Posts Tagged ‘commodity super-cycle’

What the commodities super-cycle is and isn’t?

Wednesday, November 12th, 2008

There are many skeptics of the commodity super-cycle. They have seen the rise of commodity prices as a bubble and consequently, see many resource stocks as being extremely over valued. The recent reports by the media of “fears of a global slowdown” and a significant slowdown of China prompted the sell-off in commodities and thus, add fuel to the belief that the commodity bull market is over.

On the other hand, there are many ardent believers of the commodity super-cycle theory. They sees that China and India are going to de-couple itself from the Western world and power the global economy regardless of what happens to the United States. Consequently, they see that commodity prices are not in a bubble and there is more to go. As a result, they start to bid up resource stocks to a sky-high level.

For us, we believe there are some truths in both camps. Yet at the same time, both camps tend to exaggerate the truths in their beliefs, resulting in bad long-term investment decisions. Both camps fail to understand the big picture and let the short-term price movement cloud their judgement. Today, we will repeat this explanation, for the sake of our newer readers.

Let’s turn to our earlier article, Understanding secular vs cyclical,

One of the most important distinctions that investors have to understand is the difference between secular and cyclical trends. Confusion between the two can result in lost profits or worse still, losses. Before we can give examples of secular and cyclical trends, let us begin with definitions from the Encarta® World English Dictionary:

Secular – occurring only once in the course of an age or century; taking place over an extremely or indefinitely long period of time

Cycle – a sequence of events that is repeated again and again, especially a causal sequence; a period of time between repetitions of an event or phenomenon that occurs regularly

Now, let’s turn to Example of a secular trend- commodities and the upcoming rise of a potential superpower,

It has been said that today?s 21st century will see the secular rise of China. During the 20th century, China endured non-stop revolutions, civil wars, invasions, social upheavals, ideological experiments (e.g. Cultural Revolution, Great Leap Forward). It was the last couple of decades of the 20th century that China began to slowly emerge from her self-imposed shackles to catch up with the West. Napoleon once said that China is a sleeping giant that will shake the world when awaken. Today, despite the breakneck growth of the Chinese economy, China still have a lot of catching up to do in order to attain the same level of affluence, standard of living as the West- there are still hundreds of millions of peasants in China that is still relatively poor by Western standards.

To be a successful long-term investor, you have to appreciate the magnitude of the length and scale of this long-term secular trend. To help you do so, consider these real-life scenarios:

  1. Sydney is considering building a desalination plant that is projected to be completed in 2009. This project began as an investigation in 2004.
  2. A proposed brand new railway line from Rouse Hill in Sydney to the city may take up to 2015-2017 to complete.

So, you can see that major large-scale capital infrastructure projects can take several years to complete. In these examples, we are citing only a desalination plant and a railway line.

Now, take a look at China. They have plans to develop their nation towards the Western standard of living. They still have hundreds of millions of poor rural Chinese living in the countryside who have yet to taste the newly-found wealth of the coastal cities. Ditto for India. Combined, both of them have around 2.5 billion people. Can you imagine the colossal magnitude of the tasks ahead? If a Sydney desalination plant and railway line requires so much time, material and financial resource to complete, imagine how much more is needed to develop two nations with gigantic populations to a level that we, who live in the West, now enjoy? Whether they eventually succeed is irrelevant. The fact is, they are going to try, with major consequences to the rest of the world.

So, you should be able to see by now, the development of this secular trend will require decades and colossal amount of resources and commodities to come into fruition. This fact is the basis for the commodity super-cycle theory.

But life is not always so straightforward. As we said before in Will the China boom go in a straight line?,

However, the market always latches on to the generalities of a story and takes a simplistic projection of the story too far into the indefinite future. What do we mean by that? Put it simply, we do not believe that the rise of China will take on the path of a straight line.

As we said before, this trend will take decades to come into fruition. Within the decades, there will be business cycles, setbacks, problems and so on. As we wrote in that article,

Any time when the path does not look like a straight line upwards and take a temporary dive, the market will flip to the other extreme of this story and project extreme pessimism into the indefinite future.

Currently, with commodity prices taking a beating over the past couple of months, there are some who believe that the commodity bull market is over. Well, isn’t this taking a too short-sighted view?

Furthermore, let’s say China falls into a major economic correction in the near-term (see Can China really ?de-couple? from a US recession?)- we believe this is a real possibility. Does this mean that’s the end of the bull market for commodities (note: we are NOT talking about stocks here)? That is, will China’s long-term needs for resources and commodities going to decline from then on, forever and ever and return to the stone-age just because of a recession? We are sure there will be many experts pronouncing the end of the China growth story when such a day comes. To use an extreme example, it looked that way too for the US during the 1930s during the Great Depression. But history proved that’s not the end. In fact, the US went on to become a superpower in the 20th century. But on the other hand, if China falls into perpetual anarchy/revolution, then all bets are off and we will have to reconsider the commodity super-cycle theory.

The point we are trying to bring across is that this secular commodity trend is a very long-term trend that will take decades to unfold. Within this secular trend, there will be cycles of bad years. But do not mistake these cycles of bad years as a permanent decline that will stretch on forever and ever.

Understanding this big picture is one thing. Translating this understanding into a successful investment strategy that is suitable for you is another. In fact, it is tricky and many pitfalls and potholes lie on the road.

Firstly, since this is a multi-decade trend, some of us may not live that long enough to see it, let alone invest in it. For young working adults who have an expected lifespan of 50 or more years to go, it may be feasible to ride on this secular trend.

Secondly, for many of us, to take advantage of the commodity trend, the only available avenue of investment is through resource stocks. As we mentioned before in What is the meaning of ?oversold?? Part 2: Value perspective,

But having said that, remember that as we said before, all mines/oil/gas fields have a finite life. In the absence of potential new production from future exploration and mining development projects, a mining business will cease after a estimated number of years. The implication is that if the downturn is severe and long enough, some mining businesses may not last long enough to be able to realise the value of the long-term inflationary trend of commodities.

Thirdly, even though this secular trend have decades to run, you still have to decide (1) when is the right time to invest in it, (2) which commodity-related investment vehicles/stocks to put your wealth in and (3) at what price to pay for it. For example, if you enter during the cycles of bad years, you may end up with major disappointments in your investment results. As such, you will have to consult other research and professionals who will take your personal situation into consideration for advice as this is beyond the scope of this article.