Lesson From China: A Swift Decline in Commodities Could Happen

You probably caught the news that the global rice shortage has kicked it up a notch and is starting to impact retail outlets in northern California (Costco and Sam's Club I believe).

The price action in commodities has been extreme for the last few years as perceptions or realities (take your pick) of demand have changed, investor awareness has increased dramatically and the space can now be accessed by retail investors through brokerage accounts with an abundance of choices - and more product to come.

The commodity space has all the allure and intrigue of Frau Farbissina. I have been on board with the theme and had exposure for the duration and will keep exposure (subject to the occasional tweak), but there are some important things to keep in mind about commodities now and these things will pertain to other spaces in the future.

The point here is not to analyze the supply and demand for any part of the space as I am as bullish as anyone, but we do need to recognize the human/market behavior that has accompanied commodities over the last couple of years or so.

There can be no disputing the fact that commodities are up a lot in recent times. There are many people who are new who have bought in one way or another (mostly with ETFs and ETNs) and that the investment industry has created a lot of new supply in the form of investment products to meet demand for this "new and exciting" area.

Still not thinking about fundamentals for a moment, something that can go up a lot in value in a short time frame can go down a lot in a short time frame. The Shanghai composite has cut in half in a very short time. People will say China is/was a bubble and they might say commodities are not. I think the word "bubble" is overused and prefer the word "mania" instead.

The underlying fundamentals can be great and prices still take on mania-like ups and downs. I think the fundamentals in China are great (I readily concede there are negatives), but that did not prevent prices from going up too far too soon and coming right back down (maybe too far too soon?).

Given the human factors cited above and what this has meant in the past, a swift decline in commodities could easily happen even if nothing changes with the fundamental story. Jumping on me for suggesting commodities could encounter a dip is counter-productive as I am as bullish on the supply and demand as you are. But remember - gold dropped 10% from $1000 in about half an hour (intentional hyperbole).

How much exposure do you have? If there was a six or seven month stretch that took prices down 30% (Shanghai dropped 50% in about six months) what impact would that have on your portfolio and how would you react? You should look in the mirror on that one now while everything is going gangbusters. I'm not trying to predict a big decline - I'm just asking what you would do if it happened.

The fundamental story for China looking out for a decade or more is fantastic, but that did not prevent the market from cutting in half. Exploring the other side of your trade is crucial for risk management.

Comments

[Danville Jim:]

Although it's pretty clear that demand for commodities is strong, but if you look at the charts there's no way that demand has risen as quickly as prices. This mania could reverse rapidly, although when this happens is anybody's guess. Roger's comments are definite food for thought.

2008 Apr 24 10:27 AM

[Urbane Gori...:]

I don't really follow food-style commodities, but one thing that has been bugging me is the (almost) daily news article stating that another country has disallowed the export of rice. And then this morning, there was a 'news-blurb' advising that Walmart was limiting purchases of bulk rice to 4 large sacks (or something like that..)...

Thx jegan ;-)

2008 Apr 24 01:34 PM

[growthvalue:]

The long bull in commodities is still in tack. This downward consoildation is healthy and will shake weak hands. It is the only thing that will allow for the next move up. (This move will be fast)

2008 Apr 24 01:55 PM

[Lex Luz:]

Growthvalue: when you say, "the long bull in commodities is still in tack," do you mean that the bullish action will continue in equestrian paraphernalia, or that the bullish action is in a tacking pattern as one might see in sailing upwind?

On another point what are the likely financial ramifications of our quickening loss of ability to think, read, and write in standard English?

2008 Apr 24 06:06 PM

[GrapeApe:]

Lex Luz: Although your clarification may be completely warranted, there is no need for an attack on the commenter's writing skills.

2008 Apr 24 07:33 PM

[User 183217:]

I try to avoid consideration of the opinions of the illiterate, so I support attacks, in the hope that the uneducated will post on some forum that I don't follow.

2008 Apr 25 02:05 AM

[semuren:]

Yes, clearly a typo is sign of defective education, an inability to write in "standard English" --whatever that might be -- and that the sky is falling. Drawing this "argument" out further, maybe speaking with an "accent" is a sign of being sub-human. Unless, of course, it is an RP accent, in which case it is elegant.

Lex Luz, I suggest that you publish your data demonstrating that some people, despite on going loss, think in standard English. I am sure many researchers in cognitive science, linguistic and linguistic anthropology would be deeply interested in your results. Unless the publication happened to contain a typographical error. Then, of course, your finding would not have any value.

2008 Apr 25 05:40 AM

[Shanghai Ad...:]

Chinese stock market trend is NOT applicable to ag commodities trends. Shanghai market went down for purely 2 reasons. Govt pressure to slow the economy and most importantly that the huge huge overhang of locked up shares will hit the market in 2008 - almost twice the current market cap of the entire Shanghai market will hit the market in the next 18 mos. THAT is why the market tanked. Ags are in an uptrend that will last for 5-10 years. People want to eat well - as much as they can afford. 3x the number of people will be eating well in 5 years than currently. Most of China and India currently do NOT use high grade fertilizer or seeds. Read the writing on the wall as they adjust. Not to mention Brazil and Africa.

2008 Apr 29 11:27 PM

[Roger Nusbaum:]

The point is about human behavior--at no point does this post compare fundamentals.

2008 Apr 30 10:37 AM