Thursday, September 28, 2006

Commodities decline has ominous meaning

A normal market cycle has commodities peaking after stocks. This time around it looks like commodities have already peaked. The impact of this mis-ordering could be quite significant, as normally a downturn still has strong commodities performance that allows the gravel pits and raw materials producers of the world to stabilize the economy.

In fact I did some checking and the last time I found a commodities peak before stocks peaked was in 1929. This led into a very deflationary environment where commodities were unable to maintain their normal strength into the later business cycle.

Egads!! 1929, the great crash and depression!

Stop worrying. In 1929 the Federal reserve had something called the “real bills” doctrine – a pro-cyclical stance where they responded to business demand for money instead of inflation and deflation numbers. The Fed, in 1929, was run by bankers and tended to act in the interests of immediate bank profits. In 1935 the Federal Open Market Committee was formed under Mariner Eccles and the modern Fed really began, that is when the Fed first became counter-cyclical and began raising rates to fight inflation and lowering rates to fight deflation. One simply can’t expect to recreate 1929 after that change. Keep that in mind when people compare modern markets to 1929 (I see this a lot in the financial press).

In short, the reversal of the normal stocks-commodities peak relationship is probably a bad sign that may make our next Bear market worse, but there is no reason to believe it will be another depression.

What to do? Expect and prepare for a deeper Bear market than usual once the next recession starts.

== WSJ MarketBeat note on Commodities ==

Falling commodity prices are likely to rear their heads in several companies' third-quarter earnings reports, and as a result, bring share prices down in the coming weeks. Earnings season traditionally kicks off when aluminum company Alcoa reports, which it does on Oct. 10. Aluminum prices are down 22% from their recent highs, while crude is off 17% from its summer peak; lumber is down 26% and copper, nickel and zinc are all 13% lower than their recent highs.

"Since earnings are very closely correlated to physical commodity prices, it is a very good bet that earnings in related companies will soon disappoint," Sherry Cooper and Bart Melek, economists at BMO Nesbitt Burns, wrote in a recent note. They expect commodity prices to "remain under serious selling pressure for much of the next year," citing a cooling global economy led by the U.S. and easing demand in China as it is "finally responding to repeated central government measures to discourage over-building and over-investment." On top of slowing demand, they say, "commodity supplies are rising in lagged response to the earlier record-high energy and base metals prices" for everything from natural gas to steel and copper.

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