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Commodities: On the Downhill Slope?

by: Roger Nusbaum August 06, 2008 | about stocks: DBC / EWZ / IAU / SPY / USO    

Roger Nusbaum

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All things commodities have come way down in the last few weeks.

  • PowerShares DB Commodity Index Fund (DBC) is down 17% from its July 2 closing high.
  • iShares Comex Gold Trust (IAU) is down 10.4% from its recent July 15 closing high.
  • iShares Brazil (EWZ) is down 25% from its high a couple of months ago.
  • United States Oil (USO) is down 18.6% since July11.

You get the idea.

So it is over? As one reader asked, are we done worrying about inflation? What will become of equities and bonds as a result of this? What about the dollar?

Before we worry about how meaningful this is or isn't, the very recent turn down in the related areas is exactly why I preach moderation with exposure to these themes. I have talked repeatedly about 5% or so being, IMO, a good number for commodity exposure. If you put 5% into some commodity proxy and it doubled, that would be enough to add real value to a portfolio. On the other side of the coin a 5% weight in something that cuts in half (I realize that is not where we are) cannot set you back for a year or two and reasonably would not cause undue angst.

I have been as bullish and early as almost anyone but have stressed moderation throughout. The entire resources theme has offered many chances to reduce exposure as prices often got ahead of reality, or sentiment just got too carried away (here is one example I wrote about in May).

In the last couple of months, I gave two interviews, one for SmartMoney magazine (this was in late June when I was in Boston and have no idea if the magazine actually used my quotes or not)  where we touched on oil. In those interviews I said I could see oil headed to $120-$125 (I may have said $115 but you get the idea).

So if I thought $120 was possible I probably shouldn't be shocked that we are here. Can we go lower might be one question on people's minds but the better question is, if it goes down will it stay down? In late 2006/early 2007 oil fell from the mid $60s down to about $50 in what seemed like ten minutes which was a bigger drop than the current decline. The current decline is smaller still when you consider that the drop to $50 started from close to $80 a few months earlier.

Last summer EWZ fell 22% in a month. In the spring of 2006 EWZ fell 24% in about a month. And it had a 22% decline in the spring of 2004.

Many people talked about how over extended all the resource names were and the reaction seemed to universally be oh yeah, we agree they're over done and should pullback. So now they pullback and the bubble has popped? Really?

The fundamental story has not changed in the last couple of weeks. The places using resources are still using them. The long term trajectories for demand growth have not changed. These trajectories never changed in such a way that justified oil going from $88 or whatever up to one-forty-whatever--that's why people used to say they were over extended.

I don't think this correction, or end of the story, whatever it turns out to be, means the end of Fed's vigilance. It might relieve some immediate concerns about inflation, however. I would note that I think the asset deflation issues trump the issues with the prices that are rising.

The dollar has had plenty of snap-back rallies like the current one in the last few years so I am not sure why this would be different. As far as interest rates go, they have to rise (not talking about the Fed Funds rate) for several reasons but long time readers will know I would have expected this to have started quite a while ago so I probably don't have a good feel for this aspect of it.

As for equities this is still, in my opinion, a bear market rally, aka a feel good rally. A couple of weeks ago I said in a video that 1310 might be a place for a rally to go. But in the context of this being a feel good rally in a bear market, that means that I still think normal bear market. Normal means 30% from the peak which works out to SPX 1095. Regardless of whether that is right or wrong I would start to reequitize in a meaningful way when the market takes back its 200 DMA as that has been my plan since long before the bear market started.

More important than any of the above is that if you took a moderate approach to this, then you have much less riding on being correct. With a moderate approach you have benefited from the multi year rally without being piggish and this decline hasn't killed you. For that matter none of the previous commodity corrections killed you either.

The reason I am so preachy about the moderation of these things is that the idea of waiting until there is a problem, as depicted on TV, creates unnecessary anguish. Obviously no one can be out in front of everything, but pre-planning and discipline can go a long way toward smoothing out the ride.

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This article has 11 comments:

  •  
    Aug 06 10:52 AM
    Agreed. People talk a lot about demand destruction. I went out to dinner yesterday and from my vantage point in the parking lot there wasn't a whole lot of demand destruction.
    Reply
  •  
    Aug 06 11:08 AM
    In order for the commodity "bubble" to continue, the dollar must continue to drop. I dont see that happening. The commodities have been in a 8 year bull. Nothing goes in the same direction forever.

    The commodity bull was caused by a weak dollar. A real increase in prices could only be caused by a roaring economy. I dont see it.

    This has nothing in common with the 1970s (stagflation). We are in deflation this time like Japan in 1990s.
    Reply
  •  
    Aug 06 11:59 AM
    CLH,
    Unless you are living in China of course you don't see it. Commodities are used in manufacturing. When was the last time you bought something that was made in U.S.A.? 1970?
    Reply
  •  
    Aug 06 12:13 PM
    Hi, I agree but EWZ is not the same as oil. May be you should say PBR instead, which is an important component. If you compare historic prices of OIL vs. EWZ you will understand what I say.

    Regards,
    Federico
    Reply
  •  
    Aug 06 01:15 PM
    Federico, I was trying to cover many bases throughout the resources theme as opposed to implying that EWZ is similar to USO. sorry if that was not clear.
    Reply
  •  
    Aug 06 02:36 PM
    I don't understand why moderate amounts, or only 5%, should be allocated to the commodity theme if you think they continue to be in a secular bull market. Just because they are volatile and can drop 50%? What about financials, home builders, high-tech, retail? What about a strategy of increasing exposure during a pullback and then reducing it during periods when commodities are soaring? What else is currently in a confirmed bull market? If allocating only 5% to commodities, that means 95% is being allocated potentially to sectors in a bear market! Yes, it's very possible there is still some ways to go until commodities reach a bottom--I for one wouldn't be surprised by oil trading under $100--but one could utilize put options to protect against the worst case scenario while still maintaining a reasonable exposure to the sector. But don't bother with a constant 5%, it ain't worth the effort unless you are talking about gold buried in your back yard.
    Reply
  •  
    Aug 06 03:30 PM
    After the summer olympics in China,when they fire up all there smog (that they are trying to cut back on right now)machines,oil and metals should rise.
    Reply
  •  
    Aug 06 03:39 PM
    Oil drop from $79 to $52 during the second half of 2006. A 34% drop.
    Since early July of this year, oil corrected from $146 down to about $118 as of today. A 20% drop.
    A similar correction as happened in 2006 would bring the price to about $96.
    Reply
  •  
    Aug 06 07:55 PM
    silveraxis, yes because they can drop 50%. more specifically commodities are usually more volatile so you get more bang for the buck. I would add 5% is my number, anyone else should have their own number.

    as far as 95% in stocks in a bear market I probably have a couple of hundred posts on my blog about taking defensive action when SPX goes below its 200 DMA.
    Reply
  •  
    Aug 07 03:19 AM
    I handle the allocation question by reference to a risk reward ratio, similar to say a Sharpe ratio or Sortino ratio. Six months ago these ratio's implied to me that the resources area was favorable and deserved a higher allocation. While the outlook for commodities probably hasn't changed that much, the stock market risk/reward structure has, and it is appropriate to scale back the allocation to resources until these ratio's become acceptable.

    The other thing is the psychology of seeing stocks fall 10% in one day and recover 6% the next day. It is very very hard to maintain investment discipline while moves of this magnitude occur on a regular basis, and I would rather have my mind (and pocket) free of the distraction.
    Reply
  •  
    Aug 11 12:07 AM
    Some studies suggest an allocation of 1/3rd to stocks, 1/3rd to bonds and 1/3rd to gold will actually increase overall portfolio performance while reducing volatility. This is over the long term, which is what most investors who are looking to invest for retirement would care about. I know gold isn't the same as commodities but the point is that you need more than a mere 5% to make much of a difference in any allocation strategy.
    Reply
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