Struggling Stocks, Booming Commodities

NASDAQ dropped -12.5% year to date in 2005. S&P500 index
suffered -5.7% this year. US stock market has been terrible
over past few months.

Not only general market is down, oil stocks recently had a
significant correction as well. It is easy to be nervous
because of the short term setback. However, to succeed
with long term oriented value investing, we can not be distracted
by the volatile short term market movement. It is time to
step back and look at the big picture of the current stock
market and review investment strategy to profit in this kind
of tough environment.

Stocks in General and Oil Stocks

Below chart is past 1 year performance chart between Energy
Index ETF (ticker: XLE) and S&P500 index (ticker: SPY). By
looking at the chart, even a fool will know that oil market
is booming while US stock market in general is struggling.

Simply put, the current US stock market is not in bull
market. The heydays of 1980’s and 1990’s when anyone can
simply put some money in S&P500 index fund or a decent US
mutual fund to earn 10% to 20% plus annual performance is
long gone. I expect for the next 8 to 10 years, the US stock
market in general will be stagnant.

If you have believed that 20 years of stock market
performance between 1980 and 2000 is stock market average
performance, then you will be shocked to know that just
before that period in 1960’s and in 1970’s, US stock market
went nowhere. Dow hit 995.15 in 1966 and Dow was back to 800
in 1982. If you were the long term investor who invested in
Dow index fund between 1966 and 1982, you got a negative -20%
return overall for your 16 years of loyalty, how would you
feel about that ?

Still remember the NASDAQ peak of 5000? In my opinion,
NASDAQ is screwed up index with full of expensive stocks
even today. I predict that we may have to wait another
decade to revisit NASDAQ 5000.

Current Stock Market Average Valuation is Not Cheap

Currently SP&500 index trades at about 17x average PE today.
Although this valuation is not terribly expensive, it is not
that cheap either.

Over past 100 years of US stock market history, market
usually bottomed at average PE of 10. That happened in 1974
or 1929 or 1980. We are not there yet, not even close over
past 5 years even though the technology stock bubble bursted
in 2000. In a major stock market bottom, we should see
plenty of big cap stable companies trading at PE of low
teens. Now look at this: Coca-Cola (KO) PE 20, Walt Disney
(DIS) PE 24. Even worse, a no-growth stock like Sun
Microsystems (SUNW) is still trading at premium PE of 19.

What is the Overall Earning Outlook of US Stock Market?

Even though the current stock market valuation is not that
cheap, if earning is good, market should do fine.

Are we going to get excellent overall earning outlook in the
next few years for the US stock market in general?
Unfortunately, my answer is no. My take is that US stock
market earning overall is decent, but not good enough to
trigger a bull market. This market is still digesting the
past bubble over-valuation coupled with poor earning
outlook.

Here is one reason of my not-so-enthusiastic earning
outlook: the rising oil and commodity prices.

The Booming Commodity price

Commodity and oil market has been booming since 1999 and the
high commodity price is taking toll on overall stock market
earnings. Companies need to pay more for the things needed
in business: steel, copper, oil, natural gas etc.
Historically, when commodity market was shining, stock market
did not do very well, and vice versa. In 1960’s and 1970’s,
oil and commodity had bull market run for nearly 20 years
while Dow Jone index had horrible performance for nearly 20 years. From
1980 to 2000, the stock market soared while oil hit as low
as $15.

The Bull Oil and Commodity Cycle Could be Very Long

Jimmy Rogers is famous investor who co-founded Quantum Fund
together with George Soros. In his recent book titled “Hot
Commodities”, he is predicting that the current commodity
bull market can last until 2013 strictly due to supply and
demand.

In one chapter of the book titled “Goodbye, Cheap Oil”, he
clearly lays out the reasons why oil and natural gas bull
market can last until next decade. This is as simple as
supply and demand: rising demand coupled with declining
supply.

The supply of oil and natural gas was diminished partly due
to extremely low oil and gas price in 1990’s. Over past 35
years, there was no major oil discovery in the world while
the old oil fields deplete. Oil and natural gas production
level of a well does not stay flat over the life of a well
reserve. The production level of a well actually declines
gradually due to geophysics of oil well until the reserve is
fully depleted. Even there is new oil field discovered, it
will take a decade after the discovery to actually produce
oil! Increasing supply to meet demand is a very difficult
and slow process.

Coupled with declining supply, the demand of energy from
China doubled since 1990 consuming 8 percent of world’s oil
in 2004. US economy is growing with increasing oil demand
year over year while US oil production has seen sharp
decline over past 50 years.

Still the oil price is not that high on historical basis.
Even with today’s oil price of $50 a barrel, the oil price
is still significantly lower than the inflation adjusted
peak price of $90 a barrel in 1970’s.

Value Investors Do Not Need a Bull Market to Make Money

As scary as the potential trouble in stock market, this kind
of tough environment is great money-making time for value
investors to pick up cheap shares.

Warren Buffet is the greatest value investor in the world.
He averaged 20% annual investment performance over past 50
years. However, Mr. Buffet’s performance in bear market of
1960’s and 1970’s was actually 30% per year return, much
higher than his average performance.

Focus on Dirt Cheap Stocks and Booming Commodities Market

Stocks do not go straight up or go straight down. There will
be huge run up or sharp sell off in short term. While market
is not in good shape, this is and will be wonderful time for
long term oriented value investors.

Commodity price is volatile. Just like stock market,
commodity price does not go straight up or straight down.
Although oil price weakened recently, I firmly believe that
oil price is not going back to cheap oil price below $40 a
barrel. As long as oil and natural gas prices stay high, oil
stocks will do fine in its business. As painful as the
recent sharp sell off in energy stocks, energy stocks in
general are still very cheap and my investment strategy is
to continue to stay long term oriented in them.

In the short term, it is very hard to know when a stock will
go up or go down. But I do know that valuation and earning
matters and investing in cheap stocks trading significantly
below market average will be rewarding in the long run.

Leave A Reply

Your email address will not be published.