Commodities - Signaling Reflation or Stabilization?
By Chris Puplava, March 18, 2009
Probably the biggest development in the commodity sector is the solid break of oil through its 50 day moving average (MA), which has acted as price resistance since crude’s peak last year. Not only has crude broken above its 50d MA but it has also broken the declining trend since its peak last year, as well as broken the declining trend in its relative strength to the stock market (S&P 500, middle panel), with a break into above neutral territory on the RSI, all bullish developments.
Signs of oil prices stabilizing were presented several weeks ago in a prior article, “Myopic vs. Strategic Thinking,” in which several leading indicators were highlighted that pointed towards crude oil stabilizing and even strengthening. Some of those indicators are presented below, which show even more bullish implications for oil than they did when first presented. For example, my commodity currency index has strengthened further with oil along with it. A break above the January highs in the commodity currency index and oil’s January highs would clearly be bullish for oil, and could mean that oil is more than stabilizing and setting up for a significant rally ahead.
A great leading indicator for oil prices is the MSCI Asia Ex-Japan Index, with the index also breaking above its 50d MA recently. Probably one of the best leading indicators for oil appears to be the Chinese Shanghai Index, which has lead turns in oil since 2007. This can be seen in the second chart below that shows peaks and troughs in the Shanghai Index occuring several months before oil, and the recent surge in the Index likely points towards higher oil prices ahead.
Dr. Copper Speaks
In addition to equity prices implying strength for crude oil ahead, there are other relationships that are pointing to stabilization in other commodities such as base metals, which would imply signs that all of the fiscal and monetary efforts across the globe may be having their desired effect. While it is too soon to tell as a month or two of data does not make a trend, the data at least tells us to pay attention.
For example, a great economic leading indicator in terms of gauging reflation and economic growth is the yield curve and the ratio of gold to copper. When reflation efforts first begin one of the strongest commodities to react is gold, while copper lags as base metals typically peak just prior to or during recessions, which was the case last year as copper peaked earlier in the year. The reflationary efforts of central banks and governments experience a lag as the desired effects take months to be felt, and so signs of copper stabilizing signals that reflationary efforts are beginning to take hold. This can be seen below which shows that the gold to copper ratio and the yield curve both turn down as the economy begins to stabilize. Both were at historical extremes a few months ago and have come down from their respective peaks. The last time we saw the gold to copper ratio decline was in the middle of 2003 when the U.S. economy was beginning to come out of its malaise with employment figures expanding as well as industrial production, and China’s economic juggernaut getting ready to take off as well. While the two relationships can retest their highs, any further decline should grab everyone’s attention as they are likely discounting economic stabilization in the coming quarters.
Similar to the gold to copper ratio, the gold to oil ratio is also hinting at possible economic stabilization on the global scene. The gold to oil ratio has declined off its recent high like it did late in 2001 as the U.S. was coming out of a recession. One more indicator to highlight is the gold to silver ratio, with silver outperforming gold during economic expansions as it has greater industrial usage than gold. After the recovery of the Asian Currency Crisis late last decade and the U.S. recession earlier this decade, silver began to outperform gold and the gold to silver ratio collapsed, highlighting an economic recovery has taken hold. The same may be taking place for silver stocks as they are starting to outperform gold stocks, though the ratio is still near the extreme and may take more time to reverse.
As mentioned above, with global exports collapsing recently, the relationships highlighted may only be signaling that economic growth is getting “less bad” rather than signaling an outright recovery, but the improvement to “less bad” is a hallmark for bear market conclusions as the markets discount the future. Thus, the relationships highlighted above may not necessarily be signaling economic growth ahead, but rather the conclusion to the bear market in commodities. A clear break of the CRB index below support at 180-200 would invalidate the above analysis and prove that recent developments were only working off oversold extremes before resuming their declines. However, if the CRB can hold support then we may have indeed witnessed the end to the commodity bear market that began last year.
Valuations at Bear Market Levels
While the conclusion to the commodity bear market can only be known with the benefit of hindsight, what is known currently is that commodities are near cost of production levels and commodity-related stocks are at bear market valuations and current price action may be hinting at relative outperformance to the broad stock market ahead.
My composite valuation for the S&P 500 Energy sector is based on the historical extremes for several price multiples for the sector, and at more than two standard deviations from its historical average the energy sector is currently the cheapest it has been in more than a decade, even below the valuations seen in the last bear market.
Moreover, the historical extreme of the sector’s relative performance to the S&P 500 has returned to neutral territory, a place that has often marked a shift to the sector outperforming the S&P 500. The outperformance of the energy sector in the first half of last year drove the sector’s relative performance to nearly two standard deviations from its historical average, indicating a period of future underperformance was likely which was indeed the case. A similar event was seen after Hurricanes Katrina and Rita in 2005 that drove energy performance well ahead of the S&P 500, with a period of subsequent underperformance following. The 1990s was a secular bear market period for commodities and this can be seen as the relative performance for the sector remained below the historical average for most of the decade, while the current decade has seen the sector’s relative performance remain predominantly above its historical average. Returns to near or slightly below neutral territory have marked buying opportunities in the sector, and we may be presented with yet another opportunity to invest in the sector before it resumes its leadership role as the commodity secular bull market remains in place.
While the energy sector is showing attractive valuations, the materials sector is the most attractive sector in the S&P 500 with its composite valuation more than three standard deviations below its historical average with the sector nearly reaching four standard deviations at the November 2008 lows.
Like the energy sector, the relative performance for the materials sector has shifted this decade from bear market territory to bull market territory as its relative performance has spent the majority of its time above its historical average. The recent sharp relative underperformance of the sector is at levels that have marked tipping points to the material sector outperforming the S&P 500, possibly presenting an attractive entry point to new investors for the next bull market.
It appears that the value in commodities is not being overlooked as China hinted that it may diversify away from the US dollar and purchase commodities and commodity-related companies. I highlighted this development in my prior article mentioned above, but since then China has voiced their growing concern in regards to the implications of US fiscal and monetary policy on their US holdings as the following article makes clear.
China, the U.S. government's largest creditor, is "worried" about its holdings of Treasuries and wants assurances that the investment is safe, Premier Wen Jiabao said…
China should seek to "fend off risks" as it diversifies its $1.95 trillion in foreign-exchange reserves, Wen said. Yu Yongding, a former adviser to the central bank, said in an interview on Feb. 10 that the nation should seek guarantees that its Treasury holdings won't be eroded by "reckless policies…"
Delegates of China's legislative advisory body suggested that the government diversify away from Treasuries into more risky assets. Jesse Wang, executive vice president of China Investment Corp., said on March 4 that the nation's $200 billion sovereign wealth fund may invest in "undervalued" commodities.
China is quite the savvy investor by observing the tremendous value in commodities and commodity-related assets. Commodity undervaluation is not their only merit for investment, as some of the world's smartest investors are sounding the inflation alarm, which also supports investments in commodities as a hedge against future inflation. The article below highlights this (emphasis added).
Pacific Investment Management Co. [PIMCO] which runs the world's biggest bond fund, joined investors Warren Buffett and Marc Faber in saying inflation will quicken, sounding a warning for Treasury investors.
U.S. government and Federal Reserve efforts to snap the recession will increase costs for goods and services as soon as 2010, Pimco said in a report today on its Web site by Chris Caltagirone and Bob Greer. Commodity producers are also delaying projects, which may limit supply and lead to higher prices when global growth resumes, according to Pimco.
"Inflation will rise," Pimco said. Treasury securities that give investors protection against higher prices in the economy are "attractive now...”Buffett, the billionaire investor, said March 9 on the CNBC television network that efforts to stimulate a recovery may lead to inflation rates exceeding those in the 1970s.
While a decline in the markets to their March lows or even lower is still in the cards, various segments of the market may not reach their prior lows as the next market leaders begin to assert themselves. We are already seeing this with energy, materials, technology, and the health care sectors which are outperforming the S&P 500. When the market eventually bottoms these sectors are likely to continue as market leaders, holding their relative outperformance.
The market is over extended in the short term and has failed at initial resistance in the 800-805 range on the S&P 500 and is due for a short-term pull back. It will be interesting to see how far the market pulls back or if it can even continue higher. With either case, the above mentioned sectors should be monitored closely as they are likely to remain future market leaders.
It is too soon to say whether March represented “THE” lows for the bear market. My personal gut tells me no, and I will highlight some developments next week that cause me to lean towards a retest of the prior lows at a minimum with new lows still possible. In the interim, it appears the March lows due represent an intermediate low and the message of the markets needs to be respected. The S&P 500 met resistance at the 50d MA (803.51) and was stopped dead in its tracks, with the 50% Fibonacci retracement of the January highs at 804.29 also acting as resistance.
Whether the market continues northward or takes a few steps back before heading higher, it appears that the rally has underlining strength to it and will likely break through the 800-805 resistance on the S&P 500 over the next couple of months. Some key signs to watch for health to the current rally would be a breakout in key areas. Three ratios to watch closely are relative strength (RS) ratios of the Homebuilder Index and Retail Index relative to the S&P 500, as well as the relative strength ratio of the consumer discretionary sector to the consumer staples sector. The Retail Index RS ratio has already broken out with the Homebuilder Index RS approaching a fifth retest of its declining trend line, while the Consumer Discretionary to Consumer Staples RS ratio is close to another retest of its declining trend line. If all three ratios breakout from their bearish trends the market will be sending us a clear message that the worst is likely behind us in terms of what the market is discounting.
If the March lows prove to hold in the future, given what I see as several quarters of further negative economic news, a retest is still likely, or at least a significant correction of the current rally whenever it finishes. While there are several market leaders that are emerging from the November 2008 and March 2009 lows that investors will gravitate towards, the material and energy sectors should remain a key area for investment. The commodity bull market that began earlier this decade is still intact, with the decline over the last year representing a pause in the secular bull market. Current valuations are very attractive for each sector, with relative performance momentum also at attractive levels. The Fed announcement today to significantly expand its balance sheet through the purchase of agency debt as well as US Treasuries led to a jump in commodities and a decline in the dollar, supporting the fundamentals for both sectors. The more aggressive the Fed becomes, the more likely the bottom is in for commodities, as they signal reflation rather than just stabilization.
© 2009 Chris Puplava