Commodity Prices & Share Prices Diverge

By Kurt Kasun | April 10, 2008 | 9:51 AM | 0 Comments

In two of my recent commentaries, "Commodity Boom? You Ain't Seen Nothing Yet?" and "Fishing in the Commodity Pond" I attempt to make the case for a commodity rally resumption and rapid rocket-like rise. As of this Wednesday's close, commodities are thumping world stock markets once again. This might be the resumption of the rally on to new highs or simply a bounce from the lows and the forming of a healthy consolidation pattern. Given the fact that oil hit a new high yesterday, I am betting on the former. If my view on commodities is correct, then expect to see more action like yesterday when commodities soared almost across-the-board and the broader US stock indexes sold off:

 

The focus of this commentary is on the trend which has been developing over the last six to twelve months, depending on the commodity. While commodity prices themselves are seeing tremendous gains, we are starting to see the companies which mine, produce, drill for, or grow the commodities lag. Yesterday's trading activity decidedly illustrates this point. Look at the charts (from yesterday) below for select commodity groups:

 

 

In each of the charts above the ETN/ETF for the underlying commodity(s) is presented first followed by the sector ETF which represents the companies which either provide the equipment or products for the commodity or produce the commodity. Then I have provided select names of the types of companies you are likely to find in the company ETF.
My first observation is that while all four commodity categories had huge up days--ranging from 2.5% in grains and in precious metals, to an over 3% rise for base metals (composite of copper, zinc, aluminum, and nickel), and to almost 4% gains for natural gas--the stocks of companies in these commodities significantly underperformed with two groups,base metal miners and agriculturally-focused companies, actually experienced negative gains. The Amex Natural Gas Index barely eked out a 0.17% gain on a day when natural gas exploded almost 4% higher. Though gold and silver prices were up roughly 2.5%, the Gold Miners ETF GDX was up only 1.90%.

While yesterday's price dichotomy was stark, this trend has been emerging for over a year and it raises several questions: Could this phenomenon be a harbinger of a new trend and if so, what might explain it and how should you adjust your portfolio?

I think we need more time before we make any conclusions. I am not yet ready to ditch my mining, equipment, and agriculture companies and go full bore into the commodities themselves. I am, however, sufficiently motivated at this point to consider the possibility that this might one day be the right move. Each of the four commodity groups exhibits and trades on different characteristics which need to be factored in accordingly. Some factors which may be negatively affecting all groups, however, could be input costs such as the higher price of oil, the price of labor and a diminishing qualified labor pool, and, most importantly, new sources of supply becoming harder to find or grow.

Examples of CEOs and other company spokesmen voicing such concerns are becoming more frequent. During the first few years of the commodity boom, you would see companies' leverage result in gains in share price that far surpassed the gain in the price of the underlying commodity. In gold for example, we would consistently see a 3% gain in the gold miners index for every 1% gain in the price of gold. Over the last year, however, the price of gold is up almost 50% while the gold indexes (HUI and XAU) have only risen around 40%. Not only have gold and silver mining company share prices not kept up, it is registering less of a gain. If this continues to be the case, you would be a fool to invest in the gold and silver mining companies because of all the operational, political, and environmental risks associated with owning them. For all of the risks, I believe that we need to be paid at least a "2X" premium versus the gains in the price of silver and gold in order to justify continuing to own them. Perhaps the mining companies' share prices got ahead of themselves and the prices of gold and silver have merely caught up. If this is the case, then we should see significant outperformance of the mining companies in short order. We will see.

As I mentioned earlier, the commodity groups all have different characteristics and need to be evaluated on their own specific factors. At this point we need to carefully monitor this developing trend and be open to the possibility that it might be necessary to at least overweight positions in the underlying commodity relative to positions in the commodity companies themselves.