S&P GSCI, one of the world’s most followed commodity benchmarks, is down by 41% over the last year. Imagine if the the stock markets were down by that much. The news would be very different. Since most investors don’t invest or trade in commodities, the financial media doesn’t cover it that much. But as far as our real lives are concerned, we are far from immune.
Are We Entering a Commodities Bear Market?
A better question to ask would be are we in a bear market already? The IMF’s Managing Director Christine Lagarde warned that the global economy is slowing down as $11 trillion in world shares were wiped in the previous quarter and the eurozone is entering a deflationary period.
China’s market correction of about 40% since June (SSE Index) has forced the global markets to remain volatile. The Chinese government has done everything it can in the past few months to reduce market volatility including lending money to their brokerage firms to buy blue chip stocks (to counterbalance the selling pressure), announcing a stimulus, halting trading for half of the listed companies, blocking IPOs, and devaluing their currency. Yet most of those attempts have yielded limited or no results.
Two days back, India’s central bank cut its interest rates more than expected. The Reserve Bank of India cited global economic slowdown and commodities as the primary reasons for the rate change. Quincy Krosby, market strategist at Prudential Financial, seems to be of the opinion that the market is trying to find a bottom and “is primed for a repricing, unless there is a catalyst that could take it higher.”
The China Factor
China’s reduced demand for metals has had a rippling effect in the economy. Copper, which is one of the widely used metals in the world (and in a lot of ways an effective barometer for economic health), is at a six-year low. From $4.50/lb in 2011, it is now well below $2.50/lb.
Glencore, one of the world’s largest resource companies, lost almost a third of its share value on September 28, 2015. Investec (INVP) estimated earlier that if weak prices persist, their earnings could be consumed by their debt obligations, eventually wiping out their share capital. Experts say this could be a “Lehman-like moment” for the mining industry. Rio Tinto (RIO), BHP Billiton (BHP), and Noble Group all have fallen sharply since June.
This is just one example. China is actually the biggest consumer of a lot of commodities.
A persistent slowdown in Chinese buying capacity would not only force commodity prices to keep falling, it has the potential to push the global economy into a deflationary period.
What Can You Do as an Investor?
Inverse commodity ETFs:
Falling commodities could be handy information for the speculators (if you are one of them). Inverse commodity ETFs could give you an opportunity to gain from the continual fall. Etfdb.com has compiled a list of inverse commodity ETFs/ETNs worth considering, such as DGZ, SZO, DDP, and BOS. If your risk appetite allows, you could even invest in some leveraged inverse ETFs like DGAZ (3x Natural Gas), BOM (2x metal), and DGLD (3x Gold).
Note: Any leveraged ETF (long or short) is not advisable in a volatile market. They are most useful when held for short periods of time.
Commodity futures might be intimidating (as they should be) for most individual investors but they are an effective tool to make use of falling commodity prices. Investors are frequently unaware of the underlying securities used in ETFs to achieve leverage. If you take short positions in futures directly, you have more control over the outcome.
Index futures can give both the diversification and the hedging ability for investors to protect against price drops (or take speculative positions).
Bear Option Strategies:
Options don’t achieve asset positions directly but rather a right to take positions at a later date. A bear put spread (e.g. buying a copper put at higher strike and selling a copper put at a lower strike) is an example of a strategy that can be used to benefit from falling prices. This strategy can be applied to commodities directly (by buying/selling commodity contracts) or by picking a stock that is negatively affected by falling copper prices.
Investors can also consider buying stocks that benefit from low commodity prices. There might be many companies that will incur lower transportation or manufacturing costs due to a fall in commodity prices.
The Bottom Line
The commodities bear phase might continue or get worse in the coming year. In the near future, given the situation, a positive outcome might mean a moderate fall in commodities prices (instead of a heavy fall). It may not seem like that volatility will affect you, but there might be some stocks in your portfolio that are directly or indirectly affected by commodity price drops. To hedge against the price falls, consider taking temporary short positions through one of the vehicles given above or long positions in companies that will benefit from the fall in prices. Using broad or sector indexes to take positions is always a good idea if you are not sure about which commodities or companies to pick.
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