Tales of a Technician: Will 2018 be the Year of the Commodity Comeback?
One of the most enlightening parts of the CMT program I completed back in 2013 was its thorough teaching of intermarket analysis and the relationship between asset prices and the business cycle. I had obviously heard bits and pieces of both topics previously, but never in a cohesive, comprehensive manner. In one of the most memorable lessons, a schematic was presented that represented the idealized business cycle. Within it showed how the three major asset classes (stocks, bonds, commodities) performed at different stages. Two key takeaways were:
Bonds lead due to their interest rate sensitivity. They rise first when the economy hits the skids and the Fed starts lowering interest rates. They fall first when the economy is heating up and the Fed starts rising interest rates.
Commodities lag since they’re driven by inflationary pressures. They rise last because inflation doesn’t kick into high gear until the economy is firing on all cylinders. Typically this occurs during the latter stage of an economic recovery. And they fall last since inflation doesn’t typically abate until after the economy begins to falter.
The way I always remember the rotation is the old Bear Stearns ticker symbol: BSC. Bonds turn up, then Stocks, then Commodities. Bonds turn down, then Stocks, then Commodities. At least that’s the typical rotation.
Market spectators already know how terrible the relative performance of commodities has been over the past five years. Stocks have spanked commodities six days a week and twice on Sunday. So says the following chart comparison. By the way, I’m using the Reuters/Jefferies CRB Index to represent commodities (it’s a basket including 19 of them) and the S&P 500 Index to represent stocks. The relative performance is shown in the lower panel and reflects the relentless underperformance of commodities for months on end.
But upon closer inspection, it appears we have a possible bottom forming in the CRB. The nascent strength has been led by industrial metals, precious metals, and energy. For evidence, I suggest taking a peek at the likes of XME, SLX, XLE, and XOP.
While I’m already on the bull bandwagon with industrial metals and energy, I’ll need a bit more convincing on precious metals, particularly silver (SLV) and gold miners (GDX). The low implied volatility plaguing that entire space has made most of the ETFs untradeable for me, at least from a premium selling perspective. But from a business cycle perspective, it’s the likes of XME, SLX, and XLE (or, even, XLB) that provide a more clear indication of economic-driven inflationary trends.
If inflation does finally heat up in the next year or two, I fully expect the relative weakness from the commodity complex to stage an about-face and finally –finally!– score some outperformance for a change. I suggest keeping an eye on the CRB index as your tell moving forward. You can use the ticker $CRB in stockcharts.com. If there are any savvy sleuths reading this that know how to chart it in ThinkorSwim, then share with the class.
Since there are numerous ETFs that track commodity-related markets, you have your pick of the litter with building trading systems around this theme. My favorite funds for the space right now are XOP, XME, and even EEM. Emerging markets stocks have a strong correlation with industrial metals as they both tie-in to the global growth narrative. It’s no coincidence that emerging markets have underperformed for ages alongside commodities’ suckitude. The sole difference is emerging markets have already turned a corner and started outperforming U.S. stocks. This has been a long time coming, and my bet is we continue to see money rotate into the likes of EEM for the foreseeable future.