Online Stockmarket Trading Update

Historically, the relationship between stocks and commodities has been that when commodities prices increase, stock prices decrease and vice-versa. The primary reason for this is that inflation tends to drive commodities prices higher and stock prices lower.

Contrary to most global markets however, the Australian market tends to do better when commodities are on the rise.

S&P/ASX 200 (.AXJO – blue) overlaid with CRB Index (.CRB – red)

In the chart above we can see a positive correlation between the Australian market and commodities prices. The reason behind this correlation is that a large part of the Australian stock market is related to commodities exports, in particular raw metals and energy-related commodities. In the S&P/ASX 200 (which equates to 78% of the stock market) material and energy stocks account for 28.7% and 7.4% respectively. In other words, commodities-exporting stocks account for over a third of the top 200 companies listed on the ASX.

Logically, if commodities prices rise, domestic companies that export commodities would receive a higher value for the same quantity sold. Therefore stocks related to commodities exports will increase in value as their earnings increase.

On the opposite side of the trade, as commodities become more expensive, overseas consumers will pay more for the same quantity. This leads to demand for the Australian dollar increasing, which strengthens our domestic currency.

Australian dollar vs. US dollar: (AUD – blue) overlaid with CRB Index (.CRB – red) which is a measure of performance of a basket of commodities (19 worldwide commodity prices).

In the chart above, we can see the correlation between the Australian dollar and the CRB index. We also know that a strengthening Australian dollar coupled with a bullish stock market will attract risk-taking investors from overseas to invest in the domestic stock market.

When overseas investments increase, the demand for the Australian dollar will also increase, thus completing a virtuous circle. A virtuous circle is a complex of events that reinforces itself through a feedback loop and has favourable results.

In the meantime, more overseas investments in the Australian stock market would naturally boost it, leading to another completion of a virtuous circle.

Below we can see the relationship between commodities prices, the Australian stock market, the Australian dollar and overseas investors.

The reason behind movement in commodities prices

Commodities prices follow the simple rule of supply vs. demand. If supply stays the same and demand increases the goods will become rarer, and consequently more expensive.

As most commodities are priced in US dollars, we need to extract the strength of the US dollar from our data in order to study the movement resulting from the supply vs. demand law more accurately.

In this chart the US Dollar index (USD – blue) measures the performance of the US Dollar against a basket of currencies, overlaid with the CRB index (.CRB – red).

The CRB index mirrors the movement of the USD index. The commodities price increases whilst the US dollar becomes weaker, and vice-versa. The CRB index is negatively correlated to the US index.

To neutralise the impact of the US dollar’s strength, we can weight the commodities price with the US dollar index value following this simple formula: CRB * US index / 100.

Source: Reuters

As we can see on the weekly chart, from the end of the Global Financial Crisis up until January 2011, commodities prices rose steadily within a channel.

Within the global economy, demand for commodities is rising as developing countries, such as China and India, are increasing their consumption of raw metals or oil derivative products. However, supply is not rising accordingly. For example, petroleum-exporting countries registered with OPEC have agreed on exporting quotas, which will limit supply in order to increase their benefits.

We now understand that on a long-term basis global market demand is greater than supply, and following the supply vs. demand law commodities prices are increasing. Even though a long-term view of commodities shows prices rising, in the medium term the increase is not always achieved at a steady pace. External factors such as natural disasters or war can disturb the fragile balance between demand and supply. For example, if a war in a petroleum-exporting country arises, it will impact on the supply curve, which will lead to a rapid increase in the price of this commodity.

From October 2010 to January 2011 the US dollar-adjusted price of the CRB traded above its natural steadily rising channel. Unfortunately if the rise is sudden the demand will not adjust accordingly in the medium term, as importing countries are forced to pay more for the same quantity demanded. The demand will then lower until the price comes back to its equilibrium where it is globally affordable. In the chart above, we can see the decrease in prices at the end of April 2011.

Implication of a spike in commodities prices for the Australian stock market.

In the same way that an increase in commodities prices will benefit the Australian stock market, a significant decrease will cause it to plunge.

When commodities prices stop rising, the Australian dollar will follow the trend. Overseas investors will find that their earnings have decreased and will start to withdraw their assets, putting the stock market under bearish rules. As we now understand, the reverse for these patterns is also true.

S&P/ASX 200 (.AXJO – blue) overlaid with: CRB Index (.CRB – red), and Australian dollars vs. US dollars (AUD= – green).

The chart above shows that when the Australian dollar and CRB Index stabilised earlier this year, the Australian stock market plunged instead of stabilising too. Since commodities prices started to gradually increase at the end of June, the Australian dollar and the share market have tended to follow the trend.

Conclusion

After looking into the relationship between commodities prices and the Australian stock market, we can identify that while a globally sustainable steady rise in commodities prices will benefit the domestic share market, a quick upward shift in commodities prices, above the steady rising channel, will inevitably be corrected with a corresponding decrease. This decrease is certain to trigger big losses in the Australian share market.

There are no guarantees when trading, but investors could take a sudden upward shift of commodities prices as a signal to sell commodities-related stocks, as we now realise that the shift will not be sustainable.

By Bryce Dupuy

The information provided within this blog is general advice only and you should consult the services of a financial professional in order to ascertain whether the information is applicable to your investment strategies and risk profile.