Are Commodities Topping Out?   (December 29, 2011)

Commodities have been on a tear for years as investors bet on permanent growth of developing economies and dwindling supplies. A global recession could change the picture, at least temporarily.

The past several years have seen a growing backlash against "paper" investments as more and more investors consider hard assets to be a safe haven against the implications of central bank money printing. But as the global economy visibly slows, this question arises in many minds: Are commodities, which have been on a tear since the March 2009 bottom, finally topping out?

The question requires both a fundamental economic response as well as a technical chart analysis.

We can start by observing the common-sense connection between demand for commodities such as copper, cement, steel,etc. and economic expansion. When demand rises faster than supply, prices rise. Since supplies of commodities face all sorts of restraints in terms of extraction rates, energy costs, and declining reserves, increased demand quickly pushes prices higher.

The Big Picture

As developing world nations such as China, India, and Brazil have expanded, their consumption of basic commodities has skyrocketed, pushing prices higher and stimulating exploration for additional sources of these materials.

Now there is evidence that these developing world economies are slowing, along with the developed economies of Europe, Asia, and North America.

If demand for commodities falls significantly while supply remains ample, then prices will soften. If demand continues to exceed available supply, then prices will rise.

In other words, there are two potential drivers of commodity prices: demand and supply. If supply of a specific commodity were to plummet due to geopolitical turmoil, its price could skyrocket, even in a recessionary environment of declining demand.

Absent a sudden drop in supply, however, a global recession would crimp demand, and thus commodity prices could be expected to fall.

So the question, are commodities topping out? boils down to the question, is the global economy expanding or contracting?

The rough outlines of the bullish and bearish cases are well known to anyone who follows the economic/financial media.

The Bulls vs. The Bears

On the bullish side, Europe’s credit crisis is seen as abating, the US economy is viewed as continuing its slow but steady expansion as unemployment declines, and China is seen as transitioning from an export-dependent mercantilist economy to one based more on domestic consumption.

The bearish position sees the European debt crisis as a long-term force for economic contraction as austerity and debt service are diverting national incomes away from productive investments and consumption, China’s real estate bubble is bursting, with no equivalent source of spending available, and the US is sliding into recession, a call supported by the Economic Cycle Research Institute’s Leading Economic Indicator and the Chicago Fed National Activity Index (CFNAI), depicted on this chart courtesy of The Technical Take.

Since much of the bullish case for rising commodity prices rests on China and India, common sense suggests that we take a look at those stock markets, as equities tend to be indicators for the underlying growth prospects of the economy. Here is India’s Sensex Index:

And here is China’s SSEC index: 

In both cases, key support levels have been broken and downtrends that began months before the US market broke down in August 2011 are still firmly in place. Without any fancy footwork, it’s difficult to view the action of these critical markets for commodities as being remotely bullish or supportive of stronger demand for commodities going forward.

The Technical Picture

To get the technical pulse of the general market for commodities, let’s look at the Reuters/Jefferies CRB Index, courtesy of

In this chart, we see the tremendous spike in commodity prices that accompanied the top of the pre-financial meltdown global economy in 2008, its free-fall heading into 2009, and the gradual recovery since February 2009. The trend line that has been in place since that low has been broken, albeit briefly.

For additional information, let’s turn to another view of the CRB:

The bull sees a double bottom; the bear sees a potentially serious break in a rising trend line. The bullish case remains unsupported by key indicators such as RSI, CCI, and MACD, all of which remain weak.

To many, the bullish case for global commodities relies on a positive reading of US gross domestic product (GDP), currently clocked at an annual rate +1.8% by the Bureau of Labor Statistics (BLS), and on a rising US stock market, which is seen by bulls as a leading indicator of future growth prospects.

In this view, the US has “decoupled” from weaker developed/developing economies, and is now the engine for future global growth and thus demand for commodities.

If the US stock market is taken as the leading indicator for this decoupling/continued-growth/higher-commodity-prices story, then we should ask what actually drives the valuation of the S&P 500. Courtesy of, here is a chart of margin debt and the SPX (S&P 500). Rather than being the leading indicator for future commodity demand, this chart suggests the market is far more correlated to margin debt than it is to commodity demand. In other words, when margin debt expands and the proceeds are dumped into stocks, the market rises. When margin debt declines, the market declines.

It is noteworthy that margin debt has led the SPX since the March 2009 low. If debt is the key driver of U.S. stocks rather than global growth, then this calls into question the bullish assumption that the S&P 500 is a leading indicator for future commodity demand.

In Part II: Hard Times Ahead for Assets, we dive deeper into examining the leading indicators for commodities and what they predict regarding where prices are likely headed. In our exploration, we're able to make similar forecasts about how the equity market in general will fare in 2012.

Click here to access Part II of this report (free executive summary; enrollment required for full access).

This article was first published as "Hard Times Ahead for Assets" on

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