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Commodities and the law of gravity

Shawn Hackett
Published 04/01/2011

All 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.

One 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 bearish.

You 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.

Looking 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.

Since 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.

You 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.

Anyone 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.

We 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.

But 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.

Given 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.





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