The Bear Market Nobody Is Talking About!

Question: “Hey Doc, have you ever seen so many commodities charts look so much alike? The way price is acting along with the indicators it looks to me like a bear market rally in stocks is in the making and it looks like it's going to drag a lot of other markets with it..........and gold down!"
---Thanks, Tom

Answer:

Actually, it all goes back fundamentals. Inflation has been very high — not just for you — even more so for producers. This can easily be seen in the CRB Index. Let me explain the index.

The CRB Index

In 1933 and 1934 president Franklin D. Roosevelt was doing the same thing Obama is trying to do today — reduce the corruption in our capital markets by increasing transparency and regulation. Most investors know that the SEC and our key securities laws were enacted in those years.

Few know that in 1934, at the request of the U.S. Department of the Treasury, the Bureau of Labor Statistics began the computation of a daily commodity price index, using quotations for sensitive commodities. By 1952, the index was based on a sample of 22 commodities and was calculated on a 1947-49 base.

In May 1981 the Commodity Research Bureau (CRB) began calculating the index on a daily basis.

The index let’s you see what the commodity markets are doing overall in a way similar to a major stock index like the S&P 500. You have to read it differently though in terms of fundamental meaning.

The CRB index is very different than S&P 500. It’s also very different from the Producer Price Index (PPI) which measures average changes in prices received by domestic producers for their output.

Let me explain,

Indices Are Similar In Constructions But Stocks Aren’t Commodities!

A stock is just a piece of paper. The value of stock is really only what share price everyone in the equity market generally agrees on since the corporate executives don’t have to pay out profits to shareholders — even though shareholders are the owners of the corporation. This is even more so now that the trend of new companies is to not pay dividends since this would hold the executives feet to the fire to keep up the payments —centuries ago dividends were invented by financiers to lure investors away from the guaranteed interest payments of bonds.

The theory of the firm in micro-economics explains how competition stabilizes costs, and retail prices. The first firm in an new niche makes stellar profits. This attracts competitors into the field who gradually drive down any excess profits above what it takes to keep the corporate machine running. This is where industries hit an equilibrium called “zero economic profit.”

That means all the firm’s operating costs are covered but nothing is left over. Many industries are somewhere near zero economic profits — for instance utilities are known for low excess earnings because of zero growth opportunities.

That’s why so many executives have been caught cooking the books as their industry ages and they try to please Wall Street with false earnings. They know that higher profits attracts in investors to buy shares; profits they don’t have to pay out — imaginary or real!

Skyrocketing Commodity Prices Whack Industries!

Commodity markets are very different since they represent raw goods purchased by thousands of intermediate manufacturers who convert these resources directly into consumer products or indirectly as intermediate industrial products. This creates a very real relationship between the profitability of producers that consume commodities and the prices that mines, wells, and growers can charge intermediate manufacturers.

As commodity prices rise the production costs of manufactures increase as well. The CRB gives a view of the cost side of the theory of the firm equation and the PPI gives the price side. If the CRB goes up really fast but the PPI goes up slower it gives you an indication that corporate profits are seriously being squeezed!

Reduced intermediate manufacturing profitability causes massive layoffs at first followed by the collapse of weaker competitors. A major criticism of the futures markets is that some economists consider speculators unnecessary pariah because they believe that speculation injects excessive volatility that hurts economic output and efficiency.

This is why you are seeing an explosion in unemployment.

We’ve just been through 2007 and 2008 where skyrocketing volatile commodity prices have been combined with reduced consumer demand on a global scale. This has helped create what has become the harshest recession since the depression since no part of the planet has been left unscathed. This reduced demand has also been filtering down to the producers of source commodities creating the perfect storm for a serious bear market in commodities.

Understanding the CRB Index

The 22 commodities are combined into an "All Commodities" grouping, with two major subdivisions: Raw Industrials, and Foodstuffs. Raw Industrials include burlap, copper scrap, cotton, hides, lead scrap, print cloth, rosin, rubber, steel scrap, tallow, tin, wool tops, and zinc. Foodstuffs include butter, cocoa beans, corn, cottonseed oil, hogs, lard, steers, sugar, and wheat.

For 3 decades from 1979 to 2006 the index channeled between 200 and 300 before shooting up to an all time high of about 475 in a single year. The index dropped off its all time high in 2007 as a number of other markets broke — the energy complex being the most notable.

The CRB index is almost back to the top of the 30 year channel indicating that an end of the global recession is in sight in a few years — 2 to 5 is my best guess.

An interesting aspect of the CRB index in the 30 years that it channeled is that had perfect support at about 205 — making that an interesting level to watch for entries into new commodity bull markets — as is the mid point of the channel at 250. These factors make for interesting times in the commodity markets. Look for commodities that are still very high on a 20 year monthly chart but have begun to drop off all time highs.

Be very cautious as tops are treacherous and can unexpectedly soar before a final break. For this reason long puts or short contracts protected with calls can yield excellent profits if your timing is right. Just remember that you have to have enough margin in your account to cover the cost of the contract since the options are not marked to market even thought they really do offset your risk.

Happy trading,

Scott a.k.a Doc Brown