Dr. Copper is in session

Copper has been called one of the better economists throughout the modern age since it’s used in everything from cars to housing to pretty much every mechanical knickknack you can imagine. So what does it tell us when copper falls 30% in a few months? Probably that the recovery that equity buyers are hoping for isn’t around the corner. Probably that the Chinese miracle that some have been betting on is NOT a new economic model of government interference that works. And probably that consumers and real estate have NOT yet stabilized.

That’s JJC with SPY overlaid. The correlation is obvious and the lead time for copper is about in the range of 1-2 months. Judging by that, today’s 7% decline is a bad omen for the equity markets. Dr. Copper has been wrong before, but she tends to be better than most of the other economists out there, so it’s probably worth paying attention when she tells you that equities are sick.

Relevant ETFs: JJC, SPY, SH

World Growth is Slowing

World growth is slowing and that means that not all commodities are equal. Commodities have 2 opposing forces at play determining their prices. The first, is a complex, global, supply and demand equilibrium. It’s complex because it takes into account population dynamics and preferences, time to bring new supply on line, transportation costs, and more, much, much, more. Assuming investors can get the supply and demand equations right (a stretch), the second dynamic also comes into play, namely, currency depreciation/appreciation, and relative moves. These factors sometimes magnify moves, so that world demand for beef increasing as eating habits change is magnified by currency depreciation. Sometimes, these factors oppose each other, such as copper demand decreasing when global GDP growth slows as compared to global central banks depreciating currencies. Thus, in the current environment, we are left to tease apart which factors will play a larger role in the different commodities. That being said, we’re already starting to notice some patterns.

Global demand for copper is slowing. China’s real estate growth is slowing (popping?) and the magnitude is so large globally, that depreciating currencies will not provide support.

Copper is often called Dr. Copper for its ability to give insight into the economy. Having this key metal roll over is definitely not a good sign for the economy going forward. I anticipate continued weakness from it and the entire industrial commodity space.

On the other hand, we have the agricultural commodities. As staples, the food sector is more impacted by population dynamics than by GDP, although, shifts in preferences can make large impacts over the long term. Additionally, when currency fears (inflationary) hit, people tend to rush out to buy food, not build another apartment. So I anticipate that the agribusiness sector should hold up relative to some of the industrial commodities.

All of that is good, but brings us to two of my favorite commodity groups: energy and precious metals. Energy is one of the more difficult sectors to value, but one of the most important. Here’s the bottom line, the world population is growing and using increasing amounts of energy. Against that, in the long long term, human ingenuity will help drive energy costs down. The question for investors is what happens before in the meantime? In my mind, the biggest factors investors need to prepare for is geopolitical instability and currency debasement. Both of those factors will lead nations and individuals to try to increasingly secure and develop sources of energy. China is buying strategic access, but also developing internal sources such as nuclear. Japan will continue to depend on nuclear to some extent because it’s the only way they can secure domestic supply, but it will take years to redevelop it and in the meantime, they’ll need to depend on natural gas. The US, in the meantime, will need to develop domestic access, which means natural gas, coal, and nuclear. The alternative space is still not a viable large scale source, and valuations are all over the place so, it’s not a large area of concentration for me.

The best ways to play long term access to energy are not through the commodities which are volatile, subject to wild speculative moves, and provide no yield. Instead, we concentrate on NLR, FCG, and KOL.

NLR offers an especially interesting opportunity because it comes with a 4+% yield and has significantly underperformed since the Japanese earthquake.

Lastly, just a quick note on precious metals, gold being the main one, but silver getting a lot of attention.

Notice that silver is still trading away from the group, and maybe that’s justifiable, but if so, I’m not sure why. The precious metals should not be viewed as commodities in the same breath as ag and metals. They are trading as currencies, and while commodities and currencies are integrally related, the dymanics in the current environment imply that gold needs to be looked alongside the USD and the euro rather than alongside pork bellies and coffee. In that vein, I continue to stay out of silver, but like the other precious metals.

Relevant ETFs: GLD, SLV, PALL, PPLT, JJC, MOO, DBA, XME

OK, there are other things to look at

There are some funky moves happening in commodities and it will take time, perhaps even years, for all the dirty laundry to be aired and balance sheets to be cleared. At the center, of course, is JP Morgan (JPM) which has been rumored as getting squeezed in silver, while at the same time holding a dominant position in copper. One thing is for sure, there are big players afraid of revealing their hands.

Look at copper:

And now at silver:

And here’s just one of dozens of articles on JPM: this one from ZeroHedge.

Now if silver is going to squeeze higher, would that make copper the easier position to unload to cover any margin calls? Is JPM actually short, or just short against forwards from clients? In other words, is JPM getting squeezed on a timing issue or is it taking a prop directional position?

I have a long position in the precious metals and continue to see opportunity for them to be stores of value in a volatile time, but I’m not a big fan of the industrial inputs as I see a major slowdown coming. This might would put fundamental pressure on copper, which could result in a magnified move if indeed JPM gets squeezed as (if?) their silver:copper spread goes crazy.

Once again, all eyes on currencies

Structural deficiencies make the euro vulnerable (and the US a safe haven), but demographics, savings rates, and fiscal policies will make the emerging markets currencies more attractive once the dust settles.

The emerging markets are not the place to be these days, but then again, neither are the developed markets. As risk trades get taken off the table emerging markets, small caps, high yield, etc. will continue to come down significantly. At some point we will look in those areas for the potential opportunities. For now, we wait.

As long time readers know, we have continued to build a cash position, and we maintained our short euro and short yen positions. Additionally, we have a diversified metals portfolio, which we anticipate will actually decline (except for gold) as financial assets face a correction regardless of class.

Europe continues to be the focus, but soon I believe it will shift to China and determining how it will sustain its growth. We will write more later today, but copper should be one of the main signals to look at.