The Commodity Supercycle: Is This Time Different?

While the stock market has recovered from its most recent short term stumble, commodities continue to provide richer returns. For example, silver (which my contrarian instinct forces me to ignore) rose 20% compared to the S&P 500’s rise of 6%.

Of course, such outperformance by raw materials has been the case for some time. Over the past 10 years while equities have provided appx. zero net returns, commodities have been the place to be.

This interplay between commodities and equities is one of the most important and all to often overlooked cycles that rule the financial markets. I suppose this is because it occurs over the long term, where most don’t care to linger.

I’ve mentioned the equity and commodity cycle a few times in the past in order to orient ourselves within the grander scheme of things. When commodities are in a bull market, as they are now, the result is that equity returns suffer. And when the equity market is in a secular bull market, commodity prices invariably fall.

The explanation for such reversal is rather simple. Commodities are the raw material that businesses use to produce goods and to transport them to market. As the costs of a business rise, they are able to pass on some but not all of this marginal expense. The result is that profit margins are squeezed and earnings become anemic. When commodities decline in price, the reverse occurs.

To put this in perspective, below is a 200 year chart showing the 10 year average rate of return for all commodities:

Source: Hackett Financial via Maclean’s

You can see in the above chart that as commodity prices fall from major cycle highs, they provide the fuel for a new equity bull market. I’ll briefly go over the most recent few cycles.

A Brief History of Raw Materials
The early 1920’s iss certainly a good place to start. As the chart shows, commodity prices fell quite sharply during the whole decade. Had you been invested in commodities, no matter your skill, in all probability, you would have lost money. But during that same time, the stock market was going absolutely gangbusters. You didn’t even need any skill. All you had to do was buy.

The next commodity top occurred in the early 1950’s. Again, as commodities fell, the equity market suddenly woke up from its long slumber of sideways trading and shot higher like a rocket. Until the 1960’s when commodities stabilized and started to rise. We all know the inflation of the 1970’s of course and the devastating equity bear market that coincides with the raw material boom of that same time period.

The next cycle top brings us to the early 1980’s when the hyper-inflation of the past decade ended and commodity prices started to recede. That set the stage for a new bull market in equities that lasted until the late 1990’s.

Right now, we are clearly closer to the end of the commodity boom than to its start. Depending on which index you decide to use, we’ve been in a bear market for appx. 12 years. So commodities have a few more years to go. And those remaining years could be spectacular as more and more retail interest enters this aging bull market. Those entering now will mistakenly believe that “things are different this time” and that the normal rules of all previous cycles just don’t apply.

China and India
John Carney, the governor of the Canadian central bank argued recently in a similar way. He pointed to the rapid development of countries like India and China who have an insatiable appetite for raw materials. But that smacks of rationalization to me. After all, during each and every single boom (or bubble) there were many persuasive arguments put forward why “it is different this time”. And each time it certainly was not different. We saw reversion to the mean and all those carefully crafted arguments came tumbling down.

For the record, John Murray, the deputy governor of the Canadian central bank disagrees with his boss.

Also, we should not lose sight of the fact that as most are celebrating the rise of the middle class in India and China, there is a massive Chinese property bubble being inflated. Like all previous manias, predicting when exactly it will implode is a fool’s errand. But we do know that it is simply unsustainable. So when the inevitable happens, all that demand will come to a screeching halt and commodity prices will plummet.

If that happens abruptly, it could cause some serious volatility in the financial markets. Just as now, there will be losers and winners. But the difference is that after passing the cusp of the commodity boom and entering into a bust, the winners and losers will switch places. Countries that are now experiencing a boom like Canada, Australia, Brazil, etc. will suddenly find that a large component of their economy is left sputtering.

The silver lining in such an approaching dark cloud is that as the commodity boom dies, it will birth a new secular bull market for equities for us to enjoy.

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10 Responses to The Commodity Supercycle: Is This Time Different?

  1. takloo says:

    it would be interesting to know what happened to commodity exporters during commodity bear markets and equity bull markets

    as a Canadian, I agree with your comments on Mark Carney; the commodities boom is instilling an invincible mentality which will not end well…

  2. Hans says:

    Excellent thread, Babak. I am sure about your time line, but at this stage I would rather be out early then too be drag into a horrible correction….

  3. Tiho says:

    Commodities are going up for at least another 5 years. At this stage of the commodity secular bull market also known as the Brenner cycle, usually you have increasing supply. This therefore limits any further rise for an extended period, other than say a speculative blow off top. This is what we saw in the 1970s, when supply overwhelmed demand in Crude Oil by late 70s and yet Crude still went up, but only for a year or so.

    On the other hand, today, we are nowhere near a top. Demand remains solid and as a matter of fact, it is increasing, while supply has not caught up at all. During the Financial Crisis of 2008, majority of commodity farmers, miners and others producers scrapped their plans to expand supply or bring new source online. Others had cancelled projected altogether. As supply continues to lag behind, you can bet your dollars that CRB Index will once again make new highs. And for all of those trying to get out to be safe rather than sorry, you are about to miss out on the best gains in the next few years.

    Also, most other secular cycles last more than 11 years, and that is where we are currently upto. We have several years to go, so after the upcoming commodity correction and US Dollar rally (due to extreme sentiment), I expect the Dollar to be in trouble and real assets to explode much much much higher!

    • OntheMoney says:

      Tiho, your confident outlook for continued gains appears to rest on ever-strengthening demand. If China and other EMs begin to falter, that certainty may prove misplaced.

  4. Hans says:

    TiHo, excellent post, with the exception that miners reduce production or expansion due to the recession…That did not occur, at least in the PMS sector….

  5. Tiho says:

    I disagree with you OntheMoney. Your point is valid only to a certain degree. Commodities rallied throughout 1930s which is known as the most extreme of all recessions US ever had – A Great Depression. One should ask themselves, why did that occur, when demand faltered, as you stated above?

    The answer lies in the demand and supply equation. You see if China was to experience a property market crash of some sort, demand you fall rapidly, so I agree. But you see, what would happen to supply? It would also fall in dramatic fashion and it would actually stay prolonged. So therefore, you could still have a bull market in place if supply falls quicker than demand does.

    And do not forget that if China crashes, or the United States enters another recession, governments and central banks will stimulate demand side with spending deficits and money printing (i.e. QE 5 by that time). This cloud in theory stabilise demand to a certain degree. However, governments and central banks do not stimulate supply side.

    I know this for a fact, I work in an Australian mining industry. We make huge salaries for exporting Coal to China, and if China was to collapse tomorrow, majority of us would lose our jobs and the mine production would be almost completely shutdown.

    So, my point is, commodities can experience a secular bull market even during recessions and depressions, as history shows us, as long as supply is overwhelmed by demand, even if they are both falling.

  6. OntheMoney says:

    While you make a number of valid points, Tiho, I guess my argument is more about the perils of taking a dogmatic approach.

    Agreed, following a China crash / western recession we can be assured of another round (or three) of QE. But you still have to make a number of assumptions to get from where we are today, through that chain of events and beyond any coming carnage in order to be confident that prices will be higher then than they are today.

    First, you have to assume the crash in commodity prices which would follow from Chinese construction grinding to a halt etc. would be reasonably short-lived and not too severe. Then you have to assume that QE – and the Chinese government – would be able to revive that demand to the same degree that it did in 2009 – ie. essentially re-blow the greatest bubble in construction ever seen.

    Of course not only do you have to assume that demand revives, you also have to be sure that supply will first fall rapidly enough to put a floor under prices. Then you have to assume that speculation in commodity prices would revive just as it did after the 2008 crash – and let’s not kid ourselves that speculation isn’t a huge part of the ramp up in prices. Assuming the same degree of speculation does revive, what is the likelihood it will plough straight back into commodities instead of finding its way into other vehicles?

    We’ve had two major spikes in commodity prices since the boom began – 2008 and today. Wouldn’t it be, let’s say, optimistic, to expect a third as a certainty?

    What’s more, there are bound to be other ‘unknown unknowns’ in the fallout from another recession or construction crash (Chinese banking crisis anyone?), making predictions of a revival in commodities ‘no matter what’ not quite as slam of a dunk as your statements would imply. You say yourself that your job is riding on a continued mining boom which is reliant upon strong Chinese construction. At the very least, might it be wise to hedge against the possibility of being wrong?

    Incidentally, your posts suggest you think a China slowdown is years away. I’m afraid I’m not so sure.

    • Hans says:

      Mr Goode’, that is a very interesting article you have posted on your website…

      I will be spending some time on it…..Thank you kindly…

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