It's official: As of Friday, commodities moved into bear market territory.
True, given the extremely volatile price trends in commodities, the line between a bull and bear market can be crossed several times in any given year. And some commodities – like corn – have still seen their prices surge recently. This time around, however, the kind of bearishness doesn't only reflect supply/demand fundamentals in each market – soybeans, say, or copper – but also investors' views of the broad economy and the confidence that they have in policymakers to restart growth.
The catalyst for the selloff also was of a macro nature. Last week, the Federal Reserve failed to do what many economists and speculators had been desperately hoping it would: announce that it would embark on a fresh round of quantitative easing, or QE3. Instead, Fed policymakers settled for a tepid compromise, extending "Operation Twist," selling short-term Treasury securities in exchange for longer-term bonds in an effort to lower the far end of the yield curve. Coming hard on the heels of still more underwhelming economic data, that wasn't what the market wanted to hear. How is the U.S. economy expected to grow without more active support? And without growth, who will buy commodities?
Speculators spent much of the winter building up large positions in commodities futures contracts – not to mention commodity ETFs and other related securities. Their rationale? That either the U.S. economy was returning to a more robust growth pattern or, if it wasn't, that the Fed would step in with more stimulus measures. The events of this spring, culminating with the Fed's decision to hold off on QE3, proved those speculators wrong on both counts.
There is only muted good news here – and it's not of a kind that is going to make investors happy, since it's not likely to translate into very many stock ideas.
Lower commodity prices go hand-in-hand with lower inflation expectations – that means that the Fed and other central banks trying to figure out a way to stimulate growth have less to worry about. And there are some companies for whom lower commodities prices will offer a kind of saving grace. ConAgra Foods (CAG) reported last week that commodity costs eased up enough that it was able to generate a slightly higher than expected profit for its fiscal fourth quarter of 51 cents a share (before the impact of accounting changes related to its pension liabilities). Airlines will pay less for jet fuel; shipping companies like FedEx (FDX) and UPS (UPS) will see their costs decline as well. But it remains to be seen how much of that benefit will be wiped out by sluggish economic growth: as we discussed last week, FedEx is worried about not only the widening of the impact of the Eurozone's debt crisis on demand for its services, but also the prospect that when growth returns, consumers will have changed their preferences for good.
What does the bear market in commodities mean for stock prices as a whole? Not that much, argues Kevin Pleines, an analyst at Birinyi Associates. In a recent report to clients, he noted that in six of the 11 cases in which commodity prices – as measured by an index – plunged at least 20 percent, the Standard & Poor's 500-stock index traded at a higher level six months later. That means in five of the 11 cases, they were lower.
And although commodity prices typically decline nearly 22 percent more after crossing into bear market territory, extending their declines for an average of 15 more months, Pleines says that isn't always a reason to avoid the materials sector of the S&P, home to mining firms and oil production businesses. Indeed, that sector typically trades higher one, three and six months following the commodity index's move into bear market terrain.
But that is historical data, and what we are witnessing now is the kind of global economic uncertainty and fear that we haven't really witnessed since the 1930s. Until now, major economic problems have tended to be confined to one region of the world, with the fallout on the global economy being more manageable. The Latin American debt crisis was a major regional problem, and bad news for some banks outside the region; the emerging markets meltdown of the late 1990s certainly rattled nerves and markets in North America, but didn't do more than that when it came to the stock market's growth. The slowdown that ended with a recession a decade ago was a global one – but that was more a question of the business cycle. This time around, it is different.
So this time around, perhaps the data to look at doesn't deal with past experiences of stock and commodity markets and the correlation (or lack thereof) between them, but on the undoubted correlation between inflation expectations and stocks. When inflation expectations, as measured by the Treasury's inflation-protected securities, are higher, stock prices tend to rise – and vice versa. It's eminently logical: lower growth means lower potential corporate profits. And that's the relationship that investors are likely to focus on for the time being – and it's one of the reasons stock prices sank again Monday.