There's nothing magical about a 200-day moving average for the DJ-AIG as shown above. There are plenty of reasons it could be sliced right through. But I'd suggest plenty more reasons and bids rest below if this cycle resembles even an average one. My firm has studied 248 years of commodity prices. The CRB Index has doubled since 2001 in what we count as the seventh bull market since 1760. We use the CRB for this study because it has a very long history. The DJ-AIG doesn't but is now more efficiently weighted in my view. After the recent plunge, it's now all the way down to being only up 10% year-to-date.

The correct assumption is that commodities have run hard in those seven years. But as I shared earlier this year (and we're right back at those levels), the correct context into which it rarely gets held up against might be more helpful to share. If this bull is broken it would be breaking all-time history for the shortest run on record. We would be only half-way home in terms of average price rallies in the six prior bulls and one-third of the way done in how long they lasted. Oh, and in none of those did I find a billion or two new capitalists to feed either.

Stripping out all opinions and projections and simply looking at what has happened over 248 years of price data, you would see that none of those prior six bulls stopped at a double. Not one stopped at a triple either. As for where we are now in 2008, if you add all six prior CRB bulls together you actually get +2008% on the nose, and that's an average of more than 334% per bull, which lasted an average of 21 years. Kinda puts this recent "huge double" over seven years in context huh?

There's an ETN from Barclays that tracks the DJ-AIG Commodity Index (DJP). In addition there is the DJ-AIG Agricultural (JJA) and the DJ-AIG Grains (JJG).

Within the equities market, many related stocks live in the Materials sector which have different sets of problems and potential, but will participate in my view. Investors tracking the S&P 500 and mutual funds doing much of the same do not agree. There's only $4 out of every $100 indexed to the S&P 500 in Materials stocks. How much can that change? Energy recently started a run from $6 before more than doubling its weighting. Wall Street analysts are also rather uninterested. The median Materials stock has an average of 11 analysts covering it. By comparison Microsoft (MSFT) and Intel (INTC) still have triple that amount, covering a move that happened last decade.

There's no shortage of potential replacement candidates among the current index constituents. There are 29 single digit midgets in the S&P 500, with share prices below $10, a group that has cost shareholders an average decline of (60%) in the past 12 months alone. Another 12 members have negative earnings, for an average of a whopping (-$8.70) lost for each share among that dirty dozen over the past four quarters. So there are at least 41 stocks uncomfortable with their coveted roster spot.

The Materials (XLB) have provided the largest EPS surprises so far this quarter (+7.9% above consensus on average) of any sector and it's not even close. What would not be a surprise at all to me would be if the sector's tiny 4% weighting continues to grow organically but now also with some acquisitions by the committee at Standard & Poors which may increase the number of holdings. Six natural candidates would be the largest Materials stocks in the S&P MidCap 400: Cleveland-Cliffs (CLF), CF Industries (CF), Steel Dynamics (STLD), FMC (FMC), Terra Industries (TRA) and Airgas (ARG). Those six, on average, have grown their earnings +87% over the past four quarters compared to the decline of -9% in earnings for the index.

Looking for the largest U.S. based Materials companies that are not members of either index would lead you to: Mosaic (MOS) $54 billion, Owens Illinois (OI) $7.8 billion, and Celanese (CE) $5.7 billion. But that's only if the committee would be comfortable mixing an average of +236% earnings growth over the past four quarters.
No positions in stocks mentioned.
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