If The Economy Is Truly Weakening, Commodities Should Be Vulnerable

• The Long-Term Trend for Commodities Remains Bearish
• What the Stock Market is Telling Us About Commodities
• Short-Term Picture Not So Strong

Recently, we have seen several reports of a weakening economy. These include a sharp drop in both the University of Michigan and Conference Board consumer sentiment and confidence numbers, along with some deterioration in the ISM manufacturing reports. Since commodity prices are very much influenced by swings in economic activity (and are themselves an economic indicator), it’s worth taking a look at the longer- and shorter-term technical position of the CRB Composite to see whether that picture is consistent with the deteriorating consumer numbers.

The Long-Term Trend for Commodities Remains Bearish

The CRB Composite peaked in the summer of 2008 and has been zig-zagging down ever since. In 2016, it broke below a multi-year support trend line and, aside from a brief period last year, has remained below it ever since.  The Index recently violated a 3-year uptrend line and crossed below its declining 12-month MA. The solid red arrows flag long-term KST peaks that were each followed by a meaningful decline. The dashed arrows flag false negatives. The latest sell signal was triggered in the middle of last year. Even though the Index has been in a trading range for the last several years, these negative long-term indicators argue that a primary bear market is still in force.

Chart 1

Chart 2 shows what would have to happen to generate a bullish signal. In the past, all major bottoms have been signaled by an upside reversal in the long-term KST. One signal in 2014 was followed by a disappointing rally and very unfortunate decline, but the vast majority were followed by a valid bull market. In order to have a high degree of confidence that a new bull market has been signaled, several events would need to transpire. First and foremost, it would be important to see a KST reversal to the upside. The second requirement would be a month-end close above the previous high (around 203). Such action would also result in a move back above resistance at the extended red breakdown trend line. Finally, in order to reverse the long downtrend that began in 2008, we would need to see the Index push above its secular downtrend line at around 220. Until at least the 203 area is bettered, it would be wiser to adopt a cautious stance.

Chart 2

What the Stock Market is Telling Us About Commodities

Chart 3 offers us the stock market’s viewpoint in the form of my Inflation/Deflation ratio. This indicator divides an index of inflation-sensitive stocks, such as resource and basic industry sectors, by another index comprising sectors that do well when the economy is in a deflationary phase. The chart clearly shows that the Inflation/Deflation series is fairly well correlated with the CRB Composite. Moreover, this ratio has a habit of leading the CRB at major turning points. Previous instances have been flagged by the dashed right-sloping arrows. Equities do not lead in every cycle, as we can see with the solid arrow at the 2008 peak. Generally speaking, though, players in the stock market smell out forthcoming changes in the commodity pits. One educational point to note is that false breakouts are often followed by above-average price trends in the opposite direction of the original signal. A classic example appeared in 2014, where the temporary joint upside break was followed by a very nasty decline in both series.

Chart 3

Another lesson to be learned from this CRB/inflation/deflation relationship is that a rising trend for both series tells investors to emphasize inflation hedge assets, while a falling one is more appropriate for interest-sensitive and other deflation-sensitive vehicles. Currently, both series are in a primary bear market. Note that the KST for the ratio (plotted in the bottom window) is also declining. In the past, joint breakouts by the two series above or below their respective downtrend or uptrend lines have afforded useful signals of a reversal in the CRB Composite's fortunes. Note that another potential setup is being formed at present. The line for the CRB Composite is just below the 203 level, as discussed earlier, while the line for the equity market ratio is around .25. Remember that this can be plotted by dividing my Inflation Index (!PRII) by the Deflation Index (!PRDI). Both series are updated after the close of trading on a daily basis. It is easier, though, to update the chart by clicking on it and saving it to one of your chart lists.

Short-Term Picture Not So Strong

The shorter-term picture is portrayed for both series in Charts 4 and 5. Chart 4 shows that the Inflation/Deflation ratio is very close to a downside break. Note that such a possibility is enhanced because both KSTs are in a negative mode.

Chart 4

Chart 5 tells us that the CRB Composite recently bounced from a major support trend line. Short-term momentum is still rallying, so a downside break may be avoided.

Chart 5

However, Chart 6 compares the CRB Composite to an indicator that monitors a basket of commodities registering net new highs over a 10-day timespan. The red arrows show that when it peaks from an overstretched level, as it has done recently, the CRB usually experiences some form of short-term decline. That observation argues in favor of a test of that red support line.

Chart 6

Chart 7 indicates that the 9-day RSI was recently at an overbought reading and backed off. If this is truly a primary bear market, it would seem likely that the Index will remain extremely sensitive to overbought readings and head lower in the immediate future. If it isn't, however, and the potential reverse head and shoulders is completed, that could be the first step in reversing to a bull market.

Chart 7

Good luck and good charting
Martin J. Pring

The views expressed in this article are those of the author and do not necessarily reflect the position or opinion of Pring Turner Capital Group of Walnut Creek or its affiliates.