In the market, history often repeats itself. Although the second time around is never exactly the same as the first, knowing the past can help you make better decisions about the future.
In particular, the recent rapid rise in commodity prices has precedents. History shows that extreme moves in the price of raw materials affect the stock market in two stages.
First, when commodities rise too fast, their soaring costs suck profit out of the industrial economy. If the stock market cannot take this, it cracks.
Second, the market's fall scares consumers and prompts them to curtail spending; the ensuing reduction in demand for goods and services causes commodity prices to fall; and lower costs boost corporate profits and liberate money for investments, which often makes the market zoom.
Note that the above scenario holds only at extremes - when the rise and fall of commodity prices is very rapid. When the change is more moderate, other factors can be more influential.
Recently, however, we've seen just such an extreme move: Commodity prices - oil, copper, silver - had been on a tear, before topping recently. So what does this say about the market?
Let's look at two roughly similar periods from the past: 2007 to 2009, and the 1970s.
In 2007 and 2008, soaring Chinese demand caused a fast rise in commodity prices. By the end of 2008, the heavy cost burden on the world economy caused the stock market to crack. (Yes, the highly levered banking system and the housing bubble were bigger contributors to the economy's decline. But soaring commodities were, in my view, not just a trigger but also a prime culprit.)
In 2009, after the economy and the market had cratered, commodity prices had fallen, too. This, plus the U.S. Federal Reserve's massive money-printing, helped the market recover.
A similar roller-coaster ride took place nearly four decades ago. Following the 1973 Mideast war, the Organization of the Petroleum Exporting Countries (OPEC) decided to use oil as an economic weapon, and raised its price. Since oil is a big part of Western economic costs, the price shock caused the Dow to fall from 851 in October 1973 to 608 in July 1974. But then, as the economy weakened and oil prices fell, the Dow rose above 1,000 in April 1976.
Now back to the present. Over the last two years, as the Fed embarked on a quantitative easing program, commodities zoomed yet again. Since rising input prices increased corporate costs and sucked money out of the economy, I noted a month ago that I would be cautious on commodities. Recently we saw their prices begin to weaken.
Will they continue to slip? My contention is they likely will, especially since the Fed is now on the other side of the bet. While in 2009 it was printing money, it now plans to stop buying Treasury bonds at the end of June, halting the liquidity pump.
Meanwhile, China has been raising interest rates as well as margin requirements for banks. Any slowdown in China will put a damper on the world economy and cause commodity prices to slide further. This could make for a softer market in the short term, but once the economy begins to benefit from lower commodity costs, the market should eventually resume its rise.
Of course, there are differences between this cycle and previous ones. The main one is the Fed's position. In 2007-09, it could act forcefully by slashing interest rates; ditto in the mid-1970s. Today, with short rates close to zero, the Fed's scope for further cuts is limited.
Yet my conclusion is the same. If and when commodity prices fall sufficiently low and sufficiently fast, they can help the market recover and zoom. This would be particularly true if oil prices participate in the decline, because oil counts for the highest external burden on Western economies.
If the current scenario plays like past ones, we are facing a decline in commodities' prices due to looming economic weakness. But this decline, although it may first act as a drag on the stock market, should be very good for it long-term - especially for the market in large, high-quality U.S. stocks.
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