The major question on the minds of all resource investors at the present time is whether we are at the end of the commodity bull market or does this sector, which has been battered from pillar-to-post, offer an attractive buying opportunity? We maintain our fundamentally positive view with respect to the outlook for the resource sector. Whilst it may take some time for confidence to return, the fundamentals of strong commodity demand from China and tight resource supply will continue.

Without doubt we are experiencing one of the most difficult and volatile markets of recent years. The continuing economic slowdown in the US and in other G-7 countries, combined with more than 12 months of bleak news from the financial sector, has left investors in Australia dazed and desperate.
With reference to events in the US, the liquidity crisis has forced leveraged investors and companies to unload assets across the board to comply with new accounting rules, which in turn has created a domino effect as investors panic.

The amazing thing is that nearly all of the news that investors are reacting to is not new: we knew last least year in the wake of subprime that the US was heading for a recession during 2008, and that this would have knock-on effect in terms of the world economy.

We also knew that the skeletons in the closet as far as the world's financial sector was concerned were likely to be much more serious than initially thought. What has happened though is that investors have started to panic and when they do so, they are more likely to make ill-considered investment decisions.

According to independent estimates, around US$15 billion was pulled out of US stock funds during the month of July, about four times more than June. For the first seven months of 2008, total outflows from the US sharemarket were a staggering $52.4 billion, an all-time high.

Of course, Members will already know that July was also a very tough month for commodities and commodity stocks. Again with reference to the US market, the S&P Natural Resources Index fell by 15%, whilst in Australia the ASX300 Resources Index fell by 12%.

All of this represented the worst monthly sell-off in the resources sector since August 1998, when the Russian currency crisis triggered the implosion of the hedge fund Long-Term Capital Management.

Prices for underlying commodities also suffered during July, with the Jefferies/CRB Index down 10.1%. This was just short of the worst monthly performance for this index since 1970. The Index is currently correcting lower, following strong gains over the prior 18 months.

Since the January 2007 major low of 285, the Index had rallied as much as 66%, reaching a high of 474 in July. Following such extensive gains, the current correction is not surprising. In our opinion, this retreat is likely to terminate in the region of 395 to 363.

As visible on the weekly chart, this range encompasses a 50% retracement of the prior 18-month rally and the major high of May 2006. While holding above 365/363, we believe that potential remains for a revival of the broader upward trend.

The quote that perhaps best sums up the situation as we see it was provided by former Oxiana boss Owen Hegarty, speaking at the Diggers and Dealers conference this week, and was reproduced in the AFR:
"There's lots of prophets of doom, gloom and despondency out there at the moment. But make no mistake, we are in a period of long-term expansion. Don't be...depressed about short term blips on the screen."

We agree, but the problem for investors is that the short-term blips look like nose dives to financial oblivion whilst they are being experienced. The 'blip' is only recognised as one in hindsight. That's where conviction comes into play. And we retain our conviction in the long term commodities story.

And what about claims that we are technically entering a resources 'bear market'? While the idea that a decline of 20% from a high represents a bear market has become a widely accepted rule of thumb among market followers, it has absolutely nothing to do with technical analysis. It probably owes more to the fact that it provides media outlets with a short, simple sound grab that will attract people's attention.

So let's examine the fundamental picture and try and introduce some sanity into proceedings. Commodity prices in some instances and resource share prices in all instances are being impacted by the knock-on effect of the crisis of confidence affecting the world's financial system.

However, the long-term fundamentals relating to China and the world's other major emerging economies remain firmly intact.

Let's begin with gold, where the basic fundamentals have not changed. As you can clearly see from the chart below, July and August generally mark a seasonal lull, before prices begin to climb with the arrival of the northern hemisphere autumn buying season.

Furthermore in the US, where they are experiencing negative real interest rates and the ongoing outlook for the US$ is bleak, we believe the appetite for gold amongst investors will grow.

Providing further encouragement is the fact that from a global perspective, the world is very different from a decade ago. Back then, the world was experiencing a global currency crisis that began in Asia in 1997 and peaked in 1998, with Russia defaulting on its sovereign debt. This was the final blow that doomed Long-Term Capital Management.

Let's fast forward a decade and China and other emerging economies have massive US dollar surpluses, and these countries are committed to infrastructure spending. This week China's government announced that it will focus more on sustainable growth than worry about inflation, which we believe is highly significant.

Last month's resources plummet can be traced back to the latest troubles related to the worldwide financial sector that began more than a year ago with the subprime mortgage collapse, and was accelerated by the new US accounting rules in late 2007.

The market is now seeking liquidity in response to the recent moves by Merrill Lynch and others to sell mortgage-related assets at huge losses (which recently impacted on the likes of NAB and ANZ) and the persistent rumours that more Bear Stearns-like failures are yet to come.

The regulatory actions in the US during July to prevent shorting of 19 financial stocks, including Merrill Lynch, was well-timed. These stocks have rallied 50% off their lows, and more importantly for Merrill, it was able to refinance its losses. Had the Securities Exchange Commission not stepped in, illegal short-sellers could have crushed Merrill's stock, just as they did Bear Stearns.

Returning to the resources sector, whilst energy and resources felt the impact of July's turmoil, it's important to keep in mind that this performance did not reflect the sector's solid fundamentals. Historically, oil dips in July before rallying from August through October, as illustrated in the seasonal chart below. So when punters talk about oil's recent price drop as spelling the beginning of the end, think again. Prices typically behave this way at this time of year.

Many market pundits have predicted the demise of high crude oil prices after a peak near $150 a barrel, but with numerous energy stocks already trading at levels not seen since crude was under $100, we maintain that much of this forecasted price adjustment is already reflected in energy stock valuations. It appears, based on valuation metrics, that oil stocks are priced as if oil were selling at around US$70 a barrel.

In addition, unlike other bull markets where equities traded at challenging valuations, energy and resource stocks are historically cheap. Price-to-earnings ratios are well below the broader market, and these companies have tangible assets that are unaffected by mortgage write-downs.

We reiterate our view expressed in last week's Market Comment, with BHP Billiton and Rio Tinto both on price-earnings multiples of less than ten times 2009 consensus earnings.

When we look at crude oil fundamentals the picture looks as rosy as ever. We reiterate that despite record prices for crude oil, OPEC production has been unable to eclipse peak output levels. In addition, spare production capacity remains critically low relative to prior decades.

Outside of the OPEC cartel, countries such as Russia and Mexico have struggled to keep up with demand and are experiencing significant production declines. Meanwhile, costs continue to escalate as marginal supply is typically located in geopolitically sensitive areas or extracted from expensive unconventional resources.

A similar fundamental story holds for the metals and mining sector, where new discoveries and production are not adequate to keep up with strong global demand.

We also refer Members to some very interesting comments by Howard Balloch, President of the international Balloch Group, made at this week's Diggers & Dealers Conference in Kalgoorlie. RBC Capital Markets reported that in his keynote address, in which he focused on the health of Asian economies and the ongoing resources bull market, he made the following very positive points:

Beware of under forecasting the Chinese economy!

He believes the IMF is systematically overestimating US and European growth and underestimating Asian growth.

The key reason China will not slow down considerably is sustained and enormous domestic rural-to-urban migration (a point we have consistently made).

He also pointed to sharply growing consuming middle-class and entrepreneurial spirit, reflected in average GDP growth of almost 10% for the last 30 years.

The Chinese housing boom is still very much in full swing. The real estate market is obviously still cyclical from city to city, but at an aggregate level it is effectively smoothed.

Critically, China's development will be more basic materials-intensive than earlier developing countries at comparable GDP/capita levels - a simple function of technological advancement over that time (eg. cars these days have more copper in them than a few decades ago).

China's export share of GDP is overstated by looking at gross export value... Need to focus on true export value (which is effectively the value-added component of aggregate exports). In other words, China is not as dependent on US imports as people believe.

Inflation is the only real worrying trend for the Chinese economy in the current environment.

Average Chinese growth rate over the next four years will be 10%, not the 8% consensus in the market at present.

Balloch says... "I wish I was an Australian miner!"

With respect to the broader resource sector, Lehman Brothers recently published an interesting research piece on resource sector corrections between mid-2006 and early 2008. As can be seen in the chart below, during that time, there were five significant corrections in the Dow Jones STOXX Basic Resource Index (SXPP) averaging 22%, and these corrections were followed by rallies averaging 29%. That trend appears to be holding for last month's correction as well - after bottoming out on July 23, the SXPP rose 10% by month-end.

And if the malaise continues, the world's miners will be snapped up by bargain-hunting resource companies further up the food chain. And this is happening now.

One of the world's biggest miners, Xstrata, on Wednesday made an unsolicited 5 billion-pound (US$9.8 billion) bid for Lonmin Plc, the world's third-largest platinum producer, to add mines in South Africa and diversify its metals output. Xstrata is offering 3,300 pence in cash for each Lonmin share, representing a whopping 42% to Lonmin's previous closing share price of 2,319 pence. This demonstrates how over-sold Lonmin was, and there are countless more examples in the resource sector at present. Will investors wake up we ask?

We maintain our fundamentally positive view with respect to the outlook for the resource sector. Commodity prices in some instances and resource share prices in all instances are being impacted by the knock-on effect of the crisis of confidence affecting the world's financial system. Whilst it may take some time for confidence to return, the fundamentals of strong commodity demand from China and tight resource supply will continue.

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