Profiting from a Bearish Bet on Commodities

It was a terrible week in global stock markets with the Dow Jones down 2.74%, the S&P 500 tumbling 3.14% and the NASDAQ dropping 4.45%. Surprisingly, the MCSI Emerging Markets Index was down only 1.87%.

You were stopped out of three positions in your Bull Market Alert portfolio: Flextronics International (FLEX), United Rentals, Inc. (URI) and the iShares Transportation Average (IYT), all at a loss.

The market pullback was worse than I anticipated. Market sentiment actually ranked a “1” on my favorite summary of these indicators — the lowest I have ever seen.

If you’re a diehard contrarian, this is the time to “buy, buy, buy” in anticipation of a sharp snapback.

That said, this week I am not going to recommend for you to do that.

This week’s Bull Market Alert recommendation switches gears to try to seek to profit from prices going down through a bearish bet on commodities by (shorting) selling the PowerShares DB Commodity Index Tracking Fund (DBC).

DBC is the largest commodity-related exchange-traded fund (ETF) and tracks a broad basket of the 14 most heavily traded commodities. These include Light Sweet Crude Oil (WTI), Heating Oil, RBOB Gasoline, Natural Gas, Brent Crude, Gold, Silver, Aluminum, Zinc, Copper Grade A, Corn, Wheat, Soybeans and Sugar.

As the chart below confirms, commodities in general, and DBC in particular, have entered into a freefall since the start of September.

Brent Crude dropped almost 24% since midsummer, despite perennial unrest in the Middle East, thanks in part to increased production of shale oil in the United States. The Bloomberg industrial metals index is down 37% from its post-crisis high. Gold is down 38% since its high in 2011. Even U.S. farmers are harvesting a bumper crop year, with record corn and soybean crops pushing the prices of those agricultural commodities down.

Here’s why I think commodities prices are set to fall further.

First, the much-vaunted commodities super cycle is over. I wrote about the end of that boom back in 2012. After meandering in a trading range, the collapse of commodity prices really started to accelerate since the start of September.

Second, global demand for commodities is dropping as much of the world’s economy is sluggish. The International Monetary Fund (IMF) recently cut its global growth forecasts for 2014 and 2015.

The IMF announced it expected global growth to be 3.3% in 2014, 0.4 percentage points lower than in April and 0.1 points down on interim forecasts made in July.

Third, don’t expect China to jump into the breach as it has in the past. It turns out a good chunk of China’s commodity demand was due to a bit of financial engineering known as the “collateral trade.” Commodities of all types shipped to China have been used as collateral via the shadow banking system to finance other investments offering higher returns — in particular, property. Instead of being used for something productive, many commodities have been stockpiled with over 100 million tons of iron ore tied up in finance deals.

You can short commodities directly by buying the ProShares UltraShort Bloomberg Commodity (CMD). But that is a small and illiquid ETF and is not my formal recommendation this week.

It is better to just short (sell) PowerShares DB Commodity Index Tracking Fund (DBC) and profit as that continues its downward trend. Set your buy back stop on DBC at $23.75.

If you want to play the options, buy the January $23.00 DBC put options (DBC150117P00023000), which will rise in value as the price of DBC falls.

Portfolio Update

Visa Inc. (V) lost 3.31% last week. It was a week where the Dow Jones Industrial Average itself lost 2.74%. Visa was one of the “better houses on a bad street” last week. Visa will report earnings on Oct. 29, after markets close. V is a HOLD.

Gilead Sciences Inc. (GILD) fell 2.62%. The Food and Drug Administration cleared GILD’s new hepatitis C cure, Harvoni, last Friday. This medication could be used for the treatment of over three million cases of this disease and costs $1,125 per pill. A typical treatment regime is 12 weeks, or $94,500. Harvoni’s “sister pill,” Sovaldi, fetched $5.8 billion in sales for the first half of 2014. Harvoni will likely be another huge win for GILD’s bottom line. GILD is expected to report earnings on Oct. 28, after markets close. GILD remains a BUY.

Bank of Ireland (IRE) tumbled 8.84% last week as investors threw the baby out with the bathwater in selling risk assets across the board. With the Irish economy now recording rates of economic growth not seen since its days as the “Celtic Tiger,” this sell-off is about as unwarranted as you can see. Still trading below its 50-day moving average, Bank of Ireland is a HOLD.

P.S. Join Me for the World MoneyShow London, Nov. 7-8

I invite you to join me for The World MoneyShow in London, Nov. 7-8, at the Queen Elizabeth II Conference Centre. I will be presenting on Saturday, Nov. 8, 3:30 – 4:30 pm. Register at no charge by calling 1-800-970-4355 and identify yourself as a Nicholas Vardy subscriber by mentioning code 036913 or by clicking this link and following the instructions.