What we are seeing in the commodity complex is the drip, drip, drip of orderly liquidation. Commodity funds are losing assets and/or being shut down. Tourists who ventured into commodities to protect against macro fears that didn’t materialize have started to sell. And the sell-side commodity hype machine is now behind us. This is why commodities have stayed so oversold for so long with high negative sentiment readings, yet still go down pretty much every day.
When performance is dragging, less experienced traders often lock in profits on their winners and double down on laggards. The pros, however, prune their losers, and pros are the big holders of commodities. Hence, the drip, drip, drip. (NB: liquidations usually start with drip, drip, drip and end with flush.)
How far does the unwind have to go? These things are always hard to say with precision. But what we do know is that the commodity unwind should be a function of the size of the build-up—plus a reverse-bubble psychological dynamic once the selling gets going. Rapid rate of change influences emotion much more than level.
Since I believe the buildup was significant, with a good portion of it predating QE, I expect the unwind to be large and sustained. But, ultimately, every investor/trader has to come to his/her own determination of how big the unwind will be.
Do you think the US has put crisis behind it? This is really the only question you have to consider when you look at the above chart of gold since 2000.
What we have been seeing is that silver and gold are developing an increasingly negative correlation with the S&P. And it is in the precious metals where most of the tourist dollars reside. So hedging your equity longs with silver and gold—though it has worked very well for the past few months—will become more painful to hold onto in countertrend days, and possibly brutal in a selloff (both your longs and shorts may well move against you). It you have a cast-iron stomach, you should be fine. The reality is, however, that most of us don’t—and hanging on to a winning trend is the single hardest skill to learn in investing. A better hedge will help you do that.
Enter copper. During the speculative run on commodities, there was a lot of broad allocation to the asset class as well. This means copper (and to a lesser extent oil) will correlate in part to precious metals, and in part to the S&P, since, as an industrial metal it is more sensitive to growth. The bottom line: copper right now makes for a better macro hedge than silver or gold.
The point of this is that if you have been suffering from being underinvested and you are looking for a way to add stock risk to your book, a really solid way to do it that minimizes the risk of being the goat in two months’ time is to buy the stock you like based on your process, and hedge the beta out by shorting copper. It sensitivity to growth should make it go down on down equity days, but on up days it should lag—or even outright decline—based on the drip, drip, drip of the commodity unwind.
Here’s the chart of copper of the same time horizon, FWIW:
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