Commodities: The Key to Predicting the Next Market Movement

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Commodities and equities are very different investment vehicles.  One represents ownership in a company or business, while another represents ownership in one of the most basic units of production.  While they aren't interchangeable, commodities typically lead any stock market rebound.

The Basis for Correcting Recessions

The Federal Reserve and Congress both spend significant amounts of energy and money to correct slowdowns in the economy.  The idea behind this blatant Keynesian think-tank is that when the private sector slows, the economy can be grown through the public sector.  Often, the solution is the expansion of the monetary base, easier credit, and direct infusions of cash through Congress to the American people.  Inflationary policies help lift important economic indicators, including the Gross Domestic Product, Consumer Spending, and Consumer Credit, among others.

Expansion of the Monetary Base

Never in history has the federal government and its government sponsored entities done so much to stop an ailing economy.  The Federal Reserve, trying to undo the lack of credit in the credit markets, increased the monetary base by nearly 100%!  In doing so, it has allowed the aggregate money supply to double from $5 trillion to $10 trillion.  But first, it needs borrowers.

Commodities Indicate Borrowing

Investors often look to commodities and price changes as an inflationary or deflationary indicator.  During the credit expansion of the housing boom, commodities, namely oil and gold, soared in value as the amount of dollars grew.  Through the banking system, and the ever increasing housing prices, the monetary base (the same one that has been doubled this year) was leveraged up to 10 times.

Oil and gold, in contrast, rose at rates far advancing the reported inflation, but right in line with the growth in money supply.  The case can also be made for the boom in stock prices during the 1990s.  From 1990 to 2000, the money supply grew by more than 1000%, and the stock market followed suit.

Trying to Tip the Scale without Breaking the Bank

Ultimately, monetary policy has two goals: holding the reigns tight during economic expansion and letting them loose during slowdowns.  In the most recent case, the Federal Reserve has a job to expand the money supply while being able to cut it back as the recovery arrives.  Should the Fed fail to time either movement correctly, the resulting chaos could be drastic.  On one side, if the reigns are not brought back quickly enough, it will create an inflationary environment where businesses are not able to make long term deals.  One the other side, cutting back too quickly could send the economy into a death spiral, known better as a double dip recession.

Why Commodities Matter

Commodities are not only a measure of inflation, but also a measure of economic activity.  Economists often view oil and coal supply as a means to measure manufacturing and transportation strength.  In the same way, heating oil and natural gas often signal how many people are cutting back the thermostat to save money.  In accurately assessing the state of the economy and market, commodities will be extremely important to stock traders, who use commodities to judge the future strength of equities.

Correlations Count

During the 2004-2007 stock market run, oil preceded stock's bullish run.  Nearly every day, commodities moved upwards, followed by stocks, and often by several full percentage points.  As oil neared its peak, however, the stock market began to lose value, mostly due to the economic consequences of $147 per barrel oil.

Inflation, at This Point, is Desired

Inflation is the ultimate goal of today's monetary policy.  Last fall, all eyes were on deflation and its impact on business.  When the money supply shrinks or stagnates, long term debt obligations are more difficult to fulfill, largely in part to a limited amount of dollars chasing the same debt.  No matter how many dollars are in circulation, contractual obligations still apply in the dollar terms noted in the agreement.  For example, should Company A agree to a contract with Company B for $1 million in five years, a 50% reduction in the money supply would mean that $1 million is worth $2 million in today's terms.

Looking Forward

The deflationary environment that scared investors into fixed income will reverse when commodities and inflation begin returning to the global stage.  At that point, the run for commodities, hard assets, and even equities will be so powerful that it will jumpstart the marketplace.  The inflation is there, but first the economic fundamentals must support it.  When jobs come back, expect financing of household goods and even homes to continue, and at that point, the markets should well outperform.