Seeking Alpha
Long/short equity, research analyst, portfolio strategy, commodities
Profile| Send Message|
( followers)  
After a 900+ percent and nearly 500 percent skyrocketing run-up in silver and gold prices, respectively, since 2001, the market finally woke up last week and corrected the soaring investor enthusiasm which has carried the prices of precious metals, oil, and commodities to extreme and historically unsustainable levels. Moves of such magnitude are never sustainable and are almost always inevitably due for a much more severe collapse as institutions, skilled investors, and -- ,most devastatingly – the average investors who got in too late panic and sell as prices continue to plummet.
[Click all to enlarge]

Source: Bespoke Investment Group
Gold was the first focus of investor enthusiasm, as it:
  1. Offered a much better alternative to the struggling stock market.
  2. Was expected to offer the only real store of value at a time when dollars and paper money seem to be doomed to fail.
  3. Would protect investors from both inflation and deflation (though someone has to be wrong).
  4. Continues to see demand growth across the globe.
  5. Has many fundamental reasons to continue rising (see “The Impending Collapse of the Gold Bubble”).
As gold continued to rise, silver started rising at an even more rapid pace, as enthusiastic investors bought it in a frenzy because it was both more affordable and because it has industrial uses.
Take a look at how silver has tremendously outperformed gold recently:

And not only has silver utterly destroyed gold in terms of performance, it has also taken a much bigger hit as investors flocked out of it last week. Silver dropped nearly 30 percent, while gold dropped less than 10. The massive drop in silver shows us what can happen when extreme enthusiasm comes to a screeching halt – something that could easily happen to gold and the entire commodity space almost instantly.
Moreover, the relatively small drop in gold over the same period shows that gold has some more strength behind it. At the same time, however, the massive drop in silver has taken a lot of attention away from gold – and since I expect gold and silver to move up and down together, I think that the largely ignored move in gold will lead us to much more severe downturns in gold in the future. In other words, when people forget about the huge drop in silver and start to remember that gold could be in danger as well, they will start selling their gold – and prices will drop much faster.
Silver and gold were not the only commodities to drop. Oil prices dropped from nearly $115 to below $100. High oil prices hurt the economy because businesses have to spend a lot more to produce and consumers have to spend a lot more at the gas pump. Though we have been in a recovery, supposedly, high energy prices are a huge drag on the economy and could be the final warning signal before the next recession (see “Sector Rotation: How Energy and Consumer Staples May Reveal a Contraction”).
Commodity Price Declines Ignored?
I will also point out that even though the commodity theme has been tremendously profitable over the past year or more, it is showing increasing signs of weakness. While we’re continuously hearing stories about rising input costs for retailers, manufacturers, food producers, and almost the entire business world, the prices have actually been falling. In other words, producers and manufacturers are struggling to maintain profits and are doing so by raising the prices for consumers – but they are doing so as the prices of those inputs are dropping.
Consumers are actually the last ones to suffer, and are paying higher costs even while those input costs are falling; higher costs on the consumer are therefore lagging behind the higher commodity prices, which have now dropped.
Not only are the huge drops in Sugar (NYSEARCA:SGG), Cotton (NYSEARCA:BAL), Palladium (NYSEARCA:PALL), Copper (NYSEARCA:JJC), and others largely ignored, but investors continue to pour money into commodity ETFs and fail to acknowledge the huge risks they pose. The massive 30 percent drop in silver (NYSEARCA:SLV) is nothing compared to what will happen when the commodity bubble bursts.
When the bubble bursts – and I am almost completely sure it will, since my analysis and previous articles are too hard to ignore – you can bet that the drop will not be limited to one or a few commodities. You will certainly see a massive drop in oil, gold, silver, cotton, sugar, platinum, palladium, corn, and just about any ETF or investment that has soared while investors have poured their money into the commodity space.
Has the Bubble Popped?
The question now, however, is whether the commodity bubble has popped or whether it is just a correction before the next leg up. Since I am a full believer that this commodity bubble will pop and will tremendously hurt the average investor, I would caution investors to stay away from the commodity space unless they can monitor it constantly and set very close stops in case prices start to tumble.
On the other hand, such a huge correction is definitely due for at least a short-term bounce as the next wave of investors piles its money into silver, gold, and other commodities. Moreover, I am still unsure if the bubble has truly popped. I am seeing increasing signs of froth and danger in the commodity theme, but I cannot yet rule out a continued run-up that sees even more extreme enthusiasm as investors jump aboard for the final run.
Just like on the way up, prices cannot move straight in one direction without taking breathers or corrections. Therefore, if we have reached the top of the bubble, we will undoubtedly see corrections as some investors buy gold and commodities at what they think to be a bargain. After last week’s huge drops, then, we could easily see why silver has seen a nice bounce up this week.
We are left with two choices:
  1. The top of the bubble has been reached.
  2. This has just been a correction before the next leg up.
If we have reached the top of the bubble, these temporary bounces and corrections on the way down are a great entry point for selling short. In this case, one would be making very good bets by selling short gold or silver, or buying put options to leverage the drop in prices.
On the other hand, if this is just a correction before the next leg up, this could be a great buying opportunity with a very good support level just under the lows reached last week. If the price drops below last week’s lows, you can simply sell out of the position at a loss of a few percentages.
Since I am a believer that this commodity bubble will ultimately collapse, I would rather wait for a more definitive sign that we have reached the bubble top. Placing small bets here near support levels in order to take advantage of a bounce or continued rise is also a decent idea, but must be done with caution.
In my opinion, this has been a very sharp correction and we could still see gold prices reaching new highs – even much higher prices. But whether we have reached the top or will continue to rise to new highs, there is one thing I am sure about: Gold and commodities are in a bubble and will ultimately collapse to the utter shock of millions of people across the globe. We could see a continued run-up to new, and even extreme, highs – but we are entering the final move, if we have not seen it already.
The commodity bubble in general, and the gold bubble in particular, has lasted over 10 years. Much of the move has already taken place, and the enthusiasm has had time to build. Now, with much of the fundamental story already factored in, it is time for investor emotions and expectations to take control. Will investors rush to buy as enthusiasm peaks? Or are we just taking a breather before the next, and much steeper, drop? The possibility of a further frenzy and soaring prices is still out there; but even if it is, it will ultimately end in massive drops in prices, huge losses, and a big fat “I told you so!”
Disclosure: I am short DBA, GLD.
Additional disclosure: I am also considering hedged options plays on GLD, GDX, and OIL
Source: Commodities Still a Bubble - But Prices May Continue to Rise