In many ways, commodities are, or at least they should be, great indicators of economic prospects, and therefore of potential moves in the stock market, but they are not all created equal in that regard. Some have proven themselves to be good in that role, while others have not. So, to which commodities should investors pay attention to, and what do price moves in them mean?
Some, like agricultural products, are driven almost entirely by supply. For example, the demand for pork bellies, from which bacon is made, moves a little based on price but is otherwise fairly stable. People don’t typically eat less bacon because times are tough or more when times are good. Should there be any disruption of supply, like a rampant disease among hogs or the kind of supply chain disruption we saw during Covid, pork belly futures will spike. The prices of agricultural commodities, therefore, are driven primarily by the supply side of the equation and are thus not good guides to economic conditions and prospects.
On the other hand, some industrial-use commodities, like copper and iron, can be great early indicators of rises and falls in industrial activity. The supply of those metals is relatively stable — new mines don’t just spring up overnight and while output from existing mines can be tweaked, overall, the level of supply changes slowly most of the time. The exception would be when the supply chain is disrupted, as we all saw all too clearly in 2021. That, though, is very visible and can be factored in, so price moves in industrial metals are usually good indicators of fluctuations in demand. And demand for industrial raw materials is a pretty good guide to economic conditions and prospects, albeit one with a slight time lag, so can be seen as a leading indicator for the stock market.
In the middle comes oil, where both supply and demand can fluctuate quickly. The supply side of the oil pricing equation is interesting because it is partly controlled by things other than market forces. The OPEC cartel, along with the OPEC+ group that includes Russia and a couple of other countries, set output levels for a big chunk of the world’s total production. America is now one of the world’s largest producers of oil, but while the oil industry in the U.S. is not centrally controlled, there is the Strategic Petroleum Reserve, or SPR. As we have seen a few times over the last few years, releases from that stockpile can substantially change the supply of oil, and therefore its price.
When it comes to using commodity prices as predictors of stock market moves, it is not as simple as just tracking a commodity ETF like DBC or GSG. They will typically trend in the same direction as stocks, but there is no consistent pattern of them being predictive. Sometimes commodities ETFs lead a move, sometimes they trail the stock market. What investors can do, though, is look at things like copper and oil, things that typically reflect demand and confidence in industry and, with allowances made for supply fluctuations, they can give an indication of mood.
Right now, for example, the supply picture for oil suggests that its price should be climbing. At the end of last month, OPEC+ announced a surprise cut in supply, which prompted a quick pop in oil prices, but after just a week or so of strength, crude turned tail. It has been falling for a couple of weeks and is now back close to where it was before the supply cut was announced.
However, if we look at the chart for the S&P 500 over the same period, we will see that stocks continued to show strength through most of that time:
In this case, oil was a good indicator for stocks as the price of crude started to fall, despite restricted supply, five days before the S&P 500 hit its short-term high. Oil traders, who are extremely sensitive to forecast economic conditions, were looking forward and reacting to big picture concerns about interest rates and demand, while stock traders were still looking back at decent economic data and looking forward only to earnings. Nor is that just a one-off or a coincidence:
The above chart tracks USO, the US oil ETF (blue line) against the S&P 500 (green line) over the last five years. The interesting part is around the time of the pandemic, when oil began its drop in late December of 2019, a couple of months before stocks topped out, then started to bounce in mid-March, a month or so before the S&P turned around.
It is that kind of thing that can make tracking commodities a good idea for investors, but if you do, be sure to know what to track and add some nuance to your analysis. The price of things like oil and copper can tell you a lot about economic conditions and the market mood, but you must understand that unlike most of the time with stocks, supply as well as demand influences commodity pricing. When you take that into account and see a move that is about demand or demand expectations, it is a good idea to listen to what the commodities markets are telling you.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
