First, I hope nobody shorted MOS! It’s just on the short watch list. And it still is, but commodities and commodity-related stocks riding the trends. See below for a great little Sanford C. Bernstein summary that’s been going around for a while and is still 100% relevant. Previous MOS update here.
Ok, let’s start with what we know. We know from yesterday’s testimony to the Senate that the U.S. Federal Reserve is not sufficiently worried about the dollar’s plummet or inflation to change or adjust its policy on interest rates. We know that ever since the Fed started cutting aggressively that the marginal investment dollar has flooded into the commodity markets, quite rationally given the Fed’s green light and the need to capture a rate of return that will not be eaten away by rampant inflation. Additionally, they are physical assets that can not have any write-down risk, which as we have seen is not limited to financial companies (just look at WAT today and AVR last week). We know that there are real supply issues for several commodities due to the snowstorms in China, power outages in South Africa and very low stockpiles for certain agricultural commodities such as wheat. We also know that the U.S. is slowing much more than expected, Europe is not far behind and Asia has to slow the only question is by how much. Thus we know the commodity rally is one of fund flow, a good story (which has been know for four years now) and momentum. Nevertheless, fighting those things based on the fact that the 2008 rally is in large part not fundamental is dangerous. Instead it makes sense to wait for one of two things to happen and prepare for how this story ends…
How the Commodity Rally Ends – Wait for one of these two signals.
1) Bernanke Changes Course: So far this turmoil has shown us that the Fed responds to two things more than anything else. Political pressure and stock market movements. So far, Congressmen have been aggressive in calling for more cuts as some sort of quick savior for the world so they don’t get fired in the November election. To be fair to Bernanke, this has put him in an almost impossible position. He realizes that in an election year if he doesn’t cut like mad every politician will scapegoat him and blame him for the recession. So the Fed decides to cut and cut and cut knowing that when that when the economy is bad anyway, they can at least say they did all they could. The one thing they underestimated is how smart markets are and they are making the task much more difficult by pressing the dollar lower and pushing commodities to astronomical levels. What happens next? Well, it’s entirely possible that the politicians get enough complaints about food and energy from their constituents that this becomes the primary talking point. Invariably there may be calls for price freezes and the Fed may have to ultimately address inflation. Interestingly, the best thing for the market may be the Fed cutting one more time and saying they are done and will work to support the U.S. dollar. This would lead to a speculative run for the exits in commodities, sector rotation and ultimately lower inflation. Then, if necessary, they can cut more later. In other words, all the Fed has to do to nip inflation is to recognize it. Until they do, the dollar may continue to sell and commodities may not decline. If you can’t beat them join them, so buying Gold still makes sense.
2) Clear Evidence of a More Significant Slowdown in Asia: Even if Chairman Bernanke doesn’t change course, clear evidence of a more significant slowdown in Asia is enough to deflate the commodity bubble that has started. There are two types of investors buying commodities here. First, are the macro speculators that are playing a falling dollar and higher inflation, while shorting equities. Second, are the fundamental bulls that will live and die by the de-coupling myth and do not think oil is a bubble here but believe it is fundamental. If there is clear evidence of a major slowdown in Asia, both groups will want to sell but the macro guys will sell and then go short, while the de-coupling crowd will frustratingly buy the dips.
Until one of these two things happen, commodities may not sell off on a sustained basis. However, once it does happen it will likely mark one of the biggest rotations of capital this decade and may mark a near-term top in commodities and signal we are close to a bottom in equities. Commodities have now outperformed the S&P500 by 23% this year (chart below).