The face of today’s mainstream financial media has gone from meaningful analysis and commentary to constant tub-thumping between undisciplined Main Streeters, overambitious Wall Streeters, and ignorant bureaucrats. It has turned into a showcase of the blame game, everyone looking for a scapegoat to shoulder the iniquities of the masses.
Though these recent financial-market shenanigans are of historic proportion and have scared stiff nearly every investor on the planet, folks seem to be growing complacent. And it has been easy to fall into this trap and lose sight of investment strategy considering the indiscriminant selloff of virtually every asset class. Everything has been hit so hard that even the anti-commodity CNBC commentators have toned down their bubble-bursting rhetoric.
But now more than ever investors need to step back and revisit their strategies. The markets have changed, and for better or worse we need to know if what has worked in the past will continue to work going forward. And what has worked in the past is commodities.
Hands down, commodities have been the top-performing asset class of the 21st century. This powerful commodities bull was driven by strong global fundamentals that saw skyrocketing demand far outpace supply. Based on simple economic principles this imbalance prompted commodities prices to launch stratospheric.
Regardless of the mainstream financial media’s continual disdain for this commodities bull, which has run parallel with a secular bear for their precious stock markets, legendary gains were won for those prudent investors and speculators who saw the writing on the wall.
Now there is certainly a valid argument to be made that exuberant speculators caused many commodities prices to reach overbought territories and perhaps even launch into bubble-type parabolas. But there is no denying that it was the fundamentals that provided a solid foundation for the run on commodities.
Well with the crumbling financial markets taking their toll on the global economy and launching what is expected to be a recession of historic proportions, is the commodities bull over? Over the course of the last several years the financial media has proclaimed the end of the commodities bull on countless occasions. And much to their chagrin they have been wrong every time.
But is it different this time? Is the commodities bull really over? In the past it has been easy to defend this bull market using anecdotal evidence of real-time hunger for scarce raw materials. But this time there seems to be little defense for commodities. And over the last several months there has been a massive selloff in the commodities realm. Nothing has been immune to the carnage.
While the dust may not have fully settled yet, fundamental changes in the global marketplace are already beginning to unfold. And I believe it is prudent to catch our breath and see if and how these interim fundamentals are changing the secular nature of the commodities bull. But first we need to assess the damage. To place the commodities bull in strategic context I put together a table that captures its essence.
Since there is no official date that marks the beginning of the commodities bull, as individual commodities began their bulls at different times, for reference sake I used a date that I believe marked the end of the secular stock bull. March 24, 2000 was when the flagship S&P 500 (SPX) index reached its apex, and this is as good a point as any to mark the beginning of the commodities bull.
The first column shows the price of each component at the beginning of the commodities bull. In the preceding 17 or so years that molded these starting values the flow of capital poured into the stock markets and left commodities with reckless abandon. After years of a grueling bear that ravaged the commodities industry, many of these March 2000 prices neared historic lows.
But after years of neglect in which investment in commodities exploration and infrastructure all but dried up, suppliers would get a rude awakening when there was resurgence in demand. The supply side of the commodities trade was unprepared for the rapid demand growth that was soon to come.
From these March 2000 lows, commodities prices would soar as suppliers scrambled to meet demand as well as take advantage of the new higher prices. But unlike a widget factory that can increase supply with the turn of a dial, it is much more difficult to ramp up commodities production.
At the turn of the century much of the commodities supply chains consisted of aging and depleting resources within shoddy and rundown infrastructures. A lot of work needed to be done in order to materially increase the capacity of natural resources production. But especially for those resources that are finite, hidden in the bowels of the earth, fresh new operations would only come about after intense exploration, discovery, and development. And this process is neither quick, easy, nor cheap!
Petroleum and mineral production offer fine examples of this tedious process. The first phase involves establishing the economic feasibility of a mineral deposit or oilfield, which takes years of intense exploration. If a project is actually revealed to be economically viable, only then do the directors of the producing company hammer out the details and make the decision to develop operations.
After a positive development decision the project owners must then procure financing for what are usually sizeable capital expenditures. The development/construction phase then takes several more years, and if all goes well the project will eventually be ready for commercial production. Ultimately it can take between 5 to 10 years and hundreds of millions of dollars just to commission a medium-size mining or drilling operation.
As a result of this slow response time on the supply side, supply growth was nowhere near meeting demand growth. And when supply can’t meet demand, the only thing capable of quelling demand is rising prices. As you can see in the second column, prices responded with sharp ascents.
These bull highs returned the massive gains we see in the third column. And keep in mind these gains are measured from a common point of reference. Many of these commodities launched into their respective bulls from prices that were even lower than those in March 2000.
For example the HUI gold-stock index didn’t achieve its low of 35.99 until later in 2000, giving it a trough-to-peak gain of 1331%. Many of the base metals didn’t hit their lows until years later. From trough to peak aluminum, copper, nickel, zinc, and lead had respective gains of 165%, 581%, 1124%, 537%, and 896%. And oil’s low of $10.73 was actually achieved in late 1998, giving it a trough-to-peak gain of 1259%.
Regardless of their exact lows, these bulls were secular in nature. And as you can see in the fourth column most commodities achieved their interim tops at some point in 2008. And with oil being the largest and most influential commodity, when its bull ran out of steam in summer 2008 so marked the top of the venerable CCI.
As you can see in the next two columns the recent global selloff of anything and everything has hit commodities hard. Prices are vastly lower than their highs achieved not too long ago. And these price declines are massive. Many of these commodities have seen their prices lopped in half, or more, in short order.
Oil is off by a whopping 53% since its July high. Measured by global consumption this translates into a staggering $6.5b swing to the downside in daily capital flows in just three short months. Copper, which is the highest-profile base metal, is down 49% off its July high. And the grains are also suffering, with corn and wheat off 41% and 61% from their 2008 highs.
So with this across-the-board slaughter does it mean that the commodities bull is over? I don’t think so! And I know this stance is of extreme contrarian nature right now but hear me out. The commodities bull is not over for one simple reason, and this is Asia.
I understand that many folks are getting tired of the constant beating of the Asian drums, but these drums have been loud for a reason. And while the thumping sound may not be as audible in these chaotic markets, it is not going away. Led by China, Asia’s developing economies will continue to thrive for decades to come.
One way to look at Asia’s growth prospects is through the eyes of its massive population. Using China as an example, we know that its government is hell-bent on growing its economy to become the decisive world powerhouse. And as part of this growth its people will prosper.
The 1.3b+ people in China and even the 2.7b+ people in the rest of Asia combine for a massive consumer base that has never been party to past commodities bulls or economic prosperity. The Western economies, US and Europe, have long been the sole drivers of market cycles until now.
With an infrastructure build-out that is still in its early stages mixed with wealth and discretionary capital in the hands of folks that long to live the Western lifestyle, commodities consumption should continue to rise in the years to come. Measured by per-capita commodities consumption the Westerners have been through a growth cycle that has likely seen its peak. But in Asia per-capita commodities consumption is expected to rapidly rise as people improve their lifestyles.
And this per-capita commodities consumption growth should not be too affected by the stock market travails. A lot of the funds pulling out of the Asian markets are sovereign and speculative, and were held by a limited number of hands with large positions. I don’t expect these losses will impact the average Asian citizen in the same way they will the average Westerner.
Now I’m not saying that we aren’t experiencing a period of contraction on the commodities front, even in Asia. A global recession will reach far and wide. In fact we are likely in the midst of an extended cyclical bear on the commodities front. But I don’t believe this bearish cycle has the moxie to put an end to the secular bull. And neither does China.
Just recently the Chinese government commented that while economic growth will slow a bit during this turmoil, the unfavorable international factors and even serious natural disasters at home won’t change its core economic growth strategy. China made it emphatically clear that its economic growth machine has the ability to repel whatever external risks are thrown at it.
And when you consider that China hosts well over 50% of the world’s construction, that coal-fired power plants are going up at a rate of one per week, and that oil demand is expected to increase by 50% in the next 10 or so years, it is apparent that China has some clout in the global commodities markets.
But regardless of this China rhetoric, many still ask how I can possibly believe that this commodities bull is still alive in the face of such rapidly declining commodities prices. For many folks “correction” is an understatement. As you are likely aware analysts of all walks of faith are using “crash” with impunity. And depending on whose definition you go by some commodities prices may have indeed experienced a crash from their tops.
Ultimately however you define the shellacking that commodities have endured, I don’t believe this activity is bull-ending. This extraordinary selling pressure is likely a combination of commodities prices perhaps getting too high for their own good mixed with extreme and unprecedented market fear.
Looking at the last column on this table we can see that even though commodities prices have seemingly fallen off a cliff, most are still way above their lows. And I included the SPX in this table to offer some perspective. If there is any challenge to the ironclad reality of the secular bear in the general stock markets and the secular bull in commodities this table ought to clear things up.
Investors who’ve had their money in the SPX since 2000 have had a tumultuous and unrewarding journey. A brutal 2000 to 2002 cyclical bear that shed 49% was followed by an impressive 2003 to 2007 cyclical bull that doubled-down, bringing investors just back to par. But when you throw inflation in the mix, flat performance after 7+ years is devastating to one’s portfolio.
After the SPX peaked nearly a year ago, which was only 2% higher than its March 2000 high, it has spiraled down by 41%. Investors in commodities over this 8-year span have fared much better. As you can see even after the commodities carnage of late, the gains are excellent.
From March 2000 to current most commodities and the stocks involved in their trade are still sporting impressive gains. The ride has certainly been wild, and traders have had to befriend volatility, but it has been very rewarding for those who got in early.
As for calling a bottom my inner contrarian tells me it is here now. I believe commodities and commodities stocks are vastly oversold and represent incredible bargains. But it is also prudent to consider how much farther the trepidation that is driving these markets mixed with a broken financial system can drag prices to the downside.
Right now we are going through a period where leveraged speculative positions are being unwound and the economic landscape is being rebalanced. Commodities demand has definitely slowed, but it has not disappeared. Unfortunately the financial media is currently using the careless phrase “demand destruction” far too loosely when describing the commodities markets.
In reality the only thing being destroyed is commodities prices. Demand is not being destroyed. My business partner Adam Hamilton has an alternate view of this demand-destruction paradox. In the 10/21/08 issue of our Zeal Speculator weekly newsletter he wrote:
“...traders are acting as if a recession means demand Armageddon, but that is silly and irrational. If a normal year is given a baseline of 100, a recession with 2% economic shrinkage still comes in at 98. An unthinkable 5% annual decline in US GDP is 95% of the normal baseline year. Oil demand will contract modestly in a recession, but not implode totally. We Americans will still eagerly consume vast quantities of raw materials.”
“Similarly, Chinese and Indian demand aren’t going to fall off a cliff either. Growth may slow, but demand will still be immense from an absolute perspective. China just reported that its Q3 GDP came in at 9.0% growth, which hammered commodities. Yet this wasn’t down from 30%, just 10.6% in Q1 and 10.1% in Q2. Chinese demand for oil and most key commodities is still growing rapidly...”
Adam goes on to explain that even in slow economic times there is still a lot of demand for raw materials. Recessions don’t wipe out demand, they are slight reductions in overall aggregate consumption levels. It is fear and panic that is driving this massive commodities selloff. And these price levels are unsustainable over the long run.
In fact, these depressed prices are likely to snowball into yet another severe supply pinch. We are already seeing widespread production cuts not only in the oil industry but the mining industry. Many operating mines cannot profitably produce their metals at today’s prices, causing production stoppages. And many development projects are being put on hold not only due to these low commodities prices but the dried-up credit markets and lack of investor interest in equity offerings.
Shifting gears, while weakness may persist for a spell as most commodities prices seek to stabilize and find their balances, especially the industrials, the precious metals should really thrive in today’s environment. In the table above you can see that gold has not given up its ghost, and has retained most of its gains.
This strength is a result of rock-solid and unchanging fundamentals. Gold’s commoditized nature is unique in that it acts as a safe haven and store of wealth. And in these uncertain times when even cash is risky, gold offers investors true value. The economic balance of gold is also unique compared to other commodities. Gold mine production continues to fall in the face of rising demand.
These are just a handful of gold’s stellar fundamentals. And this global financial crisis should be a great boon to gold’s desirability. When these gargantuan government bailouts start to filter through the system the world will experience a huge inflationary period as the printing presses are stressed to their limits. And this is where the demand for gold will really flourish as investors diversify out of the fiat mess.
Overall I believe the greater commodities bull market is not over. Throughout history commodities bulls have run for an average of about 17 years, and I have no reason to believe this one will be any different. As you can see in the table above commodities have been the strongest asset class over the last 8 years, and I believe they will continue to be the strongest for at least the next 8 years.
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The bottom line is it is fundamentals that ultimately drive the secular nature of any bull market. And the long-term prospects for commodities remain very strong. China will continue to be the stalwart of the world’s developing countries, and it is these countries that have and will continue to drive this commodities bull.
The interim growth trends may recede for a while, but they will not grind to a halt. And we may even find that the chain reactions caused by today’s extreme fear will quickly pinch supply and cause an even sharper run on commodities as soon as this recession runs its course. Investors who haven’t given up on the commodities bull should again be in line for legendary gains.
October 31, 2008
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