Will crashing commodities crash the stock market?

There are some analysts out there who maintain that the precipitous decline in commodity prices this year bodes ill for the stock market. 

 

Witness for example the dramatic drop in the price of corn.  Below is a chart of the Teucrium Corn Fund (CORN), a proxy for corn futures.  As you can see, corn prices are at multi-year lows right now.  This is ironic given that the mainstream media assured us earlier this year that higher ag commodity prices were on the way.

 

 

The price of wheat on the Chicago Board of Trade (CBOT) doesn’t present a rosy picture, either.  Here you can see an equally conspicuous plunge in the wheat price to multi-year lows.

 

Question: Do falling commodity prices always lead to falling stock prices?  Answer: Not always.  To be more specific, a major decline in commodity prices is more likely to lead to equity market weakness if the decline in commodity values hurts countries which are big consumers of those commodities.  This holds especially true for industrial metals like copper and iron as well as crude oil.   

 

Consider the classic example of 1998.  In that year there was a major bull market in stocks that extended into July of that year.  Simultaneous to that was a major decline in commodity prices across the board.  By the end of July, the general weakness in commodities spilled over into equities and led to a swift, dramatic plunge which saw the U.S. stock market briefly enter bear market territory by the end of August.  It was in fact the shortest bear market on record for the U.S.  There was an equally dramatic recovery for stocks in the fourth quarter of that year, but the correlation between weak commodity prices and the stock market was undeniable.

 

Flash forward to 2014.  Many commodities have been weak this year, including grains and crude oil.  Unlike 1998, however, oil prices can be described as fairly buoyant on an intermediate-term basis.  In fact, the oil price rallied from a major low in January until peaking last month.  The pullback since the June peak has been fairly small and contained up until now notwithstanding media rhetoric to the contrary. 

 

 

The copper price, which is an important barometer of global economic strength, has also held its own in recent months despite being relatively weak on a longer-term basis.  Copper prices were much lower in 1998 and were closer to all-time lows at the time. 

 

 

Another consideration is the major foreign markets.  Heading into the summer of 1998, most foreign markets were in considerable danger and some were outright crashing.  China, Japan, Russia, Argentina, Brazil and many others were swooning.  This time around the aforementioned markets are either holding their own or are at or near yearly highs.  If the commodity market weakness were truly deflationary on a global scale, it would show up in the form of foreign stock market weakness since foreign markets are much more dependent on commodity prices than the U.S.  But right now we’re not seeing that.

 

While it’s possible that there could be a “summer swoon” later this summer as we head closer to the 60-year cycle bottom in late September, the odds of a 20 percent or greater correction are looking pretty slim right now.  Most of the commodities weakness is relegated to grains and oilseeds; even the financially sensitive gold market is showing a moderate amount of strength.  In short, most barometers of financial/economic strength aren’t suggesting an imminent bout of financial contagion, unlike the 1998 episode. 

Is Argentina doomed by its debt crisis?

Will Argentina’s impending debt crisis prove fatal for the country’s economy and financial market?  

The jury is still out but the likely answer is “no.”  

Consider the evidence of the Buenos Aires Stock Exchange Merval Index.  Argentina’s stock market is still flying high after an extraordinary rally since February.  The Global X FTSE Argentina 20 ETF (ARGT), another reflection of Argentina’s stock market, made a new 52-week high as recently as a week ago.

If Argentina’s public sector is destined to collapse in the wake of its debt crisis, why has the country’s stock market been so bullish of late?  The implication behind the rally is that Argentina’s insiders know something that the rest of us don’t.  Regardless of how messy things may get in the very short term, the message behind Argentina’s equity market is that the country should emerge from this crisis without any major long-term hitches. 

Is it 1999 all over again?

The ebullient mood on Wall Street today was stimulated by a rash of merger and acquisition announcements. 

Consider the following: In the energy sector, Kodiak Oil & Gas (KOG) agreed to be acquired by Whiting Petroleum (WLL), resulting in a sizable jump for both stocks.  Among industrials, URS Corp. (URS) agreed to be acquired by Aecom (ACM), leading to 10-12% leaps for both stocks.  Among health care companies, Shire Pharmaceuticals (SPHG) was reported to have accepted a $53 billion takeover bid AbbVie (ABBV); also, Mylan (MYL) announced a $5.3 billion deal to purchase a segment of Abbot (ABT). 

If you get the feeling that M&A is becoming bubbly, you’d be right.  According to the Business Insider web site, the first quarter of 2014 witnessed the largest aggregate deal value since 2007 and the largest average deal size since 2007 (see chart below).  In the second quarter alone, there were three U.S. merger proposals worth at least $40 billion, says MergerMarket’s M&A Trend Report: Q1 2014.

Zacks, meanwhile, points out that M&A activity hit a 7-year peak as of June 26 with consolidate deal values increasing 75% year over year to $1.75 trillion.  While it’s true that the return of “merger mania” often marks the terminal phase of a bull market, it would appear that this particular M&A boom still has some room to run before topping out.  Due to the enormous levels of cash on corporate balance sheets in recent years, not to mention record low interest rates and favorable credit markets, the M&A trend has had lots of fuel behind it. 

So while the M&A trend is definitely building momentum, it hasn’t yet turned into the dangerous “merger mania” episode of the 1990s.  Mergers and acquisitions are symptomatic of the greed (or “irrational exuberance” as Alan Greenspan put it) which accompanies the late stages of a bull market.  At some point, however, the trend will run to an extreme – just as it did in the late ‘90s – and will evoke its own reversal as per the “Rule of Alternation.” 

While we’re on the subject of irrational exuberance, another newsworthy item came to our attention today which reminded us of the late ‘90s.  Remember the Internet stock craze and the often ridiculous valuations (or lack thereof) behind many Internet startups of those days?  Well it would appear that the bromide “history repeats” is playing out once again.  A company operating under the name of Cynk Technology Corp (CYNK), which markets itself as a social network firm, is headquartered in Belize and has just one employee.  Moreover, the company has no reported revenue and zero assets, yet its stock price has rallied 25,000% since June is now worth $6 billion as of last week. 

Comenting on CYNK, options strategist Jacob Mintz of Cabot Options Trader said: “It appears to be a case of ‘pump and dump’ gone haywire. The SEC finally stepped in on Friday [Jul. 11] and halted trading of the stock due to concerns about “the accuracy and adequacy of information in the marketplace and potentially manipulative transactions in CYNK common stock.”  Could the stock symbol for this company turn out to be a prescient, yet ironic, commentary on the company’s future?

Global deflationary undercurrents still visible

Not only is there a complete absence of inflation in most major inflation barometers, but deflation is still a problem in some quarters.  

We’ve already seen that several major commodities are under intense selling pressure, including agricultural commodities like corn and wheat.  This is all the more amazing when you consider that crop conditions are less than ideal in many parts of the country and ag prices should be rising if the fundamental factors are to be believed.  Instead we see plunging prices for several major commodities along with a worrisome trend in China’s producer price index.

Economist Ed Yardeni points out that China’s monetary and fiscal stimulus has, ironically, produced the unintended result of excess capacity.  “The result,” he writes, “has been deflation in China’s various PPI measures.”  China’s overall PPI fell 1.1% year-over-year during the latest reporting period.  The decline was precipitated by an 11% drop in the coal industry, a 6.5% drop in ferrous metals and a 5% decline in chemicals. 

With the world’s number two economy experiencing such deflationary currents, it’s no wonder that global growth has been lackluster in recent years.  If the Kress Cycle theory is a reliable guide, this trend should reverse starting in 2015 or shortly thereafter as deflation gives way to re-inflation. 

The pathway to re-inflation is likely to be a gradual one.  There are two potential scenarios which could cause inflation to become a problem much sooner, though.  One is an outbreak of major war.  Normally it takes at least 10-15 years after the bottom of the 120-year Kress cycle before inflation becomes firmly entrenched in the economy.  But following the 120-year cycle bottom of 1774, inflation was a major problem in the colonies during the U.S. Revolutionary war in 1777-79.  At that time a pound of butter cost $12 a pound while flour fetched nearly $1,600 per barrel in Revolutionary Massachusetts.  Keep in mind this was only 3-5 years after the long-term Kress cycle bottomed.

In his commentary of Benjamin Graham’s classic book, The Intelligent Investor, Jason Zweig observed that inflation was also a major problem during the U.S. Civil War.  During the war years in the early-to-mid 1860s, “inflation raged at annual rates of 29% (in the North) and nearly 200% (in the Confederacy),” he writes.  He also points out that immediately following World War II, inflation hit 18.1% in the U.S.

The other possible scenario for a rapid re-inflation in the next couple of years would be if the world suddenly became smaller, i.e., if China and the other major components of the global economy inexplicably decided to withdraw and restrict imports and exports.  If this ever happened it would reverse the trend toward excess capacity and would eventually lead to the classic inflationary problem of “too much money chasing too few goods.”  It should be emphasized, however, that this scenario is a major outlier and not at all likely to occur.

The most important lesson to take away from this is that the deflationary undercurrent is still very much alive and appears to be accelerating as we head closer to the long-term Kress cycle bottom this fall.  

The "wall of hatred"

What is behind investors’ apprehension toward stocks?  A combination of concerns ranging from fears of a speculative bubble in small cap stocks to misgivings about Fed policy to geopolitical instability and rising oil prices is putting a lid on investor optimism.  Michael Purves of Weeden & Co. was quoted by Businessweek as calling this phenomenon the “wall of hatred.”  That’s as good a description as any to describe the mass feeling right now….

On a related note, a new Gallup poll revealed that fewer Americans are satisfied with their level of freedom.  The report ranked the U.S. number 33 in the world in the freedom poll.  A separate poll by Pew Research found that the percentage of Americans who believe their country “stands above all other countries” dropped from 38% in 2011 to 28% in 2014.  Only 15 percent of 18-29 year-olds said the U.S. is the world’s leading nation. 

Rick Newman writing in Yahoo Finance commented: “The recession that ended in 2009 ravaged the economic fortunes of many American families, with median household wealth still about 40% lower than it was before the recession.  Jobs have finally started to return, but for many workers, pay is lower than it used to be.  People feel they’re falling behind, and the data show they’re not imagining things.  That’s a loss of economic freedom, which impacts other choices.” 

The latest Gallup and Pew Research polls provide even more insight into the currently depressed psychology on Main Street.  This jibes with the above mentioned investor sentiment surveys which reveal a decidedly negative view of equities....

[Excerpted from the July 7 issue of Momentum Strategies Report]

Gold supported by European, Middle East turmoil

To give you an idea of the damage suffered across European bourses in the last two days, France’s CAC40 stock index is currently 4% below its 6-month high from earlier this month.  The following chart of the iShares MSCI France ETF (EWQ), a proxy for the France stock market, shows the extent of the damage. 

Britain’s FTSE stock market index was particularly hard hit by selling pressure on Wednesday.  The iShares MSCI United Kingdom ETF (EWU), a proxy for Britain, was some 6% below its year-to-date high from just over a week ago.  The stock markets of Germany and Italy were also lower in the last two days.

In London on Thursday, the Bank of England (BoE) identified rising house prices as a major threat to financial stability, imposing new “loan to value” limits on mortgage lenders.  This is part of an ongoing concern as two chief U.K. financial-policy makers warned earlier this month of a U.K. housing bubble.  BoE Governor Mark Carney called real estate “the greatest risk to the domestic economy.” 

Commenting on this, the Wall Street Journal wrote: “Britain’s concerns highlight a central challenge to policy makers in the era of low interest rates: how to prick bubbles early without sapping a tremulous recovery.”  The preemptive strategy for preventing the sort of real estate crash the U.S. suffered a few years ago isn’t without peril, however.  Putting the brakes on lending and trying to deflate bubbles can often backfire and create panic in the investment markets, thereby creating a self-fulfilling prophecy of deflation.  Such a scenario would undoubtedly benefit gold as investors would likely run to the safe havens (much as they have since the beginning of June).

These are just some of the front-burner events driving the price of gold right now.  Analysts at major investment banks, meanwhile, continue to downgrade gold’s prospects.  Several analysts were quoted on Thursday’s in the financial press as saying  that gold faces limited upside prospects from here, and may even decline due to bearish fundamental factors.  A Reuters report noted that gold’s recent gains were “largely driven by short covering as speculators bought back their bearish bets, while gold-backed exchange traded funds have also failed to attract buyers despite bullion’s rally.”  According to an analyst quoted by BullionVault, gold imports to China via Hong Kong fell to their lowest levels in 16 months at 52 tons net of exports, which was given as a reason for remaining bearish on the metal. 

As long as events in the Middle East and Europe continue to drive investor uncertainty, however, it should provide continued support for the yellow metal.

[Excerpted from the Jun. 26 issue of Gold & Silver Stock Report]