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  • Commodity stocks have been top performers this year.
  • A slowing economy could ease supply pressures and prices.
  • Commodities are cyclical stocks that tend to lose some luster during a recession.

The commodity bull market this year has been impressive, but there are some cracks emerging that could suggest tougher days ahead for them. 

Year-to-date, the Invesco DB Commodity Index Tracking Fund  (DBC)  is up 29%, while the S&P 500 is down nearly 21%. That's some impressive relative outperformance, but it somewhat masks more challenging performance lately. For example, the DBC did gain a little over 2% in the second quarter, but returns would've been much higher if not for a 7% decline since the S&P 500's low on June 17.

The commodity basket's strength isn't surprising given that historically, commodities do best in the late stage of the business cycle, when inflation runs hot but the economy hasn't yet slowed because of inflation-busting rate hikes. Now that the Fed's become increasingly hawkish and GDP is falling, demand for commodities could wane, making it more likely that markets are pricing in the "best of times" for them, and related stocks.

In "Commodity Bull Runs Have Proven Unsustainable; Can This Time Be Different?," Real Money Pro's Carly Garner explains the situation so well that I'm including her article in its entirety:

"There is a saying in finance that goes "Don't confuse genius with a bull market." The massive commodity rally in recent years has likely resulted in overconfidence and complacency regarding the long commodity trade. We've seen this movie before; the ending is somewhat tragic for those who adopt the mantra "this time is different." Commodity bull market narratives are always compelling, frightening, and overwhelming; they are also temporary.

Unlike stocks, which tend to move higher throughout time while paying investors dividends to wait for capital appreciation, commodities don't pay dividends. In other words, commodity traders don't get paid while they wait for the market to make a move. This conundrum tends to attract fickle speculative dollars, leaving commodities plagued by downtrends with occasional upside volatility. Thus, many investors wisely choose not to be long-term investors in commodities. Instead, it is a trade.

This mindset contributes to market impulsiveness and opens the door to dramatic trend changes that seem to front-run fundamentals. Not surprisingly, this can catch green traders off-guard. Even the notorious commodity boom of the 1970s reversed sharply and failed to make upside progress for over a quarter-century.

We typically focus on charts with short-term to intermediate-term time frames, but on this occasion, we would like to focus on decades of patterns, not just months or years. A monthly chart of the Goldman Sachs Commodity Index (comprised of 24 exchange-traded futures contracts across five sectors) offers a good reminder that commodities tend to trade sideways in the long run. Bull markets bring prices to the top of a range and bear markets bring them to the bottom, but progress is rare. Occasionally, that price range shifts higher, but we've yet to see the commodity complex hold gains forged in a bull market.

The primary factor preventing commodity prices from following inflation steadily higher, in the long run, is improvement in technology and, therefore, efficiency. In farming, faster and more productive equipment have combined with scientific advancements to create farm efficiency that was once believed to be impossible.

Similarly, in the energy sector, the advent of fracking changed the energy game forever. In 2007, it was widely believed that the world was running out of fossil fuels, but by 2014 the newfound ability to squeeze oil and natural gas out of rock fissures changed the landscape seemingly overnight.

If the world continues to collectively become better at extracting and producing food and energy, the fact that the best cure for high commodity prices is high commodity prices will remain true. High prices lure producers to pick up the pace and expand operations, but those efforts often flood the market with supply. This, along with consumer rejection of high prices, enable commodities to collapse when least expected.

Zooming in on the Goldman Sachs Commodity Index chart to use weekly bars spanning the previous 20 years, we can get a better look at the fate commodity runs have faced. Some will argue this time is different and the commodity bull is just getting started. That isn't impossible, but it isn't likely, either. Along with the tailwinds of efficient production and better technology, the "long" commodity trade is still relatively overcrowded, the US dollar index is wildly elevated, risk assets are under pressure, which is working against the wealth effect and triggering margin calls, and global central banks have two feet on the brake. In our view, a lot can go wrong in the commodity space.

The commodity markets have always operated on a boom-and-bust modus operandi. The 2007/2008 commodity boom ended abruptly in June 2008 and gave way to a bust of historical proportions as the world shifted from inflation concerns to deflation panic during the financial crisis. Two years after bottoming, the commodity complex regained its composure and enjoyed a boom running on Quantitative Easing fumes, but commodities rolled over in May 2011.

Each of these commodity rallies was accompanied by compelling fundamental stories that had been adopted by the masses; in 2008, my mother purchased a Prius weeks before the tumble because she believed "gas prices are only going up." At the time, an opinion calling for oil to drop from $150 per barrel to $30 would have been laughed at by 99% of the population, yet that is exactly what unfolded.

In 2011, we were at the height of the Arab Spring, a string of uprisings and protests against politicians in much of the Arab world at least partly sparked by food and energy shortages. Further, the uprising itself was interfering with oil production in the Middle East. Similarly, the consensus opinion from the smartest analysts in the world was higher commodity prices are the new normal; consumers should simply accept $100-plus oil and $7.00 corn. We now know those prices were temporary and a decade-long bear market in commodities was looming, but at the time that outcome was far from expected. The point is that commodity rallies are generally unsustainable in the long run regardless of what seems to be obvious bullish fundamentals. To reiterate the point, let's look at how a few select commodities have fared over multiple decades.

Crude Oil

In a post-fracking environment, before the Covid lockdown and subsequent reopening, the energy complex appeared to be better behaved than it had been previously. This is largely because of US energy independence on the heels of the fracking revolution. Had it not been for the pandemic and all the chaos that followed, including an increasing money supply and eventually the Russian invasion of Ukraine, oil prices likely would have continued to behave themselves.

Nevertheless, once the shock to the system wears off, we should be left with oil prices closer to the equilibrium price range between $50 and $75, which has acted as a magnet for pricing since the early 2000s. Keep in mind that this doesn't mean we can't see short-term upside volatility; it is simply a reminder that commodities go down as much, or more, than they go up. If history is a guide, the oil rally is closer to completion than most assume it to be.

Cutting the price of oil in half might seem far-fetched given the green movement, sanctions and Chinese demand coming back online, but there could be some counteractive stories hitting the airwaves soon. For instance, the G-7 meeting revealed there is some thawing in the financial freeze of fossil fuel expansion, the Iranian deal could be rekindled to bring additional supply to the market, and a bulk of the war premium priced into oil has been justified by US and European sanctions, but Russian oil is still coming online; it is just going to alternative buyers.

Corn

The price of corn in the US spent most of the 1960s trading between $1.00 and $1.60 per bushel. The 1970s commodity run shifted the price floor higher; corn spent the next two decades mostly trading between $2.00 and $3.80. The 2007 rally shifted the price floor up again to about $3.00. Aside from a few sharp rallies into the $7.00 to $8.00 range, the price of corn has been most comfortable between $3.00 and $4.60.

Perhaps the current rally will shift the floor up to $5.00 or $5.50 (the peak in 1996 and 2014, as well as the floor in 2021). Even so, $7.00 to $8.00 corn shouldn't be expected to be the new normal. As we have seen time and time again, the price will likely settle toward the lower end of its price floor. This is because the longer prices remain elevated, the more farmers are incentivized to produce. High prices lure efficiency and volume; US farmers have proven time and time again that they are up to the challenge.

Those who are attempting to navigate markets in the short run shouldn't forget what history teaches us about commodity prices and the human propensity to overreact to price changes. Human behavior results in the same boom-and-bust price action we've seen since the beginning of the commodity markets, and especially in recent years. Despite overwhelming bullish stories, lumber has fallen more than 70% from its 2021 highs and natural gas dropped 40% since early June!

Being a complacent commodity bull can be dangerous. There could be some short-term bouncing and maybe even retesting of highs, but in the big picture we could be witnessing the beginning of the end of the commodity bull."

The Smart Play

Sure, there could be more 'gas' in the tank for commodities and related stocks, but it does seem like there's been a shift among professionals lately away from them toward recessionary stocks, such as healthcare. 

Because energy stocks tend to lead in the late stage but they offer midling performance historically in a recession, taking some profit or treating them like rentals, including protecting gains with stop losses could be a smart bet from here. Of course, there will be rallies and exceptions within the group, but I think the easy money may have been made in the basket.

  • Commodity stocks have been top performers this year.
  • A slowing economy could ease supply pressures and prices.
  • Commodities are cyclical stocks that tend to lose some luster during a recession.
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