Commodity Supercycle: What Goes Up Fast Will Come Down Faster

As a kid, my father always cautioned me to be wary of fast success.

He stressed upon the fact that good things always take time. There is no fast and easy money in life, were his golden words.

Unfortunately, he passed away at a young age of 51. The most important lesson which I learnt from him was this...

'Whatever goes up really fast without a strong basis, will come down even faster.'

That's true for life as well as the financial markets.

These days when I look at the sheer velocity of rise in crypto currencies and commodities, I can relate to the wisdom taught to me as a child.

But at times, I ask myself...

'Is the wisdom outdated? Have times changed?'

May be during my father's time 15 years ago, there was no free money doled out by central banks which could boost prices of cryptos.

But then what gives me confidence, is legends like Warren Buffet and Charlie Munger having total disregard for assets classes like cryptocurrencies.

This is how Charlie Munger voiced his disdain towards crypto currency at the Berkshire Hathway AGM in May 2021.

• "I don't welcome a currency that's so useful to kidnappers and extortionists and so forth, nor do I like just shuffling out of your extra billions of billions of dollars to somebody who just invented a new financial product out of thin air. I think I should say modestly that the whole damn development is disgusting and contrary to the interests of civilization."

Let's look at some simple numbers about the recent madness around us.

Crypto Currency prices in Dollar	Dec-20	Jan-21	Feb-21	Mar-21	Apr-21	6 months return
Bitcoin	28,949	33,109	45,164	58,763	57,720	99%
Ethereum	735	1,312	1,418	1,918	2,771	277%
Dogecoin	0.004666	0.036841	0.048129	0.053744	0.336635	7,115%

Data source: Investing.com

I shared my view on cryptos in detail in this editorial - Invest in Cryptos at Your Own Risk

What is more disturbing to me is the rise in commodity prices.

The pace at which commodities are shooting up is startling.

Commodity (Prices in Dollar terms)	May 2020	May 2021	1 Year Change
Iron Ore	92	208	226%
Lumber Futures	367	1,440	392%
Copper	2.5	4.5	184%
Aluminum	1,475	2,400	163%
Soyabean	840	1,529	182%
US Corn	325	650	200%
Steel HRC China Futures	411	968	236%

Data source: Investing.com

Imagine what would happen to inflation if the commodity basket were up by 40-50% in a year and the prices stayed high?

A 40% rise in the commodity basket for a car or an air conditioner or mobile phone manufacturer would mean at least 20-25% price increase for the final consumer.

Majority of consumer durables and home appliances companies in their recent conference calls have indicated a price increase of at least 15-20% over the past 3-6 months.

The last time I checked, automobile companies have raised prices by 8-10% since January 2021 to cover the commodity cost inflation.

The most pertinent question is this. Can commodity prices sustain at the current elevated levels?

The one word answer is NO.

Let me give you an example of steel. It's the most talked about commodity recently.

China HRC steel prices are up 236% in the past 1 year.

Why?

China, the largest producer as well as consumer of steel, came out of the Covid crisis much earlier than the rest of the world.

To stimulate the economy, the Chinese government spent heavily on infrastructure. Demand from households too surged led by pent up demand.

In short, China which recovered faster as compared to other countries was consuming more steel than ever before.

In a few months after China reopening, as the 1^st and 2^nd wave abated, other countries too opened up faster than expected.

Demand rocketed due to the stimulus checks given in the United States and other developed economies.

In a nutshell, demand exploded globally led by China and followed by the US.

Metals like steel, aluminum and copper find their application in almost every product used. From a pen to an airplane, these metals are used everywhere.

However, supply didn't keep pace with the burgeoning demand.

Let us look at the supply situation.

Iron ore was in short supply due to lockdowns in all iron ore mining countries.

To add to this a cyclone in Australia and a closure of a mine due to dam burst in Brazil, resulted in a shortage of iron ore.

Thus, the price of iron ore went up.

Steel factories were also shut completely in many countries. After the reopening, it took time for these factories to ramp up production. Also, the issue of availability of iron ore and the rising prices persisted.

The result?

Commodity prices shot up beyond imagination.

However, this global supply and demand mismatch will normalise.

The similar logic can be applied to other commodities too. The rally is largely due to supply constraints. It's not due to a secular and structural global demand recovery.

I believe these prices are not sustainable. The current trend will put pressure on demand going forward.

What about the demand scenario in India?

After the 1st wave we did see a pent up demand in consumer durables and discretionary goods.

But would you buy a car paying 20% more while your income hasn't gone up proportionately?

Now I do agree, the windfall price increase in commodities (especially steel and aluminum) over the past one year has led to many steel companies reducing their debt.

But isn't the improvement in balance sheets already reflected in a 5x increase in stock prices?

Would you be comfortable buying steel stocks which are trading above their average 10-year price to book value?

All these commodity stories would have made sense 6-9 months ago when the valuations were literally one third of current multiples.

But not anymore.

To make money in commodity stocks, timing is the most important thing.

Timing is an art which few people can master. This is why a majority of investors have lost money in commodity stocks.

I believe in identifying fundamentally strong companies which have a strong runway for growth and are backed up by structural parameters.

This is why I don't recommend participating in the hysteria in commodity stocks.

What do you think dear reader? Write to me here let me know your thoughts.

Warm regards,


Aditya Vora
Financial Writer