Yesterday the SP500 hit 870 twice: at 12:00 and again at 2:00 Eastern. It held both times and ended the day at 879. 870 – 875 had been the SP500 target for weeks as the bottom of a trading range. So, the fact that it held, not once, but twice, is very encouraging. This forms a technical formation called a double bottom, which only means that an important level was tested  by traders more than once. The market trading bears didn’t have enough selling power to push the index through that level for now. Any good earnings news like the better-than-expected Alcoa results yesterday will give the bulls more encouragement and may force out the bears at some point.

I noticed that all the cyclical / materials stocks were moving exactly with the SP500 all day Wednesday. This is an indication that materials and energy are a proxy for economic recovery. When the market feels the prospects for the economy become better, deep cyclicals and materials move higher. So FCX made a bottom at around $43.50 at both times and SU made a bottom at around $25.75. For both high beta stocks, they are off by more than 20% in the past two weeks, which means they are in their own mini-bear markets. (FCX is off over 30% from its June high).

So, is this a good time to buy? The long term thesis is inflation to correct the Federal deficits and pay for growth in money supply / weakened dollar. Commodities / materials are the best way to play that move.  But is now the time? 

I am waiting as there is a lot of downside momentum in oil and basic metals (copper).  Many traders (probably too many for a contrarian like me), feel that oil is headed to $50.  But industry experts tell us that any price below $70 today will shut down supply, leading to higher prices at some point as demand exceeds supply.  I have small positions in energy (SU, PWE an UNG) but am out of basic materials (I normally use FCX and BHP).  If the SP500 gets back above 900 with some conviction as shown by volume, I will consider adding to the above positions. I hope I can put money back in by next week.

As we begin to move towards economic recovery, it begs the question “what next?”  It is unlikely America will have a strong economy, as measured in 4+% GNP growth, for many years to come.  We have oceans of debt to pay off.  Even if the Feds are able to transfer the enormous debt hole from the private to the public sector to assist the economic recovery (and save the banking system), that debt still must be paid back in some form. 

There is a high liklihood that the public debt will be paid back through several different means: higher taxes, limited spending and most significantly dollar devaluation (aka inflation) over a long period of time.  Higher taxes and limited government spending will put a cap on American economic growth and will ensure a very slow economic recovery or even stagnation.  An extended period of 1-3% GNP  growth can be expected.  But with a weakening dollar, it is possible that rate of growth will not keep pace with inflation of 5-7%.  So, real GNP will be negative for several years undermining domestic investment returns.  All this is very remiscent of the late 1970s.

But there was a way to make decent, and maybe even excellent, real investment returns in the 1970s.  It was by investing away from America in hard or real assets like commodities and in the growth of non-dollar economies like Japan. 

In the 2000s, the new Japans are the BRIC nations: large, motivated and politically willing.  Today’s post is on investing in three of those four.  Brazil, India and especially China meet my requirements for foreign market investing.  But Russia, I do not trust.  Its political system has shown contempt for foreign investment.  It very much resembles the politics of the USSR, with a newly energized “politburo” that controls the economy and stifles free enterprise (though we here in America are catching up fast on this front).  So, I will focus my non-dollar investments in BIC, not BRIC. 

As of today, I am selling all of my long term international mutual fund investment in Fidelity Diversified International (FDIVX) and will gradually move those dollars in equal amounts to IFN (India Fund), EWZ (Brazil ETF) and FXI (China ETF).  I will dollar cost average in because all three markets / funds have just experienced a very strong surge from the bottom of the market crash and may correct. 

My goal will be to move my portfolio to 20% in non-dollar market investments.  Beyond the country ETFs, I also will buy strategic investments in Canada, Australia and non-China Asia.  I will have another 35% of my total portfolio invested in commodities and energy.  This position is already in place with most of the commodity portfolio in Canadian Royalty Trusts (Canroys).  I am also adding FXC and BHP to provide more industrial metals exposure along with additional precious metals exposure, adding to VGPMX and GGN by buying gold miners like AEM and AUY.   The balance of my portfolio will be in domestic stock and bond funds, especially high yield bonds which can keep up with the devaluing of inflation.  In this way, my portfolio will have less than 50% US dollar exposure to protect against inflation and a decade long weak economy.

Today’s Barrons runs a great story on this same subject. 

The [most important factor in the coming commodity boom is the] growth of the middle class in the rapidly developing economies; large-scale infrastructure investments in many developing nations; and the emergence in these regions of a huge new consumer cohort, which has developed out of the poverty of the past.  The size of this low-income cohort dwarfs anything the global marketplace has ever seen. Approximately one billion people, one- seventh of the world’s population, are moving out of poverty and entering the market as consumers. If these billion consumers were a nation, they would have the third-largest population in the world and the 10th-largest gross domestic product.

China lacks the raw materials it needs to manufacture steel. This has turned it into the world’s largest importer of iron ore. It has been accounting for 40% or more of the international iron-ore trade in recent years.  China’s need for steel will continue long into the future. Remember that the U.S. took 35 years to finish its Interstate highway system. It took 16 years for Japan to build its New Trunk Line railway. Even with China spending a reported 9% of its GDP on infrastructure, it will take decades to bring its roads, ports, airports, power-generation capacity and other infrastructure systems up to speed.

Read the entire story here:

Commodities’ Coming Rebound

Swiss investor, Marc Faber, still hates America, but he has a good track record for market prediction. So, I paid attention when I read this in Barrons today, in the Investor Roundtable Part 3:

Faber: When volatility diminishes (in the next few months), you want to be in cyclical industries. Among the most cyclical stocks are resource producers. They were driven up by incremental demand from China, and then collapsed. In the next six months they could have significant upside. I like Rio Tinto, BHP Billiton and CVRD [Companhia Vale do Rio Doce].

The financial crisis and collapse in commodities will keep supplies out of the market. Nobody is exploring now. There is no money, and projects are being postponed. Whenever the recovery comes, in five or 10 years, resources stocks will go ballistic from today’s low levels. If you’re optimistic about the next six months, too, when the news may be slightly better than today, you should own them. Freeport McMoRan Copper & Gold fell from 127 to 15 and is now 26. Xstrata, in Switzerland, is another one. A lot of these stocks are more attractive than gold, because gold is at a 20-year high relative to industrial commodities.

Scott Black: Rio Tinto’s balance sheet isn’t in good shape. They have a refinancing issue.

Faber: Worst-case, the Chinese government could buy them out. China has taken a big stake in the company. Meryl recommended Kaiser Aluminum [KALU] earlier today. I would add Alcoa.

Felix Zulauf: You’re not saying this is the beginning of a big bull market, but of a base-building process from low levels.

Faber: Correct, but when stocks decline by the magnitude seen in resources shares, or the Nasdaq after 2000, a base-building period follows that can extend for several years. When you print money, you can get an artificial bull market (in cyclical and resource stocks) that exceeds everyone’s expectations.

And this is a quote from Scott Black, another on the Barrons Roundtable of great investors (and a disciple of Benjamin Graham and value investing). He makes the case for XTO. But the arguments and metrics can be applied just as well to the Canroys (though it appears XTO did a much better job of hedging than PWE or PGH):

BLACK : My next pick is an old favorite, XTO Energy, in Fort Worth. The stock is 37.58, there are 577 million fully diluted shares, and the market cap is $21.6 billion. The company did a smart thing by hedging approximately 77% of its natural-gas production in 2009. They have locked in 1.6 Bcf [billion cubic feet] of gas at $8.94 per Mcf [thousand cubic feet], and 62,500 barrels a day at $118.85 per barrel. Production has been growing dramatically, and should average about 2.67 Bcf per day in 2009, up 18% year over year. About half the increase is from drill-bit growth, the rest from acquisitions. XTO bought Hunt Petroleum last year for $4.2 billion, figuring it could triple reserves, which are now 80% gas, 20% oil. It has 12 Tcfe [trillion cubic feet-equivalent] of gas and 500 million barrels of oil.

BARRONS: What are you pricing reserves at?

Black: I value the gas reserves at $3 per Mcf and the oil at $8 per barrel. Breakup value is about $44 a share, so the stock is selling at 85% of breakup value. My 2009 revenue estimate is $9.86 billion — slightly higher than the Street’s — which converts to $4.50 a share in earnings. Return on equity is 15.5%, return on total capital 10.3%. Free cash flow is $2.28 billion. XTO has cut its capital-spending budget this year, to $3.8 billion from more than $5.3 billion. They are wed to the notion of knocking $1 billion to $2 billion of debt off the balance sheet.

Their finding and development costs were $1.45 to $1.50 per Mcfe in 2007, and $1.65 in 2008. This year they could fall to $1.50. XTO is one of the few energy companies with rising earnings, because of hedging. They will earn about $3.75 to $3.80 a share for 2008, and $4.50 for ‘09. The stock sells for 8.3 times earnings and 3.6 times discretionary cash flow. It is extremely cheap. You’ve got asset and earnings protection. And they are in every major field in the U.S. — the Barnett Shale, Fayetteville and so forth. Energy is a controversial investment today, but XTO is the cream of the crop.

Schafer: If they hedged this year, does that mean next year’s earnings will be down?

Black: No, because they hedged 2010, too.

Fadel Gheit has a very good record of predicting the direction and level of oil prices, similar to Boone Pickens in accuracy. He is pointing to higher prices for oil in 2009 and thinks the sell-off is overdone. All this has good implications for the CanRoys. They are very much oversold right now. Pennwest, as an example, can be profitable and cash flow positive at $40 oil. Its costs will come down in 2009 as demand for oil services drops hard. Its fixed cost overhead is not very high (for administration only) and its debt load is reasonable with maturities out several years (much better than American companies like Chesapeake which is in real trouble after taking on too much debt).

The past couple years, it has become popular among the CanRoys to minimize the monthly distribution and instead direct a lot of cash flow to capital improvements and acquisitions. PWE and Daylight have been down around 50% of cash flow directed to distributions. The historical average is closer to 80%. PWE has announced it is drastically cutting back on capital projects in 2009 and selling some properties, so it can preserve cash flow to maintain distributions at the lower oil prices. This is more the historical model.

The lower oil prices should also discourage the Canadian national government from going through with taxing profits on royalty trusts. Oil is not the big treasure chest it was perceived to be by some in Parliament. We may see the Liberal party take control of Parliament soon and then change the terms of the taxation program, either lowering to 10% or maybe eliminating the Harper – Faherty program altogether.

It seems very possible by the end of 2009 the Canroys can recoup the cash flow they had in 2006 and rebound to the prices they were trading at when oil was at $60/barrel in late 2006 (after the Halloween Massacre), when stock price was around $30 for Pennwest (PWE), for example, and $17 for Pengrowth. Also, most of the Canroys are highly hedged for 2009, which will aid cash flow. Pengrowth (PGH) has an 50% of its oil sold forward at $80 for 2009 and 50% of its gas production at $10. The other Canroys have similar hedging programs in place which will stabilize dividends. The market has not factored this in by driving prices down 70% and yields up by 300%.

Here is what Fadel has to say:

MONDAY, DECEMBER 29, 2008
ELECTRONIC Q&A;

How to Profit on Oil’s Comeback
By NAUREEN S. MALIK

Oppenheimer’s Fadel Gheit is big on independent energy producers.

OIL AND BASEBALL — NAMELY the Yankees — are two passions that are remarkably similar for Fadel Gheit.

While he makes his living off the first and is an avid fan of the second, the managing director of energy at Oppenheimer says both markets are subject to the “bubble.” Crude-oil prices have collapsed and salaries by baseball’s A-listers could be next?

“Unfortunately the sports bubble hasn’t burst yet, and it will, mark my words it will,” says Gheit, who thinks Alex Rodriguez should be making $3 million, not $50 million, for a job some people would take for free hot dogs.

Manager’s Bio
Name: Fadel Gheit
Title: Managing director and senior analyst covering the oil and gas sector, Oppenheimer & Co.

Hobbies: Watching sports, mainly the Yankees, but also watches the Mets, Giants and Jets.As for oil, Gheit, who was a skeptic as oil breached $100 a barrel earlier this year, has turned positive while others are decidedly negative about energy at the moment. Oil prices rallied to $145.29 in early July before recently falling to the low $30-range.

Gheit, an Egyptian with chemical-engineering training, joined Mobil Oil in 1980 as oil prices touched record highs due to escalated tensions in the Middle East. He traipsed around the Arabian dessert examining oil production before jumping to Wall Street.

Gheit has seen crude oil go up because of war, revolution, and other major global events. Oil supplies in particular have been impacted, but this downturn “has to be one of the worst” because it is a global economic issue.

Oil “is not a free market,” says Gheit pointing to Wall Street speculation. He has repeatedly testified in front of Congress, urging the government to create an energy plan and a better regulatory framework to oversee the market.

While that regulatory framework will take time, Gheit sees plenty of reasons to bulk up on energy stocks now.

Barron’s Online: Do you think oil is sustainable at these levels?

Fadel Gheit: No, I never thought that oil prices are sustainable above $100. I never thought they were sustainable at $30 either. The global economy will recover, whether in a year or two or three. Two years of higher prices usually bring additional investment and will expand supply and curtail demand and consumption as companies and consumers try to become more energy efficient. The flip side of the coin is the exact opposite. When you have extremely low prices, that will dry up investment and it will take years for the industry to go back on track. That’s why you create feast or famine because of the lack of coordination between producers and consumers, the lack of transparency in the financial market [and] basically the lack of government supervision either because of indifference or corruption.

Q: What could per-barrel oil prices go and what is a suitable level?

A: I think oil prices over $60; $65 would be pushing it. We don’t need it.

Q: Do you think OPEC is going to cut production even more?

A: Absolutely, OPEC will cut production and we will feel the impact within six weeks of production cut. These people cannot balance their budget at $50 per barrel and so they are hurting pretty badly. One of the reasons I don’t want to see $30 per barrel is because I really do not want to see major disruption, regimes could be thrown out.

Q: What does this mean for profits and the marginal cost of production?

A: To operate, the cost [for oil producers] has increased by almost 16%-20% annually over the last five years. It was one of the sharpest inflationary periods in recent history and the reason is that everybody, because of the increasing oil prices, was chasing limited capacity of services, so oil-service companies were basically gouging the industry. We are hoping that the costs are going to go down, but we are talking about 10%, 15%, 20%, not 40%, 50% or 60%. We are also going to see more technology advancement because people will pay more attention to efficiency and cost efficiency.

Unless oil prices recover sharply next year, or we believe that oil prices will average $40 next year, it means that there will be about a 40%-50% drop in earnings and cash flow. Most companies will limit their capital spending to availability of funds , which may be coming from cash flow, so that means that capital spending will be down by as much as 40% [in 2009]. Longer-term projects do not get derailed once they start because any delay becomes counter productive. But new projects will be delayed.

Q: You have been touting large integrated-oil companies such as Exxon Mobil (ticker: XOM) throughout the year. Are they still a good bet?

A: Integrated oil is very simple. We believe that the dividends are safe. Companies like Shell (RDS-b) and BP (BP) offer 6%-plus dividend yield. Both stocks are down significantly this year. Shell in its history only suspended its dividend once during the Second World War. Now if you don’t trust the market, but believe oil prices will not go above $40-$45, then you should own Exxon.

A company like Exxon has been underinvested for five years, not because they are stupid because they were smart. They didn’t chase barrels for exorbitant price and cost. They have $
40 billion cash. They can buy any independent-oil company and pay them a 30% premium without going to the bank. They can buy Apache (APA), Chesapeake Energy (CHK), Devon Energy (DVN), EOG Resources (EOG), Noble (NE). The market value of Exxon treasury stock is $205 billion. That is higher than the market value of BP, Chevron (CVX), Royal Dutch Shell (RDSA) and Conoco Phillips (COP).

Q: What about natural gas?

A: The rule of thumb is natural-gas is traded at one-tenth-to-one-eighth the price of oil. Gas is stuck in a way, because what determines where gas prices go include winter demand. The other thing is most natural-gas producers in the U.S. cannot maintain production if gas prices go below $6 per cubic feet.

Q: What are your top oil and natural-gas stock picks?

A: Right now I think the upside potential will be the independent producers. They have much higher beta. They gain the most when oil prices rise and they lose the most when oil prices go down. I think we are at or close to the bottom of commodity prices. When prices move higher, Exxon doesn’t gain as much as Anadarko Petroleum (APC) or Apache or EOG or Devon.

These stocks will do much better than the S&P; 500, but more importantly, we think they [will meet] the threshold of 20% returns in 12 months for an Outperform [rating]. Most of them are onshore natural-gas plays in the U.S. The exception is that Apache has 45% of its operations outside the U.S. But believe it or not, these stocks respond to oil prices.

The best asset play is Devon. Occidental Petroleum (OXY) and Devon have the strongest balance sheets. The companies most undervalued in the group, I would say are Anadarko and Pioneer Natural Resources (PXD). Chesapeake’s debt level is double the size of the company. Anadarko has $10 billion debt, which they are trying to bring down as fast as they can.

Q: Refiners have been beaten badly throughout the year. Why are you now positive on names like Sunoco (SUN) and Valero Energy (VLO)?

A: The biggest upside potential is going to be in the refiners over the next two years. These stocks are down so far this year about 65%. I put a Sell rating on the refining stocks in January and they went down 75%. A few weeks ago we raised our rating on them to Outperform. The stocks so far are up about 20%.

Q: Thank you.