Industrial metals have risen well over 50% off of their lows in early 2016. Is that good news or bad for the market? It depends.
Chart 1. Industrial metals have been in a two-year cyclical bull market.
In this article, we will see why this jump in metals prices is probably a bear in bull's clothing. Why? In short, we should expect a significant break in the metals prices rally to confirm the beginning of a bearish stock market.
First, let’s look at the relationship between industrial metals and stocks. Over the last two years, metals prices, stock prices, and corporate profits have risen in tandem. Trailing twelve month earnings have increased about 15% from early 2016 to the second quarter of 2017. And the S&P 500 has risen over 30% since January 2016.
Chart 2. Market variables became highly correlated starting in late 2015.
At first blush then, a bullish metals market would seem to be good news for stocks, right? The limits to that logic become quickly apparent however if one simply imagines what the stock market (or the world for that matter) would look like if steel prices increased 50% every two years.
So, the question must be when is there too much of a good thing? At what point do rising materials costs become problematic?
The answer to the question, by the reading of history we will employ here, is complicated.
There has been a persistent relationship between earnings and commodities prices that goes back nearly 150 years - in other words, for as far back as we have data. This is especially evident at the cyclical level of analysis. Specifically, earnings growth and metals prices have been highly correlated with one another over cyclical durations.
Chart 4. Industrial metals are even more tightly bound to the earnings cycle. (Sources: Shiller and World Bank)
Metals prices, therefore, can often be an early indicator of earnings. The strong performance of metals this year might be said to have foretold the earnings surprises of recent days.
Perhaps we should then reconsider what conclusions should be drawn from our hypothetical scenario of a perpetual rise in metals prices? If metals prices are closely linked to earnings, then would a constant rise in metals prices not translate into a constant rise in earnings and thus stock prices?
No. As it turns out, when metals prices rise faster than earnings, the stock market tends to be relatively bearish. The stock market has been in a secular bull market for over a century (thanks Fed!) but interspersed within that secular bull have been bear supercycles (say the 1930s or 1970s) as well as numerous crashes (for example, 1987 or 2008).
This can be seen in the chart on the cyclical comparison of earnings and metals. The bull stock markets of the early- to mid-1980s, the late 1990s, and the interminable 2010s all saw higher earnings growth than metals inflation whereas the bearish stock supercycles (the 1970s, 1987-1994, and the 2000s) saw surges in metals prices relative to earnings.
So, if a massive boom in metals prices such as we saw in the 1970s and 2000s is not especially good for stocks, is a collapse in metals good? And, if not, is a collapse still better than a metals boom?
It depends. The dramatic collapse in metals prices in 2008-2009 was not good for stocks, but a long, drawn-out strangulation of metals prices such as occurred in the 1980s and 1990s was quite good. As we have just seen, the stock market tends to do well so long as earnings growth exceeds metals inflation, but in the absence of knowledge of the state of earnings at any given moment, a fairly good rule of thumb is that a dramatic collapse in metals prices indicates that there is probably also a crisis in earnings (which is bad for stocks), but a steady decline in metals prices is generally bullish for stocks.
But if all of that is true, how are we to look at the simultaneous rise in stocks, earnings, and metals over the last seven quarters?
The answer is that this particular combination is a warning about long-term prospects for each of these variables. The collective rise in assets and interest rates over the last two years is the last gasp of a dying bull.
To understand why the simultaneous rise in stocks, earnings, and metals prices is a warning, we have to look at the relationship between stocks and earnings in greater detail. In the first half of the article, we saw that although the relationship between earnings and metals is fairly straightforward (i.e. they are highly correlated with one another), we also found that changes in relative strength coincides with changes in the supercyclical conditions in the stock market. Simply put, when earnings grow faster than metals prices, that is good for stocks, and when they grow more slowly, that is bad for stocks.
In fact, we can say this about the broader commodity complex, as well, as seen in this chart that goes back to 1870: multiple expansion tends to coincide with bearish commodity prices.
Chart 6. Primary commodity prices have been strongly correlated with the ratio of stock prices to trailing earnings (the earnings yield) for a century and a half. (Sources: Robert Shiller, Stephan Pfaffenzeller, University of Michigan Library, FRED Graph)
So, we can set the commodity/earnings relationship aside for the moment and focus on the relationship between stocks and earnings. What we find is that during those supercyclical booms in stocks such as occurred in the 1980s and 1990s, the cyclical behavior of stocks and earnings growth becomes negatively correlated. In other words, during downturns in the earnings cycle, stocks accelerate, and when earnings growth picks up, stocks decelerate, but that is only true during bullish stock supercycles. During bearish stock supercycles (or what many refer to as “secular bear markets”), stocks and earnings cycles become highly correlated with one another.
Chart 7. Historically, stock market cycles and earnings cycles have been inversely correlated during supercyclical stock market booms and positively correlated during supercyclical bears. (Source: Shiller)
Chart 8. Stock cycles have tended to be negatively correlated with commodity cycles during stock market booms, and positively correlated during bears. (Source: Shiller, World Bank)
Chart 9. Stock cycles have tended to be negatively correlated with industrial metals cycles during stock market booms, and positively correlated during bears. (Source: Shiller, World Bank)
Let’s repeat that:
1. During bull supercycles in the stock market, earnings cycles and stock market cycles are negatively correlated.
2. During bear supercycles in the stock market, earnings cycles and stock market cycles are positively correlated.
3. But in the transition from a bull supercycle to a bear supercycle in stocks, the cyclical correlations transition first. More specifically, in the last quarters of a bull supercycle, stocks and earnings become positively correlated with one another.
In the dotcom boom of the 1990s, for example, this convergence probably began with the August 1998 correction, after which stock market growth declined (albeit from a very high rate) and commodity prices came alive again.
Chart 10. At the conclusion of the stock market boom of the '90s, particularly after the summer 1998 correction that marked the final cyclical upswing, key market variables became strongly correlated with one another.
When we combine all of the principles discussed thus far, we come to the conclusion that in markets that see simultaneous rises in earnings, stocks, and metals prices, stock returns will tend to be positive but low, and if it is occurring in the late stages of a supercyclical bull market in stocks, stock growth will be decelerating, and stocks will peak more or less with metals prices.
This is precisely the situation we face now. For all of the talk of how unrelentingly bullish the market is, it has failed to regain the momentum it had before the correction that preceded it. In fact, stocks have been decelerating since late 2014, when they began to more closely correlate with more reliable cyclical elements of the market (i.e. earnings and metals prices).
Chart 11. The stock market boom has become decidedly less vigorous after the late-2015 correction, typical of the final cyclical run-up at the conclusion of a bull supercycle. (Source: Shiller)
The markets are in sync again, after a brief break from the three years prior to July 2014, a period in which stocks rose over 60%. In the three years since, stocks are up about 25%, and the next slide in commodities will take stocks and earnings with them.
Reliably cyclical sectors of the market typically peak every five years, and the trip from trough to peak typically runs a little quicker than the slide down, so that metric alone suggests that the cycle is quite close to peaking. What the market may be waiting for is higher oil prices and a more hawkish rate regime. Although oil prices bounced over 50% off of their 2016 lows, historically that has been too weak a jump, according to Stephen Leeb's '80-20 rule'.
Another indicator of how much faith we should put in this cyclical upturn in commodities is, oddly enough, the stock market. As I showed in April 2016, almost no significant commodity upturn began without a stock market crash first. This is axiomatic from what has been said above:
1. Commodity supercycles coincide with rising yields (or, falling P/E multiples, if you prefer), and falling P/E multiples almost always means bearish stock market activity.
2. Both during and just before a bear supercycle in stocks, stocks become highly correlated with the commodity and earnings cycles.
3. Thus, the beginning of a commodity supercycle begins after the collapse of a stock supercycle, but at the cyclical level, stocks and commodities become linked as the stock market boom wanes. Once stocks crash, they bounce up with commodities, but commodities outperform. Stock market crashes at the end of supercyclical stock market booms, as well as during commodity booms, tend to be dramatic. Thus commodities surged after the 2003 and 2009 stock market bottoms.
Chart 12. Commodity booms "reflect" stock market crashes: commodity booms have almost always been preceded by stock market crashes. This chart compares how far off the current stock market price was from its 72-month high monthly average (a measure of stock market crashes) versus how much higher the subsequent 72-month high monthly average of a broad commodity index was from its current price (a measure of commodity booms). (Sources: Shiller, FRED Graph, World Bank)
The best contradictory example is probably the 1987 stock market crash which occurred roughly in the middle of a cyclical upswing in commodities. In that case, commodities continued to rise, and some metals saw impressive gains that coincided with the peak of the Asian boom, but it was not a genuine commodity supercycle.
In any case, there are precious few examples of extended, powerful commodity booms that were not preceded by a stock market crash. When they are preceded by a stock market correction such as we experienced in the summer of 1998 or late 2015/early 2016, a nice bounce in commodity prices will follow, but only enough to set up stocks for a big fall.
Therefore, we have reason to believe, if both our reading of history is correct and history is cruel enough to repeat itself, that this cyclical upturn in commodities cannot last much longer and it cannot carry stocks and earnings with it for much longer, either.
I have written in the last couple of years that I believed that 2017, and specifically February to October of this year, would most likely mark the peak of the stock market supercycle we have been in since March 2009, and that this would be followed by a depression that last until 2030. I will not recapitulate that argument here. I stand by it. But I would be remiss to my readers, old and new alike, if I did not point out that although I was generally right about the path commodities would take when I wrote about them in April 2016, I was wrong in suggesting that oil could be a big outperformer.
Chart 13. Mea culpa, Part I: Oil has not nearly as strong as I predicted it would be back in April 2016.
Second, it appears that as of this writing (November 2 where I am), at least on an intraday basis, the benchmark S&P 500 attained a new all-time high, which means that stocks did not peak, as I argued they would, in February to October of this year.
Chart 14. Mea culpa, Part II: The stock market did not peak between February and October of 2017, as I predicted a year ago.
I still believe that my long-term outlook is correct and that this particular cycle cannot last much longer, but I have been wrong before.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.