Commodity prices and natural resource stocks have certainly been shaken up in recent months. The underlying forces behind the bull market, however, haven’t been stirred. The only real questions are the following: When will the correction end? And when will the next leg up begin?

When we began authoring Vital Resource Investor last October, we introduced a complementary, bi-weekly commentary on commodity markets, Commodity Trends, authored by our friend and colleague George Kleinman. Although we’ve focused on stocks, stocks and more stocks, George has put his expertise to work helping us time our buys and sells.

Earlier this summer, George’s cautionary comments helped us time some profit taking at very attractive levels. Now he’s taking a slightly more bullish tack. Those arguments were laid out in the Aug. 18 issue of CT, History Doesn’t Repeat, but It Does Rhyme.

I’ve been looking for commodities as an asset class to bottom out as the Olympics come to an end. Beijing has effectively shut down 350 industries and an estimated 7 million cars are off the roads. No wonder world oil consumption is down. Just a 1-million-barrel swing in demand can swing the world’s marginal demand from a shortage to a surplus condition.

As oil goes, so goes a host of commodities. The stock markets of the world are bouncing, but after a 25 percent break from the October top, an 8 percent to 9 percent upside correction is considered normal for a major bear market. Certainly, most of the major markets and asset classes are related today.

Bottom picking is tricky. Markets in bear trends will exhibit sharp, short-covering rallies at times, and bottoms rarely occur in a “V” (straight down, then straight up). Still, I see signs in two commodities that bottoms are forming. This often takes place after the blood in the streets, and this is what blood in the streets looks like.

The two commodities George cited are silver and corn, both of which have suffered major retracements of previous rallies. And although he wasn’t ready to make a bottom call at the time, the downside action in many commodities has at least appeared to level off in recent days. Moreover, share prices of natural resource producers appear to be leveling off and even moving higher after the recent selloff.

One good example is Mechel (NYSE: MTL), easily one of the most volatile of the VRI Portfolio stocks. The obvious reason is fear that the Russian government would make the major steel and metallurgical coal producer into another Yukos, essentially stripping shareholders of their interest.

The good news: Despite Russia’s adventures in breakaway areas of Georgia and rising tensions with the West, Mechel’s relations with the government appear to be mending rapidly. As a result, the shares have come well off their lows and are back in the black based on our original recommendation last October. And we think they’re heading a lot higher going forward.

The lesson here is commodities are an extremely volatile business, and natural resource-producer stocks are among the most volatile stocks in the world. That means we can roll up profits in a hurry, but they can erode quickly as well.

When we suffer a major shakeup such as the one this summer, it’s easy to forget that the recovery often comes swiftly, without notice. All that’s needed is for the weak hands to be shaken out and the buyers to return in force.

Earlier this summer, we saw quite a few weak hands enter the market. Some bought commodities simply because they had been bearish–and dead wrong–for so long. Now that prices have come down, these people are running for the exits, and the stage is set for another big move up. And our VRI Portfolio stocks–despite their recent volatility and downside–are getting ready to run.

The brutal selloff has brought the share prices of well-run companies down to very attractive levels. Our assessment is that investors should sit through the short volatility, carefully adding to positions selecting quality companies with expanding margins and good handling of costs.

As we’ve mentioned in previous issues, the commodity super cycle is still intact, even though the in-between business cycles will continue to play their role. We’re surprised with the current market environment–not because of the selloff, which was somewhat expected–but with investors’ attitude.

The prevailing idea is that China’s growth is falling of a cliff and, therefore, demand will also drop substantially. However, China is experiencing a gradual slowdown that the government welcomes. Most important, it’s clear that China’s big infrastructure plans will go ahead, and the state will provide financing. China has the financial resources to keep its promise as it enhances and solidifies its domestic demand.

India’s demand and America’s contribution also hasn’t been taken into consideration. In India’s case, we’re not surprised; the majority of investors have never fully understood the country’s potential in the first place. As a result, India’s economy is also slowing. But India will continue to grow comfortably by 7 to 8 percent in the next few years.

The US recession is obviously the most serious argument. And although the timeline is unknown, it’s certain that the recession will end eventually. Now is the time to start buying some of the companies that will benefit from the new cycle–and it won’t be banks.

The main themes we’ve discussed over the past year–namely mergers and acquisitions (M&A), supply constraints, solid demand and infrastructure problems–remain as fresh as ever.

Investors should be particularly cautious of costs associated with certain companies, particularly resource companies. Pay special attention to how these companies handle costs. This is one of the parameters we looking into before adding a company to the VRI portfolio.

Historically, August and September have been strong months to buy resource stocks as demand starts coming back and companies gradually report better results.

Three Favorite Leveraged Bets

Coking coal remains at the forefront of non-agricultural commodities. Strong steel demand has been the catalyst here, and supply has tightened as a result.

The floods that hit Queensland’s Bowen Basin in the beginning of the year have proven very restrictive to production and pushed contract prices to USD300 per ton. VRI portfolio favorite Xstrata (OTC: XSRAF) recently secured contracts at USD362 per ton. Buy Xstrata.  

Iron ore has also been hit hard. The selloff was magnified because of China’s high iron ore stocks. Nevertheless, demand remains strong, and domestic production is turning out lower grade ore. We expect iron ore imports to remain strong in China, and our leveraged recommendation is Brazilian-based Companhia Vale do Rio Doce (NYSE: RIO, CVRD).

Uranium prices are also on the rise, after hitting their low of USD57 per pound in mid-June. We recommended gaining exposure to uranium in late May, and we still believe that this is a solid, long-term investment. See VRI, 29 May 2008, Faraway Places.

Uranium prices have more room to rise as demand increases. Near term, Cameco’s Cigar Lake operation, currently undergoing remedial work, is leaking again and constraining supply. This is important in the short-term because utility companies are now also starting to buy again to cover their winter needs.

Cigar Lake is one of the most important projects in the global uranium universe; it’s projected to produce 18 million pounds per year starting in 201. Total uranium production from mines around the globe is projected at 125 million pounds for 2009.

Our leveraged recommendation is Australia-based Paladin Energy (Australia: PDN, OTC: PALAF). The company has projects in Africa and Australia, but it’s currently focusing on its African projects, Langer Heinrich in Namibia and Kayelekera in Malawi. See VRI, 29 May 2008, Faraway Places, for more.

Paladin is one of the most leveraged plays in the industry with only 1.1 million pounds per year hedged out to 2012. As a result, it can substantially benefit from higher uranium prices. Buy Paladin Energy.