Based on the recent bloodbath commodities and commodity-based stocks have suffered, it might be a good time that commodities paraphrase a Mark Twain quote and declare - "The rumors of our demise have been greatly exaggerated."

After a couple of weeks where the energy and materials heat map are a sea of deep red, it is incumbent for investors to seek to understand what is happening that causes this kind of nose dive. In some cases, it isn't always easy to understand the narrative that is pushing a sector upwards or downwards. The current narrative with commodities is an easy one to decode: Commodities have had a good run over the last few quarters in this high inflation environment, but with the Fed committed to tightening the screws and recession very much on the horizon - demand for commodities is going to fall, bringing prices down with it which will eat into the margins of all commodity producers.

Personally, I remain as bullish as ever on almost all commodities. Generally, when most people are saying one thing, but I am seeing something else, I try to start with the assumption that most likely I am missing something. I will freely admit that the thinking that "commodity prices are heading for the toilet due to the coming recession" narrative is a very sensible line of thinking. If you look at the historical precedent, there is ample evidence to back it up. Over the past 40 years, there has been a strong correlation between the transition of the global economy from a period of growth to contraction on one hand and a dive in commodity prices on the other hand. Not only does historical precedent support the narrative, but it logically makes sense too. If we assume that there are properly functioning commodity supply chains, then it is perfectly logical that the supply chain (from production to delivery to consumers) would be tuned in such a way to accommodate anticipated future growth. But if that growth disappears and is replaced by contraction, the obvious conclusion is that the supply chain would very quickly move into a state of oversupply and commodity prices would have to adjust very quickly downward to limit the bleeding. 

I get why this all comes across as a really compelling argument and why it has resulted in a bloodbath among commodity-based stocks. BUT... tapping into my inner-Paul Harvey, we need to look at the rest of the story. 

Even with 40 strong years of evidence supporting the correlation between the growth-contraction transition with plummeting commodity prices, if we zoom out beyond those 40 years, the relationship (which works in conjunction with the Philips Curve) is even deeper and can be seen going back at least to the 1860's. But, there is one major and important exception to that strong historical correlation... 1970's Stagflation.  

References to stagflation are all the buzz these days. For the last several decades, stagflation was relegated to the status of an antiquated economic condition that had the same likelihood of coming back as plaid suit coats, super-wide ties, and corduroy bell-bottoms. Purveyors of modern monetary theory suggest that we learned the necessary lessons from the 70's and stagflation can be relegated to the history books. But there is a reason why the prospect of stagflation has become a new buzzword. Working through recessions are painful, but it is something that has been regularly done. Working our way through higher inflation is painful, but that is also something that has been regularly done. But working through an environment where there is economic contraction at the same time as high inflation/high unemployment is a nightmare scenario. That is because the traditional medicine for solving recession is loosening monetary policy (create a pro-inflationary environment), while the approach for handling inflation is to induce a recession (tightening monetary policy). Stagflation is not just a really bad recession or really high inflation, it is an economic condition that defies almost all of our generally-accepted economic models. There is a reason people still talk about stagflation more than 40 years later. I know this is ECON 101 for most of the well-informed investors on CEO.CA, but I appreciate you all humoring me as I build up the pieces to the point I really wanted to make here.

There are those moments when the old paradigms and rules of thumb are no longer applicable or sufficient to address a new or unusual circumstance. Stagflation is one of those circumstances.  The real question is whether we are heading into a normal recession/inflation cycle (where each is a counter-pull on the other), or is this going to be second outlier like the 1970's. Standard probability says that you should bet on the normal cycle. But I think that model has become flawed and invalid because it makes the faulty assumption that there is sufficient commodity production capacity/supply in the pipeline so that if there is a quick reduction in consumer demand that the markets for all these commodities will automatically transition into an oversupplied state. That is where the rude awakening is going to come. The criminally negligent disregard for developing future supplies (particularly domestic) for commodities (especially in the mining sector) will prevent the market from transitioning to an oversupplied state except in the really horrific case of a super-severe economic meltdown (i.e. 1929-style). 

Most of the economic prognosticators are banking on a slight-to-moderate economic turn to the negative causing major price reductions in commodity markets. Because the future drop becomes expected, the speculative market gurus have tried to jump the opportunity (selling out of their commodity positions) resulting in a short-term reduction in commodity prices. As they have jumped the opportunity to sell early before the predicted price crash, that act has caused commodities to drop which reinforces their confirmation bias.  

My guess is that it will only take a couple months (up to a year) for those same prognosticators to begin realizing how fundamentally dysfunctional the commodity markets are and how current production capacity is simply incapable of meeting demand even in a recessionary economic environment. We are already beginning to see this to a certain degree. There has been some demand destruction for gasoline already (people are driving less, organizing schedules to be more economic, or taking other actions to limit gasoline consumption). But even with some of the demand destruction we have seen, production and refining capacity for oil (particularly refining capacity) still can't keep up with the lower demand. When the full realization that a downturn will not be causing commodities to become oversupplied hits, the narrative will quickly overreact and shift in the opposite direction. The reluctant acceptance that taming inflation is going to require more than tinkering with the interest rate dial will be the trigger that causes future high-inflation expectations to get baked into every economic decision and the consumer forces start becoming counterintuitive and pushing hard against what is trying to be done with monetary policy. Political expectations for the government to bail out those that are caught in the fallout of stagflation will result in fiscal policy acting in direct opposition to monetary policy. And we haven't even got to the public debt bomb that is primed to explode as we come to the realization that severe monetary restriction (very high interest rates) are needed to control the inflation monster.

With all that said, that is why I am still very bullish on gold, precious metals and most other commodities over the long haul. Nevertheless, I believe there is still some more pain ahead (except for energy which will have its own political problems) in the near term (3-6 months). Even though the long term bull thesis for commodities is sound, there are institutional forces driving a counter-narrative that are very powerful, even if the narrative is wrong. Confirmation bias is a formidable force and it takes overwhelming evidence to overcome it. It is going to take some real intestinal fortitude for us diehards to stay in this sector. Things that look like amazing undervalued opportunities might be even more amazing a few months from now. But those further drops when you thought there was no way it could possibly go any lower will make even the most ardent believers begin to doubt. My crystal ball says 3-6 months before we see the narrative change. But that best guess is exactly that... an educated guess. While I feel strongly about the outcomes that will ultimately happen, I am not as confident on the timeframe. It could happen in a month or 3 years. But my sense is that we really need to fortify our resolve and buckle our seat belts because the road to the promised land might be a little bumpy.