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March 19, 2008

Picture du Jour: Commodities - Too Much Too Quickly?
by Prieur du Plessis

Can money trees in fact grow to heaven? It was certainly beginning to look that way when considering the frenzied surge of many commodities to new highs week after week.

The following table shows the strong performance of most commodities over various measurement periods.

Source: Plexus Asset Management (based on data from I-Net Bridge)

But the past few days have seen commodity prices pulling back from their lofty levels. What should one read in this?

Let's firstly consider a picture of the Reuters/Jeffries CRB Index, a basket of agricultural, energy, industrial metal and precious metal commodities.

Source: StockCharts

The graph only shows the last portion of the seven-year bull market in the CRB Index in order to illustrate the parabolic rise over the past six weeks, resulting in a heavily overbought condition. Considering a combination of technical indicators, a sell signal seems to have been given. Of special note are the Bollinger Bands where a top was made outside the top band, followed by a top inside the top band, indicating a trend reversal. A move originating at the top band often tends to decline to the bottom band.

Part of the reason behind the strong rise in commodity prices was undoubtedly the plummeting US dollar, but very strong underlying demand from especially emerging markets, together with a tight supply situation, has naturally been a primary driver. Although I am a strong believer in a multi-year uptrend, I am concerned about commodity prices having become detached from the fundamental picture over the short term in the light of the rather dismal global outlook for economic growth.

The graph below illustrates the close historical relationship between the annual change in the US Leading Indicators Index (blue line) and The Economist Metals Index (pink line).

Source: Plexus Asset Management (based on data from I-Net Bridge)

Unless one expects a turnaround in economic activity, it would seem that a breather of at least a few months could be on the cards for commodities in general.

Andrew Garthwaite, chief global equity strategist of Credit Suisse, remarked: "Sharply rising commodity prices may ... exacerbate a growth downturn, but eventually weak growth gets its revenge, as falling real demand triggers speculative liquidation."

Also emphasizing growth concerns, but specifically from an emerging-market point of view, Albert Edwards, co-head of global strategy of Société Générale, said: "The unfolding US consumer recession is likely to suck liquidity away from the emerging-market region as the US current account deficit declines and emerging-market accumulation of foreign exchange reserves slows sharply. As emerging-market asset prices slide and decoupling arguments evaporate, commodity prices will react sharply as recent speculative 'safe haven' froth unwinds."

I believe that irrespective of high demand from China and other emerging markets, commodity prices will remain cyclical and that it is only natural to expect periodic corrections within a long-term uptrend. Profit-taking/deleveraging by hedge funds may result in sharper sell-offs than otherwise, but negative real interest rates in the US should temper the downside potential. Different commodities, needless to say, will behave in different fashions, but in general one's approach should be to be patient and await better buying opportunities down the line.

Dr Prieur du Plessis
investmentpostcards.com

With 25 years' experience in investment research and portfolio management, Dr Prieur du Plessis is one of the most experienced and well-known investment professionals in South Africa. More than 1 000 of his articles on investment-related topics have been published in various regular newspaper, journal and Internet columns. He also published a book, Financial Basics: Investment, in 2002.

He holds the following degrees: BSc (Quantity Surveying) (Cape Town), HonsB (B & A) (cum laude) (Stellenbosch), MBA (cum laude) (Stellenbosch); and DBA (Doctor of Financial Management) (Stellenbosch).

Prieur is chairman of the Plexus group of companies, which he founded in 1995. Previously he was general manager: portfolio management at Sanlam, responsible for the management of investment portfolios with total assets in excess of $5 billion.

Plexus is a pioneer in the mutual fund industry and has achieved a number of firsts under Prieur's leadership. These include the authoritative Plexus Survey, a quarterly analysis of the consistency of the performance of unit trust management companies, the Plexus Offshore Survey, the Plexus Unit Trust Indices, and the PlexCrown Fund Ratings.

Plexus is the South African partner of John Mauldin, American author of the most widely distributed investment newsletter in the world, and also has an exclusive licensing agreement with California-based Research Affiliates for managing and distributing its enhanced Fundamental Index™ methodology in the Pan-African area.

In 2001 Prieur received the Santam/AHI Business Leader of the Year award for corporate leadership, business acumen and entrepreneurial flair. He was also profiled in the book South Africa's Leading Managers (2006). Plexus received the AHI/Old Mutual Enterprise of the Year award in 1997 and was also included in the book South Africa's Most Promising Companies (2005).

Prieur is 52 years old and lives with his wife, TV producer and presenter Isabel Verwey, and two children in Welgemoed, Cape Town. His recreational activities include long-distance running, motor cycling and reading. He belongs to the Cape Town Club, Johannesburg Country Club, Gordon's Bay Yacht Club and Swiss Social & Sports Club.

Copyright © 2008 Dr Prieur du Plessis

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