Stock Market Crash! Blog

The Commodity Boom's End is Near

In the four years starting in 2002, commodities as a group, have experienced the longest, most powerful bull market since the late 1970's, with the Commodities Research Bureau (CRB) Index nearly doubling. Aluminum prices have doubled, gold is up 150%, platinum up 180%, crude oil up 300% and copper up an astounding 450%. The performance comparison chart below is from Stockcharts.com. Click on the chart to see a larger version:



This raw materials bull market was fueled by the US Dollar Index's 32% decline, insatiable demand from the fast growing economies of China and India, and the oil price shock which was spurred on by terrorism fears, war in Iraq, hurricane Katrina and the Iran crisis.

(It's worth noting that agricultural commodities haven't experienced any unusual behavior, helping to temper some of the CRB Index's rise. Agricultural markets are driven by a different set of dynamics than the more commercial metals and petroleum products.)

Though this bull market has its roots in strong industrial demand, the recent white-hot nature of this trend can be attributed to pure speculation, especially by hedge-funds. Indeed, economist Howard Simons from theStreet.com quips, "the industrial-metals markets are anything but conservative these days. They are bubblier than a shaken can of warm beer", in his article, "Metals Bubble is a Lead Balloon."

Simons purports that the commodities markets are experiencing an overheated bubble, not unlike that in internet stocks in the late 1990's. And we all know how that ended.

According to Simons:

"All bubbles begin in reality: We did invent and bring to market a few things in the information technology world in the 1990s, none of which could justify the excesses seen by the end of the decade. We do have growing demand in China and elsewhere today; once again, none of these developments can account for the speed and magnitude of the price gains witnessed.

Given the growing fears of inflation, it is tempting to blame these conjoined rallies as investors seeking protection against currency debasement. It would also be laughably wrong. Copper and zinc are up more than 88% and 94%, respectively, year to date, and while inflation may be rising, that's a little bit of overkill on the protection side, don't you think?"

Amidst lackluster US stock returns for the past 6 years, hedge funds have searched far and wide for trending markets, piling into the commodity markets since 2002, and serving to dramatically amplify any movement caused by industrial demand alone. The impact of hedge funds in the commodity markets should not be underestimated, as they account for "one-half of the (trading in the) commodities sector", according to the article "Demystifying Hedge Funds".

Over the past few years, hedge funds have seen greater than 13% annual returns, trouncing the performance of stocks and helping to supercharge the growth of the hedge fund industry. Indeed, hedge funds have garnered "$1.5 trillion in assets, double the level in 2000," as reported in "Demystifying Hedge Funds."

Such record growth has helped the highly-secretive hedge fund sector enter the more mainstream retail investment market, now enabling investors with as little as $25,000 to invest in "funds of hedge funds." Once the domain of those with millions to invest, such hedge funds now provide small investors with the ability to profit from a decline in the stocks as well as participate in a wide array of markets including grains, metals, bonds, currencies, petroleum products and foreign stocks and bonds. Standard mutual funds, which can only buy and hold stocks and bonds, may see increased competiton from the increasingly accessible hedge funds, especially if stocks continue their trend of mediocre returns.

Hedge funds' contribution to the commodity bubble stems largely from their trend-following trading methodology. Trend following doesn't entail calling a top or bottom in market, but rather seeking to gain a big piece of the middle of a long trend. For this reason, trend following hedge funds tend to extend the length of market trends as they plow billions of dollars into relatively small markets such as commodities, causing them to achieve bubble-level valuations. Many pundits are attributing recent commodity action as being the result of "Chindia's" demand, but the reality is that funds are inflating the commodity markets like an elephant jumping into a kiddy-pool.

Trend following hedge funds don't usually bail out at tops, preferring to sell their holdings only upon a clear confirmation that the uptrend is over, serving to further exacerbate the markets descent. The commodity markets will experience a violent free-fall as some funds take on short-positions, anticipating a multi-year downtrend.

There are several indications that the commodity market bubble is nearing its end, likely within the next two months:

1)Prices are beyond over-extended, with many markets going nearly vertical since January 2006. This action isn't justified by fundamental demand, but rather caused by excessive speculation. Several articles from BCA Research back this claim, such as "Gold: Mania Phase", "Be Wary Of Materials Stocks" and "Commodity Prices: Following Natural Gas Prices Up, And Down?", calling the present market environment a "mania."

2)The Dollar's five year bear market, which helped fuel the commodity boom, seems to be ending as I've written in this post. A decline in the Dollar helps boost gold and precious metals prices upward, due to their inverse relationship. In general, a weakening Dollar is bullish for commodities, and vice versa.

3)Global bond yields and interest rates will continue their upward trend for a bit longer, helping to temper some of the strong economic growth that led to such strong commodity demand in the firstplace. Read my post explaining why bond yields have further upside ahead. Even though rates have been increasing for a while, there is likely a delayed effect before the economy feels the impact.

4)The US economy has already begun to show signs of a slowdown, with more to come, according to April's Leading Economic Indicators which fell by a greater amount that expected, foretelling slower growth environment 3 to 6 months in the future. The article says of the Indicators:

"It is saying what we all know: second quarter growth will fall short of the first quarter," said Stuart Hoffman, chief economist at PNC Financial Services Group. "And growth for the second half of the year, will be slower than the first."

Hoffman expects GDP growth will be between 3 percent and 3.5 percent in the second quarter, and no more than 3 percent in the second half of the year.

Gary Thayer, chief economist at A.G. Edwards & Sons Inc., said several recent economic reports point toward a slowdown. For example, earlier this month the Commerce Department reported that the number of new housing projects in April dropped by 7.4 percent to a seasonally adjusted annual rate of 1.849 million units."

Additionally, BCA Research reports that theU.S. Consumer Slowdown Is On Its Way and that there are Signs That Global Growth Momentum Is Peaking found.

5)The housing bubble has popped and that homebuilding activity and prices will continue to decline, causing a decrease in demand for building materials such as copper, cement, wood and sheetrock. Even Alan Greenspan has capitulated, saying "the housing boom has ended." In a post a while ago, I detailed why the housing market and related stocks are entering a bear market.

6)The emergence of commodity exchange traded funds likely signifies that the commodity trend is over, as these types of developments tend to occur too late, created in response to the commodity speculation fever. There is now an oil ETF, symbol USO, a gold ETF, symbol IAU, a silver ETF, symbol SLV and rumors that a copper ETF is receiving SEC approval soon. Once the little guy has a chance to get into such a trend, its usually over, according to contrarian thought.

There are a plenty of ways to profit from the commodity collapse, and investors should look forward to this event with just as much alacrity as with a bull market in stocks. Not surprisingly, the strategy involves shorting commodity stocks that have benefited from the long commodity bull market. Take a look at the following chart from Stockcharts.com:



One great stock to short is BHP Billington, symbol BHP, which is the world's largest metals miner, and deals in a wide range of commodities. Phelps Dodge, symbol PD is a great play on copper as is Aluminum Corp. of China -Chalco, symbol ACH, a play on aluminum.

As far as gold stocks go, some great short candidates include AngloGold Ashanti-AU, Newmont Mining Corp.- NEM and Barrick Gold Corp.-ABX.

I am bearish on oil on the intermediate term perspective, however, I wouldn't short oil stocks just yet. My reason for this is a potentially bullish pattern in oil, that I mentioned here.

Before shorting commodity stocks, I would wait for a topping-type chart pattern, which I will post if and when it arrives.