Top Gun FP Client Note: Commodity Crack-Up May Signal Start Of Larger Correction

NOTE: Every week or two I write a Client Note for my clients.  For a limited time, I am allowing non-clients to sign up and receive it at the same time as my clients.  You can sign up at the top right hand corner of the website.  I will also be posting the notes on my blog with a time delay from time to time.

Originally sent to clients May 17.

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Financial markets have been in correction mode since the start of May led by commodities.  Silver has dropped $15 (more than 30%) from $48 to $33.  Oil has dropped almost $20.  Copper is down about 60 cents from its mid-February high to around $4.  As a result, the commodity stocks which had led the stock market since September (see “Top Gun FP Client Note: The Limits Of A Commodity-Led Stock Market”, April 24, 2011) have led it on the downside the last 2+ weeks.

 

There are a number of different views about what this means.  Some – apparently including SAC’s Steve Cohen – believe this represents a buying opportunity in commodities and commodity stocks.

 

The most popular view holds that the end of commodity leadership will result in a rotation into industrials, consumer discretionary, technology and other sectors which benefit from lower commodity prices.  These sectors will take the baton from commodities and lead the bull market going forward.  David Bianco, Chief US Equity Strategist at B of A-Merrill Lynch, succinctly expressed this view on CNBC’s Closing Bell last Wednesday.  Jim Cramer took this position on Mad Money last Wednesday as well.  Thomas Lee, Chief US Equity Strategist at JP Morgan, is also of this persuasion.

 

Finally, there are those who believe the commodity crack-up is the beginning of a larger correction.  At the same time commodities have been selling off, the $ has been rallying.  The Dollar Index is up 3.5% and the $ has gained 7 cents (almost 5%) against the Euro since the beginning of May.  Because of its foundational role in the global currency system, the $ is a true barometer of risk taking/aversion.  Taken altogether, the market action suggests to me a reining in of risk by market players.  It is surely no coincidence that this risk aversion coincides with the coming end of QE2 at the end of June.