The Commodities Profit Rollercoaster

As a seasoned investor and long term bull in commodities markets, I would rather write about the bullish potential that exists in these markets than the downside risk.  The problem, for lack of a better word, is that nothing in financial markets goes up or down in a straight line.  Bull and bear markets are full of corrections and bounces.  Identifying and understanding the near-term catalysts that could possibly change an intermediate trend is essential in investing in these volatile markets, whether it be a stock index, commodity future, or your favorite micro-cap stock.  The wonderful thing is that you, dear reader, don’t have to worry about a thing.  That’s my job.

As I see it, we are in a potentially massive corrective stage in most commodities.  This does not mean that I  believe the commodity bull market is over and crude oil, copper, or wheat will be cheaper at this time next year than it is now, and in fact, it’s the exact opposite.  What we have here is a situation where both domestic and global growth are slowing in the intermediate-term.  Being that as economic growth goes, so goes commodities markets, I feel that we are in for a short-term correction.  I don’t want to get too much into this notion as I plan to touch on it in future articles, but it is an important premise for the rest of this article.

So, we will take for granted that economic growth around the world is slowing.  With that comes my view for a rather deep correction in commodities markets. 

Commodities Charts Looking Toppy

Here are charts of the Goldman Sachs Commodity Index and the Power Shares DB Commodity Index Tracking Fund, and they are beginning to appear toppy in my opinion.

As you can see from these charts, these indices have gone on fantastic runs, but have corrected in the past few days.  The correction, which hasn’t run too deep thus far, is not enough to make a bearish argument.  Some of the other things we can take from this chart are the recent crossovers of both the MACD and DMI.  These are also bearish indicators.  The final and most important item I would like to take from these charts is the severe divergence between the 50 day and 200 day MA.  What that really means is that these commodities indices have moved to the upside very quickly, and when we do correct, it will be violent and most likely take us down at least to the 200 day MA.

Moving on, many investors will ask the question:  is this going to be THE correction, or is this another blip in the chart that will soon be forgotten?  Will commodities be higher in a couple of weeks?  I’m here to tell you that there’s a trade you might want to consider that makes the prior questions completely irrelevant.

Commodities Inter Market Spreads

Timing peaks and troughs is a very dangerous game in any financial market and trying to do so is like catching a falling knife.  So were not going to do that, because I’ve got something with a much more desirable risk reward scenario.

Have a look at this chart.

This is the gold to light sweet crude ratio chart.  As you can see the last time the ratio was down near six, it rallied to twelve.

What does this chart have to do with the notion that it doesn’t matter what commodities near term price action is?  The answer is everything.  I am talking about inter market spreads.

If you have no experience with inter market spreads, please do not get intimidated by the notion.  If you are familiar with such spreads, than you’ll know what I’m talking about.  It is actually quite simply.  Allow me to explain.  Using spreads, especially inter market spreads, is a great way to limit market risk and still assume the majority of the upside potential.  

Let’s get into some of details of this specific trade.  With global growth slowing, we can expect growth in demand for commodities such as oil to decline.  With the lower demand will obviously come a lower spot price for oil.

On the other side of the trade we have to look at the market fundamentals for gold.  Actually, gold is one of the few commodities that I’m near term bullish on.  In fact, because of gold’s technicals, I’ve recently turned very bullish on the precious metals sector in the intermediate term.  Although you will have to wait for another article for me to fully explain gold’s bullish fundamentals and technicals, what I can say is that this will be an inflationary recession.  These are rare occurrences in global economic history, but with the foot steps of deflation being heard not far off, monetary authorities around the world will do everything in their power to prevent it.  This action by global central banks to prevent deflation has, and will continue to take the form of lower interest rates (negative real) and money supply growth…inflation.

Gold and oil are obviously correlated by their ties to inflation, and we know that inflation fuels gold.  What we have here is a situation that whether gold goes up or down, we will still see a reversion to the mean in these price ratios.  If gold gets caught in the massive commodity sell off along with oil, oil will most likely fall at a faster pace than gold does.  Now if gold rallies, and commodities contract, you can do the math.

By going long gold and short oil, we are able to still give ourselves exposure to commodities markets but still limiting our risk.  The beautiful thing about this trade is that investors of all shapes and sizes can make a play on this trend.

Commodities Spreads For Everyone

If you are comfortable trading futures, simply go long gold futures and short oil futures.  If you have the prowess of trading options, you either can buy gold calls and buy oil puts.  For the majority of today’s investors who either have a stock broker, or online account, we can take advantage of the many ETFs that are now offered.  You might consider buying the StreetTRACKS Gold ETF (GLD) or the iShares Gold ETF (IAU) and either selling short the United States Oil Fund (USO) or buying the Proshares Short/Ultrashort Oil and Gas (DDG/DIG).

Any and all of these trades will work, it just depends on what your comfort level and investment experience is.  What we have here is a dangerous climate for investment in commodities markets.  This is an easy way to side step the risk and give yourself an opportunity to tap into the massive pool of potential profits that exists in both the up and down swings of commodities markets.

Nicholas Jones
Analyst, Bourbon & Bayonets