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Don’t shun commodities!

March 27, 2007

CRB Spot Index overlaid on Dow Jones Industrial Index

>>Commodities are in a secular uptrend likely to last another 10-15 years. The DowGold Ratio chart affirms this fact as does the chart above showing the long term historical performance of the CRB Spot Index* plotted against the Dow Jones Industrial Index.

>>Viewed down the diagonal line in the chart above, the performance of the CRB Spot Index and the Dow Jones Industrial Index has been antithetical to an uncanny degree.

 >> Given that western equities are in secular downtrend, there is every reason to believe, based on this unique historical relationship, that commodities are likely to continue trending upwards for a number of years yet.

>> The unique relationship between US equities and commodities makes them a great asset class for diversification purposes and lends themselves to a buy and hold ideology using a suitable commodity fund or well diversified portfolios of commodities.

>>The economic growth stories of India, China, Russia, etc all add credence to this view. Given that commodity infrastructure takes time to build, demand is likely to outstrip supply in the short term leading to higher prices.

 >>But don’t go in blindly: remember, there will be cyclical vacillations within this secular uptrend that will test your nerves  – as we are currently enduring. We never go up in a straight line.

Commodities undergoing a cyclical correction

CRB Index is currently in the cyclical bear phase of the secular uptrend – don’t lose faith!

>>Trading the cycles by participating in the bull phases of the cycle and avoiding the bear part increases the chance of profitability. Within the class of commodities some will be more appealing than others – especially the more liquid commodities (Copper, Oil, Gold, etc). Choose those commodities that appeal to you – both on a risk and return level.

>>Certain commodities(especially the more liquid ones traded by hedge funds) are more prone to unsustainable parabolic rises – owing to speculative activity as more and more traders and speculators catch onto the “hype”. Parabolic rises, while fun on the ride up often end in tears on the way down. This is only normal, as prices fall to more “fundamental values” to readjust to the long term story.

Copper has also exhibited parabolic rises

 Copper has exhibited bouts of parabolic price** rises fueled by speculative price action

Gold prices parabolic indicating speculative activity

Gold has also exhibited parbolic price rises** over the period 2005-2006, explaining why it has been very volatile since, attempting to adjust to more normal levels.

>>Investors needs to be cautious of such activity which, unfortunately, results in high volatility especially if adopting a “buying and hold” strategy for commodities.

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*The CRB Spot Index is a bellweather for Commodities and more information on this can be found from the creators

** Parabolic rises are easily identifiable by their charcteristic rocket-like rises. They can also be identified by calculating the deviation of the price action from some mean value – in the chart of gold and copper above, the deviation from the 200D MA has been calculated and the results compared to the long run history. It is observable that during parabolic rises, the deviation of price from its 200D MA surpases two standard deviaitons – a truly rare event(statistically!)

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