Playing a Commodities Correction

10/31/2007 12:00 am EST

Focus: COMMODITIES

Eric Roseman

Editor, The Commodity Trend Alert

Eric Roseman, editor of Commodity Trend Alert, says commodities have had a huge run while the US dollar is oversold, and he suggests ways to play the likely correction.

A weaker US dollar, lower interest rates, and supply deficits across a spectrum of raw materials promises to snowball into another formidable rally for commodities—but only after a period of digestion. Commodities indices have come a long way following the mid-August market low, and heavy investor speculation in many raw materials—namely oil, gold, and wheat—imply a short-term correction is highly likely.

If commodities are overbought near-term then the US dollar is oversold. That relationship will parlay into a severe dollar rally over the next few weeks even as the Federal Reserve aims to cut interest rates again on October 31st. The Dollar Index has once again hit fresh lows in October— its lowest level since the index began in 1973.

Banks, hedge funds, individual investors, and sovereign wealth funds are all on the same side of the dollar bear market ship; historically, too many bears on the same side of a trade means someone will lose their shirt—and soon.

I don’t see a structural change in the dollar’s direction (e.g. deficit reduction, Iraq pullout, booming economy), but a cyclical short-term rally is possible following six years of relentless selling. A violent reversal, if only for several months, would cause major damage across world currency markets and spill over into commodities, which I suspect will correct heavily.

This is yet another inflection point for commodities. Despite stronger foreign economies, commodities have not adjusted for a slowdown in the US growth cycle. I think oil prices, more than any other commodity right now, do not accurately reflect the current state of inventories and seasonal weakness, particularly in the United States where supplies continue to rise–not decline.

There’s no doubt in my mind that energy prices are heading lower over the next few weeks following a mind-blowing rally that has more to do with geopolitical fears and leveraged hedge fund trades than underlying fundamentals. Too many people are bullish with call options flooding brokers’ desks. At this price, $90 oil has posted a wicked nonstop rally and will viciously correct.

After two weeks of declining prices on the heels of a continued charge for the energy stocks, the Ultrashort Oil & Gas ProShares ETF (AMEX: DUG) finally broke out in a huge way on October 19—up 9% on the day. This ETF provides twice the inverse performance of the Dow Jones Oil & Gas Index. Maintain your hedged position at a maximum 5% of natural resource assets. (It closed below $41 Tuesday—Editor.)

Though I’m cautious about a short-term pullback at these levels, ASA Limited (NYSE: ASA) is the cheapest way to ride the bull market. This closed-end fund trades at a fat 13.6% discount to net asset value, meaning an investor gets to buy a dollar’s worth of great global gold-mining stocks for just 86 cents on the dollar—a terrific bargain. Buy ASA up to $76.25. (It closed below $78 Tuesday—Editor.)

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