Is There a New Bear Market in Commodities on the Horizon?
The Evidence Says Yes.
By Al Martin
(11-13-06) Although we have seen record highs in certain of the fungible contracts in recent weeks, we have also seen, particularly in the last week, a gradual increase in selling pressure. Although this has not been reflected fully in prices, despite Friday, November 10th’s general pullback in many of the commodity boards, what we are seeing is that professional short-sellers are building their offers just above the market. Now there are an awful lot of sell orders above the market on rallies that you didn’t see -- even a few weeks ago. What has changed to cause this creeping bearish sentiment?
To determine what this means, you’ve got to look at macroeconomics, or the big picture, as it were. What is changing is that global GDP continues to decline. At the same time, global interest rates on balance continue to increase. Although the U.S. Fed is likely done raising rates, we see that the ECB and BOJ and others are not.
Furthermore, and, I think, more importantly to commodity prices, is that global liquidity is diminishing, since central banks are reducing globally the money supply and are reducing the liquidity in the marketplace to borrow, a key component of the commodity funds, which, in many commodity contracts, now constitute 50% or more of the market.
Also, as we have pointed out in recent weeks, commodity funds have had net outflows for 3 consecutive months -- the first time since 2003 that you have seen this phenomenon – and without the continued ability to borrow, particularly from the Bank of Japan, where commodity funds do most of their borrowing on the so-called rate-spread differential between Japanese and U.S. interest rates.
Bank of Japan Governor Fukui mentioned, as recently as Friday, that the Bank of Japan would continuously reduce lending to the planet’s commodity funds. This is something that frightens the heck out of the commodity bulls.
Commodity funds are professionally managed funds, which are traded similar to what stock mutual funds are traded, the largest on the planet of which are managed by Goldman Sachs, J.P. Morgan, etc.
However, with commodity fund capital shrinking, global GDP falling, global liquidity – money availability, in other words – falling at the same time global consumption is falling -- this does not speak well for future commodity prices, particularly when looked at in the light of the global supply/demand equation for many commodities.
We see, for instance, commodities which have had substantial run-ups, for example, sugar, coffee, and cocoa. The carry-forward supplies of these commodities are at near record levels at a time when demand is falling.
Simply put, we are having the second or, in the case of the coffee and the cocoa, the third largest crop carry-forwards on the planet ever – this at a time when general global consumption for these two commodities is falling.
One of the signs to look for, if one believes a new general bear market in commodities is coming, is to track the fungibles, and see if the fungible commodities – coffee, cocoa, sugar, cotton, etc. – begin to break in earnest.
If they do, it is likely other commodities, such as metals, will also break.
To break in earnest means a steeper decline than the small corrections that we have seen in the market in the last 90 days.
We have seen, last week, substantial declines in industrial metals, including copper. Ii is interesting to note that copper, which has the greatest long position of all of the commodity funds, fell Friday below its 6-month low and, indeed, now threatens to put in a new annual low.
We have also begun to see, for the first time, selling in the very hot markets – like nickel, tin, and zinc. These commodities have reached prices virtually unimaginable, even as little as 10 years ago -- zinc having reached $5,000/ton, tin having reached $10,000/ton, and nickel trading above $30,000/ton. These are numbers that are unimaginable. But this is what, I think, a lot of people in commodities don’t understand – the industrial metals are the absolute leading indicators of economic growth or lack thereof.
The China and India stories that we hear about on CNBC and Bloomberg all day long, which have largely been responsible for driving industrial metals higher – those economies are now softening. Demand for these industrial metals is softening, at a time when production is actually increasing.
Double-digit GDP growth in China and India in recent years has fueled the demand for industrial commodities, i.e., those commodities that a country needs to expand its infrastructure.
When we were coming off the period from 2001-2003, at a time when economies had contracted, inventories of industrial metals were rather low. By 2003-2004, global inventories of industrial metals were the lowest since the global slowdown of 1994, when the Chinese and Indian economies took off, thus forcing prices higher in a tight supply market. When they began importing these commodities to a greater extent, their importing of the grain contracts, for instance, and the corn and the beans particularly – their importing of the oil, certainly, fueled the last $20 move-up in the oil.
Now, however, we are beginning to see these moves unwind as the “China and India stories,” as they’re called in financial media, begin to strike a sour note, since both countries have taken efforts to purposely cool down their economies by raising interest rates and contracting their money supply lest both economies face what would be potentially an inflationary spiral.
It should be remembered that the growth in China has already fueled an inflation rate of nearly 20%. And this is what frightens the Chinese – too much economic growth is not a good thing.
So if you take the China and India story out of the commodity markets and then look at the underlying supply/demand equation, suddenly you find such things as coffee, cocoa, sugar, copper, aluminum, nickel, zinc, tin, lead, and steel are extremely overvalued relative to their current and likely near future supply/demand equations.
When you see the staged debates on CNBC and Bloomberg with the bears and bulls arguing their point of view, it’s just the typical blather. These commodity bulls and commodity bears debate each other just to generate some hype and more interest.
In fact, the commodity bulls are singing the same old song that they’ve been singing for 2 years -- that commodity funds can continue to push up prices counter-fundamentally, that is, counter to the fundamentals of the underlying item that they’re buying, and that their sheer financial capability is such that they can continue to bid up prices of commodities far in excess of the underlying supply/demand equation. This is not true, as we have found out in recent weeks.
However, eventually prices reach to the point where the short-sellers stepped aside and then started to sell on down-ticks instead of trying to chase up-ticks, in other words, instead of waiting for a price to come up.
The change was that, for the first time, you saw professional short-sellers coming down. Instead of waiting for Joe Six-Pack retail buy orders to come up to where they were, you saw professional short-sellers hitting the bids in size and driving the bids lower.
Is this is a sea change? It’s far too early to tell whether it’s just a short term phenomenon or the beginning of a more significant downward trend. But it is yet another sign of overvaluation in commodity markets, and exhibits the commodity funds’ diminished capital positions, in that they can’t support the bids like they were.
The orange juice was a prime example of that last week. For instance, you saw the bids underneath the market in the January orange juice contract to what’s called large number “fill-or-kill” bids. You would see 300 or 400-bid lots, contracts, in other words, bid in the orange juice on what’s called “fill-or-kill” tickets. That means either the buyer wants all 400 or he wants none.
Those tickets are typically used by funds to try to support the bid -- and you saw that effort on Friday. But, for the first time, you saw sellers had the power to drive those bids down -- large-scale commodity fund bids.
Those are the clues that give you the idea that there may be a major sea change coming. Despite price run-ups, you have seen professional short-sellers, which have been largely absent from the market, get gradually more aggressive. And, remember, the short-sellers are very flush with capital right now -- because they’ve been largely out of the market. They’re everyday traders that have been building war chests.
In conclusion, it is too early to say that we are now going to experience a substantial intermediate or longer term decline in commodity prices. However, every sign is there that this 3-year run-up we have seen in many commodity prices is getting tired. And the supply/demand equations are so stretched. Those who had been providing the support on the long side, namely the commodity funds, are now in a diminished position. And the short-sellers are extremely flush.
You put the pieces together...
* AL MARTIN is an independent economic-political analyst with 25 years of experience as a trader on NYMEX, CME, CBOT and CFTC. As a former contributor to the Presidential Council of Economic Advisors, Al Martin is considered to be a source of independent analysis for financially sophisticated and market savvy investors.
After working as a broker on Wall Street, Al Martin was involved in the so-called "Iran Contra" Affair as a fundraiser for the Bush Cabal from the covert side of government aka the US Shadow Government.
His memoir, "The Conspirators: Secrets of an Iran Contra Insider," (http://www.almartinraw.com) provides an unprecedented look at the frauds of the Bush Cabal during the Iran Contra era. His weekly column, "Behind the Scenes in the Beltway," is published on Al Martin Raw.com
Al Martin's website "Insider Intelligence" Insider Intelligence provides a long term macro-view of world markets and how they are affected by backroom realpolitik, as well as weekly market trading recommendations.