Sunday, June 1, 2008

CRB inflection point

I think commodities are now at an inflection point. I'll explain why. Let's start with the first chart.

What we are looking at is the first phase of the commodity bull market which ended in what I call the fifth year decline. Secular bull markets tend to all have this major counter trend correction around year five. Apparently it takes five years for enough people to get sucked in before a large correction wipes them all out and resets the bullish sentiment low enough for the next phase to begin. Black Monday in 1987 was just such a decline.

We've obviously started the second phase of the bull market. This phase often drags on for years. It lasted from 1987 to 98 for stocks. I doubt the commodity bull will be any different. During this time we will see many scary corrections. Every one of them will bring out the doubters. Every rally will bring out the calls of a bubble from the media. The swings will likely be larger in each direction during this period as more and more investors jump on the bull.

Each new leg up will draw in enough new investors to push commodities to new highs probably often stretching the averages quite far above the 200 DMA's. Each correction will fall hard as these stretched levels collapse under the forces of gravity.

During this time infrastructure will start to expand. It will take time. You just can't find a giant oil field and bring it into production quickly. It will take many years to bring this online. Probably 5-10.

Somewhere in the future we will see another correction that will be completely out of character to what has transpired during the second phase. Again the calls will surface about bubbles and commodity bull being finished, etc., etc. This time it will be close to being true. By then enough supply will likely have come on line to meet demand and quell prices. However that won't be the end of the bull.

That's not how human nature works. At the bottom of this correction a strong rally will take hold. By now the public will have watched for 10+ years as the commodity bull roared ahead. They will take this rally as a sign of a sure thing. You won't be hearing anything about bubbles at this point. The media will be full of stories about paradigm shifts and rising commodity prices for the foreseeable future. People will by buying gold and silver and hoarding food to protect against inflation.

The problem is that it actually will be a bubble at that point. Supply will now be more than enough to meet demand. The only thing pushing commodities higher at this point will be human greed and our inability to see change coming. We are forever stuck projecting the past into the future. People are doing it right now with the real estate market. Despite 2 years of losses they continue to try and call a bottom in housing. Don't even get me started on the financial sector. (One year does not a bottom make.) Investors are still trying to project the remembered gains in real estate into the future. I've got news for everyone there won't be a bottom in housing until everyone becomes convinced that real estate is the worst investment ever.

The final phase will last about 1 to 1 1/2 years as the general public piles into a "sure thing" Then and only then will we get the final blow off top in the commodity market. That's when we will likely see the Dow:gold ratio approach 1:1.

Now take a look at the second chart. The inflection point IMO is the $420 support level. The CRB has consolidated for a couple of months and broken above $420. It is now testing that breakout. If this breakout holds and commodities begin to move higher from here then we are all in for some serious inflation in the coming months and probably the next year.

The question comes down to will the Fed let the banks pay for their mistakes and start targeting inflation by raising rates or will they continue to throw money at the financial system and rescue their buddies at the rest of our expense.

The BKX is very close to breaking down to new lows at the moment. I'm going to say right now that it is important for the BKX to break down. We have to cleanse the system. The only way for this to happen is for the banks to suffer the consequences of their greed. As long as the Fed continues to prop up the financial system our future is not going to be very bright. Granted things are going to be in a shambles for a while as multiple banks go bankrupt. That is the price that has to be paid for the spectacular misallocations that were seen in recent years.

I will be watching the CRB and the BKX closely in the coming weeks.