Friday, September 30, 2011

Spitballing a Peak in the Commodity Cycle

Just thinking out loud here.
Back on May 5 we posted "Commodities: Did Jeremy Grantham's 'Paradigm Shift' Letter Call the Intermediate-term Top" just after one of the tops in commodities:
Remember: A paradigm is only worth twenty cents.
Like a lot of blogs we relayed Mr. Grantham's thinking.
Here's the Jeffries Global Commodity ETF chart via Finviz:

I'll be back with more. In the meantime here's the April 26 post that linked to FT Alphaville's Grantham story:
The End of Cheap Commodities (or not)
Later that day:
Commodities Have Reached a Permanantly High Plateau* (or not)
April 29:
Commodity Prices tend to be Mean-Reverting (cotton)
May 3:
Commodities: "The Case for Human Ingenuity"

You can probably guess that I tend toward the optimistic.
Today Market Anthropology extends the "Broad sunlit uplands" theme:

...I believe we are now on the backside of one of, if not the greatest - commodity super cycles the world economy has had to absorb. The ramifications of this towards the global economy will be far reaching - from the lower input costs in manufacturing and shipping goods, to the considerable benefits of cheaper energy to the average consumer. I spoke tangentially to these points in my note, the Usual Suspects in August. 
- Our economy through tremendous gains in productivity (and accounting) has transitioned to profitability at such a historically high petroleum and commodity cost multiplier, that by dialing energy and commodity prices lower here through the relative tightening (no additional QE) of monetary policy could in fact provide the most comprehensive stimulus to the economy and the consumer - just when the Fed was perceived to have no additional rounds left in the chamber. To think that even five years ago before the financial crisis hit, that the US economy would be able to maintain the degree of profitability it has exhibited today (with over 9% unemployment, a 12% output gap and until last week - $100 oil) would have been perceived as pure academic fiction. No economist in their right mind would have believed that these economic conditions could have produce such results. -
Certainly, it will not come without the perceived negative effects to those emerging economies that have up until this year, led the global markets and have benefited disproportionately from the booming commodity trade. However, that has historically always been the case with emerging markets. Those that have managed the profit windfalls responsibly, and have found a foothold on the global stage - will transition to a more developed economy. 

But for the sake of argument and clarity, I created the chart below from a historic chart of the DJIA and the excellent long term commodity chart created by Hackett Financial. I estimated the retracement move since the chart was created based on the CRB index. I did not scale the components to each other for the basic reason that its utility is to simply convey what directional relationships between the two asset classes develop after the commodity cycle peaks. 

As evident in the last two occasions where the commodity cycle has peaked, the stock market has initially followed commodities lower for only a spell - before breaking out of the long term trading range it was confined to. This makes rational sense, in that investment capital that was riding the commodity boom will eventually make its way over to the market that had been underperforming on a relative basis.