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Walking a Lonely Road:

There’s been a lot of discussion recently about the fundamentals of oil, commodities and the general economy while we witness the Canadian benchmark TSX Composite Index breaking new highs in the face of uncertainty south of the border and around the world. With oil peaking well above $127 per barrel and other commodities prices moving material stocks higher; financials, utilities, insurance and consumer stocks have been left behind.

There’s nothing wrong with an index moving in certain directions away from other components when there continues to be weakness in those other sectors, but it’s the time and scale of such a move that has many concerned that things have gotten well ahead of themselves.

As a value investor I expect to see rational movements in the markets that resonate with clear fundamentals seen elsewhere that impact our economy and businesses; even when I know that doesn’t happen and value is created from that. At the moment I question the parabolic movement of oil and other commodities when there are clear signs that growth has moderated or slowed in the face of the US credit crisis, mortgage collapse and manufacturing struggles worldwide.

Oil is clearly not a renewable resource and price appreciation should reflect the general amount of supply and demand in global markets. What many investors don’t realize is that over the past few years many emerging market economies have subsidized the price of oil and gasoline through their governments in an attempt to accelerate/maintain growth and not restrict expansion as they pursue development of their economies and society. At some price it becomes too expensive or unsustainable for them to continue this practice and true price inflation begins to have serious impacts on growth with substantial impacts.

When investors globally look at oil production costs, there is clearly a movement upwards. But just because the cost of production has increased doesn’t mean that demand is willing to pay that price at any cost in the future. China, India and other developing countries still don’t have nearly enough domestic infrastructure to meet demand for cars, let alone have the per capita incomes to afford those vehicles in the numbers that investors now believe. With high energy prices currently, what is to stop these countries from focusing more on mass transit to solve transportation issues of their middle class than adopting how we use transportation in North America with abundant freeways and suburban roads? It is true that they have a larger population and therefore larger potential middleclass in future years, but what good is a cheap car when you can’t drive it due to heavy congestion on non-existent roads, astronomically high gasoline prices relative to your real income or expansive distances when mass transit is simply easier and more efficient to utilize?

There are clear dangers in the world economy that the markets at this time appear to discount or not take seriously. In the face of an obvious credit crisis and mortgage collapse the US consumer is dead in the water. They cannot go on spending at the rate they have using the home equity as an ATM without any increase in real incomes over the past five years. They are being crushed by massive debts and we haven’t even gotten to the point where the European RE bubble has been noticed or significantly analyzed.

High oil prices will have the same effect on economics as it did during other periods of history and inflation is around the corner to take care of this massive amount of debt that’s been created. Nothing is different this time. The 40-year mortgage in Canada is just another ploy by financial lenders to begin tapping out the very last of new home-owners who can realistically afford a home and the current inventory for sale in Canada doesn’t have enough potential buyers because everyone else has already bought as much as they can afford in the past 5-8 years.

I’m not proposing a “Doom & Gloom” outcome or scenario from all of this; simply that fundamentals and rational value have been lost for the moment in the markets and we’re going to experience some painful headaches when investors realize what happens when you ignore them. Oil may continue to appreciate and reach highs well above our predicted expectations, but those prices will likely do more damage to the global economy and developing nations than any credit crisis has to date for us.

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