Stathis on Commodities, Gold and Treasury Yields

July 2013 Intelligent Investor (Part 1) Opening Statement

Originally Published on July 7, 2013

The correction in the commodities bubble continues, as overall global demand continues to weaken. The impact of a weakening global economy on the commodities market is especially evident when one considers the current situation in China, which is now revealing some manifestations of an economic slowdown.

We should not forget that at the beginning of 2013, everyone was talking about the strength of China in addition to momentum in the U.S. economy. We specifically discussed that this interpretation was completely inaccurate, and in fact we insisted that both China and the U.S. economies were weakening.

As many subscribers will recall, we first discussed a correction in the commodities bubble in the February 2011 issue of the Intelligent Investor. Although we discussed that a correction was imminent and in large part irrespective of the forward strength of the global economy, we were biased towards a gradual weakening of the economy due to the depletion of global stimulus combined with misguided austerity in much of the advanced world. We have included excerpts of this forecast in this issue. [1]

You might recall that many so-called “experts” were claiming commodity prices were headed much higher (Peter Schiff, Jim Rogers, etc.). Hopefully by now you realize that every so-called “expert” in the media is nothing more than a yapping billboard that should be utilized as a contrarian indicator.

In our February 2011 Commodities analysis we laid out three levels of correction we felt would ensue in the CRB Index, each level based upon how much the global economy would weaken. Since this warning was published, we have been reminding readers of these three levels in every issue of the commodities forecasting report.

Thus far, the CRB Index has corrected down to the highest of the three levels. We feel this 500 support represents more of a normal correction and has not yet factored in the full extent of the global economic weakness. Thus, over the next several months we feel that the second level in the CRB Index (450) will be tested. Furthermore, we are biased for the lowest level at the 400 support.

While most commodities have collapsed since February 2011, certain commodities have held up nicely. Specifically, among the commodities covered in the Intelligent Investor, the Grains (Wheat and Soybeans) and Meats (Milk) have held up in the face of a correction in the commodities bubble due to supply-demand dynamics due to weather-related issues. 

Declining prices for most commodities is in large part a reflection of global demand for raw materials required for economic growth. It is for this reason that many commodities generally provide a nice hedge against inflation. Thus, a large drop in commodity pricing often signals decreased demand for economic goods and services. This is specifically what we are now seeing. There are two relevant caveats pertaining to a drop in commodity pricing. [2] 

First, when the decline is sudden, (similar to what we experienced during the previous commodities correction in the fall of 2008) the aftermath of such a correction often provides investment opportunities in select commodities due to the almost invariable overreaction seen in the marketplace.

In contrast, when the commodities market experiences a more gradual and protracted decline such as what we are now seeing, the bearish price trend is more often an accurate indicator of declining economic momentum as well as a prognostic indicator of future commodity pricing. As such, commodities investors must be especially careful when trading commodities when the trend is bearish because it is likely to remain bearish over an extended period until fundamental issues have changed.

In short, if it is even possible to formulate general conclusions from these statements, we argue that after a sharp and rapid correction in commodities (such as what we saw in 2008-2009), it is generally best to be biased towards the long end of the trade because under these conditions, commodities are likely to experience at least somewhat of a rebound in the short to intermediate-term. That does not mean that profits cannot be made by taking the short side of the trade. It merely means that traders should hold somewhat of a long bias when determining trading outcome probabilities, which will of course affect trading decisions.

In contrast, during a more persistent bearish trend in commodities (such as what we have been experiencing since early 2011), it is generally best to be biased towards the short side of the trade.

Of course, these generalities are very generic and dependent on numerous variables. That does not mean that profits cannot be made by taking the long side of the trade. It merely means that traders should hold somewhat of a short bias when determining trading outcome probabilities, which will of course affect trading decisions.

There are two significant macroeconomic ramifications pertaining to declining commodity pricing. First, resource-based nations such Australia, Brazil, Canada and New Zealand are likely to experience economic weakness during a period of declining commodity pricing. In contrast, nations like the United States, Germany and Japan are more likely to benefit from low commodity pricing. Interestingly, we feel that China falls somewhere in between these two types of nations. Finally it is also important to keep in mind that these relationships will influence many macroeconomic variables, not the least of which includes economic growth and currency pricing.

Although investors have overreacted to the Federal Reserve’s statements regarding the future course of its bond-buying program, this has not boosted commodities pricing.

The statements made by Fed Chairman Ben Bernanke on May 22 riveted the bond market, resulting in some $80 billion total bond outflows in June, the largest one-month selloff on record. This exodus from bonds boosted yields and served as a sentiment by investors of higher rates to come. In this case, when higher rates do arrive, they are not likely to be the result of excessive inflation. For this reason, commodity pricing has largely been unaffected by the surge in yields. 

On the other hand, rising Treasury yields and a stronger dollar are viewed as negatives for gold and silver. Furthermore, although the S&P 500 suffered from a nearly 6% correction since reaching an all-time high of 1687 on May 22, it has since rebounded and now stands at 1632, or just over 1% down from record highs.

In contrast, during this same time period, gold declined by as much as 12%. Although gold has made a small rebound, it remains down by more than 10% since May 22. This is an important point because gold typically serves as a hedge against market declines. Gold’s historical ability to hedge against market declines has been its most valuable characteristic. But here we continue to see that gold has lost this feature. Once again, this points to the blanket abandonment of gold by investors. Obviously, this is a bearish indicator for gold.

Although we have not heard much from the Middle East in several months, the problems have certainly not disappeared. The latest confirmation of this can be seen upon examination of the current events in Egypt. While Egypt is not an exporter of crude oil to the United States, the nation’s control over the Suez Canal has fueled speculation that this vital oil conduit in the Middle East could be blocked. Even though the possibility of this event is very unlikely, commodities traders always latch onto any excuse to speculate.

[1] Mike Stathis, chief investment and trading strategist of AVA Investment Analytics also predicted the prior commodities correction in the 2006 publication of America’s Financial Apocalypse.

[2] Note that we do not consider gold and crude oil as pure commodities due to geopolitical and other variables, although we consider crude oil and related assets to provide a good hedge against inflation, unlike the case with gold).