Will Commodities Outperform Stocks?

By Michael Sabo ISSUE 806 | June 2009

The stock market rally in March, April and May has brought a renewed interest in stocks. Some believe that the stock market has seen a bottom and many are ready to get back on board, but I wouldn’t be so quick to call a bottom. I strongly believe that investors looking to diversify and traders looking for opportunities will find many more in the commodity markets than in stocks.

The stock market has seen some substantial gains in the past months, with the S&P 500 reaching a new high for the year. Part of the reason for the equity rally has been attributed to a few improved economic reports.

In order for a full economic recovery to occur, the housing market needs to improve more substantially. Housing, which led us into the recession, is the main factor that will lead the economy out of the recession. At this point, I’m still not convinced that we’ve solved the fundamental problems in the housing market. Foreclosures and delinquencies have continued to rise.

What about a recovery in the banking sector? Banks are now operating under different rules. Accounting rules have been changed so that banks can report their toxic assets differently. This only creates a balance sheet that looks better than it really is. I’m not buying it. Seems like a lot of smoke and mirrors.

Given that some of the major problems have yet to be solved, I think the average investor needs to be careful in buying into this stock market rally. There is no need to chase it. Who’s buying stocks at these levels? There’s certainly some institutional buying. There are also some short sellers who have been squeezed out of the market in recent weeks. But I wouldn’t expect this rally to go on for a prolonged period of time.

Many fundamentals of the economy are keeping us from exiting the recession. Mortgage rates are beginning to climb, a bad sign for the housing market. The jobless rate has continued to increase; most economists expect the unemployment rate to reach nine percent at some point this year. Personally, I think unemployment will reach 10 percent by next year. Consumer confidence is up slightly. But if we start seeing gas and food prices climb, goodbye to that confidence. I think the economy is set up for stagflation, a combination of an economy that is not growing (stagnant) and inflation. Eventually, construction and housing will lead us out of the recession, but in my opinion, it’s not going to happen any time soon.

A Strategy for Rising Inflation

The U.S. dollar has been getting killed lately and I expect it to continue its decline. All this money that is being printed due to government stimulus should continue to weaken the U.S. dollar and lead to inflation. That should push commodities higher across the board.

In addition to the inflation factor, many of these commodities have positive supply and demand fundamentals that can push them higher. Sugar production is estimated to be at the lowest on record. Many corn farmers are having trouble getting their corn in the ground because of a cold, wet spring.  

If you’re expecting the U.S. dollar to decline in value and inflation to rise, you may want to consider taking a position in the gold market. I’m not a doom-and-gloom person, so I don’t recommend throwing all your assets into gold, but I do expect to see a continuation in the current rally.

There are a number of ways to take advantage of a rise in the price of gold. There are simple ways to get involved (such as buying bullion), but there are also more strategic ways to position yourself.

One strategy you might consider involves positioning yourself in an options ratio spread. To illustrate this trade, I will use numbers that were current as of this writing. Market prices are constantly changing, so think of this example as a way of explaining the mechanics of this option strategy rather than a specific recommendation. If you would like updated numbers, you are more than welcome to call me directly at 800-798-7671.

Here is an example of a gold ratio spread trade:

• Buy one $1,000 call at about $33.50
• $100 x $33.50 = $3,350 trade cost (not including commission)
• Sell three $1,100 calls at about $12.50 each
• $100 x $12.50 x 3 = $3,750 collected in premium (not including commission)

Please note that each gold contract involves 100 oz., so a $1 move in prices is equivalent to $100.

In the above scenario, look at your cost and the amount of premium you collect. This trade would leave you with a credit of $400 in collected premium (not including commission costs).  

These options expire on July 28, 2009, and the goal of this trade is for gold to rally past $1,000 an ounce and continue toward $1,100, the sweet spot.  Under ideal circumstances (if gold gets to $1,100) you can potentially make $100, or $10,000.

Watching Your Risk

The risk in this trade occurs when the market rallies above $1,100. But what if the market doesn’t rally? If gold declines to $800, for example, both options expire worthless and you keep the $400 in premium, minus your trade costs. However, if the market breaks $1,100, we get into risky territory, but all is not yet lost. Your breakeven on the upside is $1,150. To sum it up, your goal in this trade is the expectation that gold will rally above $1,000, but not above $1,150 before expiration on July 28, 2009.

Just like any other trade, there are ways to manage your risk depending on how the market moves. You don’t just set it and forget it. Much of how you manage this trade depends on how quickly the market moves up or down.

This ratio-spread offers a good strategy if you think gold will be in the range of $1,000 to $1,100 before the end of July. However, if you think gold is going to rally above $1,100 in this timeframe, call me to discuss a strategy that you can use to position yourself with calculated risk on the upside.

Gold is one of many commodities that I expect to outperform the stock market going into the end of the year. Be wary of sharp rallies in the stock market. The U.S. government stimulus and the actions of the Federal Reserve could easily lead to inflation, a bullish factor for all commodities. Combine that with favorable supply and demand factors, and commodities may be the best place to realize gains in these volatile markets.

Michael Sabo is a Senior Market Strategist with Lind Plus, the broker-assisted division of Lind-Waldock. He can be reached at 800-798-7671or by email at msabo@lind-waldock.com.

Kristina Zurla Landgraf is editor of Lind eWire. She can be reached at editor@lind-waldock.com.

Futures trading involves substantial risk of loss and is not suitable for all investors.

Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.

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