I posted on July 17th that a historic reversal was at hand in Oil has Peaked, Banks have Bottomed, and that has proved prescient advice. Shorting commodities and resource stocks has been a great trade in the last few weeks, and one I have consistently recommended since late April, despite the continued hype and ludicrous price targets from many investment bank analysts, who have yet again revealed themselves to be glorified cheerleaders dancing around the latest momentum trade. The short banks/long energy trade was dangerously crowded, as evidenced by hedge funds suffering their worst month in years in July in a stampede for the exit. I wrote back on 26 May in It’s the oil price, stupid, but for how long more? that ‘Peak Oil is not at hand but peak speculation in oil may well be. Given the weight of resource stocks in key global indices (and earnings), it will be interesting to see how markets react to a looming reversal in oil; some pretty brutal sector rotation would certainly result and the dollar would resume its stalled rally’. The CRB index suffered its worst month since 1980 in July, US financials had the biggest one week move of any sector ever, and there’s plenty more where that came from. Although I believe there is a secular bull trend in commodities and indeed emerging markets, both asset classes had become a classic bubble in the face of a global demand slowdown (China still growing at 10% is about as credible as George Bush winning a Nobel Prize) and are now in the throes of a deep medium term correction that will probably see most commodities halve or more from their peaks. The chart below nicely summarises the characteristic behavioural pattern of an investment bubble, and commodities (and particularly oil) fit perfectly. Although there will be volatile rallies, the uptrend has been decisively broken.

Emerging markets have now underperformed developed markets from their highs and all are in bear territory, but not compellingly cheap yet. I’ve said before that investment is like a beauty contest where the least ugly contestant wins, and that’s the dollar and US equities right now. Not only is there a huge rotation of cash imminent from the commodity/emerging market reversal, but the ratio of money market funds to equities stands at an all time record high, equivalent to 27% of total US market capitalisation. Two conditions have been required for a sustainable rally in US equities; firstly, a bursting of the oil bubble, which has evidently begun, and secondly stabilisation in the housing market, which is also tentatively becoming apparent in many regional markets, although not yet nationally.

All this is good for the US dollar (and very bad for commodity currencies like the Canadian and Austrlian dollars), and good for blue chip US equities, which will resume a tradable bear rally that should take the S&P to 1350 or so over the Summer. It’s wise to ignore momentum (and headline) chasing ’star’ analysts whether they’re calling oil at $200 or Citibank at $2, and take some sober perspective on the markets. If anything, their guru status is usually a contrary indicator. Although we are in a structural bear market that will last well into the next decade, and we may well see a final cathartic sell off in the Autumn to test the 1100 level (marking a classic 30% peak to trough correction), it’s now a good bet that on a 12m view, inflation concerns will have abated, the dollar will be in a surprisingly strong uptrend, and US equities will be materially higher from here.

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Commodities, Market Commentary