Commodity Funds

The Commodity Research Bureau index of leading commodity prices has slumped 8.5% so far this year.

In the middle of the week, as I glanced through an array of charts on my Bloomberg terminal, I noticed that the index is sitting on support at its lowest level since Dec. 1, 2005.

That moment in time marks a turning point for commodity prices, which had spent the previous two months since October in gradual decline.

Let's face it. Commodity prices are notoriously volatile and face bigger daily swings than do most individual stocks.

Today's first chart takes a look at this established bull-market trend for commodities. Since 2001, the surge in commodity prices has seen this index come within 4% of doubling in value since October of that year.

Once again we find that commodity prices are visiting that area of trend line support.

Recently I have been laboring the point that oil, gold and copper are heading lower.

As I prepare my column for this weekend, I find my views coming true once again. However, I'm not sure that I have come to the conclusion that the bull market for commodities is over.

But should the price of gold fall back to $525 per ounce, oil go back to below $55 and copper return to $2 per pound, the damage to the CRB index would be pretty telling and we'd have all manner of Jonahs sounding the death knell for the global economy. See my earlier articles on gold, oil, and copper.

So here's the question for anyone considering whether to switch from traditional investing in equities to commodities right now: Is this latest bout of pessimism simply a reversion to trend or is something more sinister afoot?

Just to plant a seed of doubt in the minds of commodity bulls here, I wanted to mention an article I picked up during the week about the surge in retail investments in commodity funds.

According to that article, Barclay's Capital reports that the budding commodity market has attracted investors who have thrown as much as $80 billion into commodity mutual funds last year.

As the old phrase goes: You know it's time to sell your shares when the cab driver is handing you stock tips!

That's because the public is often the last to know about what's hot and what's not.

With stock prices sliding as much as 50% in the bear market to 2002, investors turned their attention to bonds to seek out added yield.

However, the low inflationary environment and rising demand for fixed-interest coupons have driven bond yields to extreme lows.

So, when investors hear about gains of 51% in mining and natural-resource funds such as Luxembourg-based VCH Expert Natural Resources, they are quick to jump in on the act.

When you compare the two-year jump of 66% for the Goldman Sach's commodity price index to the 12.3% gain of the S&P 500 index, you might understand the proliferation of investment bank funds that have spawned to attract client money into commodities.

Of course, 2005 saw strong global demand for commodities. Copper is used for wiring and cabling in hot housing markets, while steel is used for constructing bridges, buildings and cars.

China continued to grow, averaging a pace of 8.8% during the last five years and gobbling up natural resources like mad.

Plus, the hurricane effect in the United States caused a surge in energy prices as fears over oil shortages soared, sending crude oil prices to a record of $70.85 per barrel.

Instability in the Middle East - coupled with refinery closures - was a nasty cocktail for the economy.

All of these factors brought on a boost to commodity funds as investors grabbed the coattails seeking fast, super-sized returns.

This year, while Middle-Eastern tensions have not exactly eased, speculators' worst fears aren't being played out. Oil inventories are growing while traders still choose to play the oil market from the long side.

The dollar is bucking the fundamental viewpoint and is flexing its muscles.

That fact is eroding the need for alternative asset classes to diversify against the U.S. currency. As such, it's not just copper prices that have fallen. Gold too is suffering and has dropped from $571.25 to $538.55 this week.

However, it may be too early to bury the commodity markets. This could be little more than one of those usual setbacks before a fresh leg back up to new highs.

In order to successfully pierce those heights, we'd have to have a nasty hurricane season down here in Florida and at least a continuation of strong global demand, if not an actual strengthening.

With interest rates rising globally, that might be a hard thing to accomplish.

My solution is not so much a fix as it is an agnostic approach.

It's the same as ever. I prefer to take a view based on two patterns. First, is the technical chart pattern unraveling from day-to-day across an array of stock, bond and commodity prices.

Second, is the ongoing fundamental supply-and-demand picture that unfolds. I like to keep abreast of global statistics that depict how strong world economies are when it comes to utilizing scarce natural resources.

As I have proven in recent issues, keeping an eye on what speculators are doing from week to week is pretty useful, too. The declines in measures of open interest in both copper and gold predicted that those prices would decline.

I continue to keep my eyes and mind open to trading both sides of this wonderfully volatile and choppy market.

Editor's Note: Our view: Oil prices will reverse to $50 and probably below in 2006. For other sector-specific recommendations, check out our new report. Go here now.

Japan

I remember five years ago in a business class, our Canadian professor was asked about the potential for the Japanese economy to emerge from recession. Surely more than a decade in the cesspool was long enough?

He shrugged his shoulders and replied it would never happen unless they dared to deal with the problem loans across the entire banking system.

And that change would take not only guts on the part of the banks to admit their past errors - it would also require years to achieve.

So it was a momentous week in the Far East with the Bank of Japan (BoJ) electing to commence the tightening of monetary policy.

Although there was no official rate rise announced, the central bank reduced the amount of available liquidity to the banking system.

That marked the end of what's known as "quantitative easing," which has been in place as an emergency measure for five or six years.

The Bank has been flooding the system with money each day through its daily operations in an effort to encourage borrowing.

On Thursday it announced that over the next several months it would mop up the liquidity, or inject less each day. The effect of this would be to make banks compete for the declining pool of funds, forcing up the price they pay - the rate of interest.

It's the first step - and essentially a preparatory one - to getting the economy primed for a change in the official monetary stance.

The BoJ has decided that it will revert to targeting its so-called "call-rate" (or the day-to-day lending rate) based on a vague inflation target. But that will come later, after the liquidity path is better paved.

Seemingly well aware of the pending change, borrowers sent the value of bank lending up this week, and according to bank data, this is the first time in nine years that bank lending has expanded.

Loan growth rose in February following a surge in fourth-quarter growth and rising land values that spurred customers and companies to take out fresh loans.

The encouraging data plays a part in the BoJ's decision to change its deflation-fighting stance.

Ever since the property bubble burst in the early 1990s, loans have shrunk.

Of course stock prices followed the value of property downward. Companies were left debt-laden and carrying loans worth more than the underlying assets on which they were secured.

After three recessions and a decade of slumber, signs have recently been rather encouraging. Consumer prices rose for the third consecutive month accompanying the jump in land prices.

Corporations have paid off bad debts and are flexing their muscles, searching for fresh loans in order to expand business.

Strength of demand was the highest in six years, according to bank data, with further survey evidence pointing to more loan-demand expansion over the next three months.

The nation's bigger banks are expanding their loan books and are set to benefit from this.

However, the potential onset of higher interest rates spurred a bout of jitters in the world's stock markets this week.

The Nikkei index appeared to be scared in the build-up to the meeting this week, having lost 4.5% since the end of February.

The index roared back as the BoJ removed uncertainty and the yen weakened.
  
This week, The Wall Street Journal asked whether the change in monetary policy would deter short-term stock investors from borrowing money and piling into the stock market.

I'm not altogether sure that's a solid argument in the big scheme of things. For sure, traders were able to borrow the yen equivalent of $10,000 for as little as just 36 cents per day to speculate on Japanese stocks.

According to the Journal, individual traders made up 28% of all stock trading in 2005, compared to 19% in 2003.

Last year, about one-half of that speculative trading was performed on margin thanks to the abundance of cheap-to-borrow funds.

But I'm not sure that it is simply a low cost of capital that drove corporate earnings - and therefore share prices - up by 40% in 2005.

When all is said and done, the BoJ is moving slowly and, if anything, the yen is weakening, as the day when higher interest rates bite is effectively postponed.

The silver lining could well be an extension of the rally to Japanese and Asian stocks.

Editor's Note: Could the U.S. housing crash of 2006 be as bad as Japan's housing crash in the 90's? Check out Sir John Templeton's report. Go here now.

Commodity Corner

You hear so much about the actively traded and notoriously volatile gold market - but not so much about the silver market.

Perhaps over time, silver's become the poor relation!

But hold on just a second. In case you missed it, silver jumped 30% compared to gold's rise of 18% throughout 2005.

And as the commodity boom rolls over, the gains have become bigger and better still. Silver has kept going strong and is now up 45.5% since the start of last year. Gold is up 24.5% at the same time.

In the chart above, you can see that since metals prices took off in May 2004 the ascent has been pretty steep. Gold is up 140% while silver has skyrocketed 161%.

Silver is the least precious of the precious metals, and although it is mined directly, it's also a byproduct of gold, zinc, copper and lead mining. Of course silver is also recyclable.

The largest producers of silver are Mexico, Peru, the United States, Australia and Chile.

The metal is not only used in jewelry but also has a major place as an industrial metallurgy and in the production of photographic film. Indeed those three areas make up 95% of annual silver consumption.

Thanks to a variety of different properties - ranging from beauty to portability as coinage, conductivity and uses within electronics - silver finds itself filling a variety of roles, making it more than simply a precious metal.

In November 2004, a gold-backed ETF was launched, allowing buyers to invest in gold without actually owning it. The increased interest in gold as an asset drew more investors into this type of fund.

Now, Barclays Capital is awaiting approval for its new silver ETF.

According to the world's largest silver producer, Coeur d'Alene Mines Corporation, once it's launched, this ETF could add as much as 20% to current world mine production. That's because, like the Gold ETF, the fund is backed by actual silver.

The continued diversity of usage for silver is causing a depletion of above-ground stockpiles, which adds to demand and creates a robust market for silver.

Last week, silver futures in New York reached the highest price in 22 years when they touched $10.22 per ounce.

It's beginning to look as though silver is not just an alternative to bonds and equities - but also one for gold itself.

With the price of the May future closing at $9.94 this weekend, if there's one thing I wouldn't hesitate to buy on this decline in commodity prices, it's silver.

I reckon silver will trade at $11 before expiration.