Are Commodities Reversing or Consolidating?

It has been a dramatic week in the markets, with the long oil and short financials trade reversing hard and a number of the relationships that have been intact for the past nine months being thrown into disarray.

As I have been maintaining since early in the year, speculative money is likely to be flowing into either commodities or equities, but not both. That basic premise has not changed, but what has been called into question is whether the second half of 2008 will be more friendly to commodities or equities.

I believe the answer to the commodities or equities conundrum is that it is still too early to tell, but commodities still have to be considered the preferred asset class. Two charts below tell a good deal of the story. The first graphic is a weekly chart of the Reuters/Jefferies CRB index, which is heavily weighted toward energy. It shows that the recent pullback in commodities is consistent with previous pullbacks and consolidation periods. Neither the magnitude nor the duration of the recent reversal in the bullish commodities trend suggests that the bull market in commodities is winding down.

The second chart last appeared on this blog two months ago. It reflects the ratio of the commodities basket in the Rogers International Commodity Total Return Index (RJI) to the SPX. [RJI is an ETF linked to the Rogers International Commodities Index that has a broad weighting, with less emphasis on energy than most commodity indices] The ratio chart also shows much more of a consolidation ongoing in the present market environment than a reversal.

Of course, one more week of soaring financials and plummeting oil prices will dramatically change the tone of the chart, but for now at least, consider the commodities trend to still be intact (and susceptible to buying on the dips), which means the case for a reversal in equities is still a weak one at this stage of the game.

Equities or Commodities?

Ever since the bear market of 2000-2003 found a bottom and started up, equities and commodities have largely been moving up together. That relationship came to an end when the equity markets topped in mid-October. Since then, as the first chart below indicates, the SPX has been falling while the Reuters/Jefferies CRB Index of commodities has been on the rise. While the direction of these indices has recently changed, the inverse relationship appears to be holding up. The SPX and CRB chart below shows that commodities turned down about two weeks ago, just before the equity market bottomed.

A quick and dirty explanation for this change might be that speculative money started getting out of equities last August and September as the market topped, concerns were raised about the credit markets, and the Fed started cutting rates. The Fed’s actions clearly caused many investors to be more concerned about inflation and pushed them in the direction of assets – such as commodities – that have historically performed well in an inflationary environment.

In addition to the StockCharts.com SPX and CRB chart, I have also included a six month heat map, courtesy of FINVIZ.com, which shows in dramatic fashion, that commodities have been one of the few areas of strong performance during the past six months.

As financial firms de-leverage, it is possible that speculative bets will be limited to equities or commodities, but not both, so it is important to watch which asset class is soaking up most of the money currently on the sidelines. I will update this story as it unfolds.

[graphic: StockCharts]

[graphic: FINVIZ.com]

Speculation in Commodities vs. Technology

During the course of the five year bull market that appears to have ended last October, the technology and commodities sectors have been two areas where a considerable amount of speculative money has flowed in search of extraordinary returns.

Since October, money has flowed out of technology, as indicated by the action in IGM, a popular technology ETF. Conversely, speculative money has been flowing in large quantities into commodities, as the action in gold, agriculture, oil, natural gas and other commodities can attest to. While there are a number of commodities indices and ETFs out there, many of them (notably the CRB Index, but also the GSCI) have such a heavy weighting in oil and gas as to make them de facto energy indices and not a good proxy for a broader representation of industrial metals, precious metals, agricultural commodities and the like. For this reason, I have chosen to highlight the iPath Dow Jones AIG Commmodity Index (DJP) as my broad-based commodities benchmark (the Rogers International Commodity Index, ticker RJI, is also broadly diversified, but is only it its fifth month of operation.)

Looking at a ratio of the IGM and DJP ETFs or stacking them on top of each other, as I have done below, you can see the flow of speculative money out of technology and in to commodities. For those seeking a strong upward trend in the current downturn, commodities represent an excellent opportunity. Conversely, when speculative money starts flowing out of commodities and back in to technology, expect to see the NASDAQ and other broad indices stage a more sustained move to the upside.