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Wednesday, March 16, 2011

Stocks versus Commodities: Can the tail wag the dog? - published in the SB News Press in January of 2011

For some time now, stocks and commodities, for the most part, have been moving in the same direction – up.  Historically speaking however, this is not normal.  There are a variety of economic reasons, both for the current relationship between the two, and the historical relationship as well.  Understanding these relationships may provide some insights into the future directions for both markets, and for the economy as well.

The historical relationship between stocks and commodities has been that when stocks go up, commodities go down, and vice-versa.  The primary reason for this is that inflation tends to drive commodity prices up and stock prices down.  Inflation, by definition, means prices increasing, so it makes sense that commodities would benefit from inflation.  Stocks, on the other hand, suffer from inflation, because the profits that companies are making are worth less and less, as inflation increases.  Another way to look at it is that the profits companies earn will buy less as inflation increases.

Inflation can be tricky.  As with most economic factors, inflation doesn’t always affect the economy, stocks, or commodities exactly as expected.  The relative impact of inflation has a lot to do with the rate of inflation.  Also, as with every asset class, prices for stocks and commodities are largely influenced by expectations of future performance, rather than simply by what is happening in the present.  In other words, the future expectation for inflation can and does affect stock and commodity prices, probably much more than the current rate of inflation.

The recent performance of stocks and commodities has not followed the historical relationship between these two asset classes.  In fact, it has been just the opposite – stocks and commodities have both performed exceptionally well.  During 2010, stocks (the S&P 500) gained about 13%, while commodities (CRB Index) gained about 20%.  Gold, which is considered the most effective hedge against inflation, gained about 26% during 2010.  How can we explain why stocks and commodities have been moving together recently, instead of moving in opposite directions, as is their normal relationship?

The answer is complicated, and I’m not sure I have all of the answers.  One thing we do know is that we have experienced a very unique set of economic circumstances over the past two years or so, which provide some interesting information, and which may help explain.  First, stocks were crushed in late 2008 when Lehman Brothers failed, along with several other major financial firms.  The American investing public lost confidence in the financial markets and in banks for the most part.  Stocks reacted immediately and violently to the panic, shedding half of its value from the beginning of 2008 at about 1,450 to the low in early 2009 of 666 (intraday).  From that low, stocks began a slow, but steady recovery that is still in process today. 

At the same time, commodity prices, which also experienced a dramatic decline, falling from July of 2008 through the end of 2008 by about 40%, have also enjoyed an amazing run, gaining almost 80% from the beginning of 2009 through today. 

Both markets suffered extraordinary declines, and have been in recovery mode ever since.  Because both markets were rebounding from such artificially low levels, which were caused by massive shocks to the economy and financial markets, we have seen the two markets move together, in the same direction, over the course of the last two years. 

Returning to our discussion of inflation, the pace of inflation can provide some additional clarity regarding the correlation (both markets moving the same direction together) of stocks and commodities.  Simply put, a little inflation can be a good thing, especially for stocks.  What I find interesting about inflation expectations today is that it appears stock investors see only modest inflation, which commodities investors/speculators see inflation coming at a much stronger pace.  If commodities traders felt that inflation was going to be tame in the coming months and years, they would not have run the prices of commodities up so high, so quickly, especially with regard to gold and other precious metals. This difference of opinion regarding the pace of future inflation could help explain why both markets have continued to rally, even after regaining most of their previous value, which was lost during the market shocks.

Historically speaking, when the stock and commodities markets have moved in unison, one market has been “right” and the other “wrong.”  In other words, the correlation between the two markets has been temporary, and has been followed by one of the two markets reversing to the downside.  More often it is the commodities market that is correct about the direction of inflation.  I believe this is because the commodities market is driven more by professional traders as compared with the stock market, which is increasingly driven by small investors who tend to be unsophisticated and therefore less able to analyze the complexities of the economy and other key factors that ultimately determine market direction.

Interestingly, because both the stock and commodities markets have increased in value so much, so fast, I believe it is highly likely that both will reverse to the downside in the short-term.  In fact, we have already seen gold and some other commodities losing value in recent weeks.  Gold, for example, has fallen from a high of $1,433 in November 2010, to around $1,360 this week, or by about 5%.  Stocks have yet to roll over and begin to decline, but given the sizable gains, especially within certain sectors of the market – Consumer Discretionary stocks up 26% in 2010; Industrials up 24% in 2010 – I would not be at all surprised to see a healthy correction in the near-term.  In fact, we have already witnessed some companies reporting fantastic earnings results for the fourth quarter, such as Intel this past week, suffer sizable selling pressure and stock price declines as a result.

So the big question is: Will the tail wag the dog?  Can stocks continue to perform well in the face of increasing inflation (assuming that the commodities market is correct in its prediction that the pace of inflation will be robust)?  One thing is certain; both markets cannot be correct.  Either inflation will remain contained, or it will accelerate.  Tame inflation could provide the foundation for continued positive stock price performance and a sustainable economic recovery with solid GDP growth for several years to come.  On the other hand, high inflation would tend to drive commodity prices up, but could (and most likely would) result in downward pressure on stocks and a challenging economic environment.

The Fed definitely has its hands full.  I feel that the coming few years will likely be the most challenging in the Fed’s history.  The Fed governors will have to navigate the treacherous waters of the economic environment they have created, with trillions of dollars pumped into the economy, lots of downward pressure on the dollar, a mounting budget deficit and a national debt of around $13 trillion (and climbing rapidly), and very challenging global economic pressures.  If the Fed can find that magic balance between raising interest rates enough to combat inflation without stifling the economy, they might just be able to preserve and sustain the recovery.  However, it is a tall order.

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