The Black Swan Visits the Commodities Markets — Twice

Nicholas Vardy

Nicholas Vardy has a unique background that has proven his knack for making money in different markets around the world.

The bad news is that the occurrence of two “Black Swans” meant that you were stopped out of four commodities-based positions on March 20. PowerShares DB Agriculture (DBA) produced a small gain, while Market Vectors Coal ETF (KOL), PowerShares DB Commodity Index Tracking Fund (DBC) and last week’s pick, PowerShares DB Precious Metals (DBP), incurred losses. And that’s with some very wide stops that anticipated highly volatile commodity prices.

After a week like this one, and with many global markets closed for Easter Monday, it’s best to stand back and see where things settle before entering into any new positions.

It really was a remarkable week for commodities. After hitting a record high of $1,034 an ounce on Monday, gold plummeted 12% in its biggest weekly decline in 25 years. That drop includes its worst one-day percentage fall in more than 17 years last Wednesday. Crude oil fell from a record high of $111.80 last Monday to below $100 a barrel for the first time in two weeks. Silver dropped a whopping 18.6%, palladium 13.9% and platinum 0.4%. Agricultural commodities suffered an even bigger drop. CBOT May wheat plunged 17.3%, while CBOT May corn fell 9.3% to $5.07 1/4 a bushel and CBOT May soybeans lost 10.8%.

So the question arises: Why the sudden drop?

Fundamentalists argue that demand for global commodities is already slackening from its previous breakneck growth. An International Monetary Fund (IMF) report released on Thursday noted that as global economic growth is widely expected to decline this year and in 2009, “prices of most commodities should eventually start easing… suggesting a disconnect between commodity prices and the ongoing slowdown.” This bearish outlook for demand in commodities was supported by the Energy Information Administration’s weekly inventory report last Wednesday that noted overall consumption of oil and its products fell 3.2% during the last four weeks, compared with the same period last year.

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In my view, “Black Swans” are governed by anything but fundamentals. A better explanation would be to trace the sharp drops back to institutional investors and hedge funds de-leveraging their trades. With losing trades in credit markets — mortgage bonds or collateralized debt obligations — the big players are now being required by banks to set aside more cash to cover the money they borrowed to make trades. In order to raise the cash, investors and hedge funds have sold some of their commodity winners to finance higher margin requirements. Consider that just since the end of January, the New York Mercantile Exchange has increased its margin requirements five times on platinum and palladium. The Minneapolis Grain Exchange has raised margins on wheat futures four times this year, and last Thursday, the Kansas City of Board of Trade increased its margins on wheat-futures contracts by 50% as a result of "increased market volatility." These rising margin requirements, combined with the general uncertainty in the market, all came to a head last week to result in the massive drops in the market.

So where does that leave the commodity growth story today?

In my view, last week’s pair of “Black Swans” is just that — exceedingly rare events unlikely to be repeated in the near future. Yes, the market was overheated, but the long-term trend in commodities remains intact. And unless the global economy is standing at the precipice of another Great Depression, demand for commodities will hardly collapse. Developing countries, which have been responsible for the bulk of recent commodity demand growth, have so far been less affected by the global slowdown. And from a bigger picture standpoint, one week of admittedly dismal performance does not vitiate the argument for a “commodity supercycle” that is expected to last another five to seven years.

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The good news is that five of your positions in Global Bull Market Alert, three commodities holdings (plays on gold, silver, and agricultural commodities), as well as two currency investments, remain intact. It also is worth emphasizing that because your exposure to commodities is through ETFs, your own positions are not leveraged like those of some institutions. And as sharply as commodities have fallen, they tend to snap back sharply. Perspective is also key: global stock markets, where Global Bull Market Alert concentrated last year, have been much more dismal places to be invested in than even disarmingly volatile commodities markets. Last year’s stars, such as China and India, now are down 32.7% and 28.9%, respectively. And that’s just since Jan. 1 of this year.

P.S. Join my Eagle Publishing investment colleague Mark Skousen and me for FREEDOMFEST 2008, "The Trade Show for Liberty," on July 10-12, 2008, Bally’s/Paris Resort. FreedomFest will feature more than 88 speakers, 100 exhibitors, and 1,000 attendees. Guests will include John Mackey, CEO of Whole Foods Market, Congressman Ron Paul, a 2008 Republican candidate for president, Steve Moore, of The Wall Street Journal editorial board, David Boaz, vice president of Cato Institute, Robert Poole, Jr., of Reason Foundation, Jeremy Siegel, "The Wizard of Wharton," and Rick Rule, one of the country’s top money managers. Also hear Frank Holmes, Doug Casey, Larry Abraham, Ron Holland, Frank Trotter, Bert Dohmen, Keith Fitz-Gerald, Peter Zipper, John Mauldin, and many more.

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