If you have not yet read Part I, available free to all readers, please click here to read it first.

Part II: Hard Times Ahead for Assets

Are commodities topping out? Since we know commodities are physically limited in supply even while demand continues to rise, common sense suggests that commodities will outperform over the long term for as long as industrial civilization continues its consumption of those commodities.

However, it is also clear that the global economy is either slowing or entering an actual recessionary contraction. Thus it behooves us as investors to ask what that contraction of demand might do to the prices of commodities over the near term (i.e., the next 24 months, 2012-2013.)

In Part I, we examined the connection between stock markets and demand for commodities as reflected by the chart of the Reuters/Jefferies CRB Index, the commonly used bellwether for the commodities market. We determined that if the stock markets of China and India are indeed leading indicators of demand for commodities, then the market for commodities will likely weaken.

We also found that margin debt seems to be far more closely correlated to the US stock market than demand for commodities as reflected by the CRB, meaning the US stock market may not be an accurate leading indicator of commodity demand or pricing pressure.

In Part II, we examine a key technical correlation that has withstood the test of time, that of copper and the stock market, and explore a potential key dynamic which may exert outsized influence on the demand and pricing of commodities over the next few years.

As a side benefit, our examination of the commodities may also shed light on the direction of the stock market — another key interest for many investors.

If you have not yet read Part I, available free to all readers, please click here to read it first.

Part II: Get Ready for Worldwide Currency Devaluation

Derivatives

You’d think that after AIG blew up spectacularly and Lehman choked on a hairball of tangled derivatives (one that is still being picked apart), the lesson would have been learned and derivatives reduced in both size and complexity.

Unfortunately, that lesson was not learned, and we have to square up to the fact that derivatives are now roughly $100 trillion larger in aggregate than they were in 2009:

If you have not yet read Part I, available free to all readers, please click here to read it first.

Part II: Why It’s Now Easier to Predict the Outcomes of the Coming Recession

The Oil-Sensitive West

Consumption of oil in the West started to flatten out as early as 2004. And readers of my previous essays know that after the crisis started in ‘08, both Europe and the US shed even more oil demand. Let there be no doubt: Oil demand in the OECD has been highly elastic (responsive) in the face of oil prices above $80. In the data, you could even see some early signatures of reduced demand coming in 2004, when oil prices rose above $40.

One of the paradoxes that repeatedly trips up analysts, because it’s so counter-intuitive, is the fact that the wealthy Western countries are hurt more by high oil prices than the poorer, emerging market countries.

Your average Westerner is consuming quite a lot of oil, per capita. It’s embedded in shipped goods and in shipped foods, and also comes via high penetration of automobile ownership. Westerners drive lots of miles, comparatively. But people in emerging markets have only just begun to use oil. It hardly matters whether petrol is $4.00 per gallon or even $8.00 per gallon if you have just upgraded from a rural existence, and for the first time ever your family is consuming 4-6 gallons of petrol per month (enough to power a motorbike each day for a short distance). This is precisely what Bernanke is alluding to, when he allows that we have no control over emerging market oil demand.

More vexing is that emerging market economies are primarily running on coal, so they are able to produce and align their consumption with the power grid, while being more discretionary about liquid fuel use for mobility. This is really perplexing, as I said, to Western analysts but I do want to point out that its empirically true (see Stuart Stanford’s post on the subject, Wow, Just Wow, from earlier this year).

If you have not yet read Part I, available free to all readers, please click here to read it first.

Part II: How Low Will Housing Prices Go?

It’s a truism that “all real estate is local,” and to the degree that the ultimate price of a property is only truly “discovered” when a specific buyer purchases a specific property at a specific point in time, this is certainly true. It is also true that many key inputs to real estate valuation are locally derived, such as employment, wage levels, demand for rental housing, the attractiveness of neighborhoods, and so on.

But to say that interest rates managed by the Federal Reserve or subsidies provided by the Federal government have no influence on real estate valuation is clearly untrue. Valuation is directly influenced by global, national, and state economies, and by the policies of the central bank and government.

In attempting to answer the question When will housing hit bottom? we might start with the coarse-grained systemic inputs and then move to the more fine-grained local inputs.