Throughout the day yesterday commodity prices soared as did the stocks of many companies who track in such goods, including the materials and energy sectors.  Later in the day, the rest of the market fell apart as the heat from these two sectors alone deprived all others of their necessary oxygen.  Technology names in particular took it on the chin.  We’ve seen this type of action on a couple of occasions in the last few weeks and it does raise our eyebrows a bit.  While we’re exposed to these sectors through our energy and industrial holdings, the fact that the rest of the market gets hit tends to be overwhelming.    

We continue to see a slowing economy.  But actions like yesterday’s get us to ask ourselves some questions.  Is the recent move in commodities simply money chasing price momentum in the absence of other things that are working or does it represent investors placing hedges against rising inflation risks?  It is clear that inflation has been higher than the Fed would like it to be, but it is also clear that speculation in commodities is at extreme levels.  Ironically, we’ve not seen the same magnitude of performance in the stocks of commodity producers and miners as we have in the commodities themselves in recent weeks.

Current inflation readings aside, a few things cause us to question the rise in commodity prices with a certain degree of skepticism.  First of all, with the exception of financials, materials and energy companies had the largest negative earnings surprises for the fourth quarter.  Most of the management teams from these areas have suggested on their recent earnings calls that while growth is still strong, the benefits of pricing power were beginning to fade, often leading to more difficulty in achieving top line expectations.  In addition, work done by ISI suggests that futures volumes in many commodities are currently running at the level of 14x world end market demand, substantially higher than their 3-5x historical norms.  Finally, energy inventories have been building in recent months at as much as 5 1/2x normal levels while actual worldwide demand usage has been falling.  While short term discrepancies like these can often occur over short periods of time, we believe they are more likely indicative of unsustainable speculative behavior not too dissimilar from what we saw in the private equity markets a year ago.   While the world economy can still influence demand, we can’t get ourselves to believe that it will completely offset the effects of our domestic slowdown and then some.  This may explain the discrepancy between red hot commodity prices and their more sanguine management teams.

With the domestic economy slowing, the moves in these names are a siren song to those who so desperately want something to work, particularly as they flirt with technical breakout levels as they have in recent weeks.  Unfortunately, the success of these areas, particularly if it’s too hot, literally sucks the life blood out of everything else, quite literally.  While we do have investments in these areas, we think the run has become a bit long in the tooth after many years of outperformance and thus question their sustainability, particularly against a backdrop of a slowing domestic economy and fundamentals that may be better elsewhere.