Last week's rollercoaster in commodities gave everyone a shock. The S&P GSCI raw materials index dropped 11%; oil dropped below $100 a barrel; and silver fell by $10 an ounce. The drops were sharp enough to be labeled "bubble bursting" by the New York Times in its lead business story. The implication is that commodities have a lot farther to fall.
Think again. "Bubble" is one of the most overused words on Wall Street. For us, a bubble is an uptrend that breaks away from fundamentals. In 2000, tech stocks continued to soar even though there was an enormous overcapacity in tech infrastructure. When the housing bubble inflated, it was because anyone could buy a house with virtually no down payment, in many cases with no income, and using a mortgage tied to ultra-low, short-term rates that had to rise.
In stunning contrast, the uptrend in commodities (which is more than a decade old) is not some anomalous event divorced from fundamental reality. It is the result of the decline of American and European influence in terms of the world's economic growth. Between 1950 and 1999, industrial commodity prices were driven by changes in Western demand for those commodities. When prices got ahead of themselves, the Fed would typically slow things down with tighter monetary policy; and when demand weakened, the Fed would become more accommodative. There were periods in which the Fed was too accommodative – like the ‘70s, when easy monetary policy went hand in hand with rising commodities. But as Fed Chairman Volcker proved at the time, the West still controlled its economic destiny in the end.
No more. Now commodity prices have been rising steadily in spite of soft demand from the West. Gasoline today costs much more than it did in 2006 – even though the U.S. is driving less. The uptrend in commodity prices comes from outsized growth in the developing world, whose economies now rival the West and will soon surpass it. Those fundamentals remain intact, and they are the major reason we feel confident that the New York Times is wrong on two counts: First, there was no bubble; second, the uptrend should continue.
Why did the correction happen? Trying to explain a one-week decline is like trying to explain a random weather event – sometimes, stuff just happens. Still, it seems relatively clear that the big uptick in silver and the hike in margin requirements set off a margin call that fed on itself – where one commodity would be sold to satisfy margin requirements for others that were also falling. More precisely, the Chicago Mercantile Exchange raised margins in the silver markets five times in an eight-day period: an unprecedented move that was designed to discourage speculative pressure in silver prices. It worked … but the drop in silver also encouraged a more skeptical (and in some cases a more frantic) mood elsewhere.
What would convince us that this was more than a correction? A dramatic slowdown in the growth of the developing world. One clue might come from falling iron ore prices. We mention iron ore because it has been one of the strongest commodities for more than ten years, and it is also a commodity that is not traded on margin. It is a good reflection of demand and growth in the developing world. More generally, as long as the developing world continues to grow quickly, our control of our destiny will be limited. While that may be a little unsettling, it's a combination that is good news for both precious and non-precious commodities. We are bullish on commodities, and see last week's drop as an opportunity, not a disaster.
Disclosure: Leeb Group, its officers, directors, shareholders, employees and affiliated entities and/or clients of such affiliated entities may currently maintain direct or indirect ownership positions in financial instruments (i.e., stocks, bonds, options, warrants, etc.) of companies or entities whose underlying exposure is in the companies mentioned in this article.