If you’re looking at the blanks in the title…no, I’m not talking about the Guns ‘n Roses album. I would need two more letters for that, and there is no way that this report can do justice to the highest-selling debut album of all time. If you want to jam with me on some Marshall Silver Jubilees though, that is an entirely different topic for another time.
What I am referring to is the pricing of commodities, and the market’s general lack of appetite for them at moment. There are plenty of theories floating around the Internet for why commodities have underperformed, and any combination of them could be true, but as Refined Investors all we care about is price action. We do not buy assets that are in downtrends, and unless we are shorting them we will continue to keep a watchful eye on their wanderings. Here’s an updated chart on the $CRB and $SPX:
Coming out of the 2009 lows, commodities and equities moved in lockstep, reflecting the growth that was happening in the real economy and the effects of QE1 and QE2. However, at the end of 2011 a large divergence began to form between the two (in the equal-weighted $CCI as well). As of today, the $SPX has continued to rise in its now extended 4-year cycle, while commodities look like they have succumbed to the reality of increased supply, decreased demand, and/or changing habits among consumers. The poster child of the 2000’s consumption economy, the Hummer, is no longer in production, and let’s face it – a Prius just doesn’t look the same with 24″ spinners.
But the bigger chess move was the change in policy approach from the Federal Reserve in September of 2011. “Operation Twist” represented a sterilized version of Quantitative Easing, and no longer was the Fed buying agency mortgage-backed securities and agency debt outright, but it was buying treasuries on the long end and selling them in equal amounts on the short end. This was not inflationary by itself, but it gave consumers the incentive to either invest in housing at all-time low rates or search for yield in dividend stocks and junk bonds. Just one look at the homebuilders chart below and we can immediately see the dramatic effect of the Fed’s policy:
It also represented a dramatic shift in investor preferences. Consumers living on fixed-income were, for lack of a better term, “smoked out” of the comfort of their bond portfolios in order to maintain their same standard of living and cash flows. Dividend stocks and junk bonds became the new treasuries because of their yield, and ironically, treasuries became the new growth stocks because the only reason to own them was to front-run the Federal Reserve’s purchases, regardless of their yield. The thirst for junk bonds benefits the corporations that traditionally would have difficulty selling debt, and as long as that feedback loop continues it will benefit the stock market. Commodities do not generate a yield and are volatile, and so far they haven’t been a beneficiary of this game of musical chairs. For all intents and purposes, what we have experienced is a true “twist” of the traditional roles of assets in the marketplace.
Nobody can predict the future, but at this point, we have come to an interesting dilemma with regards to equities. Markets eventually top on euphoria and a lack of buyers. This process does not happen overnight, but the longer it takes the more leveraged and complacent the market must become in order to generate the same gains as before at now higher valuations. Without real wealth creation in the underlying economy supporting the market at all-time highs, the only thing that the nominal numbers tell us is that the collective portfolios of investors have simply been redistributed from the larger bond market to the smaller stock market, with the Fed filling the gap left behind. The older generations are now sitting in investments that they typically have shunned as too risky, the Fed is buying the majority of treasuries, and volatility is at multiyear lows. That is the status quo, and right now there are very little catalysts or outlets for a makeover.
Referring back to our first chart, we now have to ask the question:
If investors have nowhere to go at this point, are we more likely to see bigger gains going forward in equities or in commodities?
To be honest, I don’t have the answer. To predict whether we are going to experience _ _ _ _ _ tion or _ _ _ _ _ tion over the short-term is a fool’s errand, and it definitely has humbled the commodities bulls for the last 15 months. Ultimately, at some point the true demand being generated from the underlying economy will make the decision for us. At that time we will either see commodities rise in response or equities fall in reaction and we will position ourselves accordingly to the changes in price across all markets. Until then, we must patiently temper our own personal outlooks and biases and maintain strict risk-management in all of our positions. It is admittedly a frustrating environment to invest in, and unless you receive fees for total assets under management, you probably don’t feel like sending the markets a fruit basket at the end of the year.
There were no large changes in the markets today as everyone awaits the employment report tomorrow. Expect to see significant volatility on the news as there are many narrow range candles and tight consolidations on the charts signifying coiled fractal energy. Honor the stops in our current positions and be ready to look for new ones when the dust settles. PALL made another nice move today and I will be looking for an entry if commodities gain some momentum.
Good trading all.
Steve Chapman, TRI