Picture du Jour: Commodities – Too Much Too Quickly?

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Can money trees in fact grow to heaven? It was certainly beginning to look that way when considering the frenzied surge of many commodities to new highs week after week.

The following table shows the strong performance of most commodities over various measurement periods.

19-march-2008-tf.jpg

Source: Plexus Asset Management (based on data from I-Net Bridge)

But the past few days have seen commodity prices pulling back from their lofty levels. What should one read in this?

Let’s firstly consider a picture of the Reuters/Jeffries CRB Index, a basket of agricultural, energy, industrial metal and precious metal commodities.

19-march-2008-1.jpg

Source: StockCharts

The graph only shows the last portion of the seven-year bull market in the CRB Index in order to illustrate the parabolic rise over the past six weeks, resulting in a heavily overbought condition. Considering a combination of technical indicators, a sell signal seems to have been given. Of special note are the Bollinger Bands where a top was made outside the top band, followed by a top inside the top band, indicating a trend reversal. A move originating at the top band often tends to decline to the bottom band.

Part of the reason behind the strong rise in commodity prices was undoubtedly the plummeting US dollar, but very strong underlying demand from especially emerging markets, together with a tight supply situation, has naturally been a primary driver. Although I am a strong believer in a multi-year uptrend, I am concerned about commodity prices having become detached from the fundamental picture over the short term in the light of the rather dismal global outlook for economic growth.

The graph below illustrates the close historical relationship between the annual change in the US Leading Indicators Index (blue line) and The Economist Metals Index (pink line).

19-march-2008-2.jpg

Source: Plexus Asset Management (based on data from I-Net Bridge)

Unless one expects a turnaround in economic activity, it would seem that a breather of at least a few months could be on the cards for commodities in general.

Andrew Garthwaite, chief global equity strategist of Credit Suisse, remarked: “Sharply rising commodity prices may … exacerbate a growth downturn, but eventually weak growth gets its revenge, as falling real demand triggers speculative liquidation.”

Also emphasizing growth concerns, but specifically from an emerging-market point of view, Albert Edwards, co-head of global strategy of Société Générale, said: “The unfolding US consumer recession is likely to suck liquidity away from the emerging-market region as the US current account deficit declines and emerging-market accumulation of foreign exchange reserves slows sharply. As emerging-market asset prices slide and decoupling arguments evaporate, commodity prices will react sharply as recent speculative ‘safe haven’ froth unwinds.”

I believe that irrespective of high demand from China and other emerging markets, commodity prices will remain cyclical and that it is only natural to expect periodic corrections within a long-term uptrend. Profit-taking/deleveraging by hedge funds may result in sharper sell-offs than otherwise, but negative real interest rates in the US should temper the downside potential. Different commodities, needless to say, will behave in different fashions, but in general one’s approach should be to be patient and await better buying opportunities down the line.

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10 comments to Picture du Jour: Commodities – Too Much Too Quickly?

  • Commodities – Too Much Too Quickly?…

    Can money trees in fact grow to heaven? It was certainly beginning to look that way when considering the frenzied surge of many commodities to new highs week after week. But the past few days have seen commodity prices pulling back from their lofty lev…

  • PdP: I guess the major point becomes and one that I have tried to get a handle on is: will slow economic growth lead to a slowdown in the commodity bull market; while most commodities have gotten ahead of themselves (on the charts at least), the dynamics for currency devaluation (Euro, dollar) remain intact, and this will be a positive backdrop for commodities. Demand may falter but the perception of limited supply, poor infrastructure, geo-political concerns plus inflationary policies will all serve to benefit commodities. Lastly, I do not see any technical red flags on the monthly charts of CRB, Gold, Crude, NG, or the Dollar to suggest an imminent change of trend. Good buying opportunities are likely ahead and for those patient enough to ride out the down draft.

    On the other hand, I wonder if we cannot flip this scenario around. Will falling commodity prices help equities? In the past (pre-2003), the answer would be yes; but since then gold and stocks have travelled somewhat in tandem until the top in equities in October 2007. Commodities and stocks have benefited from inflationary policies, but can stocks now stand on their own so to speak–that is without the constant infusions of liquidity.

  • Michael Mennell

    I reckon commodities should not be treated as a single group. The demand pressure on energy is likely to continue no matter what happens to US consumers. Factor in huge political risk and prices will stay at about current levels of $100/barrel.
    Food prices depend as much on growing conditions as they do re demand. Hence a drought or a good season can affect wheat despite a strong/weak global economy.
    But base metals (only Cu listed in the table) are directly dependent on underlying strength of world economies. They have experienced a massive price increase beyond anyone’s predictions 5 years ago. Can it last with new mines coming onstream monthly and with a global slowdown?
    I foresee base metals falling by about 35% over next 18 months.

  • Kirk C Valanis Ph.D.

    Dear Mr. de Plessis:

    While there is truth in what you say, that the world economy is beginning to drift into a slowdown and possibly a recession, in some counties more so that in others, when it comes to commodities we need to distinguish between gold and silver on one hand and the rest of the commodities on the other.

    The point at issue is the value of the dollar – not its price relative to other currencies which may be artificially fixed and thus misleading, but its value in the sense of what it will buy you. If in effect you are a holder of dollars what is their worth, what things of value can you exchange them for?

    The answer? Well, you can either exchannge them in the US for things of value in the US itself, or you can use them in the world market by buying commodities whose worth is likely to increase with time. I need not comment on your likely choice.

    Unless of course the Federal Reserve opens an account for you where you may deposit your dollars and collect interest, to be negotiated between you and the FED. If the interest is high enough you may do exactly that and wait to see what happens. Given the human tendency for procrastination this may prove to be a present solution, very helpful for the dollar – if the supply of dollars does not keep on increasing parabolically.

    Gold and silver, though they are down at the moment, are the currencies of last resort. Though the price of the remaining commodities may be down because you are in an inflationary environment that does not support growth of the physical economy – such is the case right now in the US – silver and gold must go up in value because of the very existence of the inflationary environment. Dollars, eventually, will have nowhere else to go to be redeemed gainfully except in gold and silver, whose value through the ages has proved to be permanent.

    The present sale of gold and silver, possibly and in part by the central banks, will help to drive the price of these metals higher and at a greater rate, later on.

    Yours sincerely,

    Kirk C Valanis Ph.D.

  • One other thing and it is a very interesting insight I believe: Copper broke out last month to new highs; this month copper has pulled back to support. (Pull up a monthly chart.) It hasn’t violated support levels and there are some technical factors that suggest this breakout should stick. So the question becomes: why is Copper breaking out and why is it holding support in face of a commodity sell off and slowing economic growth?

  • Frank Wordick

    Thanks for this, Prieur. What you said is certainly worth thinking about. There is at least one other factor to consider, namely inflation. Some investors are protecting themselves against inflation by buying commodities especially gold and silver. But, the Fed has said again that they expect inflation to aleviate shortly. Indeed, inflation was flat in February. Moreover, M1, which measures broad cash has gone nowhere for three years, even slumping slightly lately. Milton Friedman, the noted monetarist has said more than once that “Inflation is always and everywhere a monetary phenomenon”. Furthermore, as Mauldin has shown, contrary to popular belief, the Fed is NOT INFLATING. Everytime they throw money at someone or something, they sell Treasuries to sterize the largesse. Maybe some investors have figured out that inflation isn’t on our doorstep.
    One other thing: To the best of my knowledge no Kondratiev long waves are in uptrend or due to go into uptrend for a long long time.
    In passing, I note that the copper price has gone thru the roof. Copper is the best indicator of industrial activity. Where is it likely to head in the future?
    Prieur, I haven’t got a clue as to what a Bollinger Band is except to guess that it doesn’t have anyhing to do with labelling French champagne bottles. Please explain!

  • Dan Modricker

    A factor that seems to be overlooked is that much of both inflation and deflation are actually imported (to the U.S.).

    Whereas China was exporting deflation to us, that country is beginning to experience serious inflationary problems. They may, in fact, be already exporting inflation (in the prices of their finished goods) to U.S. consumers.

    Remember that as the cost of energy goes up, the cost of “finished goods” also goes up. And because China is such a large source of finished goods, China is exporting a large amount of inflation.

    Combined with the U.S. stagnated economy, we now suffer from “stag-flation”, and the prospects of hyper-stagflation are great, I fear.

    Place your bets on Treasury Inflation Protected Securities and on a large diversified Energy stock portfolio. Don’t be fooled into betting on either black-gold or gold-gold; they are psychological rather than intrinsically stored values. Plus they don’t earn interest, pay dividends; yet one has to pay to store them.

    Incidentally, for those not familiar with TIPS, they return at least their original principal if the future brings deflation. Not a bad hedge against both inflation and deflation .. considering that no one knows what the future holds.

  • The last 2 days has been rough. I think that there are many hedge funds being forced to deleverage and reduce their exposure. The investment banks who have lent them money are in trouble and trouble is rolling downhill.

    Another viewpoint is they are going through a much needed correction. Parabolic moves are never good long term.

    Sugar and cotton look attractive based on their historical underperformance.

  • Speaking from an emerging market one of the first signs that we were looking out for was a meltdown in the commodity markets. Right up till the meltdown in 2006 commodities were everyone’s darlings… especially copper… then one day gold cracked. no one paid any attention… after all what was gold… that was for the old fogies… copper, nickle, aluminium and emerging market equities were where the smart made (and subsequently lost) their money.
    unlike the vast majority i turned bearish on the market in november 2007, when i saw a few of the headline stocks trading at 50x FY09 estimated earnings. no matter how attractive a market no company is worth 50 times is one year forward earnings. however at that time everyone on the sell side (fellow brokers) laughed at me every time the market hit a new high. to my clients on the other hand i did caution them and they did agree that perhaps the peak was nearing and it made sense to move out of the risky mid caps and to choose liquidity over stock gains. when the markets collapsed in Jan and then feb and continued they were partially insulated. now i find the brokers are panicking about the ‘bear market’ while the funds are buying at lower levels wherever and whenever they can.
    my point is that, granted, the US economy is in a mess, granted, the global economy can also go down the tubes along with the US, granted oil is at 107 to the barrel. however just as we had a bull frenzy that brushed off every bit of negative news from all across the globe right up till jan, we now have what seems like a bear frenzy where every bit of good news is summarily brushed off and news that less than 6 months ago would not have caused more than a blip in the markets is now seen as a forerunner to armageddon. i honestly feel that the worst is behind us and that in another quarter or two we will be seeing markets across the boards starting to recover and by the end of this calendar year the bull run should be back on track.
    Also as long as the bail out packages continue to be doled out i have a nasty feeling that this sort of a melt down will be a regular feature. remember the junk bonds of the 80’s and then ltcm and its derivative contracts, then came amaranth and soc gen…. the markets and their traders will never learn.

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