Commodities' Inevitable Rise

With major market indices hitting multi-year lows, now may seem like a great time for bargain hunters to invest. However, with the global economy teetering between a recession and a small depression, the market may keep falling and satisfactory return may not come about for many years. Fortunately, amid uncertainty, there is one asset class that stands a better chance than others to emerge victorious - commodities. To understand the reason, let us examine commodities in two scenarios: 1) a recession with a quick recovery, 2) a depression with a long recovery.

The first scenario is relatively straightforward. The economy slows and then rebounds. Economic activities revive within a year or two, and demand for raw materials returns to pre-recession level. So commodity prices, after having fallen nearly 60% since last summer's peak, rebound swiftly. The second scenario, with the dreaded D word, requires more analysis. On one hand, demand for all things, including commodities, are bound to fall during a depression. On the other hand, the demand for many commodities is not very 'elastic', meaning that demand will not fall off the cliff.

Take food for example. No matter what the crisis, people have to eat, and they can cut back consumption only so much. At the same time, food supply will likely fall faster than demand during a depression. This is due to two reasons. First, falling demand leads to falling prices; and falling prices lead farmers to produce less. Second, as the financial crisis deepens, banks become less willing to lend to everyone including farmers. Already, farmers worldwide are having difficulty obtaining loans to buy seeds, fertilizer, and farm equipment. Without the needed capital to increase planting, future food supply will shrink. With food inventories at 50-year low even before the financial crisis, the lack of financing will only exacerbate food shortages. As a result, food prices will have to rise to induce farmers to grow more. Finally, governments around the world are providing a tail wind for commodity prices. All the major countries are trying to solve the financial crisis by printing massive amount of money. The worse the crisis gets, the more money will be printed. Money printing devalues currencies and will lead to inflation down the road. In this environment, it is better to hold real assets such as commodities than paper currencies.

After the market decline in the last 18 months, it is hard to see why one asset class will do better than another. After all, almost everything has tumbled. However, the heavy selling in the recent past was caused by panic or forced selling that has little to do with fundamentals. Once the panic subsides, fundamentals will drive the market once again. When that happens, whether there is a recession or a small depression, commodity prices will rise. It will only be a matter of how much and how fast.

Comments

[Mad Hedge F...:]

Long term it may be the only game in town. To say the market has gone mad is an understatement. The Dow has lost 24% since January 1, giving up $2.6 trillion in value. Other than that Mrs. Lincoln, how was the play? Credit default swap risk premiums now tell you that it is much riskier to invest in Warren Buffet’s Berkshire Hathaway (BRK/A) than Vietnam, and that Russia is a safer bet than General Electric (GE). The Dow is headed for the 4,000, according to ultra bear Felix Zulauf of Zulauf Asset Management in Zug, Switzerland. The rock star fund manager believes that we entered a 10-15 year bear market in 2000. He argues that analysts are smoking something with S&P consensus earnings forecasts at $60, down from $100 a year ago, and that the real number will come in at zero to $40. We may see one more bear market rally to 9,000 in the next few months led by financials, mining stocks, and consumer discretionaries. After that the Dow will drop by half. Day traders only need apply.

Mar 08 04:53 PM

[Mad Hedge F...:]

Commodities are the only way to go. Traders looking for the Next Big Play are keeping a laser like focus on two key commodities. Chinese stockpiling prompted copper to break out of its recent trading range to the upside to $1.70, taking lead producer Freeport McMoran (FCX) up 30% on the week. Crude rose 15% to a high of $46. These impressive moves happened during a week when global equity markets were in complete freefall. This suggests that the bulk of the world’s growth will be in emerging economies, and that the next round of commodity buying will be even more ferocious than the last. Since I believe that the future is all about the ascent of hard assets over paper ones, this is music to my ears.

Mar 09 01:12 PM

[donzelion:]

"First, falling demand leads to falling prices; and falling prices lead farmers to produce less."

Farming doesn't work the same as, say, auto manufacturing. A few commercial farmers might reduce their production, but most farmers depend on farming as their sole income: they won't produce less because prices are low, they'll just earn less. If that goes on for a lengthy period, they'll go bankrupt, but since banks aren't great at farming, that'll just redistribute the land, rather than stopping production.

Likewise with credit for farmers. Banks may not like to admit it, but many thousands of them are dependent upon keeping the farmers solvent - which means they'll make loans, even when they don't want to (or they'll get shuttered in a wave of thousands of failures, much like the 30s).

The joys of agriculture: nothing in the world better approaches a 'perfect market' - and yet, in the real world, it never performs like anyone's calculations or expectations suggest it should.

Mar 12 08:06 PM