04/13/16   The Cure for Low Prices

Editor’s Corner

Ron Rowland

There is an old adage among commodity traders that goes, “the cure for high prices is high prices.” The underlying meaning is easy to comprehend—as prices move higher and higher, more supply will enter the market and eventually drive prices lower. Similarly, the cure for low commodity prices is low commodity prices.

If corn prices are high, then farmers will dedicate more acreage to corn next planting season. If iron ore jumps in price, idle mines will be restarted and new mines brought online. If prices fall too low, then production will be curtailed, eventually causing higher prices. It all comes back to the immutable law of supply and demand.

Gold is often thought to have a relatively fixed supply and yearly consumption that is nearly equal to annual production. Some estimates put the amount of unmined gold in the world at about 50,000 metric tons. With gold trading above $1,250 an ounce, there is enough known gold in the ground to solve many of the world’s financial problems. However, it is not that easy.

First, there is the cost of production. Some gold deposits can be easily mined and brought to market for less than $500 an ounce, and these are currently quite profitable. Some deposits are more difficult to access or consist of low grade ore, and they can cost $1,000 an ounce to mine. Whether or not these mines are profitable depends on other expenses and company overhead. Other deposits may require gold prices to be above $2,000 an ounce for profitable extraction. These deposits will continue to be in the ground for many more years.

The second consideration comes back to supply and demand. As the price of gold moves higher, the quantity of mines operating at a profit also increases, which in turn brings more supply to the market. Likewise, if those mines with a $500-an-ounce cost structure flood the market with gold, then the $1,250 selling price could come down. If the price of gold falls to where many mines cannot operate at a profit, then production will plunge, supply will dwindle, and prices will eventually move higher.

A few years ago, extremely high crude-oil prices spurred a wave of new production techniques that radically increased supply and drove prices from above $150 a barrel to below $30 a barrel. Even though consumers enjoyed the discounts, the price turned out to be too low for the global economy. In addition to putting financial pressure on most companies in the oil business, it also wreaked havoc on the financial conditions of oil-rich countries.

The current market environment is a case of low oil prices being the cure for low oil prices. Recently, oil supply was far outpacing demand, and many countries were considering production cuts. In the meantime, many of the new oil-production techniques that were highly profitable at much higher oil prices were being shut down once they started pumping red ink. The result: today we have lower production, lower supply, and prices back above $40 a barrel.

Commodity markets tend to be self-correcting, although the time frame is far from instantaneous, and many companies and investors can get hurt in the interim. In the current economic cycle, this concept is not evident in the world of interest rates. Economists have long thought that low interest rates would be a cure for low interest rates because low interest rates should stoke inflation, which would then be attacked with higher interest rates. Perhaps this theory just needs more time to play out, but there has been no supporting evidence in the past seven years.

Investor Heat Map 4/13/16

Sectors

The sector rankings are scrambled from a week ago, creating a new leader, a new bottom dweller, and a fast climber. Materials jumped three places to steal the leadership from Telecom, which dropped to fifth. Many segments of the Materials sector are performing well as key commodity prices begin to come out of their slump. The pullback in Telecom is not too severe given the magnitude of its recent run-up. Real Estate ascended to the second-place spot by swapping places with Utilities. Energy is this week’s big mover, surging from last place to fourth. Crude oil trading back above $41 has been a boon for the entire sector. Consumer Staples and Industrials both lost momentum but were able to hold their ranking positons at sixth and seventh, respectively. Technology was another sector losing ground, and it skidded three places lower. Consumer Discretionary slipped a notch lower, Health Care held steady, and Financials dropped two spots to now occupy the basement.

Styles

Given the massive changes in the sector rankings, this week’s changes among the style categories seem rather muted in comparison. The top three categories are unchanged with Mid-Cap Value extending its stay at the top to six weeks and increasing its margin over Mid-Cap Blend. Large-Cap Growth lost some strength, and instead of having third place all to itself, it now has Mega-Cap and Large-Cap Blend as challengers. Both Mega-Cap and Large-Cap Value climbed two spots to reach their new positions and put a large-capitalization hue on today’s style rankings. Mid-Cap Growth suffered the largest negative change by falling four spots. Smaller capitalization categories continue to lag, and the bottom three spots are once again held by Small-Cap Blend, Small-Cap Growth, and Micro-Cap.

Global

Latin America reasserted its strength to remain unchallenged for the leadership role of the global rankings. Brazil was a major upside contributor as its stock market favors the prospect of impeachment proceedings against President Rousseff. Canada, benefiting from strength in oil, gold, and its currency, has a solid lock on second place. Emerging Markets rounds out the trio at the top for a third week. Last week, the U.S. climbed a notch to secure fourth place and now finds itself being challenged by Pacific ex-Japan, China, and World Equity. Both Pacific ex-Japan and China climbed a notch, while World Equity fell two places. The four lowest-ranked global categories were in red last week, and the U.K., EAFE, and Eurozone successfully made the transition to green. Japan had a large bounce, but for now, it remains the only equity category still in the red.

 

Note:

The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.

 


“Supply and demand. That’s it.”

Economics as taught at Father Guido Sarducci’s Five Minute University, a comedy skit by Don Novello on Saturday Night Live (1980)


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