Commodities Crushed on China’s Tightening Credit, Stronger Dollar

Eric Roseman (January 26, 2010)

Dear Commodity Trend Alert Investor –

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January is turning into a nasty month for commodity bulls – and bulls on just about everything else with a risk bias. Yes, markets do go down or have we forgotten what happened in 2008 and early 2009? Risk is out there. There’s also another mini-sale on gold and silver. You should be buying in this correction.

For the first time since last July global investors faced a blitz of selling starting last Tuesday. For our purposes, gold and silver were trashed while the gold stocks got hammered even harder.

It should come as no surprise that China is trying to curb lending. Excessive bank credit – unique mostly to China in an environment of tight credit in most countries – prompted to belt-tightening in Beijing last week. The Chinese are now in the process of slowing a boom in bank credit and especially, real estate lending. Liquidity is cautiously being drained.

The result is a major sell-off for commodities, especially the base metals, which are heavily linked to China’s growth cycle. Our core positions in gold, silver and oil related securities are not being spared. But overall, the CTA Commodity Portfolio is only marginally down this month compared to bigger damage done to the CRB Index, the S&P GSCI and the S&P 500 Index.

The technical damage was largely done on Friday to world markets when the S&P 500 Index closed below its 50-day moving average again. The CRB Index, shown above, is now trading below its 50-day; by its own measure the 50-day isn’t significant. Both stocks and commodities have violated this technical support level on several occasions since March 2009 and recovered.

But this time might be tricky. We could slip into deeper selling and cross the much more important 200-day moving average.

Though I suspect the Chinese, like most governments, fudge their economic data, it’s quite obvious that inflation is now accelerating across China, mostly in real estate, bank credit growth and stock prices. China is attempting to gradually deflate an asset bubble and curb bank lending, which is expanding rapidly. I emphasize gradually. The trick is to slow things down enough so as not to blow-up its economy; many central banks in the past, including the Fed, have failed to arrest inflation in time to deflect trouble. China won’t be any different.

Credit Deflation Spreading; Enormously Bullish for Gold

The question is whether this is the beginning of another 2008-type of meltdown or just an overdue sell-off triggered by China’s liquidity curb. I think it’s the latter. China’s economy won’t blow-up now. Rates are still too low in the United States and governments will be in no hurry to hike rates sharply enough to collapse weaker sovereign borrowers struggling to raise capital. This includes Greece, Dubai and weaker credits in the European Union, European Economic Area and parts of Latin America and other regions. The debt crisis is still alive and kicking and interest rates must be accommodative at all costs to survive debt financing.

Governments, I think, will overshoot on the inflation side to conquer deflation still in their local economies and spreading contagion to weaker borrowers – including governments. This is a new dynamic in the post-2008 credit crisis and reveals we’re not out of the woods. What I’m saying is that for us to “get out of the woods,” governments will spend and overshoot budget targets over the next few years, possibly longer. This puts pressure on bond markets, their respective currencies and adds more fuel to the dysfunctional global exchange rate system. Gold is the obvious beneficiary in this mess.

The usual beneficiaries of heightened risk aversion came into play starting in mid-January as the U.S. dollar, the Japanese yen and Treasury bonds post gains at the expense of risk-based assets like stocks and commodities. Foreign currencies have pulled back heavily. But I’ve seen this price action before and the way the world is going, big inflation, I’m buying more gold and silver on weakness, better currencies and quality assets if I can find them.

The Chinese have a vested interest in keeping inflation in check. China and several other emerging markets like Brazil and India are the few centers of real economic growth in the post-credit crisis rally since March 2009. While other nations, mostly in the developed world, continue to struggle amid a wall of government spending, rising unemployment and deflation in bank credit, the Chinese are home to unrelenting loan growth — until now.

Local media in China assert that banks lent more than $146 billion dollars the first two weeks of January compared to about $1.4 trillion dollars in all of 2009. At this rate, bank lending would top $3.5 trillion dollars this year, which is unsustainable.

The question therefore is how far will Beijing go to curb credit without risking an overshoot and triggering a wholesale crash in domestic markets?

The Chinese do things pragmatically and in small steps. It’s hard to believe the authorities will rapidly drain excess credit and cause a massive sell-off in domestic markets, namely property. Yet this is becoming a dangerous game.

The trend now is for gradually tighter credit in China and if the government continues to drain liquidity then global markets will suffer more declines. Increasingly, the last few years have shown a high degree of correlation between China’s economic growth cycle and the performance of world markets; ten years ago China didn’t cause a dent. Today, all eyes are focused on the world’s third-largest economy and its biggest exporter. This week we’ve been reminded once more that China has big muscles and all investors are vulnerable to the events occurring in that country.

I’m not sure events in China this week will continue to cause a further reduction of risk. So far, long-term moving averages in the major markets remain in bull market territory.

Gold, though a disappointment in January thus far should be accumulated on weakness because dollar strength is only temporary as the Fed continues to fight unemployment, battered housing and fractured credit intermediation. It’s hard to believe the Fed will tighten this year when these three critical pillars of growth remain so impaired.

The only country in the world that should be tightening is China. The rest of the global economy – especially in the West and Japan – are still deeply entrenched in deflation and have no business to curb credit growth or drain massive fiscal priming since late 2008. But the risk that other governments will follow China and curb spending and hike rates is growing. That would mark a bungled policy initiative and result in a double-dip recession. The world simply can’t handle higher rates so soon after the biggest credit shock since the 1930s. Rates will stay at low levels for longer than most investors think.

CTA Gold Bugs Portfolio

Our long-term structural bull market for gold in place since 2002 remains technically intact. However, some damage to the primary trend occurred over the last few days as gold suffered a decline of 3.6% last week. Silver declined 8%. Gold hit an all-time high of $1,216 an ounce in December 2009. Silver hit its highest levels since 2002 in March 2008 at $20.78 an ounce.

Longer term targets for gold toward and in excess of $2,000 an ounce remain technically viable. My call is gold $1,350 in 2010, silver $22.00. These projections are valid if the United States leaves rates unchanged and if more volatility hits the dollar, which I expect, later this year.

The pullback we’re seeing now should be contained in the $1,000 area for gold; but even if we decline toward major support at $860 an ounce the primary trend will remain bullish.

Both gold and silver remain well above long-term support levels (see above charts). I’d be surprised if we crack the 200-day moving averages on this correction. The way I see it, this is another in a series of buying opportunities for gold and silver.

It’s also a buying opportunity for the gold majors, which I believe are still undervalued compared to their 2010 earnings. The gold stocks and the juniors were blasted last week but should be accumulated at these lower levels. Gold stocks are now 20% below their highs recorded in November. This correction might have further to unwind but I’m a buyer at these prices.

In January, the CTA Gold-Bugs Portfolio has declined 2.53% compared to a loss of 5.63% for the XAU Gold Index. Both indexes were hit hard starting last Tuesday.

An initial $10,000 investment in the CTA Gold-Bugs Portfolio on January 1, 2010 would now be worth $9,747, including dividends, if any. This compares to $9,437 for the XAU Gold Index. These results, however, don’t include dealing commissions or taxes.

The CTA Gold-Bugs Portfolio does NOT exercise stop-losses on gold or silver mining shares; the nature of this investment strategy is hugely volatile by definition. We don’t sell these companies or our physical gold and silver ETFs or coins.

The CTA Gold Bugs Portfolio is a BUY.

CTA Best Buys & Market Hedges

With commodities now in the midst of a sell-off it’s no surprise that most of our Best Buys posted declines recently. Junior gold stocks or GDXJ has been mauled. Large-cap gold majors fared better but remain down about 6% this month. But the agricultural commodities, which took hits the prior week following a bullish (or fabricated) USDA crop report for 2010, did hold up rather well. Both DBA and RJA remain great buys ahead of what I would coin a mania that awaits the grains complex.

Our 10% portfolio allocation to hedges marked some advances. Betting against base metals and commodity indexes overall has returned 7.7% for BOS and 5.2% for DDP this month.

CTA Best Buys remain unchanged and include small-cap Canadian uranium producer UEX Corporation (buy up to C$1.20). We’re also buying the CTA Gold Bugs Portfolio, including our newest allocation this month, the Market Vectors Junior Gold Miners or GDXJ.

For soft commodities, we continue to accumulate the Elements Rogers International Index Agriculture ETN (below $8.50) and the Power Shares DB Multi-sector Agricultural Trust (below $27). The agricultural commodities have actually held the line pretty good in this correction and we remain long-term bullish.

Click to enlarge

CTA Action Recap for January 26, 2010

The CTA Commodity Portfolio posted a bad week along with all commodity benchmarks. Gold mining and energy – our largest holdings – were not spared.

In January, the CTA Commodity Portfolio is modestly down 0.73% compared to a loss of 2.41% for the CRB Index and -5.70% for the S&P Goldman Sachs Commodity Index. The S&P 500 Index has shed 2.12% in January.

Despite all the volatility gold prices are about flat this month and silver is up 1%. That beats the performance of most other commodities and global stocks now firmly in the red in 2010. Natural gas is also stronger this month.

Of 36 open positions in the CTA Commodity Portfolio only four are showing a gain this month – McMoRan Exploration, UEX Corporation, United States Natural Gas Fund and silver bullion.

I truly hope some of you bought MMR or McMoRan Exploration. The stock has gained 91% in January and is up 160% since last July. Unfortunately, our three other insider stocks in the resource sector have failed to live up to my expectations. Mueller Water and Advanced Battery remain open; Vantage Drilling and Western Refining should be closed at this point.

As we have remained selective by not chasing the recent boom in natural resources over the past several months, I imagine we should be in a favorable position to start accumulating better values soon. This correction will be violent. Continue to buy only quality. This means gold, silver, gold stocks and selective Best Buys that are high-value investments.

In 2009, the CTA Commodity Portfolio gained 23.51% compared to 23.46% for the Reuters CRB Index and 50.30% for the S&P Goldman Sachs Commodity Index. The S&P 500 Index gained 26.50% in 2009.

Until next week from Montreal – stay long the right commodities!

Eric N. Roseman
Editor
Commodity Trend Alert