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Real Commodities Bull

Adam Hamilton
November 19, 2004

The world of commodities, long a pariah during the great stock boom and bubble of the 1990s, is finally starting to win some mainstream respect. Commodity-oriented funds are flourishing, the financial media is starting to cover commodities with something approaching regularity, and mainstream investors are gradually growing interested.

Not surprisingly, a few key commodities like gold, oil, and silver continue to capture most of the attention focused on commodities. The precious metals, of course, are the most romantic and storied of all the commodities as well as the easiest to buy and store for investment. And oil prices directly impact all aspects of our modern lives, driving widespread interest.

The Great Commodities Bull of the 00's is certainly not limited to precious metals and energy though. Other commodities are also rising over time, although these sub-bulls have gone largely unnoticed as the headline commodities dominate most of the news. My favorite tool to track commodities in general is the famous Commodities Research Bureau Futures Index.

The CRB Index was launched in 1956, and a popular futures contract based on the index has been trading continuously since 1986. The CRB tracks 17 component commodities ranging from the usual suspects like gold and oil to commodities of lesser notoriety like cocoa and hogs. The CRB can be divided into six categories of components including energy, grains, industrials, livestock, precious metals, and soft commodities.

One of the CRB index's greatest strengths is the fact its 17 components are equally weighted. Equal weighting assures that no price increase in any single commodity, like oil, can significantly skew the entire index. Major moves in the CRB are only possible when the majority of its component commodities are moving in unison with a particular primary trend. The headline commodities of gold, oil, and silver only account for 3/17th of the entire index.

The CRB has been marching relentlessly higher since its massive double bottom carved in early 1999 and late 2001. It has marched from a low near 183 in October 2001 to a bull-to-date high over 288 just last month. This rather impressive 57% gain over three years qualifies the CRB for elite secular bull status, a major new long-term trend likely to run higher for a decade or more.

Like all early-stage bulls though, much of the CRB's initial ascent went largely unnoticed, shrouded in obscurity. It wasn't until earlier this year when the CRB majestically smashed up and out of its rock-solid multi-decade-bear downtrend that folks really started to take notice. This CRB breakout, while very welcome, helped spawn a school of thought arguing that commodity prices are historically high so therefore the new CRB bull's days are numbered.

The roots of this thesis are easy to understand. The CRB Index's all-time high occurred exactly 24 years ago on November 20th, 1980. The index peaked just under 338. Today's CRB levels approaching 290 are only about 14% under these all-time commodity index highs. In fact, today's CRB upleg has taken it to its second highest levels ever, as the only other time the CRB traded near 290 and beyond was in the early 1980s. Since the CRB is almost within reach of its all-time highs, isn't it reasonable to assume that this commodities bull is growing long in the tooth?

I am writing this essay because I believe this thesis is fundamentally flawed and almost certainly incorrect. Yes, the CRB is not far under its all-time highs today. Yes, in nominal terms the CRB is trading almost as high as it ever has. But this does not necessarily mean that commodities are expensive so therefore their bull must end soon. I believe the fatal flaw in this thesis lies in ignoring the ravages of monetary inflation.

Whenever a nation foolishly opts for a pure fiat currency that is inherently worthless as the US did in 1971, the inevitable result is the relentless erosion of purchasing power. As a central bank runs the printing presses to pay for government largesse, the increase in the volume of money leads to a persistent substantial rise in the general level of prices. When relatively more money chases after relatively fewer goods and services, this resulting plague is known as inflation.

Analyzing any price chart over several decades, including the CRB's, is all but pointless when monetary inflation is ignored. A dollar today will only buy a fraction of what a dollar would buy two decades ago. While the US GDP grew by 333% since 1980, the broad US money supply exploded by 407%, nearly 75% more than the underlying economy. Every dollar you hold today is a pale shadow of its former self thanks to the gross incompetence of the Fed. Monetary stability and central banks are mutually exclusive.

While the CRB may look high today in nominal terms, comparing our watered-down 2004 dollars to those of decades past is like comparing apples to oranges. If we look at the CRB index in real inflation-adjusted terms, using constant 2004 dollars, a vastly different picture emerges. Instead of the CRB index looking relatively high late in a bull, it looks like it is relatively low near the beginning of a bull.

Our first graph documents this revelation over a few decades, with the usual nominal CRB graphed on the left axis in blue while the real CRB is slaved to the right in red. Perspective is everything in the markets, and considering multi-decade trends without accounting for monetary inflation guarantees that one's perspective will be hopelessly skewed.

Today's 290ish CRB may seem high compared to the nominal all-time CRB high near 338. But in real terms, using constant 2004 dollars, the all-time CRB high leaps to a staggering 962 in early 1974! If you don't want to go back quite that far, the real CRB hit 754 in November 1980. In both cases, today's CRB seems very low by comparison once the relentless erosion of dollar purchasing power is factored in.

In nominal terms, which is the implicit assumption of those who believe the flawed thesis that commodities are historically expensive so therefore the end of their bull must be near, the CRB is already running about 86% of its all-time high. This is up considerably from 54% at the latter half of the CRB's massive double bottom in October 2001. While technically true, this perspective is still very deceptive since inflation is ignored.

In real terms however, the CRB is now only trading near 30% of its all-time highs. This is up only modestly from 20% at the same October 2001 CRB bottom. Obviously a secular bull running only 30% of its best levels in history ought to have much farther left to run yet than one running at 86%. In real terms, it sure looks like the Great Commodities Bull of the 00's is just barely getting started!

The gaping differences between the nominal and real CRB are very striking in pure technical terms too. While both languished in brutal multi-decade downtrends since the early 1980s and finally broke out of these oppressive trends earlier this year, this is where the similarities end.

The blue nominal CRB's downtrend was long, but rather modestly sloped. Commodities lost ground gradually over a couple decades but the successive major interim lows weren't a great deal lower than their predecessors. Every five to six years or so the CRB would carve a major new bottom, but all of these were near or not far under 200 on the index. Nominally the CRB's multi-decade bear looked more like a giant sideways consolidation than a true downtrend.

In real terms the technical picture changes radically. Rather than grinding lower for two decades, in 2004 dollars commodities have suffered for nearly three. The real CRB's downtrend is also quite a bit steeper than its nominal counterpart. Each successive major low fell significantly under its predecessor, ranging from 350ish in the mid-1980s to under 200 in late 2001. In addition, in real terms the CRB's recent breakout has been far more subdued, only carrying it back up to late 1990s levels compared to early 1980s levels in nominal terms.

When the relentless erosion of dollar purchasing power is rightfully considered, the entire character of the current commodities scene becomes vastly more bullish. Instead of the CRB being well on its way to challenging all-time highs after only a few years, the real CRB seems to be barely getting started in a major bull move. The real CRB index would still have to double to get anywhere close to even its lowest levels of the 1970s and early 1980s.

And, amazingly enough, the assumptions underlying this real CRB are quite conservative. Rather than use true money supply growth, up 1079% since 1972, we used the Consumer Price Index to inflation-adjust the CRB. The CPI is "only" up by 364% over the same period of time, far less than true monetary inflation. While the majority of monetary inflation was absorbed by a growing economy, which increased the amount of things money chases, true inflation is still far higher than the CPI indicates.

The CPI is run by bureaucrats out of Washington who are directly accountable to politicians, not to paying customers like private research companies. For all kinds of reasons, the politicians want reported inflation numbers to be as low as possible. The lower the reported CPI, the lower the cost-of-living increases for tens of millions of Americans receiving various government checks. The lower the CPI, the lower US interest rates can stay. And the lower the CPI, the better the stock markets do which reflects well on politicians seeking reelection.

All kinds of nefarious tricks are employed to artificially lower the CPI. Items with rising prices are excluded from calculations if necessary. Food and energy prices are calculated separately so they don't impact the so-called core CPI, an asinine concept that effectively considers the cost of living for all Americans who eat nothing, drive nowhere, and live on the streets so they don't have energy bills. Hedonic adjustments are also used, where statisticians create fake "price drops" out of thin air for technology like computers where processing power continually increases. It is all madness.

In short, the CPI is the most low-balled watered-down inflation index imaginable, nearly a total charade. If the most conservative possible inflation assumptions underlying the CPI are used and commodities still look cheap in real terms, imagine how low they are in reality if true monetary inflation is considered. The Department of Labor pays its statisticians to lie to keep reported inflation low to please their political masters, but even their mockery of an inflation index shows a real commodities bull just waking up.

Speaking of just waking up, we also took a look at the young secular bull market in the CRB Index in Relativity terms this week and the results were interesting. Since this chart only encompasses about four years, inflation adjustments are not necessary. It is only when you get into charts running in the decades when the eroding dollar purchasing power really becomes apparent. While not directly related to the real CRB, this relative CRB chart offers some insight into the current secular commodities bull. Since neither of today's CRB charts warranted a full essay, I decided to combine them into one.

It is exciting to note that the CRB index, even though it represents 17 equally-weighted commodities, is behaving as all other bull markets do in relation to its key 200-day moving average support. During uplegs within its bull it stretches far ahead of its 200dma until sentiment waxes too euphoric, then it corrects. During these periodic healthy bull market corrections the CRB retreats back down near its 200dma support before embarking on another major upleg.

The result of this familiar behavior manifesting itself in the CRB is an interesting rCRB range. The rCRB, or relative CRB, is calculated by dividing the CRB index by its 200dma. It gives us a precise constant-percentage comparison of where the CRB happens to be in relation to its 200dma over time, removing visual distortion. The idea behind a relative CRB is to go long when this indicator nears the bottom of its range and go short or ratchet up trailing stops when it nears the top of its range.

Bull to date the CRB has carved major interim bottoms at 0.978x and 0.996x its 200dma. Following both of these 200dma support approaches in mid-2003 and mid-2004, the commodities rallied up strongly to new bull-to-date highs. So if you are watching commodities in general, and are looking for a buy signal, wait for the CRB to retreat just under its 200dma. Like all secular bulls, it tends to periodically retreat back to its core 200dma support in corrections before catapulting higher in dazzling new uplegs.

Conversely the CRB's major interim highs thus far have also been remarkably consistent in relativity terms, all very close to 1.13 or so. When the CRB manages to stretch 13% above its 200dma support, it tends to either consolidate sideways until its 200dma catches up or it corrects down to its 200dma outright. These necessary corrections ensure that sentiment doesn't get too euphoric too soon and threaten the long-term viability of the young commodities bull.

The first 1.13 approach in mid-2002 did witness a minor sideways consolidation for a quarter or so, but the CRB took off again well before it retreated to kiss its 200dma. Its second 1.13 approach in early 2003 did indeed signal a major interim top though, after which the CRB corrected rather sharply. Rather than short commodities outright on these rCRB highs, I would tend to just raise my trailing stops on longs instead. Bull markets always have far more potential for upside surprises than downside surprises as this initial rCRB 1.13 approach reinforced.

The third rCRB 1.13 approach in early 2004 perfectly matched a major interim top in the CRB right before a consolidation running nearly two quarters in duration. Once the CRB kissed its 200dma again following this consolidation though, it wasted no time at all leaping back into full-on rally mode in a new bull upleg. If this latest upleg follows bull-to-date precedent, the CRB ought to march about 13% or so above its 200dma before it corrects again. If considered in the context of today's 200dma, this yields a potential current upleg target of 311 or so on the CRB.

Watching the rCRB specifically would be most useful for anyone trading CRB futures directly, but this indicator may also be of use for investors and speculators dealing in commodities in general. Used as a secondary indicator, rCRB highs or lows could provide welcome corroboration of major long or short signals triggered in other commodity-specific indicators like rGold, rSilver, or rOil.

I suspect that a major buy or sell signal in any individual commodity would have a higher probability of proving profitable to trade if it coincided with a congruent major buy or sell signal in the CRB index itself. If both an individual commodity and the CRB were likely to enter a strong upleg simultaneously, the risk of a long trade in the individual commodity should be lower and the odds of winning higher. I hope to study this thesis in detail in the future, comparing relative buy and sell signals in individual CRB components with those in the broad CRB index itself.

The bottom line is the real commodities bull remains young and very cheap historically. While it is tempting to use today's rising nominal CRB to compare with similar levels over two decades ago, in reality these comparisons are fundamentally flawed. The Fed's relentless fiat inflation has vastly lowered the purchasing power of each dollar, so multi-decade comparisons are only relevant in constant dollars adjusted for this monetary inflation.

And while the inflation-adjusted real CRB index suggests this secular commodities bull is just beginning, it is interesting to note that our technical relativity tools are already revealing tradable consistency in the major uplegs and corrections of the broad CRB index itself. Commodities investors and speculators should definitely consider adding major long positions in individual commodities or related plays when the CRB itself has retreated back down near its own 200dma to regroup.

We will try to integrate this new CRB insight into our own trading strategies discussed in our newsletters for our subscribers as we launch new commodities-related trades going forward. Considering the state of the CRB uplegs and corrections may prove useful in farther refining high-probability-for-success moments to throw long or short in key individual commodities markets including gold, oil, and silver.

Far from nearing an all-time high as intrinsically flawed multi-decade nominal comparisons suggest, the historically very low levels in the real inflation-adjusted CRB suggest that we instead probably have many years left to run yet in this powerful secular commodities bull. Thus there ought to be countless stellar trading opportunities in the commodities arena in the years ahead.

The real commodities bull is still likely quite young!

November 19, 2004
Adam Hamilton, CPA
email: zelotes@zealllc.com

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