If These Commodity Prices Tank... Run for Your Life

Both U.S. and overseas stocks have been rallying since their ugly August sell-off.

But, if these key commodity prices tank, expect stock prices to follow.

Oil and copper hold the keys to the future of stock prices.

Here's why...

A Blueprint for Disaster

Generally, stock valuations are a function of earnings and interest rates.

How much a company has earned historically, what its earnings are today, and what its future earnings prospects are - relative to its share price - are key valuation ingredients.

Interest rates also are crucial determinants of valuations in both individual stocks and the overall market.

And with good reason.

There are many interest-rate-influenced factors that can affect the valuations of individual stocks and the broad market. There's the interest rate a company pays on its debt, what its dividend yield is relative to its peer firms, and the overall market and what competition bonds and other fixed-income investments pose.

copperSometimes, however, interest rates and earnings just don't matter. That's because stocks and markets can get hijacked by outside forces, like commodity prices.

Investors who don't understand that forces like the prices of oil and copper - which may not be raw inputs or have anything whatsoever to do with a company's business - can move stocks better learn quickly what to watch and why.

Or they'll get blindsided fast.

Right now, the price of oil is extremely important - even critical - to the markets.

While falling oil and gasoline prices are considered good for consumers and economic growth in the long term, there's another side to this story. In the short run, if oil prices were to drop back to their recent lows, stock prices would immediately start to skid.

And if oil downright collapses, stock markets all around the world will tank.

With declining oil prices, it's what's playing out behind the scenes that matters most.

Let me show you...

Bothersome Forecasts

When oil falls, it's from lack of demand, oversupply, or both.

And right now, it's both.

When oil demand starts growing at a slower rate, it's a sign that economic growth itself is slowing.

That's happening now.

According to a brand-new report from the International Energy Agency, global demand growth is expected to slow from its five-year high of 1.8 million barrels a day this year to 1.2 million next year - which the IEA says is "closer towards its long-term trend as previous price support is likely to wane."

Recent reductions in global growth forecasts are having an impact, the IEA report says.

At the same time demand is easing, oil supplies keep increasing. The U.S. Energy Information Administration's newest outlook - released this month - says "global... production continues to outpace consumption, leading to strong inventory builds throughout the forecast period."

Global oil inventory builds in this year's second quarter averaged 2.3 million barrels per day, compared with increases of 1.8 million barrels a day back in the first three months of the year.

Slowing economic growth, as evidenced by slowing demand growth for oil, isn't good for stocks.

What's worse, if the price of oil tanks, the banks that have huge loans out to energy companies will get hit.

And hit hard.

More than $500 billion worth of "junk bonds" issued by energy companies that have been bought by mutual funds and exchange-traded funds (ETFs) will get clobbered. Falling oil prices will rekindle deflation. And perhaps most frighteningly, collapsing oil prices could destabilize oil-producing countries in the Middle East - most notably Saudi Arabia.

West Texas Intermediate (WTI), the U.S. oil benchmark, is trading around $43.50. If WTI falls below $38 - thereby breaching its recent cyclical lows - there's no telling where the bottom is.

The lower oil goes, the more selling it ignites. Lower prices cause futures prices to fall as energy players rush to hedge inventories and future production, which puts more pressure on spot prices.

Big drops in the stock prices of energy companies will take down the rest of the market.

And then there's copper.

The End of Days

Everyone knows that markets went into a panic sell-off mode back in August.

But here's what they missed: the reason investors panicked in the first place.

In an almost humorous "Eureka!" moment, China had to instantly backtrack a day after announcing it wanted to devalue the yuan by 2% against the U.S. dollar.

Emerging markets tanked instantly, Asian stocks free-fell, European stocks tumbled, and U.S. stocks freaked out.

What wasn't funny was that Beijing momentarily forgot that - in spite of its slowing economy and its hope to help revive exports by lowering the country's currency - there's an almost $2 trillion game being played in China having to do with copper, interest rates, and the value of the yuan relative to the U.S. dollar.


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Almost instantly, investors and speculators in the Chinese copper "carry trade" began to unwind the bet that the Bank for International Settlements estimates is somewhere between $1.2 trillion and $2 trillion. I'm going with the $2 trillion figure because the BIS is notoriously conservative in its estimates of leveraged positions.

The copper carry trade works like this.

Chinese and other investors and speculators get loans in U.S. dollars, because U.S interest rates are so low, and buy copper that they warehouse in China. Chinese lenders then make loans in yuan, using warehoused copper as collateral. The "investors" then park their borrowed money in higher-yielding Chinese fixed-income securities, sometimes in stocks, and most of the time buy more copper to warehouse and borrow more against.

You see where this is going?

If China's currency falls in value, it will take more yuan to pay back the U.S. dollar-denominated loans that carry-trade investors and speculators took out in the first place. If China ratchets down internal interest rates to stimulate growth - which it did Friday - the rate of return that carry-trade speculators get on their Chinese investments gets cut back.

And that makes the carry trade less profitable - and riskier.

Then there's the final nail in the coffin of this $2 trillion monster...

The price of copper.

If the price of copper starts falling, the value of the collateral all these trades are based on also drops. Not only will there be margin calls, there's fear globally (for those who understand what's really going on in China) that some unknown amount of warehoused copper has been pledged as collateral several times over for different loans.

Right now, copper is trading around $2.38 a pound. If it falls below $2.20 to $2.25 per pound - where it has some technical support - the decline will likely set in motion a cascade of selling as carry-trade speculators start unwinding their trades because they're getting margin calls.

A copper sell-off will trigger the unwinding of the massive copper carry trade and put extraordinary pressure on other commodities, on emerging markets that export them, on Australia, whose economy is driven by commodity exports, and on global markets that will see panic rush of "risk-off" selling.

Watch the stock market all you want. But if you want to know if a Category 6 hurricane is about to blow over you, watch the price of oil and copper.

You've been warned...

Follow us on Twitter @moneymorning.

The Timer Is Ticking... Glencore Plc., the biggest commodities trader on Earth, is in serious trouble. Its near-term prospects are bleak. And if the price of this commodity hits historic lows, it could spark a complete global meltdown...

About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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