Just when we were all ready to put on our bear suits in mid-summer, markets from equities to copper did an about face, rallied impressively, and showed that there is just enough uncertainty in all markets right now to keep bulls and bears equally uncomfortable. The “green shoot” crowd was back in vogue come late July but stay tuned. The color of those shoots tends to change weekly.
The trouble right now is that investors are not sure which part of the glass to focus – the part that is half full or the part that is half empty. On one hand, we see tiny rays of light peeking through in existing home sales, consumer confidence, new housing starts, Chinese commodity demand and a handful of company earnings – all of which are making bears a bit hesitant to press the downside too far in many markets. On the other hand, we have real estate prices that continue to decay (albeit at a slower rate), an unemployment rate that continues to grow (albeit at a slower rate), no real demand increases for anything, and a massive federal debt load that is about to get much worse. Throw in a potential Chinese housing bubble, and you have enough bearish firepower to keep bulls up at night.
Our big picture view this month is about perceptions vs. realities in the overall economy. To paraphrase a segment I heard on a
recent financial show, “a slowing rate of descent is not an ascent.” In other words, getting worse at a slower pace is not getting better. We may very well have seen a bottom in the S&P, Crude Oil, Copper and Coffee for the year. However, even if that proves true, it does not mean that bull markets are here to stay. Much of the recent strength we’ve seen in commodities is based on hope and a falling dollar. Yet, consumption for most key industrial products (such as crude oil) is not increasing, at least in the US. Until it does, market rallies will be based on hope and speculation and not on increased demand or reduced supply, the core of any real, sustained uptrend (at least in commodities).
You will know when a true recovery is underway when consumption begins to tick consistently upwards. Look for basic foodstuffs and energies (such as wheat, cattle and oil) to lead the way.
In the meantime, 32% of all US homeowners remain “underwater” on their mortgages. Credit remains tight. The savings rate continues to grow and probably will continue through at least the next 2 quarters – at least until unemployment begins to improve. We may be growing more optimistic, but we are not spending yet.
It is consumer demand that ultimately drives prices for commodities and products. Consumer demand makes companies grow, increases profits and thus share prices. Consumer demand is what pushes prices for raw materials.
As real demand is not yet surfacing, the latest round of economic exuberance could end up being a head fake for your portfolio. Markets rallied this summer from hope and speculation. However, they will need something more than that to continue strength through 2010. That something does not appear to be present yet. This could mean that many markets, especially raw materials, could be overpriced at this point.
Investors looking for opportunity may want to steer away from the traditional “buy and hope” equities markets and expand their horizons a bit to adapt to the new investment landscape. Earnings season went better for many companies. But for most, increased earnings were the result of cost cutting, not new revenue. This is not your father’s market environment anymore.
Those used to the mindset that one can only profit from prices going up, may want to alter their way of thinking and consider alternative strategies. There are many, and they can produce handsome rewards – for those willing to do the homework and learn how.
A popular choice these days is the formerly taboo commodities markets. There was a time when the mere mention of investing in soybeans, crude oil or coffee would bring collective groans and grimaces from financial advisors across the country and thus, this attitude was adopted by their clients. The advisors still don’t like it (most financial advisors are not licensed, educated, or trained in commodities, nor do they receive any fees for recommending them and thus, are about as likely to suggest them to their clients as they are to suggest purchasing a helicopter.) Yet, individual investors are starting to catch on.
There are other investments outside of the stock market. One does not necessarily need to have his entire liquid net worth dependent on the whims, corporate greed or even global financial meltdowns that affect the value of the S&P 500.
Commodities prices are based on supply and demand. True, a drop in demand can mean a drop in price. But commodities can be played from both sides. It doesn’t matter what direction price is moving, as long as one is on the right side of it. This is a key advantage in today’s unpredictable economy.
If there is anything that 2008 taught us as investors, it is the importance of diversification. Commodities can not only be a solid choice for the more aggressive portion of one’s portfolio, they can be an excellent diversifier.
But what about the risk? Commodities are a leveraged vehicle which means profits or losses may accumulate at a faster rate in ones account. However, position size has much to do with how high of a speed one wants to move. The biggest mistake comes from novice investors attempting to position their commodities portfolio like a stock portfolio. (Hint: In commodity investments, you want to keep a portion of your account in cash to account for price fluctuations in your positions). It is my opinion that people lose money in commodities not because these markets are more volatile (they are not) but because they do not understand how to manage the leverage properly.
Market risk, however, is your only risk. Forget the old fashioned myths about commodities. We’ve all heard the stories about Uncle Joe losing his house because he bet too heavily on the soybean market. We’ve heard about the semi-truck driving up and dumping 5,000 bushels of corn on somebody’s lawn. Usually this happened to “a friend of a friend.” (Maybe the friend was your financial advisor.) Today’s US commodities exchanges offer some of the most modern platforms in the world. They are heavily regulated, lined with investor protections and come under the direct regulation and supervision of the US Government (The CFTC).
The question most investors have is “How?”
“How can I learn, start, participate?”
We certainly do not recommend reading a book or two, seeking out an online futures broker and have at it. That is what most prospective commodity investors do and that is why most of them lose money (perhaps this has something to do with the reputation of commodities).
As discussed earlier, commodities futures markets are leveraged vehicles. The biggest mistake new commodities investors make is trying to trade them like stocks. They are NOT stocks. New commodities traders often misunderstand leverage and thus, make money losing mistakes.
Another mistake is treating it like a high stakes gamble. The get rich quick crowd often jump in with dreams of 200-300-400% returns.
“There is a corn blight in Iowa – I got the tip from my uncle. The thing could take off any day now. All it takes is $3,000 each to get in – are you in?”
This is a big reason why 80% of the people who “try” commodities lose and about 20% make all the money. Commodities investments can be rewarding in the form of high returns. But they must be treated like a serious investment – well planned, well researched, well managed. There is downside risk and knowing how to handle this risk correctly makes all the difference between investment losses and a portfolio star.
There are many ways to invest in commodities and as many strategies as there are traders. One does not necessarily have to buy and sell the futures contracts themselves. There are of course index funds, ETFs but these often do not offer direct exposure to the products themselves and can come under the influence of the overall equities markets. There are managed futures, hedge funds, and good old fashioned commodities brokers. Whatever approach you choose, I recommend you seek out a licensed professional with a specialized expertise in commodities and a proven plan for investing in them.
What does a commodities portfolio look like? It depends on what kind of strategy you are pursuing. There are a variety of markets available in liquid contracts such as crude oil, natural gas, gold, silver, soybeans, wheat, cattle, sugar, coffee and unleaded gasoline. Unlike equities, the price of one of these markets often has little to do with the price of another.
Selecting a market in which to invest should be begin with the fundamentals of the individual commodity. Remember when we use the term “invest”, that could mean going long or short the market. Price can move either way. You (or your portfolio manager) only has to pick the right side.
An example of a commodity trade could be made in the crude oil market. Consider our opening segment of this article addressing consumer demand. Crude oil is a market that has been moving in the opposite direction of its underlying fundamentals. Speculative buying, hope for a brighter economy and driving season (increased demand for gasoline) have all contributed to higher prices this summer.
Yet, supplies remain near 20 year highs, global demand remains off as a result of continued economic recession and we are heading into what is known as “shoulder” season: a time of year between consumption cycles when demand tends to slack. By the Autumn months, the peak demand season for gasoline (summer) is over, and the peak demand season for heating oil (winter) has not yet begun.
Chart courtesy of Hightower Research
As these are the two primary products produced from crude oil, demand typically falls and crude oil stockpiles tend to accumulate. Combined with the economic observations made earlier and oil’s stubborn reluctance to trade much over $75 per barrel, oil prices could be at or near a peak for the year. This can be a good opportunity to profit from flat to falling oil prices.
How to do that is the subject for another article. The point here is that we are in a new age of investing. Investors should consider the wide range of investments available for them to diversify a portfolio. Someday, the economic recession will end, equities could resume a long term bull market and real estate will be king again. In the meantime, commodities offer a highly regulated group of markets traded at public exchanges with high liquidity. They can be excellent diversifiers and offer investors the opportunity to generate considerable returns in bull, bear or stagnant markets.
James Cordier is the founder of Liberty Trading Group/OptionSellers.com, an investment firm specializing exclusively in selling options in the commodities markets. James’ market comments are published by several international financial publications and worldwide news services including The Wall Street Journal, Reuters World News, Bloomberg Television News and Forbes. Mr. Cordier’s book, The Complete Guide to Option Selling 2nd Edition (McGraw-Hill 2009) has been featured by Morningstar Advisor, SFO Magazine and CNBC’s “Squawk on the Street.” Liberty Trading Group works with individual investors in establishing commodity option portfolios with professional guidance. For more information, visit their website at www.OptionSellers.com and request a Free Investor Information Pack.
