COMMODITIES SELL-OFF : CORRECTION OR MORE ? / BARRON´S MAGAZINE ( VERY HIGHLY RECOMMENDED READING )

Up and Down Wall Street

WEDNESDAY, APRIL 13, 2011

Commodities Sell-Off: Correction or More?


By RANDALL W. FORSYTH



Goldman says to cash in winning bets as demand destruction takes hold. Will the slide extend to other risk assets?


The cure for high prices is high prices. That is the ineluctable logic of the commodity markets, and it is on display in the trading pits.


Commodities took another hit Tuesday after Goldman Sachs' analyst team advised cashing in chips on its winning bets on CCCP -- crude oil, copper, cotton and platinum -- after a 25% run-up since December.


(Goldman seems to have an affinity for acronyms after having come up with the ubiquitous BRICs, for the emerging economies of Brazil, Russia, India and China, a few years ago. As for CCCP, one presumes the acronym is not out of nostalgia for Soviet Union, given those are English letter analogs for the Cyrillic initials of the USSR.)


High prices cure high prices through "demand destruction" as scarce supplies are rationed to those willing to pay high prices. Goldman contended in a report Monday that was beginning to happen in the U.S. as retail gasoline prices approach $4.00 a gallon.


That also was the view of the International Energy Agency. "There are real risks that a sustained $100 dollars a barrel-plus price environment will prove incompatible with the currently expected pace of economic recovery," the IEA said in its monthly report.


Those assessments followed a downgrade of global growth prospects by the International Monetary Fund in part because of the impact of rising food and energy prices, which take a greater toll on the fast-growing emerging economies, which have led the rest of the world out of recession.


Growth is likely to slow to 4.5% in 2011 and 2012, from 5% in 2010, the IMF estimated, as government's economic stimulus programs are wound down.


That's also the view of Richard Russell, long-time publisher of the Dow Theory Letters. In his daily Richard's Remarks to subscribers Tuesday, he wrote:


"Looking over [Monday's] close, oil down, CRB Commodities index down, gold down, silver unchanged, copper down, XLE [the Select Sector SPDR-Energy exchange-traded fund] down. In fact, just about everything I follow from the NYSE average to the Russell 2000 to the housing sector to the semiconductors to the oil-service sector -- all closed down. Taking all this into consideration, I have to wonder whether the markets aren't preparing for the Fed to end its quantitative easing program. That could be a shock to the markets, and it could put the brakes on business, and lastly, it could be deflationary -- as [Monday's] closings suggest."


It's gratifying when Russell, the dean of market watchers, concurs with the view expressed previously here. That is, the markets are beginning to discount the eventual end of the Federal Reserve's purchases of $600 billion of Treasury securities, which has been the main thrust behind the liftoff in the price of assets as well as the cost of commodities.


Stocks took their cue from commodities Tuesday with the major averages down about 1%, led by a 6% drop in Alcoa (AA), the archetypal industrial-commodity producer, after its first-quarter results met profits expectations but fell a bit short on revenues. West Texas crude oil traded in the U.S. fell 3.3%, extending its decline this week to 5.8%. Meantime, Dr. Copper -- the commodity with a PhD in economics -- fell 1.7% while cotton fell 2.4%. Gold edged down only 1% after having hit a record last week.


Especially dramatic has been the plunge in the price of lumber, obviously a key material for homebuilding and thus a key barometer of the housing industry. Lumber prices have a strong correlation with Treasury yields, according to George Goncalves, Nomura's government securities strategist. His daily research letter depicts a chart showing the benchmark 10-year Treasury and lumber moving in tandem since last August—when Fed Chairman Ben Bernanke first floated plans for QE2. "Lumber, which became the vanguard of a broader 'risk off' trade, may have been responding in large part to such fundamental weakness, as most markets realize that the economic growth of the U.S. may not be on terra firma just yet," he adds.


A number of commodities set fresh peaks Monday only to close lower -- a pattern technicians call a key reversal, which often is a symptom of a peak in a rising trend. Further technical evidence is necessary to call a top definitively, however. Lacking that, the declines of the past few days would be just a correction in a bull trend. The near-term action could be telling.


A continued slump in commodity prices would call into question the lock-step advance in so-called risk assets, from junk bonds, emerging markets and to equities, especially small-capitalization stocks. The tide of central-bank liquidity has floated all those boats. Commodities may be indicating these markets are near their high-water marks.
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