The Commodity Bull Is Still in the China Shop

By Eric Roseman

Since July, commodity bulls have been trampled during the worst credit crisis in history. The entire complex has gone from being extremely overbought in June to heavily oversold in late September.

In just 30 days, the markets have violently transitioned from concerns about inflation to a sudden panic over deflation. The credit crunch has stopped inter-bank lending and corporate borrowing, leading us to the worst panic in American capitalism since the 1930s.

It's also resulted in the most indiscriminate commodity sell-off since the bull market began in late 2001. And 2008 might be the first year since 2001 that commodity benchmarks finish in negative territory.

And until the deflation (i.e. the environment of rapidly declining prices) ceases, commodities will remain vulnerable. Never in the history of capitalism have commodity prices rallied during a severe contraction in bank credit.

But even during this wreckage, I'm setting up my next big play. Before I tell you about it, we'll take a look at the economy as a whole and hopefully you'll see the pattern I'm talking about. You'll see that these losses aren't disastrous. On the contrary, they're the bellwether of a great buying opportunity...if you know where to look.

Playing Both Sides of the Commodity Bull

If you believe, like I do, that inflation is still very much embedded in the financial system then you must also adhere to hard assets, including gold. There's absolutely no doubt in my mind that we'll see much higher inflation as a result of this extravagant spending.

In my Commodity Trend Alert [CTA] service, we've recently raised our hedges against commodities. I anticipate tough markets for most of the sector until clearer signs emerge that the Fed has arrested deflation.

Still, I'm buying distressed oil companies and oil equipment stocks - and I'm buying oil right along side some of the best positioned global insiders. The energy sector remains the only segment of the marketplace heavily accompanied by net insider buying since prices began dropping in July.

Gold, which FDR confiscated in 1933, would probably rally in a deflationary economy. We got a taste of the huge gold rally to come when gold jumped over a US$100 last week after the AIG (AIG) rescue.

Also, gold stocks haven't been this cheap and bombed-out since 2005. In fact, the mining stocks trade at a seven-year low versus physical gold! You should be aggressively buying up this sector now.

Commodity Hayride Hearkens Past Lessons

Investors tend to forget that commodities are an extremely volatile asset class.

Price swings have always been violent and the recent surge lasting through July drew a huge amount of fast money from hedge funds and other institutions - which are all liquidating as I write this. Bank failures and bailouts have also pressured prices as liquidity-starved institutions make a run for hard cash.

But you must remember that commodities plunged in value in the mid-1970s en route to incredible all-time highs by January 1980. That's happening again in 2008.

The CRB Index surged to an all-time high of 226.80 in September 1974 - at the height of the inflation squeeze, banking crisis and Arab oil embargo - and then commodities crashed to a new low of 175.90 by February 1975, a 22% plunge.

Gold prices, which Nixon set free in August 1971, soared to a high of US$184 an ounce in December 1974 based on the London monthly close. Prices then crashed all the way down to US$109 an ounce by August 1976. That's a dizzying 41% drop.

Commodities can suffer a major bull market reversal, and that can make new investors nervous. Honestly, it wouldn't be a surprise if commodities posted a negative year in 2008 after seven spectacular years of consecutive profits.

It is actually a positive development to see speculative money exiting the asset class because it takes policymakers' attention away from high prices. Case in point: Earlier this summer Congress held special hearings to voice their concern over oil price manipulation. Now that prices are falling, Congress will once again turn a blind eye to the next run-up in the prices.

Credit Crisis Is Our Problem - Not Asia's

As the United States, Europe, Japan and China all work to reflate the global financial system, the price of commodities will recover. The global economy will not suffer a hard economic recession. In fact, the emerging markets might escape one altogether.

Meanwhile, interest rates are still in negative territory if you adjust for inflation, and the Fed isn't likely to raise rates anytime soon. That's not about to change until both the housing and credit markets heal.

Inflation is not dead and commodities remain in a secular bull market as China and other rapidly growing economies continue to boost domestic consumption and increase trade.

The credit crisis is a Western problem, not an Asian one. Balance sheets across Asia are not restricted by sub-prime losses or other mortgage-related write-downs. So the sooner the U.S. finally tackles the credit crisis, the sooner Asian growth will reaccelerate. That's when I expect commodities to bottom.

The long-term picture remains bullish for these markets and commodities. Over the next 12 months, I see the greatest reflation trade of the century hitting the markets, courtesy of the United States government and the European Union.

Stock position: None.

Comments

[NOWHEREMAN:]

Contrary to your belief, I believe commodity prices have bottomed. The reflation scenario envisioned above is the only way the US population can be encouraged to spend again. Goods coming into the US have to continue going up in price. Sale, Sale, Sale has to be removed from advertising. In other words, Inflation importation has to be the Mantra.

This will be accomplished by an ever decreasing Dollar.

2008 Sep 24 09:14 AM

[TarCottage:]

Please Note: What I wrote below has come from borrowing (O.K. stealing!) the ideas of many people, all of them brighter than I am.

An Unoffical History of Gold's and Silver's Recent Correction.

Recently a New York state prosecutor announced he was going launch a criminal investigation into the shorting of financial stocks. Shorting stocks is not illegal but lying to a grand jury is! Too bad the prosecutor isn't going to investigate the U.S. banks that all shorted gold and silver on the COMEX at the same time this past July.

Many people knowledgeable in gold and silver believe that there was a massive downward manipulation of gold and silver prices by the U.S. government in mid-July. This also coincided perfectly with the U.S. dollar's miraculous surge higher. The panic inducing slide in gold and silver prices reeks of manipulation, not that of a natural free-market correction.

(Note: Compared to the foreign currency futures market which trades about $3.5 trillion per day, gold and silver futures markets are really very small markets. Gold only trades about $35 billion while silver trades about $4 billion per day. They are little tiny markets. So they can easily be pushed around.)

(The bullion banks, as primary dealers, have overwhelming knowledge and control of the gold and silver marketplace. Since all market orders flow through the bullion banks, they know where the stop-loss triggers of all long and short sellers are. To manipulate the market, enough paper gold or silver is continually issued to automatically trigger stop-loss orders. The price starts going down as sell orders are filled. This triggers yet more stop-loss orders. This process becomes like dominos, falling one after another, until the price collapses. If the collapse is big enough, investor confidence is destroyed, on a wide scale. By inducing a price collaspe, the bullion banks could either unwind hundreds of billions of dollars worth of potential losses, or position themselves to go long on hundreds of billions of dollars worth of potential profits.)

For evidence, they point to the fact that starting on July 14th, three U.S. banks sold short in one month more than 10% of the world's annual gold mine production and two U.S. banks sold short in one month more than 20% of the world's silver mine production. These were the largest gold and silver short positions ever recorded by U.S. banks. Nornally no one would be allowed to take such a large position in the futures market, but market regulators and media have been noticeably silent about this spontaneous collusion by U.S. banks. Refusal by regulators to act, points to government sanctioned manipulation. After these massive and concentrated short positions were established, gold and silver prices declined sharply, despite a record world wide increase in demand for physical gold and a shortage of physical gold and silver. (The opposite of how the laws of supply and demand should work.)

Further evidence of U.S. government sanctioned market manipulation of gold and silver was noticed on the 24 hour silver and gold charts during this correction. During this period the high physical demand for gold and silver in Asia often caused daily price gains of $5 or $10 an ounce. These gains were only lost once London closed and New York markets opened. These gains were quickly sold off on the COMEX, within a 30 minute time frame, and then transformed into deep losses. This patterned repeated itself, like clockwork, nearly every day during this correction.
The discrepancy between physical gold/silver and published gold/silver prices was possible because 99% of futures contracts are closed out with the purchase of another paper contract. Futures contracts represent digital bytes of gold and silver flying around in a paper market, not real ounces of gold and silver that exist in the physical market. This in effect creates two parallel markets for gold and silver, a paper and a phyiscal market, allowing signicantly different prices to be set for the same commodity over a short period of time. Paper markets were used to manipulate prices that were non-reflective of the physical market.

Due to record demand world-wide, a shortage of physical gold and silver has developed. This has forced the big western bullion banks, based in New York and London, who control both the gold and silver trade to essentially rationing a very thin supply while pretending there isn't a shortage of gold and silver. Most physical silver and gold, to a lessor extent, is being reserved for industrial and fabrication use while investors are simply not able to get any. The big bullion banks are artificially reducing the quantities of gold and silver delivered by refusing to extend lines of credit to all other buyers, like small banks, under the excuse that "they have run down their credit lines”. This has forced these buyers to pay down existing lines of credit before being allowed to take delivery of another gold or silver shipment. Thus investors are left to accept paper gold or silver, or have to wait months for the real thing. (Interestingly, the manipulating bullion banks made a mistake in not supplying the U.S. Mint, which ran out of gold and silver, proving that there is a severe shortage of physical gold and silver.)

To drive down the price of gold, the big bullion banks flooded the market with artificially created (fake) "paper gold and silver". To get the secondary derivatives dealers to lease this artificially created paper gold and silver, the big bullion banks (with the Fed maybe providing the seed money?) have been "paying" the dealers (a "negative" lease rate) to lease this paper gold and silver! (Normally the dealers have to pay the bullion banks to lease gold and silver.) By leasing the gold and silver, the derivative dealers then can write futures contracts, etc. because the rules allow "paper claims" to vault-stored gold and silver to legally be used as cover for futures contracts.

(Interestingly this "paper claims" rule came about because a few years back Morgan Stanley, one of the major players in precious metals, was successfully sued (quietly settled out of court) for defrauding its clients from 1986 to 2007 for charging big fees for storing imaginary gold and silver in its vaults that it never bought. Morgan Stanley’s defense was that it was simply following “standard industry practices". Apparently, it is standard Wall Street industry practice to send people monthly statements claiming that the firm is storing physical gold or silver in a vault, charge for the storage, but really never buy or store any real precious metal. If you are an American, do you still believe that the gold ETFs issued by these American bullion banks are really backed by gold? How about an ETF that mimics the price of gold. Sounds like a derivative. Is there really a counter-party? If gold goes to $2000 will they pay up? Coins and bullion are the only real insurance policy.)

With the world-wide physical shortage of gold and silver, logic tells us that the big bullion bank's "claims" of gold and silver stored in it's vaults must be imaginary. If they have issued fake paper gold and silver "claims" before, they are likely doing it again to manipulate the precious metal markets for the U.S. government.

From market reports, it appears that these U.S. banks were successful in closing out most of their net short gold positions (known in manipulative circles as "ringing the cash register"), but were much less successful in closing out their silver short positions. Speculation is that the U.S. bank's short silver positions maybe trapped?

Why was this manipulative scheme executed in the gold and silver (and probably oil too) markets? Here are a number of theories put forward.

One theory was that they were desperate to unwind massive short positions. Another theory was to re-capitalize the U.S. financial sector, at the expense of the individual investor, by taking advantage of the daily arbitrage opportunities provided between the higher Asian prices and the lower COMEX prices to quickly make profits in the tens of billions of dollars (similar to Greenspan's re-capitizing the banks using the treasuries/bond interest spread in the early 1990s). Another theory thinks this was engineered to shore up the U.S. dollar and stem the record rate which foreign banks were dumping U.S. treasuries. Another theory is that the Fed sees gold as a rival to the dollar so the ultimate aim would be to destroy investor confidence in gold, by collapsing the price for a few weeks. Another theory is the Fed was trying to destroy investor confidence in gold to hide the inflation their massive printing of money has created. Maybe all of the above and more.

2008 Sep 24 11:21 AM

[Kelly Liebe...:]

User173148,
Very good job of piecing the puzzle together so that the layman can understand.
For those of you who will be sure to claim that manipulation doesn't exist...just get yourself a q-tip and watch CNN. It has and continues to go on....which is why we find ourselves in this financial mess.

2008 Sep 24 02:48 PM

[Smarty_Pants:]

Gold at $750/oz was probably the last great "buying opportunity of a lifetime". It's very unlikely we'll see that again any time soon, but if we do, you'd be well advised to buy some and hide it in the mattress.

2008 Sep 24 03:56 PM

[cjct:]

Somehow the entire Western world and its consumer economies can enter a severe economic downturn (with a lack of lending at its core), and yet the emerging markets will soldier on, their demand for commodities unhindered as their major customer is suffering from a sucking chest wound. Please, this rediculous notion that the emerging world has decouples from the West is foolish and the downturn in places like China is evident by the +50% decline in its major stock index. Look at Steel and Fertilizer names, these cyclicals are telling you all you need to know about the health of commodity demand.

2008 Sep 25 05:18 AM