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Spreading a few fertilizer stocks and reading the bear market

This Canadian advisory offers best and worst-case scenarios for a bear market and also picks two fertilizer stocks that could grow some profits.

It seems we can’t get away from the bear market these days. More and more observers are convinced that the bear is here and that the only question is: for how long?

This is certainly the opinion of Mr. Louis Paquette, writing in Emerging Growth Stocks. He has seen the bear emerge from a long hibernation and is taking a long look at history to see just how long it might be with us.

He has a best-case scenario and a worst-case scenario. We will examine both shortly.

But stocks don’t stop trading on a bear market, nor are investors obliged to stop making money, so let’s begin with a few stock recommendations from this advisory.

The stocks in question are fertilizer stocks. One is a brand new pick that deals in phosphates. The other is a potash company that has been moving in mysterious ways.

Making the case for food

For all of the increasingly gloomy forecasts for the global economy these days, it’s fairly easy to make the case for companies that are involved in the growing, processing and selling of food.

It’s an article of faith among stock pickers that food stocks are high in the category of “defensive” stocks that can ride out a troubled economy. People won’t stop going to the grocery store.

But there’s more to the case than that. Even if economies around the world follow the U.S. into a slowdown, they are embarked on something of an agricultural revolution. In addition to stepping up food production for the masses, emerging nations find themselves with rapidly growing middle classes whose dietary habits and demands are changing.

Not least, the powers-that-be persist in pushing ethanol as an alternative fuel, which means they’re pushing for larger corn crops.

So if agriculture continues to grow, stocks that depend on it should continue to produce profits. It’s just a matter of picking the right stocks.

Because Mr. Paquette is a specialist in “finding extreme value in small caps,” as his masthead proclaims, you will not find the big agri-stocks on his list. His recommendations are more in the nature of seed stocks that may grow up to produce a rich harvest.

A world-class resource

Think fertilizer in Canada and the first name that comes to mind is potash, as in Potash Corp. of Saskatchewan (TSX-POT), the giant of the industry in this country. But phosphate is also big in the fertilizer mix, and for that we go Down Under.

Mr. Paquette’s newest fertilizer pick is Legend International Holdings Ltd. (OTC-LGDI), which is incorporated in Delaware, trades on the Over the Counter Bulletin Board in New York, and draws its wealth from Australia.

Phosphate “tripled in price last year to roughly $350 a tonne,” points out the editor, “and the trajectory remains upwards.” Legend controls a number of phosphate deposits that represent a “world-class resource” in the Georgina and McArthur Basins of Northern Australia.

“It caught the attention of the market earlier in 2007, but has been brought down to its baseline around $1.00 by a dearth of news or milestones and the overall market weakness,” says Mr. Paquette.

It has more shares than many of the stocks this advisory follows (about 157 million), but it also holds larger resources than most of them. Legend’s holding may amount to as much as 1.4 billion tones of phosphate. Within a few years, the company could be shipping 4.5 million tonnes of phosphate with $150 margins, with capital start up costs of $500 million.

“Or they could be taken out somewhere along the way at something higher than the current price,” says Mr. Paquette. The current price is $1.11.

Potash prices and target prices

Mr. Paquette admits that he is having a little trouble establishing a target price for Potash One (TSX/V-KCL). The company is a growing concern, but the share price is behaving a bit erratically.

Potash One is on solid footing for a junior, with 36 million tonnes of indicated resources and 360 million tonnes of inferred resources on the edge of the world’s largest potash basin in southern Saskatchewan. It also merged with a major uranium company in 2007.

The share price peaked at $4.50 in December 2007, “and has been bouncing either side of $3.50 since,” complains Mr. Paquette. Part of the problem is the price of potash itself, which he describes as a “moving target.”

Although the price has generally been rising steadily, it is not set at a central exchange like most commodities, but established by various producers at different ports of call.

The other problem with establishing a target price, says the editor, is the gap between Potash One’s indicated resource and the inferred resource. Since the inferred resource is ten times the indicated resource, it could produce ten times the cash flow.

In short, concludes Mr. Paquette, following a “very rough, seat of the pants, back of the napkin calculation,” the target price could be anywhere from $5 to $50! It opened today at $3.98. If the editor’s napkin is accurate, it has a tidy gain of a $1.00 or so ahead of it, or a gigantic leap to take. Either way, he has it as a buy.

Bear market: best-case scenario

“The question,” says Mr. Paquette, “is not whether we are in a bear market, but how severe we can expect it to be.”

The editor begins his assessment with a best-case scenario. And he begins that scenario with the observation that recessions and bear markets are not the best time to panic and sell.

“An average recession lasts 6 to 9 months, with an average market decline of 23%,” says Mr. Paquette. “And by the time the recession is officially recognized, the market lows are in or almost at hand.”

In this scenario, both the 1987 market crash (a 23 per cent plunge in a single day) and the 1990 recession (which shaved 20 per cent off the S&P 500’s highs) look like mere blips on the long-term charts. In short, the losses were sharp, but sudden, and did not lead to further deep declines.

How does the current crisis look in comparison? At the lows in January, the S&P 500 was down 19 per cent from its highs, roughly comparable to the previous scenarios.

“And there is a core of stock analysts out there calling for such a scenario,” says the editor, “convinced that interest rate cuts and other stimulus will kick in by the second half of the year, averting a recession and a bear market.”

Bear market: worst-case scenario

There are tougher scenarios to be found even more recently, says Mr. Paquette. The bear market that lasted from 2000 to 2002 is Exhibit A: the S&P 500 lost almost 50 per cent of its value!

“This was actually quite an anomaly,” explains the editor, “because it was composed of two separate, back to back bear markets.” The first was the high-tech bubble going burst in March 2000. A year and a half later, the terrorist attacks of 9/11 and the subsequent events leading to the invasion of Iraq sent new shock waves through the markets.

“This time around, we have the bursting of an enormous credit bubble cycle,” says Mr. Paquette. “We’re looking at two years of back to back sharp declines in home prices for the first time since the Great Depression, combined with the worst January in the history of the S&P 500 — ever!

“Compounded by stubbornly high energy costs and the cost of an ongoing war on terror, this could easily spiral out of control and lead to a much larger bear market than the best-case scenarios of 1987 or 1990.”

The long range

Ultimately, Mr. Paquette is not terribly optimistic about the future of the stock market. Looking at long-range patterns, he sees a discouraging trend.

On three separate occasions over the past century, the Dow Jones Industrial Average has found itself in a long sideways trend, going up and down, but basically going nowhere for a decade or more. (You will note that Mr. Paquette has shifted indexes here, but for good reason — the S&P 500 was only created in 1957 and doesn’t offer the same long-range historical perspective as the Dow Jones.)

“What we can see over the course of a century is a repeating pattern where stocks move up for a decade or so, then get stuck in a range for a decade or so.”

The most recent of these “stuck” periods was 1966 to 1982. Mr. Paquette believes the market may well have entered such a phase in 2000, which means that it could last at least until 2012.

Even if this is so, all is not lost. “Investors can make money during these periods,” concludes the editor. “Not by buying and holding if all the market does is go sideways in the long term — but by timing the market. Stock picking and hedging strategies become even more important than ever.”

Mr. Paquette’s chief hedging strategy at the moment consists of building a position in Horizon BetaPro Gold Bear ETF (TSX-HGD). He buys on days when the gold price is strong and trades some days when gold is weak.

Everyone knows you can’t outrun a bear. But you can still make money in a bear market. Just start spreading those investments around and see how many profits you can grow.