While No One Cares About Inflation, Commodity-Related Stocks Rise Anyway

By Dr. Duru written for One-Twenty

February 22, 2007


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On February 12, Tenaris (TS) announced it will acquire Hydril, a Texas-based oil and services company. The related indices, XLE, USO, and OIH, all went down on the day. However, Lone Star Technologies (LSS) went up over 4%. Astute investors probably remembered that TS is the same company that last year acquired one of LSS's direct competitors, Maverick Tube, for a significant premium. This latest news reminded the market about the potential untapped value in LSS. I have written a lot about LSS as I have identified it as an under-valued, oil-related steel stock. I recently decided to stop trading around my position as the stock bounces up and down in a two-year and running trading range, and instead plant my foot down on a growing position. True to form, the stock pulled back and gave back those one-day gains over three days before resuming the recent up-trend. See chart below:

LSS


I hold on to LSS because the stock undervalues the potential in LSS's business. Moreover, the persistent merger and acquisition (M&A) activities in the steel sector and the oil patch seem bound to sweep up a company like LSS at some point. In the meantime, LSS has been going about building relationships with steel companies around the globe. If these ventures begin to fail, then of course it will be time to re-evaluate the bullish thesis.

Anyway, LSS is just one small part of a larger bullish belief I have maintained in commodities and commodity-related stocks. While no one worries about inflation, many commodity-related stocks continue rising, even after a sometimes sputtering 2006. Even oil-related stocks have weathered the recent correction in oil prices, and oil seems to be regaining its legs of sludge as it returns to the prices from the start of the year. Even with the persistent strength in many commodities, and even though the Fed continues to claim it is more concerned with inflation than economic weakness, most of the market is convinced that no inflation threat looms. The 10-year Treasury rests happily underneath it's long-term downtrend, and the bulls are still lobbying the Fed to drop rates sometime this year. So when the latest CPI data for January showed a sudden uptick in core inflation, no one was surprised that the stock market opened down. But apparently there are plenty of reasons to dismiss the report as just a blip in the normal volatiliy of what is supposed to be generally benign inflation readings. This time around, inflation was mainly driven by health-care costs and increases in cigarette prices. The Fed cannot do much about either factor, but the market was comforted anyway as the buyers went right back to business-as-usual and snapped up some "bargains." The NASDAQ even managed to get back into the green.

So who is right? The buyers of commodity stocks? Or the buyers of the rest of the market? This may be the wrong question since both commodities and the stock market had no problem rising in tandem before 2006. The real question may be is there any reason to believe that commodity prices in general will undergo a substantial and sustained correction (some have already corrected like copper)? And can you afford to ignore these stocks when so many others are not taking inflation seriously, and when so many companies are buying each other up and further concentrating the ownership of capacity? It will take some clear signs of economic weakness to shake my on-going bullishness on this sector.

Let's take a look at some of the many signs that the commodity-related sector may well be gearing up for a new leg up - that is, if the new leg has not already begun!

Vulcan Materials (VMC)
VMC made an offer to buy Florida Rock Industries (FRK), a cement company. Amazingly enough, BOTH stocks essentially went up on the news: FRK up 41% and VMC is almost 10% over two days. Imagine that - the whole is greater than the sum of the individual parts. This is what we call a win-win. Other cemnt companies went up on the news as the market tries to adjust to VMC's valuation of these assets.

Gold
The bears' favorite way to go long is gold. Gold has gone nowhere since the peak in May, 2006, but it is up 10% after a sharp correction to start the year. Given how long gold has been meandering, I imagine the old highs will provide a tough test, but yesterday's price of about $673 has finally taken gold above multiple resistance levels. See weekly graph below.

weekly Gold


And if we really want to find reasons ot be bullish, we can draw an upside breakout from a bullish flag pattern last fall.

weekly Gold


Regardless, the fundamentals supporting gold's rise seem to be firmly in place: a weakening dollar, cheap money and credit, and even robust jewelry demand in countries like India. In similar news, silver has been steadily climbing since the summer, 2006 lows with higher lows and higher highs.

Heavy machinery We even have the machinery that moves commodities from mine and farm to markets selling like hotcakes. Stocks like Caterpillar (CAT), Joy Global (JOYG), and Terex (TEX) has all found new life this year. In particular, CAT finally broke an extended downtrend and looks ready to defend its recent break-out above the 200DMA.

Caterpillar


Cummins (CMI) is up over 17% this year already. It supplies engines to some of these same machinery companies. So, when CMI announced last week that engine sales for heavy-duty trucks could drop as much as 50%, the market barely paused long enough to let the ink dry on the all the cash being printed for inflating CMI's stock.

None of these good signs are guarantees that the trends and the "good times" will continue. But like the rest of the market, there currently seems no reason to sell, so the default must be to buy (see disclaimer here). Perhaps the time to sell will be soon after folks really start worrying about inflation again.

Stay tuned, and be careful out there!

DrDuru, 2007