Adam Hamilton October 13, 2006 3388 Words
With the Dow 30 continuing to carve its new series of all-time record highs, the excitement it is creating is sucking in capital like a black hole. Nothing draws in new investors faster than heavily-hyped rising prices. But all of this redirected Dow capital has to come from somewhere, and one of these places is commodities.
After being one of the best-performing market sectors of the last five years, over the last couple months commodities have suddenly been among the worst performers. Since early August many key commodities, particularly metals and energy, have been spiraling relentlessly lower. Naturally these fast and ugly losses are challenging the faiths of even some long-time commodities bulls.
Among commodities traders most are not yet questioning the underlying fundamental foundations of this commodities bull. A unique event in world history is taking place right now with the rise of Asia and its huge new demand for commodities coupled with decimated global commodities infrastructure left rusting and neglected for decades after the early 1980s commodities bust. Relentlessly growing world demand coupled with restrained and inelastic supplies is the perfect recipe for many years of prices rising on balance.
But still there comes a gut-check time for every trader when the dire short-term technicals crowd out the bullish long-term fundamentals and gnaw at your brain like a rat trapped in your skull. Every week I am blessed to talk with all kinds of traders ranging from independent speculators to seasoned investors to hedge-fund managers. In light of all these discussions, one event stands out far more than anything else as the most worrisome and vexing to tradersí confidence in this bullís continuing viability.
This troubling development is the total and utter breakdown of the CRB Commodities Index. The CRB is to commodities what the NASDAQ is to tech stocks, the flagship index and general sector bellwether. From its secular lows in late 2001 until the last six weeks or so, the venerable CRB was in a bulletproof secular uptrend that had not even been seriously challenged. But in late August the CRB suddenly plummeted out of this uptrend, causing much wailing and gnashing of teeth.
This total CRB breakdown is a big deal and cannot be ignored. Hardcore technicians would be justified in declaring a bull over for less of a secular breakdown than what weíve just suffered through in commodities. But as the vicious late-1998 stock-market breakdown about 18 months before the great stock bull finally ended illustrates, major technical breakdowns donít always signal the end of a bull. But they sure can and thus all such events have to be taken very seriously.
In light of the gravity of this situation, I want to take a look at the brutal CRB breakdown in this essay. Being heavily long commodities-related investments and speculations personally, the last six weeks or so have been my worst ever in terms of ballooning unrealized losses. With countless other investors sharing in this pummeling, we face a hyper-critical question.
Is this commodities bull over or is this breakdown a 1998-style temporary blip in a secular bull that is due to recover? If the former is true, then the best strategy is to cut our losses before commodities spiral much lower. But if the latter proves to be the case, the prudent course of action is certainly to ride it out despite the acute pain of the moment. As contrarians know, usually the worst time to sell is when we most want to.
Since all my relentless analyses have led me to believe that commoditiesí fundamentals are still very bullish, that metals and energy demand growth ought to exceed supply growth on a global basis for years to come, I naturally gravitate towards the conclusion that this CRB breakdown is temporary. But if it is indeed just a blip, then why was it so extreme and utterly unprecedented within this bull? What drove such a fast plunge?
I think the answer lies in a little-known fact of immense consequence. Like all indexes, periodically the CRB is modified with new component commodities added, old ones removed, and weightings and calculation methodologies changed. This is usually good as it better reflects current markets. For instance, the original CRB in 1957 included lard and onions, but did not include crude oil or gold. I doubt even the most radical soft-commodities zealot today would argue that lard and onions are more important than oil and gold!
Since these periodic revisions are few and far between, they are pretty irrelevant for short-term technical analysis. But when long-term technical analysis comes into play, these revisions must be considered. In July 2005 the CRBís tenth major revision of its distinguished four-decade history took place. The evidence is very strong that this tenth revision is the reason the CRBís recent plunge is unprecedented.
Since July 2005 the CRB has behaved radically differently than it had in the trading span after its previous revision of a decade before. Comparing the pre-July-2005 CRB to the post-July-2005 CRB in a single technical analysis is like comparing apples to oranges. Even without considering the nature of the tenth revisionís vast changes to the CRB, upon careful technical examination it is readily apparent we are seeing a wildly different beast.
Before we delve into the new CRB, the red technicals above show why technically-oriented commodities traders are so unsettled and worried today. Since its bottom in late 2001, the CRB has been marching higher on balance within a razor-sharp secular uptrend. It originally established the slope of this uptrendís support line in early 2002 and this support subsequently held rock solid in 2003, 2004, 2005, and early 2006 through a half-dozen major challenges. The CRBís lower support was considered nigh on impregnable for very good reason.
Until six weeks ago that is. In mid-August the CRB slid under its key 200-day moving average which it had done briefly many times before in this powerful bull. But rather than quickly recovering like usual, the CRB started spiraling lower. At this long-term scale above, the CRB looks like it fell off a cliff. It knifed through its five-year-old secular support line like a bullet through rice paper. The CRBís breakdown was massive, unambiguous, and scary. Traders have good reason to be very concerned.
But unremembered by most, todayís CRB is not the same CRB that formed the first four years or so of this well-defined uptrend. In July 2005 the CRB was revised for the tenth time since 1957, and this crucial juncture in time is marked by the vertical yellow line above. Prior to this change the CRB moved in relatively smooth and long waves, nonchalantly meandering higher on balance. After this change the CRB became hyper-volatile.
In order to better illustrate this, I traced the CRBís pre- and post-July 2005 action with smoothed lines and then moved them off of the underlying data. The blue tracings above and below the CRB highlight the crux of the CRBís action during both periods of time. The pre-July-2005 smoothed line looks relaxed and gradual, a very conservative and measured bull market. The post-July-2005 looks like an electrocardiogram of a trader on speed, frantically volatile. These two blue tracings donít even look like the same index!
So what odd alchemy transpired in the little-remembered tenth revision to so radically alter the CRB? I wrote an essay on it the week it happened, but here it is in a nutshell. The previous ninth revision was geometrically averaged and equally weighted. The new tenth revision is neither. Todayís CRB index is no longer geometrically averaged nor is it equally weighted. It is an entirely new breed of CRB.
Now I know geometric averaging tends to make eyes glaze over, but please bear with me here as it is quite important. In the ninth CRB revision, its 17 component commodities were equally weighted and geometrically averaged. To get a geometric average, you multiply all 17 commodities prices together and then take their 17th root. Because of this math, geometric averaging has a tremendous smoothing effect. It was used in the CRB explicitly to render this index not easily influenceable by individual-commodity volatility.
Interestingly this wasnít the only smoothing in the ninth CRB revision. Before they were geometrically averaged which bleeds out most volatility, individual commodity prices were averaged across their various futures contracts expiring in the next six months. So the ninth CRB not only averaged across commodities geometrically, but across time arithmetically. Often commodities will spike on the spot market but the futures move less than spot the farther out they expire. So this time-averaging smoothed out the CRB even more.
Thus the CRB was probably the most unnaturally smoothed major index in existence, like an older woman with so much plastic surgery that her tight smooth face barely reflects underlying realities anymore. In March 2005 well before the tenth revision I concluded that the CRB was so heavily smoothed that it was useless as a trading tool. It was only useful as a strategic measuring rod. The ninth revision construction made the CRB all but impossible to manipulate, very sedate, and able to carve the beautiful uptrend we see above with nary a hiccup.
The ninth CRB revision was also equally weighted, all 17 component commodities were each responsible for about 5.9% of the indexís weight. This also contributed to the CRBís traditional low volatility. For example, gold could rise 50% but if the other 16 components were flat the CRB would only be up a few percent at best. While it made the CRB smooth, this wasnít particularly realistic. At the time crude oil was weighted the same 5.9% as orange juice. Are oil and orange juice equally important in our global economy today?
Since we speculators love volatility more than normal folks love oxygen, the CRB custodians set out to eliminate the vast majority of the excessive smoothing in their index. A more volatile index would lead to more interest in the new CRB futures market that was created at the tenth CRB revision. The more volatility, the more opportunities to trade and the more widely the CRB would be followed. The tenth revision was a great step forward in my opinion, a good thing for traders.
In order to make the index relevant again, its custodians eliminated geometric averaging entirely in the tenth CRB revision. This change alone is important and can explain a lot of the CRBís increase in raw volatility since July 2005. In its geometric-averaging scheme, the CRB was effectively continuously rebalanced with the math under geometric averaging ensuring that a rising commodity price would get less exposure while a falling one would get more exposure in influencing the final index number. Todayís new CRB eliminates all the excessive smoothing of its predecessorís geometric approach.
But the CRB custodians also threw out the equal weighting, again with sound logic in my opinion. There is no reason that orange juice should be treated as an equal peer of crude oil in a commodities index since orange juice doesnít even approach the importance of oil in the world economy. Why not weight more important commodities higher than less important ones? The new weightings of the tenth CRB revision were broken down and illustrated in a pie chart I built the week the change was made in July 2005.
Out of all the commodities, there is no doubt that the energy complex is the most pervasive and important. Since energy is needed to heat or cool everything, run every electronic device, and transport everything physical that is moved in our world, it is the most important commodity sector by far. So the CRB custodians vastly ramped up the energy weighting in their tenth CRB revision.
In the ninth revision, the CRB only weighted energy 17.6% of the index, the same as grains and actually much less than the tropical commodities including coffee and cocoa. In the tenth revision, the energy sector weighting was more than doubled to 39.0%, now the biggest sector weighting in the new CRB by far. But of even greater relevance to the CRBís plunge today, crude oilís weighting alone was drastically increased. It soared from 5.9% in the old CRB to a whopping 23.0% of the new CRB!
While I think this is totally justified due to crude oilís extreme importance, technicians have to remember that now todayís CRB is almost one-quarter constituted by oil alone. With this extremely heavy oil weighting in addition to the fact that the old geometric smoothing is no longer used, the new CRB is tremendously more influenced by the fortunes of oil than the old CRB. As goes oil, so goes the latest CRB. This is readily apparent in this chart straddling the tenth revision.
Back in its ninth-revision days, the CRB was not heavily influenced by oil. There were times the CRB rallied while oil didnít as well as times the CRB barely rallied when oil spiked sharply. And perhaps most tellingly for our situation today, after the oil plunge following the second interim oil high marked above in this chart the CRB actually rose during the middle stages of it because other commodities were thriving while oil was plunging in late 2004.
With a 5.9% weighting and geometric smoothing, oil wasnít a big deal back then. The only time that oil and the CRB moved in unison was when the lionís share of the CRB commodities were also paralleling oil, as during the third major oil rally marked above. If oil was doing its own thing sans other commodities, the ninth CRB revision would follow the majority of commodities and refuse to be unduly influenced by any one, even oil.
But after July 2005 this all changed forever. With no geometric averaging this index was destined to be far more volatile anyway, but with oil now weighted at 23.0% it would suddenly have four to twenty-three times the influence of each of the other 18 component commodities of the latest CRB. Not surprisingly since July 2005, the CRB has been slaved to crude oil. When oil moves the CRB follows, so the near-term fortunes of oil are now the single most important factor by far driving the CRBís technical behavior. As goes oil, so goes the CRB.
This leads to two hyper-critical observations regarding the recent commodities breakdown that is so spooking even some of the long-time faithful. First, todayís CRB is far more volatile and radically different from the ninth CRB revision that existed for the previous decade. Trying to compare a non-geometrically-averaged unequally-weighted index with a geometrically-averaged equally-weighted index makes little logical sense.
Other than the fact that commodities are involved, the new CRB is as different from the old CRB as night and day. So if you are concerned that a five-year-old support line suddenly failed, it is extremely important that you realize that the first four years or so of this support line were created by a very different index than the one that just broke it. I would go so far as asserting that it is totally invalid to compare todayís CRB to yesterdayís CRB across the vast technical discontinuity created in July 2005. Relative to today the CRB technicals prior to July 2005 are unrelated and irrelevant.
Second, if the CRB is now oilís puppet due to its heavily-oil-weighted construction and relative lack of smoothing, then oil is the key to the CRB. The CRB broke below its 200dma and support in August only because oil led the way. Indeed I suspect oil created a vicious circle. Oil was falling forcing the CRB to fall in sympathy. But as the CRB spiraled lower and spooked traders, they sold off other commodities like the metals which caused the CRB to fall even further. Oil lit the fire of this plunge and the CRBís flagship status among professionals fanned it.
Unfortunately a discussion on why oil is faltering and when it is likely to recover is beyond the scope of this essay, but for our subscribers I have been discussing it extensively in Zeal Intelligence and Zeal Speculator lately. If you are worried about commodities as measured by the CRB then you should shift your focus to understanding oil. The CRB is going to be weak as long as oil is weak and it will recover as soon as oil does. Oil is the key now due to the way the tenth CRB revision is constructed.
I have one last chart on the commodities breakdown. A lot of analysts on Wall Street, which is perpetually anti-commodities in focus, have been saying commodities were at all-time highs and therefore needed to plunge and end their bull. But as Iíve argued many times in the past, comparing todayís prices with those of the early 1980s while ignoring inflation is foolish at best and intentionally manipulative at worst. Multi-decade comparisons only make sense when adjusted for the relentless fiat-currency inflation distortions.
So the nominal non-inflation-adjusted CRB is rendered below in blue and the real inflation-adjusted CRB in red. The conservative headline CPI was used as our inflation gauge, although true monetary inflation runs much higher and would lead to much more favorable results for commodities today. In addition, I also drew in all the major CRB revisions since 1972. They are rare but they do happen occasionally as the CRB is constantly, and rightfully, evolving with the times.
Wall Street hypes the blue nominal CRB line, pointing out that the index just hit new all-time highs and therefore the commodities crash was necessary and is just beginning. Nonsense! The red real CRB line, which shows where the CRB has traded in todayís 2006 dollars, really tells the true story. At its recent all-time nominal highs, in real terms the CRB was barely up to commodities price levels of the early 1990s. After its recent plunge, today the CRB is trading near late-1990s real levels! This bull has barely begun so far!
So next time CNBC makes one of its asinine straight-up comparisons between a commodities price today with one decades ago, realize it is just anti-commodities propaganda. Real secular commodities bulls tend to run for 17 years and take commodities to new real highs, not just nominal ones. So not only is todayís secular commodities bull far too young to be over, but it is far too small. Todayís CRB would have to soar north of 1029, more than a triple from here, to hit the all-time real highs necessary to end this bull.
Looking at the secular lows in the red real CRB above, it is obvious that commodities ought to have a long, long ways to run yet if their bullish global supply and demand fundamentals remain intact. All my research convinces me they do indeed remain intact, and in some ways are even getting more bullish as rising Asian demand grows faster than new supplies being found and delivered to market.
If this bull is still alive and well, then this stunning breakdown offers the best opportunity to add new commodities long positions in years. Thus we are aggressively buying elite commodities stocks in an array of promising commodities sectors today. The latest October issue of our acclaimed Zeal Intelligence monthly newsletter describes seven new trades that are likely to thrive tremendously when commodities start to recover. Please subscribe today so you donít miss this rare and extraordinary buying opportunity!
The bottom line is todayís CRB is radically different than the ninth revision that went before it. As it was the hyper-smoothed ninth revision that created the secular uptrend that was recently broken, it doesnít make a lot of sense to worry about the far-more-volatile and not-directly-comparable tenth revision breaking it. Worrying about this recent commodities breakdown in any context prior to July 2005 is neither rational nor logical.
Todayís tenth CRB revision is not heavily smoothed nor equally weighted, oil dominates it making up nearly a quarter of its weight. Thus todayís CRB has no choice but to follow oil like an ox with a ring in its nose with a rope tied to the oil price. If you want answers for the CRBís recent behavior, then look to oil. The moment oil inevitably starts recovering the CRB will obediently follow it northwards and erase this technical breakdown.
Adam Hamilton, CPA October 13, 2006 Subscribe at www.zealllc.com/subscribe.htm