Short-Term Correction in the Commodities Bull Market

By Eric Roseman

Commodities, especially oil and gold, are in a correction. But make no mistake: We’re NOT at the cusp of a bear market. On the contrary, smart investors should take advantage of currently depressed prices to aggressively accumulate shares in select precious metals and energy companies.

Since hitting an all-time high on July 3, 2008, the benchmark Reuters-CRB Index has declined 20% while crude oil prices have tanked 25%. Other commodities have declined even more. And gold stocks, as measured by the XAU Gold & Silver Index are down a blistering 35% since June.

Admittedly, the recent peak in oil prices was extreme, if not symptomatic of a short-term “bubble.” The same was true for most commodities where institutional fund-flows were manic in the hunt for positive returns the first six months of 2008.

Commodities have been the prime recipients of a global institutional boom. We’ve seen more commodity exchange traded funds this year. Also, hedge funds have been pouring money into commodities as managers searched for one of the few remaining profitable market segments in an otherwise horrible year for equities and bonds.

So Much for the “Big Trade”

The “big trade” over the last 12 months for hedge funds has been riding the wave in commodities, including oil and shorting or betting against financial stocks. And that trade reversed violently in July.

But while the market is right to discount a slowing global economy, it’s wrong to assume that the bull market in oil and most other commodities is over. You simply can’t make a case for the death of the bull when short-term cash rates are still below the rate of inflation and global money-supply (M-2) is growing in excess of almost 20% year-over-year, according to Grant’s Interest Rate Observer.

It seems as though investors who don’t remember the lessons of history are doomed to commit the mistakes of the past.

Remembering the 1970s Correction

Commodities are extremely volatile. Knowing that, it’s flat-out ridiculous to call this decline “a bear market” just because prices are down 20%. Oil, gold and other commodities plunged by almost 50% in the mid-1970s during the bull market. Then commodities went utterly gangbusters by 1980. Commodities can decline sharply even in a secular bull market.

But what about the U.S. dollar and its impressive 360-degree turn since mid-July against all major currencies? Isn’t that a bad omen for commodities? No. Longer term, the dollar is relegated to the dustbin as a laundry list of deficits hamper any serious gains or bear market rallies.

What’s amazing here is that everyone is running to buy dollars when the United States is still accumulating out-of-control deficits.

The Treasury’s budget deficit in July nearly tripled to US$102.77 billion, up 182% from July 2007. But what difference does it make? The U.S. just spends like crazy and the rest of the world finances this ponzi-scheme. It might not be this year or next year. But at some point, there will be a global crisis in confidence as America’s debt-to-GDP ratio, already at 6%, just explodes to uncontrollable levels.

But it’s not just budget deficits that threaten the dollar. There are also trade deficits as far as the eye can see. We’re also seeing two seemingly endless and expensive military conflicts. We have bulging social entitlement spending programs that have yet to peak. Not to mention, we have to finance more expensive financial institution bail-outs including the costly nationalization of Fannie Mae and Freddie Mac. The list goes on and on…

How can a sensible investor not own gold and other tangibles in this madness?

In order for the United States to support all of this profligate spending it must expand credit or print money. And printing this sort of money – a colossal amount – will ultimately result in much higher inflation in 24-36 months.

Central Banks Determined to Stoke Inflation

...and That Will Benefit Commodities

Any way you slice it, this has been a bruising correction for commodities. But don’t call it a bear market. Commodities, unlike stocks, are far more volatile and can record daily price swings that are extremely wild – exceeding 5% or even 10% in a single day.

But bull markets in commodities don’t end with negative inflation-adjusted interest rates or with global money-supply (M-2) expanding at more than 20%. In the 18 years I’ve been in this business I’ve never seen credit expand at this rate – never. This tells me world governments are growing desperate to grow inflation amid a deflation in credit expansion and real estate. It’s inflate or die for the world’s central banks.

The next few months might continue to be painful for commodities. We are probably more than 50% of the way through this correction now with many commodities still in net supply deficit.

The way I see it, investors are confused because they can’t identify the current stage of the economic cycle. Are we still in an inflationary surge or is this the beginning of global deflation?

It’s this seemingly new direction in asset prices since mid-July that has triggered a wholesale run on commodities and an up-crash for the dollar. It’s been lightning fast and many investors are getting mauled.

It looks like the world economy is starting to deflate after a big post-2002 expansion. The forces of inflation and deflation are now fighting each other for the first time since 2001 and ultimately, inflation will win. If it doesn’t then the banks, financial markets, housing and everything else that revolves around finance and credit goes into the gutter.

Time to Print Like There’s No Tomorrow Again

Central banks are aware of this, especially Bernanke, a devout Great Depression scholar.

For the Fed and other central banks the strategy is to rescue the global financial system from the economic abyss or deflation. That means they’ll print credit like there’s no tomorrow. The Fed, the European Central Bank, the Bank of Japan and their international buddies are going to accelerate the expansion of credit to avoid a devastating deflation. Inflation will triumph.

The world still needs oil, it still has to drill for oil and gas, and gold production won’t grow for at least another 24 months amid ongoing supply disruptions in South Africa and Australia.

Oil drilling, major oil producers and gold mining stocks are my favorite long-term growth themes within the resource complex and are incredible purchases right now. Energy and gold mining stocks are incredibly attractive at these bombed-out levels and should be aggressively accumulated. Also, the offshore oil drillers are down by a quarter since July and are still home to the best profits in the energy patch.

Disclosure: none

Comments

[Gigem77:]

First you say, "... smart investors should take advantage of currently depressed prices to aggressively accumulate shares in select precious metals and energy companies."
Then you add, "The next few months might continue to be painful for commodities." So which is it? If commodity prices are to remain "painful" for months, then why buy now?

And at the end we see that you have no disclosures, apparently not long any of the things you advise others to aggressively buy. That speaks volumes about your confidence in your own analysis.

De-leveraging, redemptions and writeoffs are not done. Unless and until some big buyers come back to the commodity sector, prices will remain moribund. Who might these big buyers be?

Inflation has two components, money supply and the velocity of that money. You correctly note the increase in supply but completely neglect the velocity. Wages can't grow as unemployment rises and productivity falters. Americans are being forced to clean up their individual balance sheets, paying off or defaulting on debt and and reducing spending. Retail investors aren't going to be the buyers.

2008 Sep 09 06:22 AM

[assesed1:]

With all the printing and loans to questionable entitys
how long will this be able to go on without causing inflation to a unprecidented level .
commodities will rise through demand & lack of supply . Miners and Oil producers are at clearance sale special & soon will be taking back off

2008 Sep 09 07:22 AM

[BrunoT:]

"Trader" = some guy in his living room who can't afford a proper trip to vegas. You might as well bet it all on "black" at the roulette wheel, despite your silly claims to various "systems". 50% of you lose money.

2008 Sep 09 10:21 AM

[traderstraffic:]

Gold, silver, prec.metals, oil, they are all tanking, sell them short. Go long the dollar. Cost dollar a lot less to make then mining and drilling. Why would anyone buy commodity. Cost of paper money = Printing press, very little. Cost of Commodities = Untold man power, billions in mining and drilling. You want commodity buy and sale the paper. No shortage of paper. Mining is so 1900s get with the program. Mining and drilling is by the way as the newspaper is by the way of the internet.

2008 Sep 09 11:46 AM

[whidbey:]

The post is right about the growth in money supply. It may be right about PM and oil, but once the negative trend is broken it will still take a while to build confidence again. The blood and grief from this correction is resistance to the future moves, if any, in this market. I am long a little gold and some energy, but not very happy about it.

2008 Sep 09 03:22 PM

[Brian in Mo...:]

Ok I'm a gold bug and I also love to short gold stocks, have the best of both worlds, hold the physical and short the paper stuff is the theme I like the best. Almost every time gold drops 3% the stocks drop 6% sometimes 10% (don't believe me look at todays numbers for GDX and GLD, the reverse when thinks go up), think about that for a moment. Cheers, Brian.(disclosure: long and short)

2008 Sep 09 10:54 PM

[Brian in Mo...:]

and read Kitco.com J Nadler, pretty even handed in his comments. Saved me from betting everything on black or gold this summer.

2008 Sep 09 10:57 PM

[BRAD IN ANA...:]

BUY ALL YOU CAN AT $650. SILVER AT $10

2008 Sep 10 01:51 AM

[cly:]

cost of paper money = printing.... printing is cheap.... thats just how cheap dollar is.... soon dollar would be worth close to nothing.... gold production = expensive... you get the picture....

2008 Sep 10 10:18 AM

[Cesato:]

Gigem77 you could not be more right. Stop leading individual investors to buy commodities in a market that is clearly a sell, when the time comes the signal will be given. For now you are leading individual investors to a bottom fishing that is not worth it. If big sellers do not cover their shorts (and there is noreason to do so now) or the Govt does not step on the so called free market and regulate the big ones then yo better stay cash or with the short term. The old saying, buy the uptrend sell the uptrend.

2008 Sep 11 08:02 AM