In this series of articles called "Entering Into 2013", so far I've expressed my negativity towards the US equity market and as well as expressed my outright favouritism towards the Precious Metals sector as a long term investor - not just for 2013, but further along as the secular commodity bull matures. Let us now turn our attention to all commodities and not just the precious type. Once again, as stated previously, I will leave the fundamentals out of the current article, as they have been discussed many times in previous posts.
Anyone that has closely followed financial markets since 2008 understands the close relationship between commodities and equities. They both corrected sharply during the Global Financial Crisis and after the cleansing was done, both bottomed between late 2008 and early 2009. Eventually, they started rising together with a close correlation for the next several quarters.
Chart 1: Commodities are experiencing a cyclical correction within a long term bull market
Source: Short Side Of Long
Commodities managed to have a super run into early parts of 2011. While the correction in almost all risk assets followed in the fall of that year, commodities never really recovered unlike US equities. The breakdown in the correlation has become evident to even the most novice of investors over the last 12 months, as S&P 500 has managed to rally towards new bull market highs, while the Continuous Commodity Index (best way to track commodities) remained in a bear market correction.
There are many reasons why this occurred. Some investors link it to the end of QE2 in 2011, while others claim that the secular bull market in commodities most likely peaked out. In my opinion, the correction is mainly linked to weakening demand out of China as its quarterly GDP growth slumped in late parts of 2011 and into 2012. As for the end of the secular commodity bull market, I tend to disagree as I believe that we just witnessed a corrective phase within a major uptrend.
Chart 2: Chinese slowdown has been a major demand impact on commodities
Source: News.com.au
Long term secular bull markets tend to end in major oversupply. When one studies history one could easily conclude that great commodity bull markets of the past have always ended during the period of major oversupply. While supply has increased over the last decade, we have not seen anything even close to what historically occurs at the end of these great trends. The current conditions are not even remotely close to those of late 1940s and late 1970s, as two pervious secular commodity bulls came to a close.
Furthermore, and even more importantly, long term bull markets tend to end in speculation and mania. Today, commodities do not resemble either. The way gambling in Technology stocks became mainstream pass time during late 1990s, in the same fashion one day Precious Metals and maybe other sectors too, could experience a similar type of euphoria. During late stages of the secular bull markets, prices tend to go rapidly parabolic as public, usually clueless towards financial developments, becomes aware of certain assets and starts viewing them as a "sure bets".
It is very difficult to claim commodities are in a bubble right now. The truth is, majority of investors are currently much more concerned about deflation and have allocated funds accordingly. Looking at the chart, we can see a very close inverse correlation between US Treasury government bonds (deflationary asset) and industrial commodities like Copper and Crude Oil (inflationary assets). Despite majority of investors constantly focusing on the US Dollar direction to gauge where commodities might head next, just as important anchor for commodity prices in recent years has been the performance of government bonds.
Source: Short Side Of Long
I personally believe investors have become very confused since Lehman Brothers bankruptcy of 2008. On one hand, majority of investors understand that markets did not properly clear themselves and therefore most likely a major bottom has still not been witnessed. On the other hand, central banks constantly intervene into financial markets to try and prop up assets which are desperately trying to deflate back towards normal levels. These phenomena has been branded by the media as "risk on / risk off" or "inflation vs deflation" trade.
As the chart above shows us perfectly, industrial commodities as well as other assets with the CRB complex, have all remained in a cyclical bear market and continue to under-perform as long as the Treasury Long Bond remains bid up. I find it very interesting that the bottom in Long Bond between Feb and May 2011, was also the top for almost all industrial, precious and agricultural commodities.
For the long two years, Bonds have done great while commodities have done poorly. However, at some point in the future as central banks print more and more money, investors will realise that inflation will become the main focus. As we approach the inflection point, capital allocation will eventually switch from a deflation trade (bonds) and into an inflation trade (commodities).
Majority of the readers of this blog, as well as regular followers of the financial markets in general, will claim that as funds flow out of bonds, they will go into stocks. I will have to disagree here.
Chart 4: Stay with commodities as equity returns could easily disappoint in the future
Source: Azioni Aurifere
Well... let me clarify that statement. I disagree in the short to medium term, but I do agree with that statement in the very long term. Investors are right in saying that eventually, the end of the bond bull market will help equities start another secular bull market. However, the way I view financial markets right now, this will most likely not occur until commodities experience a final blow off top and equities experience a final bear market correction.
Looking at the chart above, I believe that commodities could be creating a basing pattern, from which a final rally could occur. On the other hand, I believe that as commodities rally just like they did in later parts of 2007 and early parts of 2008, huge inflationary forces will squeeze consumer spending and earnings will totally disappointment. A recession and a financial crisis will follow. At that point, equities will most likely correct in a meaningful cyclical bear market.
Therefore, I urge long term investors to stay with commodities as equity returns could easily disappoint in coming quarters and years ahead.
Chart 5: A lot of commodities are now at technical decision points
The current so called "basing pattern" Continuous Commodity Index is experiencing is not yet complete and therefore not 100% reliable. Commodities could also break down too. The chart above shows that majority of commodities are in some kind of consolidation patterns. For example, we can see that industrial commodities like Crude Oil and Copper continue to triangulate towards a climax and soon enough a direction will have to be chosen. On the other hand, Precious Metals remain in a sideways consolidation between a clear cut support and resistance. While prices can continue to move sideways for a long period of time, eventually here too a break in either direction will decide the direction of the medium term trend.
Chart 6: Investors are under-exposed to commodities...
Chart 7: ... and sentiment reading show investor disinterest!
Source: Short Side Of Long / SentimenTrader
Unlike the equity market in the US, which is currently experiencing abidance of complacency as major risk factors wait around the corner, commodity sentiment is muted as investors show disinterest and underexposure in various surveys. Furthermore, many individual commodities show negative sentiment readings right now, which further support this fact.
In summary, one could make a case that commodities are currently in a cyclical bear market correction within a longer term secular bull market. This correction has lasted almost two years now and is coming closer to the end. All the usual signals seen near the end of a major trend are not yet present and the current cyclical correction has most likely shaken out a lot of weak hands and created total investor disinterest.
This type of a condition possibly creates a good chance that the current basing pattern in the CCI is gifting us a buying opportunity. While I do not see equities as an attractive long term investment, I definitely think the best way for retail investors to play the final stages of the secular commodity bull market is through precious metals or agricultural commodities. While I already covered PMs in the previous post, it is quickly worth saying that food pries remain very depressed when adjusted for inflation and could easily surprise us on the upside, as we inch closer towards another "Food Crisis" with similarities of 2008.
What I Am Watching
I know some analyst claim that 2008 peak in commodities was the "blow off" top (see oil for example). It might be but I don't know.
ReplyDeleteToday, too many analysts expect the 2007 commodity boom to reoccur but since the 2008 Lehman collapse the world is in a global slowdown with slow growth, high unemployment and lower demand for commodities. This is the "new normal" and to grow the economy it has forced central bank stimulate the economy and employment with novel approaches. But I can't see how this liquidity will create a commodity boom (while the underlying economy is weak). That is, the central bank stimulus is simply creating inflation to off set the slow or negative growth (deflation) for the time being.
The question that needs to be answered is what will happen in the economy to cause QE and low interest rates to produce high inflation or at least high commodity prices? I don't see the cause just yet and the reality is that trillions of QE is not enough and new debt is not enough of a catalyst to have commodities reach their pre-crisis 2008 levels.
So again what will be the reason for commodities to rally to all time highs? My thoughts, are perhaps we need strong sustained growth for a few quarters (I don't see that) or panic out of currencies (like Yen but also for the dollar) and into hard assets. But just because central banks are printing doesn't mean bad things will happen (at least in the short term).
That is my opinion and I would love to hear anyone comments. But people need to grasp that trillions in deficits and QE has not produced all time highs in commodities so what will occur so that commodities rally? [Note gold is above the 2008 highs but oil is well off those levels].
I have no strong feelings on commodities at the present time,meaning that I am neither bullish nor bearish(although I do agree with Tiho that we are in the midst of a secular commodities bull):I still have to see whether the economic factors or the monetary factors are going to become prevalent when the next crisis strikes(and I bet we won't have to wait much).Gold is the safest option as it usually benefits from both scenarios.
DeleteHowever on a general note,keep in mind that QE(a.k.a. money printing)IS inflation,the effects of which often become visible after a considerable time lag(the most rapid to manifest itself is the alteration in the structure of relative prices,i.e. capital/higher order goods usually become more expensive in terms of consumer/lower order goods,as the inflationary boom tends to further malinvestments mainly in the early stages of production).
I caution you against adopting what could be called the Bernanke's view("See,there is no "inflation":money printing can do no evil"),since as Mises rightly pointed out in Human Action(see quote below)all that's needed to see the devastating effects of already occurred inflation is merely a change in public perceptions(incidentally this is why our overlords are always keen to point out that they're ready and willing to implement the by now mythical "exit strategy",as in the latest Fed minutes).And unfortunately it is almost impossible to anticipate when this fateful change will occur.A final note:we're still in the reversible phase,meaning that central banks could stop inflating and save their currencies,although that would mean depression and default from many countries,which renders this solution unlikely(although it would be the only sensible one).
The quote is quite long,but it describes the phenomenon very clearly:
“The course of a progressing inflation is this: At the beginning the inflow of additional money makes the prices of some commodities and services rise; other prices rise later. The price rise affects the various commodities and services, as has been shown, at different dates and to a different extent. This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy.
But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against "real" goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them. It was this that happened with the Continental currency in America in 1781, with the French mandats territoriaux in 1796 and with the German Mark in 1923. It will happen again whenever the same conditions appear. If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds. Inflation is a policy that cannot last forever.”
I think QE + zero interest rates will produce another malinvestment bubble - like the 2008 housing bubble or similar. The thing is, this can take 1, 5 or 10 years.
DeleteI agree about caution having a view look there is no inflation so no need to worry. But in the same way we should avoid thinking inflation is right around the corner (i.e. those promising hyper or high inflation since 2008). Economics is a dismal science.
I find it very strange that a lot of people link commodity bull markets with strong economic activity. While reading the history, we cannot be firer from the truth, to be quite honest. First of all, consider that the last two major secular bull markets in commodities occurred from 1932 until 1950 and 1966 until 1980. Both of those periods, one known as The Great Depression and the other known as Stagflation, had nothing even remotely close to strong economic activity.
DeleteThe truth is, commodities prices mainly move on the basis of demand and supply. Whenever the economy is weak, demand does fall so automatically investors assume that weak demand means lower prices. We couldn't be further from truth. During weak economic periods, like in the 1940/ and the 1970s, commodities did well because supply fell even faster than demand. So in the end, we still had shortages and prices still rose despite constant economic turmoil.
I think we are in the same period again. Economy is weak and barley growing despite policy makers throwing trillions upon trillions of dollars of stimulus at it. Eventually the downturn will come again and a recession will occur. Instead of thinking about how commodities will disappoint, the asset investors should worry about not performing well during downturns is equities.
Commodities on the other hand, will do well as supply continues to lag and the more downturns we experience the less investment goes into the supply side.
As you know the Kondrarieff cycle has commodity boom in summer and winter. And I agree we are in the winter by that theory but commodities have not done much since 2008. In fact, they have been a poor investment choice.
DeleteThis winter cycle is a bit different from classical ones in that the central banks have been successful (to date) in stimulating enough to prevent deflation but not so much to produce runaway inflation. What you call a weak economy, I call it one where the central banks have it on "life support" preventing it from Kondrarieff deflation event.
Whether they are successful or not is another debate but to date these trillion dollar programs have been ineffective to produce growth/inflation but sufficient to prevent deflation. The question still remains - what will cause commodities to rally be it either high inflation or outright deflation?
PS I'm a commodity bull but that question I don't have a good answer for.
Well I'm not sure why you think commodities have been poor performers since 2008. I do not see that to be true. For example, in late 2008 bottom commodities have outperformed stocks without a doubt. Copper is up three times even with the current bear market, Crude Oil is up three times even with the current bear market, Gold is up every year since 2008 (and it was even up in 2008) and has more than doubled since the lows and despite Silver declining almost 50% since April 2011, it is still up more than three times since 2008 lows. All of the grains have done amazingly well since 2008 lows apart from Rice. I do agree that Softs have lagged and that is why I have been vocal about the value it presents. However, back to the topic... Commodities have been a speculator investment since 2008 lows outperforming equities and bonds, and they have also been a great investment over the last decade, outperforming equities and bonds. I also believe as the bull market matures and the current correction ends, commodities will enter the final phase and gift investors even better returns.
DeleteYou make some very good points Tiho.I concur that we still have to witness the top of the secular commodities bull.I also agree that it's futile to worry too much about the state of the economy,as commodities are historically negatively correlated with stock prices.However,right now I am wary of those commodities which also exhibit temporary cyclical behaviour like oil and copper,for two main reasons(there are a few secondary reasons as well):
Delete1.They could suffer during the first phases of the coming economic contraction;
2.There currently is a bit too much participation and excitement in those two sectors,probably mainly driven by the media hype over the supposed Chinese recovery and/or the risk-on trade.
I am way more bullish on agriculture and softs in particular.I own Sugar and Coffee.
Macro,my point is exactly that all this money printing has already created another bubble,the effects of which you can see on stock prices,unsustainable bubble activities in China,Australia,Canada,the US and pretty much all over the world,the desperate hunt for yield etc. etc.I suspect it won't last much longer,since money printing actively harms the economy and as such the more money is printed,the greater the bubble and the shorter its duration(particularly when the economy's pool of real funding is already severely impaired).
Moreover money printing is inflation,the effects of which generally arrive with a rather long lag.Money printing can not generate economic growth:it can only engender unsustainable malinvestments which ultimately harm the economy.It is a hugely bearish factor,something which very few people realize.
To answer your final question:the rally in commodities will be caused by what always causes all price trends,namely an imbalance in the supply/demand dynamics.It may come in the form outlined by Tiho in his answer(supply destruction)or as a consequence of the proverbial crack-up boom(skyrocketing demand).
Have only been following your posts for a couple of weeks, but I really like the way you present your opinions, of which I agree with most.
ReplyDeleteThanks for the posts, looking forward to the next one.
Tiho,
ReplyDeleteWhat do you think of Tepper interview that 2013 will be bullish and a downturn will happen in say 2014 or later. The question, how will you handle if equities rally in 2013 adn drop in 2014?
http://www.zerohedge.com/news/2013-01-22/teppers-balls-wall-reappear-lead-explosion-greatness
Mr Tepper is much smarter than I am. He is also much more wealthier too. However, I remain short equities despite what anyone famous or important says / thinks / does. Weather I am wrong or sprit, remains to be seen. Check back at the end of the year or in 2014 and we will find out I guess.
DeleteI'm a newbie so not that familiar with all the economic machinations. I was talking to a friend who said that they are pulling manufacturing plants out of China due to excessive labour costs and moving to Vietnam. Eventually I suspect there will be no place to run. So even though labour rates are not climbing in the West (yet), as we witnessed in 2008, the global economy is very intertwined and I suspect we may feel their pain (China)...just not sure how.
ReplyDeleteDefinitely not as much interest in the commodity thread as we saw in equity thread. Despite a bull market over the last decade, investors are still in disbelief that commodities can rise further. On the other hand, every man and his dog, cat, sister, cousin and BFF is now invested into the stock market.
ReplyDeleteWhat is the best way to get exposure to Cottton? Would you use the ETF $BAL?
ReplyDeleteRegards,
Alex
*Cotton
ReplyDeleteYes it is possible to play Cotton via BAL ETF. You could also buy long dated futures or OTM options. Personally I am much more bullish on Sugar than any other Soft commodity. I believe Sugar can go up a lot from these levels.
ReplyDeleteI was looking at your portfolio and found it very interesting. Both apple inc and Japanese currency Yen have crashed from the last quarter of 2012. You seem to be engaged into those trades. If someone was to tell me last year that was to occur at the same time, I wouldn't have believed it.
ReplyDeleteStuart
Tiho you make a very insightful comment about the commodity thread. Even though we are a decade into a commodities bull market and an equity bear/sideways market (bear if you use inflation), the majority of educated traders/ investors are concentrating their money in the wrong area. The majority like to feel secure as part of the herd eg equity holdings as pushed through the media but fail to recognize the commodity bull cycle. This is probably down to stagflation and people concerned about deflationary forces rather than recognizing the exponential increase in the monetary supply.
ReplyDeleteWhen the majority finally move into commodities driven by monetary inflation (likely to be the peak in the gold price) and out of equities, then it will be time to move back into equities (likely the China stock market or other members of the BRIC nations as they move from the 2nd phase to the 3rd phase of Ray Dalio's countries economic cycles. This should be after maximum pessimism in the market and their being the theoretical 'investing when there is blood in the streets').
On the area of commodities, 3 areas i haven’t heard you mention are water, arable farmland & uranium. Do you have any views on these you would like to share?
Also appreciate any views on the future of Aussie interest rates being a fellow resident.
Phil R
on water....Buy "VE" Veolia Environment SA and earn 7+% percent dividend while you wait.
DeleteTiho:
ReplyDeleteDoes Mr. Tepper own AAPL today. Cheers on that insightful call.
garbage posts galore. Where is Tiho?
ReplyDeleteCommodity bulls are sitting on their position expecting the parabolic rise. Who is going to buy and fuel the final epic? No one yet!
Apologies for all the spam non sense over the last day or two. I have been away from work enjoying a break during "Australia Day" festivities. Furthermore, a close friend has just started up a brand new business and I have been involved with that as well, helping him as much as possible. All in all, it has been a very busy week.
ReplyDeleteThank you for another the great update Tiho. I am sorry, this is a bit off the current update, got a quick question about Japan; is there an ETF that provides short exposure to JGBs? Thank you and have a nice week ahead,
ReplyDeleteEmrah
Using a ETF database website could help you. I'm not 100% sure.
DeleteThis post is so informative and makes a very nice image on the topic in my mind. It is the first time I visit your blog, but I was extremely impressed. Keep posting as I am gonna come to read it everyday! commodity tips
ReplyDelete