Commodities Cycles

Adam Hamilton
Archives
Sep 26, 2008

Overshadowed by the pathetic drama gushing forth from the ailing financial stocks these days, other markets have slipped out of the limelight. In particular commodities, a market-darling sector not too many months ago, have been all but forgotten. This lack of attention is masking great opportunities.

In commodities' case, it is not only the newfound center-of-the-universe status of financial stocks that has shifted investors' focus away. Starting in early July, commodities entered a steep correction. Wall Street, perpetually hating commodities because they compete with the stock markets for capital, gleefully pounced on this event and brazenly declared that commodities were dead. Commodities sentiment turned negative.

Fear fed on itself and selling intensified, culminating in the biggest correction yet witnessed in this entire commodities bull. Although nothing fundamental changed during these downward-spiraling 2.5 months, many traders came to believe Wall Street's assertions that the commodities bull was over. But happily for investors, commodities cycles strongly suggest otherwise.

All trending markets, even the biggest and longest secular bulls, flow and ebb over time. Commodities are no exception. Powerful uplegs climb until popular greed grows too extreme. Then they suddenly yield to steep corrections which stoke popular fear. These persist until fear gets out of control and everyone is very discouraged. Then like a phoenix arising from the ashes, this whole cycle begins anew.

Prudent investors and speculators seek to add new long positions late in these periodic ebbings, when probabilities highly favor a correction bottoming. Buying when few others want to and nearly everyone thinks a sector is doomed is certainly not easy psychologically. But as all contrarians know it is absolutely necessary to fight the crowd and buy deep-out-of-favor sectors to ultimately reap the greatest profits.

Odds are now is such a time in commodities, a fantastic buying opportunity likely to be overlooked by all but the most-disciplined contrarian traders. As the charts in this essay reveal, the technicals for commodities as a group are very favorable for spawning the next major upleg. In this study of bull-to-date commodities cycles, I used the Continuous Commodity Index as my general-commodities benchmark.

If you are not familiar with this CCI, some background is in order. Wall Street uses the venerable CRB Index as its commodities metric of choice. Launched in 1957, it has a long and storied history. The problem is what is called the CRB today is not comparable to the historical CRB. In July 2005 the classic CRB was radically revised when its traditional equal weightings and geometric averaging were cast aside.

Today's CRB is a totally new index utterly dominated by oil. It is only relevant back to its mid-2005 birth. While it was technically the tenth revision of the CRB, in reality it is nothing at all like the historical CRB. Thankfully the classic ninth-revision CRB lives on today in the form of the Continuous Commodity Index. Thus the CCI is the only legitimate and honest way to measure commodities' progress across that massive mid-2005 discontinuity.

Although all my analysis here is based off the perfectly-comparable CCI, I rendered the 10th-rev CRB on these charts as well to highlight the vast differences. Anyone trying to understand this commodities bull in context through the lens of today's CRB will be woefully misinformed. The CRB is rendered in blue while the CCI, the true extension of the historical ninth-rev CRB, is rendered in red.

From early July to mid-September, the CCI plunged 26.4%! This latest correction was indeed swift and brutal, the biggest and meanest witnessed in this entire commodities bull by far. Since a decline of this magnitude is unprecedented, it is easy to understand why commodities sentiment is so bad. And it is easy to see why Wall Street has fertile ground for sowing its old commodities-are-dead thesis.

As always though, it is foolish to consider recent events out of secular context. This newest correction in the CCI was certainly not the first we've weathered in this bull. Depending on how you want to carve up major CCI uplegs and corrections, it was actually about the sixth. And just as the five major corrections that went before it failed to slay this bull, odds are the sixth is not going to prove any more successful.

Looking at the blue ninth-rev CRB line until mid-2005 and its true extension as the red CCI line afterwards, commodities have clearly flowed and ebbed. Prior to the latest upleg, on average the CCI tended to gain 27.4% over 12.0 months in each of its previous five major uplegs. This may not seem like much, but remember it is in a very conservative geometrically-averaged index of 17 equally-weighted commodities. Many key individual commodities, like gold and oil, rallied far greater than the benchmark CCI.

As in all bulls, major corrections followed each of these major uplegs like clockwork. The five major corrections before our latest in recent months averaged losses of 8.1% over 1.9 months each. Note the asymmetry. Not only were the corrections much milder than their preceding uplegs, but they occurred over much less time than their preceding uplegs. This asymmetry is typical because the fear driving corrections flares up much faster than the greed driving uplegs.

Most investors, as long as they weren't confused by Wall Street's CRB propaganda which falsely showed a failing bull in recent years, were totally happy with commodities' progress as of late 2007. Like all bulls commodities would surge in uplegs and then retreat in corrections. But the uplegs were much larger, and lasted much longer, than the corrections. So commodities were nicely trending higher on balance.

Then the CCI's sixth major upleg was stealthily born in August 2007. Commodities are usually weak in late summer as you can see in this chart. 2008 was not an anomaly in that regard. For the first five months of this new upleg, the CCI's progress was fairly normal. It didn't reach its previous uplegs' average 27.4% gain until early February 2008. To that point this upleg was a bit faster than usual, but not larger.

Then something remarkable happened. For the first time in history, crude oil broke decisively above $100. Whether they're interested in commodities investing or not, everyone watches oil since it is so critical to our global economy. These surging oil prices, coupled with weak stock markets entering a new cyclical bear, drove growing interest in commodities. Hedge funds, tired of stock losses, started really buying commodities.

Thus in February 2008, for the first time in this bull, commodities as a group started soaring vertically. In a single month the CCI rocketed 14.3% higher! This is a staggering move for an equally-weighted geometrically-smoothed index. The only other remotely comparable time was the February-March 2005 spike capping the third upleg when the ninth-rev CRB soared 11.7% in one month.

But while commodities corrected right after their early-2005 surge, they were off to the races in early 2008. The crisis in financial stocks was getting worse and the general stock markets were grinding sideways to lower. So big speculators including hedge funds dumped their capital into commodities, really the only sector that was working. All this capital flooding in drove the CCI even higher.

This was really exciting for long-time commodities investors as it was the first time in this entire bull that mainstream investors started getting interested in commodities. The higher oil climbed, the more traders took their first serious looks at the commodities sector. Long a contrarian-only realm, this sixth upleg was a milestone as it marked the initial vanguard of mainstream involvement.

This is very encouraging because secular bulls generally don't end until the general public is totally convinced that a bull market will accelerate higher into perpetuity. Think about the tech-stock mania of early 2000 when all anyone talked about, even average folks on the street, was the New Era of technology and the untold riches to be won. It takes years, and many uplegs, between the initial signs of mainstream involvement and the ultimate apex when a sector becomes the most popular and loved on the planet.

The hedge funds finally awakening to the great opportunities in this commodities bull drove the biggest CCI upleg we've seen yet. Over 10.5 months the CCI soared 54.4% higher. It was awesome! In terms of duration, this wasn't too much shorter than the 12.0-month average of the preceding five uplegs. But in terms of magnitude it was twice as big as the 27.4% average upleg gain prior to that time.

At that bull-to-date high in early July 2008, the CCI had soared 235.0% higher since October 2001. This is not only impressive in an absolute sense, but it is incredible for an equally-weighted geometrically-averaged index. And realize some of its 17 component commodities, like orange juice, are not popular and weighed this index down. The gains in headline commodities over this period were awesome.

And over this identical seven-year span of time to the very day, the S&P 500 only climbed 16.3%. Commodities were a vastly better investment, over an order of magnitude better, than general stocks over the last seven years. Yet today Wall Street still hypes the stock markets endlessly and continues to aggressively try and hide the powerful bull market in commodities from the eyes of bleeding mainstream investors.

But no matter how big the sixth major CCI upleg was, like all uplegs it had to be followed by a correction. All bulls flow and ebb to rebalance popular sentiment. And not only are corrections asymmetrically faster and sharper than their preceding uplegs, but they tend to be of similar magnitudes. While a small upleg usually leads to a small correction, big uplegs spawn big corrections. So it is not surprising that after the largest upleg of this bull by far we just witnessed its largest correction as well.

A 26.4% decline in just 2.5 months is indeed steep and scary. While the duration isn't too far beyond the 1.9-month average of the preceding major corrections, the magnitude vastly exceeded the 8.1% average. Instead of giving back about a third of its preceding upleg's gains in line with bull averages, it took back about half. It certainly did its job, of crushing greed and igniting the flames of fear, exceedingly well.

Following this uncharacteristically-sharp CCI decline, commodities investors are scared. They are looking for anything they can to justify their fears. As always late in corrections, all kinds of theses arguing why this commodities bull has to be over are gaining popularity. News always gains prominence that justifies whatever traders want to think. Any contrary news is ignored. This is why newsflow at major tops is always exceedingly bullish and newsflow at major bottoms is exceedingly bearish.

Be careful though, as only fundamentals will end this bull. Not until the world is able to consistently produce more commodities than it consumes will commodities start grinding lower in their next secular bear. We are still many years away from universal commodities surpluses. Oil, the king of commodities, is the best example. Demand growth is soaring in a thirsty world. Yet existing oilfields are depleting and major new finds have become exceedingly rare despite record levels of capital spent on exploration.

Without global surpluses, this bull isn't over by a long shot. And interestingly the CCI's secular technicals support this. Even at its worst close in mid-September, the CCI was only at a 9.5-month low. It is kind of silly to run around like Chicken Little proclaiming the sky is falling when the CCI only retreated to October-2007 levels. No one thought commodities were doomed then!

In addition, much has been made of the CRB's secular uptrend. As you can see above it was very tight between 2002 and 2006. Once the old CRB was scrapped for the brand-new unrelated tenth-revision version, it fell out of this uptrend and spooked many investors into capitulating. Just like in recent weeks, back in late summer 2006 Wall Street eagerly declared commodities dead. Even some prominent contrarian commentators bought into this nonsense, much to their subsequent shame.

Meanwhile the real ninth-rev CRB, now in the form of the CCI, was breaking above resistance in mid-2006. The CRB's original secular resistance line became support in late 2006 and 2007. Provocatively, as of mid-September 2008 the CCI wasn't even back down to resistance yet (say 440) let alone secular support (about 400). No competent technically-oriented trader would even think about declaring a bull dead before its long-term support lines decisively failed! The CCI is doing just fine technically.

This next chart zooms in to the last several years or so to get better resolution on recent events. In addition to showing the growing gap between the CCI and what is falsely-called the CRB today, it shows how impressive commodities remain technically. The CCI may have given back its sharp speculative spike driven by the hedge-fund mainstream vanguard earlier this year, but the vast majority of its bull gains remain intact.

At 450 on the CCI last autumn, commodities investors were thrilled with these bull highs. The future for commodities as an investment had never looked brighter. Then the sixth commodities upleg evolved into a speculative spike as hedge-fund capital chased the only market sector that was really performing. Greed eventually got excessive, the spike collapsed, and the CCI returned to those same 450 levels last week.

And this deeply-oversold 450 level persisted for exactly one trading day, an anomaly. Within four trading days the CCI had already rocketed 9.6% off its correction low! Hovering around 500 on the CCI this week, it is hard to believe anyone armed with a chart showing more than a few months of data is the least bit concerned that this bull is over. Today's levels remain very impressive from any reasonable perspective.

Provocatively this isn't the case for the new oil-dominated CRB. At worst in mid-September it was back down to levels first seen in January 2006. And it is well below the ninth-rev CRB's secular support again. Even though this perspective is incredibly misleading given the radical CRB revision in mid-2005, I can't count the number of times I've seen Wall Street technicians try to build a bearish secular case with it lately.

The CRB isn't comparable! I wish everyone understood this. The CCI tells the real story of commodities. And just witnessing the biggest upleg of this bull by far followed by the biggest correction by far should be exciting, not scary. As a secular bull matures, an ever-growing pool of capital gets interested in it. As more capital trades a maturing bull, volatility ramps up. Bigger upleg gains and bigger correction losses are signs of broader interest. And volatility should continue to increase on balance from here.

Given the massive and decisive bounce in the CCI in the past week, odds are fear has already peaked and the sixth major correction has fully run its course. If this proves correct, then we are right at one of the greatest buying opportunities of this commodities bull. Conceptually every trader wants to buy right after a major correction ends before the following upleg gains steam. Today we can make this optimum strategy reality.

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The bottom line is commodities move in cycles, just like any other secular bull. Uplegs are followed by corrections to rebalance sentiment periodically. And the bigger an upleg, the bigger the subsequent correction is likely to be. While we just weathered the biggest correction of this entire bull, traders shouldn't be too surprised since the biggest upleg came before it. In fact, this is very exciting!

The CCI's first big upleg arrived because of the initial vanguard of mainstream involvement, the hedge funds getting interested. More capital chasing commodities means more volatility and bigger uplegs in the future. The higher commodities go, the more mainstream investors will get interested. This should ultimately culminate in a popular mania like the late 1970s when average investors rush to buy and temporarily drive prices stratospheric.

Adam Hamilton, CPA

September 26, 2008

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