Commodities Are Due to Catch Up

05/13/2010 12:00 pm EST

Focus: COMMODITIES

Benjamin Shepherd

Analyst, Breakthrough Tech Profits, Global Income Edge and Personal Finance

Benjamin Shepherd, associate editor of Personal Finance, says commodities have been weak this year, but their long-term outlook, particularly as inflation hedges, is solid.

Commodity-related issues have [largely] underperformed this year because short-term fears of a Greek contagion and a double-dip recession continue to weigh on investors.

But the long-term case for commodities is intact.

[O]ver the past two years, companies have liquidated inventories at an unprecedented pace, depressing manufacturing output. Companies have depleted their surpluses, and economic activity is picking up. Manufacturing output is on the rise in the US, driven by restocking. Many of the world’s economies are having similar experiences.

As demand for manufactured goods picks up so will demand for the raw materials used to produce them.

Another factor supporting the bullish case for commodities is the low level of investment in production capacity over the past two years. Mine operators put off investment in new capital equipment because forecasts for future demand were clouded by the financial and economic crises.

Farmers used less fertilizer because costs—and stocks of many agricultural products—were too high.

Now, we’re looking at potential supply shortages for key commodities and products as producers race to catch up with demand that’s rising more rapidly than anticipated. The stage is set for rising prices.

The case for commodities is particularly compelling given the uncertainties surrounding inflation.

Although it’s likely to remain under control so long as unemployment remains high and incomes stay flat, inflation is a long-term concern.

The Federal Reserve has shown little willingness or ability to remove excess liquidity from the system. On April 28th, the Federal Open Market Committee, the Fed’s rate-setting body, opted to maintain its benchmark overnight rate at its current, historically low level and reiterated its commitment to keep it at its lower bound for an “extended period.”

The failure to adequately control the money supply has led to ruinous bubbles in the past and will, eventually, lead to higher prices for just about everything.

The good news is that commodities do well in deflationary environments and in times of inflation. They’re widely perceived as stores of value. Although iPath Dow Jones-UBS Commodity Index Total Return ETN (NYSE: DJP) has underperformed, we’re sticking with it because the long-term thesis is sound.

With a current allocation of 20.9% industrial metals, 27.8% agriculture, 31.5% energy, 6.9% livestock and 12.9% precious metals, the fund is poised to capitalize on price movements across the full range of commodities.

The industrial metals and energy groups will likely provide the upside in the short term because they’ve lagged despite the up tick in the broader economy. And agriculture is attractive over the long haul; the global urbanization trend continues apace, driving ever greater consumption of grains and meat.

The recent dip is an opportunity to pile up near-term gains and establish a long-term hedge at an attractive price.

DJP is a Buy at these levels. (This ETN closed Wednesday at $39.54.—Editor.)

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