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Commodity Investing Shell Shocked
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Markets reacted to the possible end of extraordinary central bank stimulus by throwing a “taper tantrum” before ending this past week in slight positive territory. While no timetable has been given by the Federal Reserve, it has said that it plans to taper its bond purchases, potentially ending its program of quantitative easing, or QE, next year. The Fed’s plans, while not cast in stone, are being taken seriously by the market. The yield on the 10-year U.S. Treasury bond has surged to 2.5 percent, up a full percentage point in a month. As yields rise, prices for bonds fall, translating into the worst six-month performance for U.S. bonds since the first half of 1994.

But for gold investors the drubbing they’ve been taking may be just the beginning, with investors questioning just how low can it go? Gold, once seen as a natural defence against the downside of Fed stimulus (inflation and dollar erosion) has cratered, falling 23 percent in the second quarter alone. This marks the worst quarterly performance in at least forty five years. Leading the yellow metal lower are exchange traded funds, an easily accessible and highly visible form of gold investment, that have sold a fifth of their holdings so far this year.

The Fed’s taper talk appears positively benign compared to the bitter medicine that the People’s Bank of China has been dispensing recently to the country’s lenders. Worried about a credit bubble and desperate to clamp down on strong growth in shadow lending and a runaway property market, the central bank has taken decisive action. Most recently the People’s Bank of China decided not to accommodate liquidity pressures in the interbank market. That caused interbank lending rates to soar to an amazing 28 percent last week—triggering the biggest stock market rout in the past four years.

Emerging markets are taking it on the chin as money has been flowing out of these countries. The iShares MSCI Emerging Market Index Fund, one barometer of the emerging markets, has slumped 13 percent since May and there doesn't appear to be an end in sight.

But the transition that the Fed has been talking about is just a tilt toward normal monetary policy and a move away from the extraordinary policies of the past. The monetary conditions that we have witnessed over the last four years have been anything but normal. Over the past four years the S&P 500 has surged 140 percent. But this bull market has occurred against the backdrop of 520 central bank rate cuts globally and by more than $12 trillion in asset purchases.

With a return to more normal monetary policy, the third quarter is likely to look a whole lot like the second quarter. Bonds will continue to struggle, with many observers expecting yields on the 10-year bond to rise to 3 percent in 2014. But even that may prove to be too conservative, as the yield on the 10-year was as high as 3.5 percent, as recently as 2011. But despite the increased volatility in the market, the impetus behind the Fed's policy shift is positive. U.S. employment is rising, the housing market is providing a tailwind and the economy continues to expand.

The past few weeks have marked an important shift for stocks, which have begun the transition from their reliance on central bank stimulus toward the fundamentals. While the next week will be a holiday-shortened one, there is no shortage of key economic data to keep track of. The week begins with the ISM Manufacturing number, which is out at 10:00 am Monday, and regional surveys indicate that its brief dip into contraction territory should be short-lived, with consensus estimates coming in at 51.5—consistent with modest growth and a positive for stocks.

But while I’m anticipating a positive second half of 2013 for stocks, I’ve raised my cash weights across the portfolios I manage, as we head into earnings season. Bloomberg data is still reporting an extraordinarily high ratio of negative guidance to positive guidance from firms, suggesting that volatility may pick up in the weeks ahead. However, this should present ample opportunities for upside surprises when the actual numbers begin to flow, if history is a guide. I am positioned to continue to build my positions in the U.S. financials, which should be big beneficiaries of a steeper yield curve. While the next month may be volatile, I'm looking to redeploy my cash on market pullbacks.

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