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Do High Commodity Prices Signal Economic Recovery?

Do High Commodity Prices Signal Economic Recovery?
By Ron DeLegge, Editor
October 14, 2009

SAN DIEGO (ETFguide.com) – Don’t look now, but many key commodities have hit their yearly highs. Crude oil prices for November delivery on the New York Mercantile exchange crossed $75 per barrel and gold has stayed firmly above $1,000 per ounce.

  

Commodity permabulls like Jim Rogers see nothing but blue skies ahead. 

Rogers, in his usual alarmist tone, told Yahoo’s Tech Ticker he’s “quite sure” gold will hit $2,000 an ounce. Never mind that buying gold during the last recent gold rush resulted in a big fat goose egg. People that were unfortunate to try that experiment bought gold at $850 per ounce in 1980 and didn’t see levels close to that again until 2008. That’s 28 years of futility! But this time, according to the commodity bulls, things are different. 

Why are commodity prices rising and is it the signal of an impending economic recovery? 

It’s the Dollar Stupid
The swift fall in the U.S. dollar has created an opposite effect on commodity prices. Because commodities are priced in dollars, their value rises as the dollar declines. Because of the depressed state of the dollar compared to competing world currencies, it takes more dollars to buy fewer commodities today. When the dollar is strong, the opposite is true. 

This also explains, in part, the resurgence in commodities (NYSEArca: GSG) and gold (NYSEArca: GLD). The rise is not because people are necessarily using more commodities, it’s because the dollar has been so pitifully weak. 

Just how bad has the dollar performed? So many people in fact are now betting on a permanent demise for the dollar, your local grocer has probably alerted you about trading tips on the subject. A surprise counter rally can’t be that far off, can it?

Demand? From where?
Since May, crude oil (NYSEArca: OIL) has hovered between a trading range of $50 to $70 a barrel, but that’s only part of the story. The rest of the story is that demand for crude and gasoline is waning. 

This is confirmed to us by the behavior of the big oil people. 

Forced to recognize an unwelcome lack of demand for their products, oil refiners have been shutting down refineries in order to cut cost. They don’t want to get stuck with an oversupply of unused sludge. Someone will get stuck with it, but it probably won’t be them. My best guess is that it’ll be speculators that get oil pied in the face.   

Who’s Behind It?
What’s really fueling this rally? Is it market fundamentals or is it market speculation?

Over 100 years ago, Charles Dow – founder of the Wall Street Journal and inventor of the Dow Jones Averages – devised the Dow Theory to find the answer.

According to Dow’s calculations, the manufacturing and transportation sectors would mutually confirm a new bull or bear market. His idea was based on the premise that manufacturing profits are connected to increased production. Increased production would be based on higher demand which would be reflected by an uptick in shipping/transport activity. Are you following?

To Charles Dow, a bull market in industrials could not happen unless the Transportation Average (a measure of demand) rallied alongside the industrials (and vice versa). A harmonious rise would unequivocally confirm a strengthening economy. Anything else would be suspect.

What about now?

In September, the total U.S. railway carloadings declined 22% year-over-year. Contrary to the what the economist that have proclaimed “the worst is over”, this is a glaring sign of weak fundamentals. Furthermore, the divergences in performance between the Dow Jones Transportation Average (NYSEArca: IYT) and the Dow Jones Industrial Average (NYSEArca: DIA) are too significant to shove aside. You need to read, “Allow Me to Introduce: The Biggest Sucker Rally Since the Great Depression.” 

In summary, if you still believe that rising commodities are due to economic demand, I send you my personal congratulations. Can I interest you in some privately traded shares in the Golden Gate Bridge?

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