Are commodity prices about to explode?

Prices in financial markets are determined by psychology, by what people think stocks, bonds and commodities are worth rather than what they actually are worth. Recent sentiment readings for some key commodities, such as copper, gold, sugar, wheat, cattle, etc., were at extreme levels of negativity. From a contrarian aspect of course, that’s very bullish.

We see a similar pattern in many, but not all commodities in respect to commitment of traders, where knowledgeable commercials are comfortably long. On the other hand, speculators, who as a group usually guess incorrectly at turning points, are taking the other side of the trade with bearish bets.

That does not guarantee that commodities will rally, but it certainly helps to have these indicators on your side. Technically, things are starting to look up.

For a larger chart, please click here.

Chart 1 features the Pring Turner Global Commodity Index, which is constructed from yen and euro, as well as U.S. dollar-based commodities weighted by GDP.

The lower window features the OECD Composite Leading Indicator, a global measure of future growth trends. The arrows point up those periods when world economic momentum has started to pick up and, with one exception, so too have commodity prices.

A longer leading indicator that has led every peak in this series since the 1970s is still rising, so it seems likely that the global economy will edge higher over the next few months. That should mean higher commodity prices and a breakout by the index above its recent 2012-2013 trading range.

For a larger chart, please click here.

Chart 2 features the ultimate dollar-based inflation/deflation relationship, the ratio between commodities and bonds. When rising, it favors inflation hedge assets such as resource-based stocks, commodities etc.

On the other hand, a declining ratio indicates deflation-sensitive assets such as bonds or utilities will do better. The commodity part of the formula uses the CRB BLS Spot Raw Industrials. This index is favored because of its 100% exposure to industrial commodities, which makes it very economically sensitive. Except for cotton, none of its components are traded on public exchanges. This reduces the speculative element and helps it better reflect underlying economic trends, compared to more broadly based indexes that include weather-driven commodities. The bond side of the equation uses the Barclays 20-year Trust TLT -0.08% .

The chart shows that the ratio has been in a trading range for some months and is very close to a breakout. The green and red waves indicate the series of rising peaks and troughs that started late last year. This is typically a bullish characteristic. A decisive breakout, which would enable it to clear the previous tops, would require a Friday close above 5.0. To make the calculation, just divide the CRB Spot (see this link for data) by the TLT.

Momentum characteristics certainly support the idea of a break favoring inflation hedge assets. For example, the long-term momentum series in the bottom panel of the chart sets the scene for the direction of a primary trends. Turning points have been flagged by the arrows. It’s currently signaling a bull market. Moreover, the rising short-term momentum signals that a breakout could come at any time.

For a larger chart, please click here.

The fine state of technical balance in the commodity pits is probably best reflected in the oil price in Chart 3.

Here we see the price tentatively breaking to the upside following an extended period of a narrowing trading range. Short-term momentum has just triggered a buy signal and that should result in a more decisive breakout.

If so, long-term momentum in the bottom panel would almost certainly go bullish. The red and green arrows show that directional changes in this indicator have had a good record of identifying major trend reversal changes in the oil price.

Finally, Chart 4 (which you can see through this link) compares the performance of the iPath Oil ETN OIL -0.13% to that for the S&P ETF SPY -0.10% . You can see that stocks have been outperforming oil for five years, but the ratio is very close to violating a major down trendline. If it goes through, it will tell us that this long period of underperformance is most likely over, and that oil would now be the superior performer for a while. Remember, this is a measure of relative performance, so a breakout will not tell us that oil will rally and stocks decline, merely that oil is likely to outperform stocks.

If commodities do rise from here, what does that imply for the equity market?

First, it means a likely change in sector rotation in favor of commodity beneficiaries and away from previous favorites, such as consumer durables, home builders and financials. You will notice that pure interest sensitives such as bonds and utilities have already been underperforming.

Second, many months down the road, when commodities have good gains behind them and interest rates have jumped, expect purchasing power to be sucked out of the economy and a recession to follow, but let’s not worry about that right now. Our strategy has been to partially position the portfolio to take advantage of an expected commodity rally and to take a far more aggressive stance in this direction when more evidence in this direction comes to the fore. You might consider taking similar action.

Are commodities about to explode? No one knows the answer to that question, though the markets are clearly primed to respond to unpredictable geopolitical problems in an explosive way. All we can say at this point is that sentiment in the commodity pits and global economic momentum are far more conducive to a commodity rally than a fall, so stay tuned.

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