Have Commodities Peaked for the Cycle?

Anyone thinking that we may get a repeat of the spectacular 2001-2008 and 2009-2011 rallies in commodities may have to think again, at least that’s what’s being hinted at by many of the long-term technical indicators. You could say it depends on what the definition of the word “is” is, to quote a well-known Clintonian expression. In this case, it all depends on what the direction of the secular trend is, as we explain later.

What is the secular trend?

Since recorded history, which in the case of US commodities, began in the early nineteenth century, prices have swung in clearly definable very long-term or secular trends. These price movements have approximated between 18-20-years and embraced several business cycles. They arise because of huge swings in under and over capacity. Over capacity develops after many years of upward price pressures, that attract both new productive investment and the aggressive substitution of cheaper materials. This excess capacity does not suddenly appear, but takes several years to develop. Once on stream, it usually takes a couple of decades to work off. During that process, industrial commodity prices either decline, or experience a lengthy trading range.

Recent history of the energy sector offers a great example. In the 2004 to 2008 period, supply constraints and growing demand for energy in China, drove up prices. OPEC also helped maintain them at an artificially elevated level. The market was eventually pressured, as those high prices naturally, incentivized greater conservation. From a supply aspect, high prices encouraged drilling, as the international rig count more than tripled between 1999 and 2012. Substitutes, in the form of renewables, also exploded, though admittedly from a small base. Fracking was the big elephant in the room. The technology that drove it, together with an improved regulatory environment in the US, will continue to bend its cost curve and cap prices. Oil, is just one commodity of course, but Chart 1 shows how closely its price is intertwined with other industrial commodities, especially since 2001.

Chart 1 Oil versus Industrial Commodities

Oil and industrial commodity price movements are linked.

Secular trends are not only important because of the giant swings in prices that they embrace. Equally significant, is the fact that the direction of the secular trend determines the characteristics of the business cycle price swings that fall under it. These primary trend movements generally range between 9-months -2-years. When the secular trend is rising, primary bull markets tend to last longer and are much stronger, whilst counter-cyclical. downtrends are generally contained. The opposite is true during a secular bear market, where rallies are limited in scope and price magnitude is on the downside. Alternatively, some secular “bears” take the form of a multi-year trading range.

There are two aspects to this. First, if the direction of the secular trend is known, we can on the lookout for momentum characteristics that are associated with that trend. Second, if a specific characteristic is spotted and that characteristic is typical bear market behavior, we have a piece of evidence that supports the idea that it actually is a bear market and vice versa. If it walks like a bear and quacks like a bear it probably is a bear!