Price of commodities could have big impact

By E.S. Browning –
It’s unusual in these high-tech times for commodities like oil and copper to roil the stock market, but it happened this year. Those who want to see a strong stock market next year are hoping that has just changed.
As the prices of oil, gold, aluminum and other commodities soared for most of this year, the stock market languished. It was only when commodities began to run out of steam at the end of the year that stocks finally turned upward. Oil, the commodity most closely linked to stocks, peaked in late October, and many other commodities followed it, peaking and then falling last month.


The market forecasters who expect a good year for stocks in 2005 tend to be the ones who think commodity prices are under control. The ones who are biting their nails are those who fear prices will surge again.
“I think that the fundamentals are going to keep driving oil prices down, which is a good thing for the economy, for consumers’ discretionary income and for corporate profitability — and therefore a good thing for the stock market,” says Joseph Keating, chief investment officer at AmSouth Asset Management in Birmingham, Ala.
Keating is forecasting oil at around $40 a barrel next year, close to where it is right now but down 26 percent from its October high of $55.17. Copper is 6 percent off its high and aluminum is down 5 percent from its peak.
But not everyone thinks prices will stay down. They think continued demand could push them back up.
“I am not sure that the crude-oil story is over yet,” says Brian Pears, head stock trader at Victory Capital Management, the money-management arm of KeyCorp in Cleveland. “Oil is more likely to move toward the mid-$50 range than the mid-$40 range next year. Over the long haul it has to act as a depressant on the economy and on earnings.”
Why all the focus on commodities? Because the motor behind the stock recovery during the past two years has been a classic economic rebound, fired by low interest rates and resurgent Asian economies that have been eating up iron, steel, copper, aluminum and oil.
The fear isn’t that commodities will become as dominant a force as they were in the 1970s. For oil costs to get back to the same share of the economy they represented back then, some analysts have calculated, oil would have to push above $100 a barrel.
“U.S. businesses have strong balance sheets and are well-positioned to handle any price shocks,” says James Swanson, chief investment strategist at Boston money-management group MFS Investment Management. “It is more likely that oil will slow, but not stop, economic expansion.”
The question is, by how much? A year ago, U.S. corporate-profit growth was running at an annual rate of more than 20 percent. Next year, it is expected to fall to about half that, according to analysts’ estimates tracked by Thomson First Call. That still is above the historical average of around 7 percent, but it no longer is eye-popping, and some investors fear that the analysts are too optimistic. Stock gains have been based partly on views such as Swanson’s and Keating’s, that profit growth will remain strong. If profits get hit more than they expect, stocks will suffer.
And earnings are only half the story. Historically, stocks have been driven by two things: earnings and interest rates. This year, the Federal Reserve has doubled its target interest rate for overnight bank lending, and it is expected to push the target up a further quarter percentage point Tuesday to 2.25 percent. That still is only about equal to inflation, meaning it is exceptionally low.
If world growth remains strong and commodity prices rise again, and if the dollar continues to fall, that would almost certainly push up inflation and force the Fed’s hand. It would have to step up the pace of its rate increases, and that would deal stocks a blow.
“Inflation and interest rates will bring down” the stock market eventually, says James Paulsen, chief investment strategist at Wells Capital Management. He thinks that will happen later rather than sooner because he believes commodity prices already have seen most of their gains.
Source: Contra Costa

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