Commodities - the next great bull market

Our forecast at the beginning of this year was that commodity prices, as represented by the CRB Index, would be weak during the first half of the year and turn higher some time during the second half. In the August-27 WMU we refined this forecast based on our views at that time on the bond market and economic growth and argued that the CRB Index would likely bottom in September. At the same time we also made the following comment: "Although we give the CRB Index a reasonable chance of turning higher during the next month we will look to the A$ and the C$ for confirmation of a trend change. The commodity currencies tend to move in the same direction as commodity prices and they often lead commodity prices. A sustainable up-move in the CRB Index should therefore be accompanied by, or led by, an upturn in the A$ and the C$."

Since we forecast that the CRB Index would bottom in September the prospects for global economic growth have taken a tumble due to the recent insane acts of terrorism, so where do we now stand with respect to commodity prices?

The long-term

First, let's step back and take a big picture view of the CRB Index. As the following chart clearly shows, commodity prices have been in a secular bear market since 1980. Within that secular bear trend there have been a number of cyclical bull and bear markets, with the most recent cyclical bull market having ended late last year.

The most recent cyclical low occurred in July of 1999 when the cash CRB Index hit 182.67. It recently traded as low as 189, so with the 1999 bottom likely to provide solid support the downside risk from current levels appears to be minimal. Even if the 1999 low is penetrated, the bottom of the long-term downward-sloping channel is only a few points further down. From this purely technical perspective there appears to be very little remaining downside in commodity prices.

Taking an even longer-term view, the inflation-adjusted CRB Index is now at its lowest level in more than 80 years. Commodities are cheaper today, in real terms, than they were during the Great Depression of the 1930s. When the prices of essential resources are at 80-year lows and close to an area of good long-term price support, it is time for investors to do some buying provided there is a good reason to expect a change in the price trend. That good reason, in this case, is the on-going rapid expansion of the money supply.

Explosive money supply growth such as we have seen over the past year will have a big effect on prices, the only question being which prices. The excessive money creation that occurred during 1998 and 1999 had the greatest impact on tech stocks, real estate and oil. Ex-oil, commodity prices were not major beneficiaries. However, even if the NASDAQ has just made an enduring low sentiment has been damaged to the extent that the tech and internet stocks will not be the primary focus of speculation over the next few years. Partly due to the absurd under-valuation of commodity prices relative to almost everything else in the world, partly due to the evidence that secular trends may be in the process of changing, and partly due to the fact that the stocks of commodity-producing companies had been performing quite well prior to the general stock market panic of the past several weeks, we think the main focus of speculation/investment over the next few years will be on commodities and commodity-producing companies.

The short-term

Below are charts of the Australian Dollar and the Canadian Dollar, the two major commodity currencies (so called because the economies of Australia and Canada are heavily reliant on the export of commodities). The A$ had broken above its 20-month downtrend at the beginning of August and looked to be completing a normal pullback prior to the events of September-11. However, the A$ plunged with the US stock market last week due to a panic away from risk and a 'ramping down' of economic growth expectations. The C$ was weak prior to the terrorist attacks and has, over the past 3 months, appeared to be suffering from guilt by association (it is the only major currency that has not benefited from the downward reversal in the US$ and has, instead, fallen with the US$ against the other major currencies).

Recent events may have only temporarily pushed the A$ off its trend, in which case we should soon see a snap-back to pre-panic levels (around $0.53). However, a drop to new lows by the A$ would suggest that an upturn in the CRB Index is still at least a few months away.

Although we don't plan on turning short-term bullish on commodities until we see a sustained upward reversal in the A$ and the C$, we don't think our previous forecast for a September bottom in the CRB Index will be far off the mark. The events of Sep-11 have caused global growth expectations to be revised downward and probably delayed the CRB's bottom by 2-3 months, but the actions of central banks in the wake of these terrible events are going to give commodity prices a shot in the arm. As such, the CRB Index will now hit a lower level than it would have in the absence of the attacks, but the eventual upturn will most likely be sharper.

On a related matter the recent plunge in energy prices, assuming there is no immediate bounce-back, will suppress the PPI and the CPI over the next few months. This could potentially be positive for commodity prices in general and gold in particular by creating an environment in which the Fed will not feel pressured to deviate from its 'easy money' policy. In other words, the longer the effects of inflation remain hidden from view the more profligate the Fed will be and hence the greater the eventual price increases will be.

Oil and oil stocks

We were short-term bearish on oil between late-May and late-July, but canceled that view in late-July after the oil price spiked below $25. Since that time we have been neutral, expecting the oil price to range-trade between $25 and $28. Prior to the terrorist attacks and the suspicious trading in oil futures in the days leading up to the attacks, oil appeared to be headed back to the lower end of our expected range. However, over the past 2 weeks the oil price has spiked above the top-end and well below the bottom-end of this range and currently sits at around $22. The following chart suggests that there won't be much additional downside in the short-term (the oil price bounced off the channel bottom on Wednesday). Longer-term we are bullish on oil, although barring disruptions to oil supply as a result of military conflict in the Middle East we expect to see the oil price under-perform the prices of most other commodities over the next 6 months.

The following paragraph from the Jul-18 Interim Update is just as applicable now as it was then:

"As big a hit as oil and oil stocks have taken over the past 2 months, gold and gold stocks are MUCH more attractive (from both an investment and a 'long side' trading perspective) than oil and oil stocks at the current time. The reasons are: a) relative valuation, b) the oil price is sensitive to global economic growth (although we expect an economic recovery to begin over the next few months, this dependence on economic growth is a risk), and c) the SF and the euro have broken out to the upside (the precursor to a gold rally)."

Oil stocks began to break down in May, at the same time that most oil companies were reporting blow-out earnings and the vast majority of analysts were recommending the purchase of shares in oil companies. Based on the earnings that were being reported at that time, the P/E ratios of the oil companies appeared to be low despite the preceding run-ups in their stock prices. However, there are few things less relevant to a company's stock price than its current P/E ratio. The market is constantly trying to adjust stock prices based on expected future earnings, and in the case of oil stocks the market was once again prescient. 

Resource stocks

Below is a chart of MIM Holdings (ASX: MIM), a diversified Australian mining company with major exposure to copper and coal. This chart illustrates one of the difficulties of investing in the stocks of commodity-producing companies in that the MIM stock price doubled during the second quarter of 1999 while the CRB Index was still bottoming. By the time the CRB Index turned higher in July of 1999, the best percentage gains in the MIM stock price had already occurred. The stock price of Freeport McMoran Copper and Gold (NYSE: FCX) behaved similarly to MIM in 1999.

The best time to buy resource stocks is often about 3 months prior to an upturn in commodity prices. 

Below is a chart of North American copper producer Phelps Dodge (NYSE: PD). The PD stock price has recently taken an even more spectacular dive than the MIM stock price.

The recent behaviour of the stock prices of the commodity producers suggests that a sustained upturn in the CRB Index is at least 2-3 months away. However, if we are right about the effects of the massive inflation that continues to occur in the US and throughout the world, the next cyclical bull market in commodities is really going to be something. Furthermore, the stock market will begin to discount this bull market well before there is any definitive evidence that a bull market is in the offing. As such, we suggest that investors begin to build a position in some of these commodity-producers now. We will immediately add MIM to the Portfolio.

Summary

We are probably still 2-3 months away from a bottom in the CRB Index. If the A$ drops to a new low over the next few weeks then the final bottom in the CRB Index may even be delayed to the first quarter of next year. We think a reasonable approach for longer-term investors is to start building positions in the stocks of large commodity-producers now with the aim of averaging-in over the next few months.

The US Stock Market

Current Market Situation

There is very little to add to the analysis that was presented in the latest WMU. The stock market made a panic low last Friday morning and the most likely course of events is that the panic low will be tested at some point during the next few weeks.

Below is a chart of the S&P500 Index since the beginning of 1998. During 1998's stock market catharsis the market's recovery following its Aug-31 panic low lasted about 4 weeks, after which a plunge back to the August lows occurred. This year's test of the low, assuming we do get a test (there are no guarantees), could happen at any time between now and the end of October. Note that the Japanese stock market, which has led the US market throughout much of this year, has not yet made a definitive upward reversal. This supports the idea that there will be a test of last week's lows.

We purchased an initial position in QQQ (NASDAQ100 Trust) shares on Tuesday and plan to add a second position after we see some evidence that the bottom is in. What we have at this stage is a market where fear has reached a level that has, in the past, only ever occurred near major (multi-year) lows.

Gold and the Dollar

Current Market Situation

When we look at the following chart we keep thinking we must be missing something. It seems blatantly obvious that the 5-year downtrend has been decisively broken, the gold price is in a short-term up-trend and a move well above $300 over the next few weeks is a formality. However, if this is all true then why has there been only minimal speculation in the stocks of gold mining companies? We don't have an answer to that, but suspect that a daily close above $300 will be enough to cause panic buying of gold stocks.

The following extract from the latest WMU is still applicable: "If the gold price does spike sharply higher over the coming week then we would take the opportunity to harvest some profits. Otherwise, we will continue to hold as long as the trend remains bullish. New buying should only be done during periods of price weakness." By the way, a sharp spike higher would be a move of at least $25 over the space of 1-3 days.

Harmony Gold Mining, which along with Anglogold and Gold Fields Ltd has recently been a laggard, has broken out to the upside and looks to be headed much higher.

The below chart shows that the Dollar Index has edged higher over the past week within the confines of its multi-month downtrend. The Dollar's recent recovery has been weak, suggesting that another downward spike could soon be seen despite the lopsidedly-bullish (for the Dollar) traders' commitments. At some point during the next 5 weeks, possibly in parallel with the stock market dropping to test last week's low, we expect the Dollar Index to fall to 108 or lower.

Changes to the TSI Portfolio

QQQ purchased at US$29.00 on Sep-25 and MIM purchased at A$0.85 on Sep-27.