DECEMBER 24, 2015

Falling commodity prices are not necessarily bad for the US economy and certainly a falling commodity market since 2011 hasn’t stopped the US stock market from rising. But that might have changed recently.

When Low Prices Cause Serious Pain

The market has underestimated the demand erosion that China’s economic rebalancing created. Metal producers are awaiting a comeback in demand to meet the overcapacity built up over the past few years. Falling prices are not only hurting metal producers but any commodity producer. Especially, in the oil industry, which is suffering its biggest downturn since the 1990s.

With earnings down, a sharp cut in exploration and production investment has made more than  200,000 oil workers lose their jobs. Investors are well aware of it, and shares of companies in the energy industry have fallen over 40% since their peak last year.

XLE Energy Sector ETF down 40% since its peak. Source: MetalMiner analysis of @StockCharts.com data.

In addition to expectation that the two digit Chinese annual growth rate would last forever, almost a decade with borrowing costs near zero has led to a situation where there is still new commodity producing capacity yet to be built as well as existing capacity that doesn’t close and low-cost credit has permitted even unprofitable production to be maintained.

What Can We Learn From the Housing Bubble?

Housing prices in US peaked in 2005 and by 2008 prices had already come down more than 30%. But it wasn’t until the summer of 2008 when the US stock market crashed. The decline in prices and increased foreclosure rates in 2007 among US homeowners caused big financial institutions to declare bankruptcy. The economic pain and loss of jobs made equity investors throw in the towel and the stock market crashed.

US Stock Market Set For Trouble

We already pointed out last year that the stock market was topping out. Ever since, we’ve had over a year of choppy action. US stock indexes have shown only back-and-forth action, making 2015 a tough year for equity investors.

NYSE Composite Index acting like in 2007’s top. Source: @StockCharts.com.

This market action is typical before a meaningful move down. The smarter investors start to sell, while the not-so-savvy investors keep buying. This creates hesitation followed by up and down moves and some sharp declines (which we have already seen). Markets aren’t able to make new highs, forming a topping pattern, underscoring that sellers are starting to win the day.

I believe Chinese demand is not going to come back, lift prices and save producers’ businesses. The recent interest rate hike also means higher financing costs which could potentially accelerate production shutdowns as producers struggle to pay their debts. Similar to what we saw in the housing bubble, this will bring economic fear and loss of jobs.

We might need to see a wave of shutdowns to balance the oversupplied commodity market, triggering further sell-offs in US equities, which might eventually coincide with the end of this bear commodity market.

Source:MetalMiner