Markets

Where are commodities in the sentiment cycle?

The role that investor behaviour plays in the evolution of asset prices is often underappreciated, but looking through the lens of the sentiment cycle could help shed some light on what the future holds for commodities.

25/01/2016

Malcolm Melville

Malcolm Melville

Wealth Preservation Manager

Commodity prices, as measured by the Bloomberg Commodity Index, have been falling for five years and are firmly out of favour.

However, in the context of the sentiment cycle – illustrated below - we might be able to better understand where commodities really are.

Commodity capitulation

The “acceptance” stage of the sentiment cycle is often characterised by a continued fall in prices. However, it is also the phase in which the market comes to understand why prices have fallen and when it starts to question the long term viability of the asset class.

This appears to be the stage commodities reached early last year. The market had accepted the slowdown in the Chinese economy as the “why”, and press coverage often focused on the end of the commodity “super cycle”.

We believe that commodities entered the “capitulation” stage mid-2015; defined as a period in which substantial losses occur and the long term outlook for the asset class is perceived to have changed for good.

Funds often close, and the press is full of stories about the risks of the asset class and its dire future.

Feeling that they understand what is happening; the logical action for investors seems to be to withdraw from the asset class.

Commodities have since moved further through the cycle into “out of fashion” evident by little interest in the asset class.

Seeing through the sentiment fug

It is at this point that it is important not to get caught up in the negative headlines that surround “out of fashion”, but to think ahead to the next stage of the cycle.

Once an asset is in out of fashion, it’s much closer to the end of the sentiment cycle than it is to the beginning.

The optimal time to buy is when an asset emerges from the “out of fashion” phase.

Don’t throw in the towel

The approach now should be to look for signs that the worst is behind. Picking the exact bottom in any bear market is extremely difficult, but some signs are emerging that that point is approaching.

Out of Fashion can finish with a final blow that takes prices lower than many expect and forces the last few bulls to throw in the towel. Oil appears to have gone through this process in early January.

After the final wash-out, prices start to recover, but in contrast to previous stages in the cycle, the market dismisses the bounce as a correction in an ongoing bear market. In short, everyone gives up.

Looking for green shoots

Another sign to look for is differentiation within the asset class. In 2011, agricultural commodities peaked in March, followed by metals in April and oil in May.

Over the last few months some agricultural prices have started to stabilise while metals and energy have continued to fall. Is this the first sign that we are approaching the end of the commodity bear market? It can’t be guaranteed, but it’s an encouraging sign.

Commodities have come a long way over the last five years. Tentative signs are emerging the out of fashion phase may be reaching its conclusion. Perhaps the mindset should be to revisit the asset class.

Important information: The views and opinions contained herein are those of the author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This article is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Past performance is not a reliable indicator of future results, prices of shares and the income from them may fall as well as rise and investors may not get back the amount originally invested. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA, which is authorised and regulated by the Financial Conduct Authority. For your security, communications may be taped or monitored.