The Commodity Crash Playbook: A Long Overdue Rewrite and Revision

(This is an excerpt from an article I originally published on Seeking Alpha on January 5, 2015. Click here to read the entire piece.)

Three and a half years ago, I started a series that I called “the Commodities Crash Playbook” in an effort to take advantage of an investing and economic theory promoted by money manager Jeremy Grantham. {snip}

I was so convinced by this story that I decided to put my own investing and trading wrapper on Grantham’s work. I started with a two-part piece titled “Preparing for Profits in a Resource-Constrained World” and “Profiting from Physical Assets in a Resource-Constrained World – Rules and Picks.” {snip}

Moreover, China’s imminent economic collapse has proven to be one of the most highly anticipated calamities of the cabal dabbling in apocalyptic thinking. There will be a LOT of eager and many postponed “I told you so”‘s whenever it is China’s economy takes a notable stumble. Regardless, this seeming “resilience” of the Chinese economy started a rethink on the commodities crash playbook. {snip}

As it turned out, Grantham wrote his letter, and I developed my wrapper, just as commodities had indeed hit a peak. {snip}


The peak in 2011 in commodities was a failure to return to pre-recession highs
The peak in 2011 in commodities was a failure to return to pre-recession highs

Even agriculture as index peaked in 2011
Even agriculture as index peaked in 2011

iShares S&P GSCI Commodity-Indexed Trust is a common commodity index but it appears overly influenced by oil prices
iShares S&P GSCI Commodity-Indexed Trust is a common commodity index but it appears overly influenced by oil prices

Source for charts: FreeStockCharts.com

While the declines looked synchronized, each commodity had unique and interesting stories and drivers. It was impossible for me to identify a unifying theme except that prices were in a sustained, albeit volatile, decline. However, as the U.S. dollar index (UUP) continued to rise, it finally dawned on me that currency and monetary dynamics could be a core driver, something that Grantham did not contemplate. In fact, it was not until the dollar index failed to weaken in the aftermath of QE3 that it I truly absorbed what could be underway.


The U.S. dollar index responded as expected to QE2 but NOT QE3
The U.S. dollar index responded as expected to QE2 but NOT QE3

Source: FreeStockCharts.com

{snip}

Yet, even with the unifying foreign exchange theme, it is difficult to draw direct correlations. {snip}

Some of my lessons have been learned the hard way. Rare earths delivered one of my most forceful lessons. {snip}


The fall from grace for rare earth related stocks
The fall from grace for rare earth related stocks

Source: FreeStockCharts.com

REMX includes “strategic metals” that are not rare earths, but the ETF still serves the illustrative purpose. There were some times to ride high where short-term trades worked out exceptionally well, but overall, I was forced to essentially admit defeat by early 2013. I never did write an official mea culpa, so THIS rethink piece will have to do. The height of my hubris came in a piece I wrote called “Seagate Not Likely to Find ‘Ruthenium-Like’ Relief From Soaring Rare Earth Prices.” {snip}

Indeed, rare earths imploded in many worse ways that I will not repeat here. Suffice it to say that this experience helped me grow a healthy skepticism about the sustainability of high commodity prices. Importantly for the commodities crash playbook, I could not point to an implosion in China’s economy as a core driver for rare earths. {snip}

The tipping point which crystallized my new thinking came in February 10, 2014 after listening to a podcast on Econ Talk titled “Paul Sabin on Ehrlich, Simon and the Bet.” The podcast included a discussion about the market dynamics of commodities where innovation continues to produce surprising sources of supply, methods of supply substitution, and adaptations in demand. {snip}

{snip}

As they say, timing is everything. With commodities swinging widely from one extreme to another, such an adage could not hold more true.

The final milepost on the way to a rewrite of my rules came in the form of a timely December 2nd article in Seeking Alpha (hat tip to a friend of mine): “Don’t Buy And Hold Commodities, Trade Them.” {snip}

{snip}

So, with that expansive background, here are my new, and hopefully improved, trading rules for the commodity crash playbook. At the playbook’s core, I retain an assumption that a global, economic calamity will eventually take commodity prices much lower, but I now hold no expectation or projection on when or where it will start or even how widespread or significant the event will become. (And to be clear, I would greatly prefer a world where economic calamities never occur). I retain a STRONG preference to OWN rather than sell (short) commodities. Readers should consider this a lingering bias from my wariness over the ultimate impact of global monetary policies that have flooded the world with paper currencies with more to come.

{snip{

Meta-rules: STAY OPPORTUNISTIC, RESPECT TRENDS, AND DEVELOP DEEP KNOWLEDGE

{snip}

Short-term: THE TREND REMAINS BEARISH BUT WATCH FOR BOTTOMING PROCESSES

{snip}

Medium-term: EAT AGRICULTURE

{snip}

Wildcard: WATCH OUT FOR CURRENCIES AND MONETARY POLICY

{snip}


The U.S. dollar has certainly seen much better days. If the current bottoming process is actually bringing an end to the long-term decline in the greenback, all bullish bets on commodities are subject to SERIOUS reconsideration!
The U.S. dollar has certainly seen much better days. If the current bottoming process is actually bringing an end to the long-term decline in the greenback, all bullish bets on commodities are subject to SERIOUS reconsideration!

Source: St. Louis Federal Reserve

Be careful out there!

(This is an excerpt from an article I originally published on Seeking Alpha on January 5, 2015. Click here to read the entire piece.)

Full disclosure: long EEM put options, long REMX, long CORN, long NIB, long ERY, long call options in JOY, long BAL, short the Australian dollar

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