Themes for 2009 - Part 4 (Commodity Outlook)

For years, commodities were the biggest "no brainer" investments in the world. And the reasoning was logical and easy to understand: Third world countries were playing catch-up and needed more "stuff" to build their infrastructure, feed their populations, provide basic utilities, etc. There were 3 billion Asians who all wanted a western style of life - higher protein diets, their own car, a refrigerator. Commodity prices "could not go down" because of this relentless demand.

I was always very skeptical of this argument. What I understood was that this foreign demand was contingent on ever increasing amounts of US consumer debt to buy the goods they were manufacturing. Knowing that the consumer consumption binge was itself a bubble, it was easy to conclude that this could not go on forever. As a result I sold out of most of my commodity related holdings long before the blowoff top in the summer.

But where I went wrong, was to assume that because these commodities had a certain intrinsic value, they would relatively outperform the massive collapse in the western debt-based economy. That has not happened. They simply lagged the financial economy by about one year, and proceeded to collapse like everything else. Producers of those commodities fared even worse. I should have seen this coming. But the one year lag lulled me into complacency even though signs were everywhere (ie. negative divergences between stocks and commodities). Thankfully, not much was lost other than the opportunity cost of missing one of the best shorting opportunities I'll likely ever come across. Others weren't so lucky.



The inevitable question is, "what now?" Other than the best answer of "nobody knows," there are a few things I have observed. First and foremost, is that those who were previously bearish on commodities are still bearish and those who were previously bullish are still bullish. I was watching a BNN interview with some talking head who had been a commodity bull for years. They went over his past top picks (as is customary on this show) - Teck Cominco, Potash, Rio Tinto. He explained that he hadn't sold any of his positions because his firm, "always felt that the fundamentals were still strong." And naturally, he still advised watchers of the show to buy those stocks. I try to avoid listening to these analysts as much as possible. They have such an emotional and financial bias toward their favourite sector that they cannot possibly give impartial advice. They will always find an argument to suit their bias. You can confront them on things like "demand destruction" and they'll counter with "production cuts." If prices go higher, they were right, "but it's not too late to jump aboard." If prices go lower, "it's a great time to buy!"

To me, commodities and commodity producers are a crapshoot at this point. A prerequisite for much higher prices is for global economic growth to show some signs of returning - which in previous sections I've made clear is something I don't foresee for quite some time. However, with producers announcing production cuts and geopolitical tensions increasing risk premiums, supply disruptions are a definite possibility. This could cause some short term rallies in individual commodities, but unless global growth really gets going, these rallies will not be sustainable.

One potential wrench in this outlook is not just geopolitical tensions, but all out war. War is very commodity intensive. For the commodities themselves, this may prove to be what sparks the second half of the commodity super cycle Jim Rogers has been talking about for a decade. Do keep in mind though, that even in this undesirable situation, commodity producers would likely not benefit. Their mines and oil fields would be nationalized as part of the war effort as is usually the case.

In short, I do not see much of a case for investing in the industrial commodities. If I wanted to buy something because of the intrinsic value it holds and it's wealth preserving qualities, I would buy gold. Gold has massively outperformed all other commodities, and all other assets with the exception of Japanese Yen and US Treasuries.

This chart shows how dramatically gold has outperformed the CRB (which it is actually a part of, so the chart understates the divergence):



However, if you were an investor holding another currency (Canadian Dollars, for example) the yellow metal has performed even better in '08 and is actually sitting at all time highs right now:



As I mentioned recently in "Update on Gold," I do expect the price of gold (denominated in US Dollars) to revisit and likely fall below it's October lows. This would coincide with another round of deleveraging in the global economy. However, I am mindful that one set of expected resistance (the 200 day EMA) has been breached, and if the declining trendline from the March highs is also breached, I would have to re-evaluate this thesis. Gold is one of the few assets that can claim it is structurally still in a "primary bull market." Therefore, surprises will come to the upside, rather than the downside.

The opposite is true when discussing the broad equity markets, which I will attempt sometime later this week.