John Hussman: Commodities Always Have Been, and Still Are, Cyclical

Excerpt from the Hussman Funds' Weekly Market Comment (3/10/08):

[On] the commodities front, the CRB (a broad index of commodities process) has hit fresh highs in recent days, but Friday's weak employment report has spurred questions about the sustainability of the runup in commodities. If you look at long-term commodity charts, you'll quickly become convinced of one thing – commodity prices are cyclical. They don't necessarily overlap economic cycles, but it is dangerous to believe that the cyclical dynamics of commodities prices have been forever changed by China and India. The price levels may very well be higher in the future than they were in the past, but cyclicality is something that should be expected in both commodities and the stock prices of companies that produce them.

It is accurate intuition that commodities are generally stronger in economic expansions than they are in contractions, but that intuition can fail when U.S. real interest rates are negative. At those times, the heavy downward pressure on the U.S. dollar tends to be supportive for commodities. Given that commodities have already had an extremely strong run, it would be overly speculative to take positions here on the expectation that the run will continue, but the evidence suggests that we should expect a serious break only when the rate of inflation breaks...

In short, my impression is that the commodities run, though increasingly extended and dangerous, may have a final push due to further weakness in the U.S. dollar. Most likely, as we approach the second half of 2008, rising credit problems will reduce monetary velocity enough to finally put a lid on the rate of inflation. At the point where the year-over-year CPI rate drops below 10-year Treasury yields, most of the damage to the U.S. dollar will likely have been done (even if the economy weakens further), and that's probably when commodities will become poor speculations.

...

In bonds, the Market Climate remains characterized by unfavorable valuations and relatively neutral market action. The Strategic Total Return Fund has a very short 1-year duration here. While it is unusual for the Fund to hold primarily Treasury bills, this is one of those times, because there is very little yield premium for accepting maturity risk. A “flight to safety” has sharply depressed yields at maturities of even 2-5 years, real TIPS yields are negative at intermediate maturities, agency spreads are widening, and I expect rising default rates to continue destabilizing this market before conditions improve.

Meanwhile, the strenuously extended run in precious metals and other commodities provided a good opportunity to clip our exposure in precious metals shares to slightly below 15% of assets last week. The Market Climate in precious metals remains favorable on our measures, but the tone of the market is becoming increasingly speculative. As usual, we tend to trade around our core position, adding exposure on short-term weakness and clipping it on short-term strength. Consider us increasingly risk-averse, but we do allow for somewhat more strength in commodities before we zero out our precious metals exposure perhaps later this year.

Editor's note: Relevant sector ETFs include the PowerShares DB Precious Metals Fund ETF (DBP), streetTRACKS Gold Shares ETF (GLD), iShares COMEX Gold Trust ETF (IAU), iShares Silver Trust ETF (SLV), and Van Eck Market Vectors Gold Miners ETF (GDX). See also the full list of sector ETFs and commodity ETFs.