Commodities: Lots of Upside Remains

by: Toro

Panic is rife in the commodities market as investors have decided that the world is not going to end, that we have seen the worst in equities, and that the dollar isn't going to collapse to zero against the euro.

The sell-off in commodities has been brutal. Some, such as sugar and silver, are down more than 20% from their all-time highs over a few weeks. and the reasons are simple. Commodities had become over-bought, they were the anti-dollar trade, and there was fear about financial assets. Now all are of these are unwinding, and the typical reversion to the mean in financial markets is occurring. It is a painful experience for those who have opted to stay long and strong commodities.

In the near-term, this is likely to continue, though the oversold readings on some commodities have hit the roof. However, the commodity bull market remains intact. Fundamentally, nothing has changed. Well, except near-term perceptions - which definitely have changed.

Such sell-offs are common in bull markets. Remember that the Dow crashed 22% in October 1987. However, if you had purchased the Dow the day before the crash, you made over 400% over the next 15 years.

I cannot say whether or not the CRB index is going up another 400% - its hard to envision $400 oil after all. However, downdrafts, crashes, losses and all that are par for the course in a long-term bull market.

As I said, other than near-term perception, nothing structurally has changed. Consider the following:

  • Bull markets do not end when the Fed is cutting interest rates. Bulls usually end after the Fed has increased rates several times.

  • Supply/demand fundamentals have not changed. There have not been 20 new large copper deposits discovered over the past few weeks, for example.

  • Problems in subprime mortgage market may be bottoming. However, there are still large write-downs to come in Alt-A mortgages, option ARM mortgages, credit cards, leveraged loans, auto loans, junk bonds, etc., coming. That does not mean that financials are going to careen down another 40% - though they may - but it is unlikely that the Fed will be aggressive raising interest rates any time soon. In fact, futures markets are expecting further cuts in the Fed funds target rate.

  • Yes, the economy is soft, which usually means falling commodity prices. However, the rest of the world is also rolling over, which means lower interest rates elsewhere, eventually. The dollar has a natural boundary to which it cannot fall against other major fiat currencies - $2 to the euro would certainly trigger a recession in Europe, for example. The disparity in the value of the dollar relative to the other developed currencies can be narrowed by either the Fed increasing rates or the rest of the world decreasing rates. My guess is that other central banks are more likely to cut rates than the Fed is to increase rates, which will increase the supply of fiat money in the world.

  • Ultimately, yesterday's news from UBS (NYSE:UBS) that it was writing down $19 billion in assets is bullish for commodities longer term, particularly gold, since it means the European Central Bank and the Bank of England are more likely to cut rates in the future.

  • Few institutional investors are invested in commodities. Over 80% of large pension funds have no allocation to commodities. The asset flows into the group are likely to continue.

  • Prices are set by perception in the near-term, and often in the intermediate term. (In the long-term, the only thing that matters is economics.) The bearish case is that perceptions became too out of whack with the underlying fundamentals of the group. That may be, only time will tell. However, with many commodities still a long way from their inflation-adjusted highs, I think there is still a lot of room to run on the upside.

    At some point, I will become a buyer.