Thursday, March 20, 2008

Commodity Markets Imploding

As written on Feb 19th

"All this liquidity being pumped in by the central bankers is going into the "hot games", which are the commodities. Many of the charts (ie wheat) look parabolic. Similar to Nasdaq in early 2000. I suspect that the next downleg in the market will be brutal and will take out the commodity stocks, even gold (which should decouple from the rest later in 2008). This will bring out a wave of margin calls, hedge fund blowups etc...This coming commodities bear market (perhaps it is only cyclical) will help sink the Western Canadian economy as well."

After today's 427 point smashing, it is clear that something is amok. Gold down $60 (!), oil down $6 and all commodities got smashed! The last place to hide in the markets is now being taken out. Everyone and his uncle was bullish on gold and commodities. Everyone knows that BRIC (Brazil, Russia, India & China) will keep prices high for many years. I am agnostic on the long term bull market in commodities. I am sympathetic to many of the arguments of the bulls but I also know that this run-up in most commodities has beaten all of the great all-time commodity bull markets. So I say, let's let the cyclical bear do its thing and then decide.

All of the hiding places are being destroyed. In a bear market, usually no stone is left unturned. Commodities are no different.

In fact, says that the basic idea is that there is little differentiation between a commodity coming from one producer and the same commodity from another producer - a barrel of oil is basically the same product, regardless of the producer. Therefore, the price is determined purely by supply and demand. Since there is little if any pricing power for producers (versus one another), over a very long period of time, the price should be close to the cost of producing the good. If the goods are sold below cost, then over time, producers stop producing. If prices are much higher than cost, producers try to sell more, which raises supply and ultimately depress prices. This is a long term story however.

Short term, commodity prices across the board have risen due to demand from final users AND more importantly of late, demand from investors (escaping financial assets for hard assets). Supply has been constrained in many areas partly due to BRIC and partly for a multitude of individual stories (weather, underinvestment over the past 20 years, etc...). There is often an inverse relationship between the US dollar and commodity prices in the short term. In recent days, the US dollar has shown
signs of bottoming or at least stabilizing. Also, there appears to be a rotation at play as investors sell their winners and invest in the losers (financials). Finally, when there are a lot of people hiding in commodities with huge profits in this environment, as soon as things look like they are heading south, you get a huge move down.

The move was discussed here last month, as the charts all looked parabolic. Now, if you were hoping for the commodities to save Western Canada from at least an economic slowdown, maybe think again....Also, remember that the TSX is approximately 75% financials, mining and oil stocks. It could get dessimated in a commodity bear.

Positions in HGD, HXD, GLD, gold mutual funds, DBA, DUG

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