The New Year has started with a bang with oil prices slumping by 10% and commodity prices following this lead. Even the safe haven of precious metals took a tumble with gold and silver prices suffering a similar sharp reversal.
Is this so surprising with an economic slowdown in the US and even an extremely warm winter hitting demand for energy? It should also be remembered that commodities do not move upwards in a straight line forever, and that bull markets undergo quite substantial corrections.
The gold market, for example, took a tumble from $200 back to $100 an ounce in 1975-6 before resuming its upward rise, not stopping until it hit $850 in 1980.
In the mid-1970s the commodities market corrected after global stock market and real estate crashes. It is arguable that commodities might be acting as more of a lead indicator this time, and that equities and real estate will feel the pain next.
Reality for realty
This would certainly square with an end to the current over long bull-run for equities, and the US housing crash that is in progress and could move to other realty markets. And both trends would impact further on commodity price levels.
However, the economic policy response to a Wall Street crash and real estate crisis will surely be a lowering of interest rates. That would lift bond prices but eventually this excess liquidity has to go somewhere, and with equities and real estate out of favor then commodities are the asset class most likely to benefit.
Global economies would then enter a period of stagflation like in the late 1970s with higher unemployment and inflation levels and lower rates of economic growth, combined with much higher commodity prices.
For oil producing countries the point to note is that a dramatic contraction of oil prices this year would most likely be short lived, and could be followed by a period of even higher prices leading up to a classic market blow-off and oil price spike. Other commodities would follow, albeit on varying cycles, probably with oil and silver out front as an investment class.
US dollar rebound
So where does that leave investors for 2007? Well the recent rally in the US dollar at the same time as the oil price has been weakening ought to be a cue.
US dollar strength could emerge as the contrarian trend of 2007, mainly because selling other asset classes will increase demand for the US currency which will be used as an alternative store of value. It has also to be said that the US trade deficit would be corrected on the demand side by a recession, removing this pressure on the US dollar.
Therefore holding cash until market conditions stabilize later in the year is probably the only sensible option. And at that point commodity bulls should re-enter the market, while equities may resume their bear market and real estate could enter one. There will be plenty of time to consider why in the next six months.