Commodities and the
law of gravity
asset classes throughout history, especially commodities,
abide by the "Law of Gravity." The Law states
that any market that defies gravity with escalating
rising prices for too long and goes too high is destined
to fall back down under its own weight. Gravity always
will win out in the end by bringing a particular asset
market back down to normalcy, no matter how bullish
the fundamentals appear to be at the time. There are
certain "DNA" markers that every asset class
has shown over the years that have been very predictive
in ascertaining when such gravitational forces likely
will get the upper hand and bring asset prices back
down to earth and to reality.
of the best barometers to gauge this gravitational inflection
point is to look at the 10-year average return in overall
commodities on a historical basis. The greater the 10-year
average return, the more overvalued commodities have
become; the lower the 10-year average return, the more
undervalued overall commodities have become. This is
not rocket science or differential equations, but simply
the recognition of the principle of "reversion
back to the mean" of historical returns. Nothing
goes up or down forever. Remember, a major top will
be placed in any asset market when the current perceived
fundamentals are at maximum bullish levels and very
few at the time can conceive of fundamentals ever becoming
never will be able to sell a market at the top if you
wait for the perceived fundamentals to turn bearish.
You must sell when everyone is convinced that the bullish
case is the only view and that any bearish view is to
be considered a relic of someone out of touch with the
"new normal." As we all know, the term "this
time is different" is what sucks everyone in to
abandon sound long-term historical valuation metrics.
A companion to that are claims of a "new paradigm."
We heard those claims regarding equity market P/E ratios
up until 2000, and more recently regarding housing before
the credit collapse. It is never different. The only
thing that is different in every one of these cycles
is the individuals who will lose their entire fortunes
as a result.
over a 200-year analysis of overall commodities using
this 10-year average return metric gives you a perspective
where commodities currently are positioned in the historical
valuation range. The previous peak based on the 10-year
average came at the end of the bull commodity run of
the 1970s and the most recent trough corresponds with
the low in 1990.
1804 there have been five major tops in commodities
that have occurred anywhere from 30 to 45 years apart.
The average 10-year return for all major overall commodity
peaks was 7.6%. That means that when such a level is
reached or exceeded, commodities have entered the overvalued
category and are in a dangerous position for a major
correction. Energy commodities always have outperformed
all others and have shown a 10-year average return of
15% to 20% at peaks. In 2008, the energy complex reached
a 10-year average return of 20% just before crashing,
as would have been predicted from the DNA of its history.
The all-time record overvalued commodity market was
the top set in 1980. "Feeling a little toppy"
(below) looks at the period from 1966 to the present.
can see that the all-time record overvaluation, using
the 10-year average return metric, in the CCI (continuous
commodity index) occurred in 1980 at 12.37%. The interim
peak set in 2008 occurred just underneath that level
at 10.75% before crashing. Currently, overall commodity
markets are even more overvalued, having reached 11.25%
by the end of January 2011 and since have risen further
in the month of February. This suggests that overall
commodities are currently near the most overvalued levels
in 200 years.
who ignores this startling fact should do so at their
own peril. Also, keep in mind that it has been 30 years
since the last major commodity top. That places the
current bull market in the historical 30- to 45-year
duration between commodity peaks. Maybe it will be different
this time and maybe we will rewrite 200 years of commodity
pricing behavior and set a new normal for commodity
valuations for generations to marvel at, but maybe not.
The odds do not favor this bullish paradigm shift and
instead suggest that a nasty spill in overall commodities
likely is imminent. This is not the time to be all in
on buying commodities. This is a time to be looking
at the short side of the equation as fortunes will be
made when the "Law of Gravity" takes hold
and works it magic, and sets commodity markets back
down in a normal corrective process.
can’t be sure a major turn is imminent, but the likelihood
of a significant correction similar to what occurred
in 2008 is high. It would be perfectly normal to expect
a 20% correction in overall commodities at some point
in 2011. The time to buy will be then and not now.
what commodities do you sell? One way to play this potential
setback in commodities would be to short the commodity
currencies like the Australian or Canadian dollars or
the Brazilian real. All three proved to be very vulnerable
to the 2008 crash as money flowed out of these countries
looking for safer havens. A commodity correction brought
on by a deceleration in the global economy would make
the "industrial commodities" the most vulnerable
in the group.
Australia’s higher output of these kinds of industrial
commodities vs. Brazil or Canada and Australia’s proximity
to China makes the Australian dollar the most vulnerable
to a major correction. "Two of a kind" (below)
shows the Aussie dollar’s sharp correlation to the CCI.
Those wanting to play this bearish commodity view could
consider shorting the Australian dollar at current prices.