Sunday, February 24, 2008

Historic bull market in commodites

We've got a 4 year cycle low coming sometime in the first half of this year I suspect. As I pointed out in the previous thread when this final low comes in it usually takes down everything and that includes commodities. I'll say right now that commodities are going to hold up better than the paper markets. They certainly have held up much better during the first leg down. The second leg is going to be when the real panic will be generated. This will probably play havoc with margin calls and everything is going to get hit including commodities. We'll see all the old familiar faces coming out and predicting the end of the commodity bull. The media will tell you that commodities were in a bubble and it's now bursting, yada, yada, yada. It will all be baloney and here's why.

Take a look at the first chart. This is the S&P/CRB ratio. What we see is a historic rise from 1980 to 99 in the price of paper assets compared to commodities. From 99 to the present we see a major trend change from paper to hard assets. Now let me digress for a second and remind everyone how human nature works. Our emotions take us from one extreme to another. The larger the extreme in one direction the larger will be the swing back the other way. We don't go from one extreme to average back to extreme. It would be much better if we did but that's just not how human emotions work. So now we are in the process of swinging back to extreme overvaluation in hard assets. Keep in mind the run from 1980 to 1999 was the biggest in a long shot. So far we haven't even come close to approaching the level we saw in 1980. We're only half way there and 8 years have gone by. Now the average for a hard asset cycle is between 15 and 20 years. The shortest was 9 years from 71-80. At best we're likely only half way through this commodity cycle and if human nature unfolds like I'm sure it will, we will correct the historic undervaluation from 80-99 with a move to historic overvaluation before this is over. This bull should make the 71-80 commodity bull look like child's play. This makes sense as we are now seeing a huge segment of the global population expanding at a tremendous rate of growth. Fuel for this growth has to come from somewhere. It needs energy for one thing. Energy that hasn't expanded it's infrastructure or found a giant oilfield in 40 years. It needs basic materials. Again an area that has not expanded as the devastating bear market crushed prices for almost 20 years. If the price of what you sell is consistently going down I can tell you that you are probably not in a big hurry to find more of this cheap stuff. It costs a lot of time and money to bring more production online in the commodity bussiness. Not a big priority if you are barely hanging on to profitability.

Next take a look at the ratio of the S&P to commodity related equities. We see a steady move down as the S&P consistently under performs commodity based companies year after year.

In the last chart we see the Dow/Gold ratio for the last three great secular bull markets from 21-29 the gold ratio declined to almost 20/1. Meaning that it took 20 oz. of gold to buy 1 share of the Dow. When the trend changed that ratio declined to almost 2/1. Then the next great secular bull market from 32 till 66 took the Dow/Gold ratio back up to 28 oz. of gold for 1 share of the Dow. This was followed by another commodity bull cycle and a trip back down to 1:1 on the Dow/gold ratio. Then we have the greatest secular bull market of all from 82 to 2000. Gold was crushed to the point where it took 45 oz. to buy one share of Dow paper. Now we are in the process of correcting this gross undervaluation. I have no doubt that we will see the Dow/Gold ratio approach 1:1 again and if the extreme nature of the undervaluation is any indication then we could very easily see gold surpass the Dow this time.