Yesterday, Goldman Sachs decided to call the top in commodities by dumping its profitable positionin the CCCP basket. The man who tried to call a top, Jeffrey Currie, chooses to lock-in a 25-percent-profit on the trade he opened in December 2010. He thinks the near term risks have become too excessive, especially with the recent rally in oil prices.
Although potential contagion risk in the Middle East and North Africa (MENA) remains elevated and has pushed prices above $125/bbl, at these price levels the risks are becoming more symmetric, which shifts the risk/reward of being long oil. Not only are there now nascent signs of oil demand destruction in the United States (see April 5 Energy Weekly), but also record speculative length in the oil market, elections in Nigeria and a potential cease-fire in Libya that has begun to offset some of the upside risk owing to contagion, leaving price risk more neutral at current levels.
As a side effect, Currie also fears consequences in the metals arena:
We still see significant upside in soybean prices, but believe that copper and platinum will face near-term headwinds as higher oil prices potentially translate into a negative demand shock for the metals and as these commodities are exposed to supply chain problems resulting from the earthquakes in Japan. This is particularly the case for platinum given its large exposure to global automobile production. Copper also remains vulnerable to slowing observed demand as high prices and tight credit motivate tight inventory management from key consumer China, which tempers the inventory draw we had expected and the risk of price spikes. As result, we are also closing our long copper and platinum trades, but even in these commodities the structural supply-side story remains intact, and we would look for new entry points to establish new longs.
At a first glance, these arguments seem very logical: demand destruction as a result of rising costs.
But why call the top in commodities now? Like we reported last week, we aren’t seeing large optimisme in precious metals, and to a wider extend commodities. Very few market participants are ready to really believe in this long term secular bull market.
In fact, as we look at it — from a Big Picture perspective — commodities have just begun to outperform.
Take oil for instance… compared to stocks, oil just started to ‘let loose’!
The Dow Jones / Oil ratio only started to tumble in the recent weeks to 115x, while the ratio was hovering around the 130 mark for the last 2 years. In terms of purchasing power, oil never really got expensive in the last 2 years, even with prices running from $60 up to +$100 per barrel over the same period.
With the recent downturn of the Dow/Oil ratio, there’s even more room below. When oil prices went ballistic in ’08, with prices reaching almost $150 per barrel, the ratio dropped below 80x. At the current position of the Dow at 12,260 index points, that would lead us to oil prices trading above $150: a new all-time high!
Of course, one could argue that the Dow Jones could start to tumble, but even in that scenario, we don’t see oil prices retreat very much
By the way, the Dow/Oil ratio could drop much further than 80x in the current secular bull cycle. The ratio submerged to 20x back at the end of the 70′s and early 80′s, when the Dow Jones stood at 800 and oil topped $40.
So we don’t think oil is getting very expensive compared to other asset classes like stocks. In fact, the commodity complex (CRB) as a whole has become cheap compared to stocks over the last few years.
As can be seen in the chart above, the Dow Jones / CRB ratio has only begun to drop in the past half year. At the current rate of 34x, commodities are still cheap compared to stocks in terms of purchasing power, as the medium bandwidth hovers around 32x.
If we take into account other segments within the commodity complex, like precious metals, we also notice that there is more room left on the upside for prices, with downside risks rather limited.
There’s nothing wrong with taking a hefty profit like the Goldman CCCP trade, but keep in mind that trading in and out of positions during a secular bull market is almost an art. Many traders miss the bottom when they went to trade back in, which leaves you chasing a position or bailing out of the trade.
Our advice: if you want to take some profits, don’t trade out of your whole position(s) in commodities, but rather sell a part (half), so you stay involved with the bull. If things get nasty on the downside, you can always start to load up again when the potential sell-off reaches a climax.