A lot of my financial wealth was created riding the great commodity super cycle during the previous decade. In 2004, when I first had enough money to invest, it was apparent to me that the industrialization of China, the underinvestment in mining, and easy US monetary policy would create an ideal setting for commodities to rally. To speculate on this, I bought a basket of Junior gold exploration companies and watched their value multiply several-fold.
But in 2010, short seller Jim Chanos opened my eyes to the growing fixed asset investment bubble occurring in China. Fearing that a popping of the bubble could lead to a drop in demand for commodities and a stronger US dollar led me to believe that the great commodity super cycle was about to end.
Sure enough, commodities have been a house of pain for investors since then.
Most commodities have declined by 30-50% during the past 4 years with one exception: palladium. Palladium has been resilient while even platinum (a fellow PGM metal) lost 35%. Why did the palladium price decouple from the rest of the commodity complex in 2014?
Early 2014 saw the rise of tensions between Russia and Ukraine leading western countries to slap sanctions on Russia. That spooked the palladium market because Russia is the world’s largest palladium producer supplying 40% of mine supply annually.
In the late ’90s, western countries implemented stringent auto emissions restrictions requiring car companies to fit their cars with catalytic converters which require palladium. This caused a surge in palladium demand that Russian mines could not fully supply. The Russian government, desperate to build up foreign exchange reserves after their debt default, sold off its palladium stockpiles to meet the increased demand until it ran out of inventory. To rebuild its inventory, the government delayed issuing palladium export licenses causing a spike in palladium prices.
That experience has made market participants worried about any sanctions that may affect Russian palladium exports. In addition, mine workers in South Africa, the second largest palladium producer, were on strike during the first half of 2014. However, a resolution was reached last June and palladium prices topped out shortly thereafter.
Fears of western sanctions that block Russian palladium exports appear overblown to me because they would hurt western auto manufacturers, while Russia could still sell their supply to China and India. The global automobile industry consumes almost two-thirds of annual palladium supply.
As a side note, I believe the rise of electrical vehicles (which do not have catalytic converters), could cause a significant drop off in palladium demand down the road. But it will take a few more years for battery technology to be price competitive with and as efficient as internal combustion engines.
Nonetheless, I still believe that the palladium price will soon join other commodities and experience a significant decline. My confidence is based on chart analysis.
From 2010 to 2013 palladium prices were tracing an alternating series of lower highs and higher lows – a pattern that chartists call a triangle. When the price eventually breaks out of the triangle, it could lead to a sharp move in the direction of the break. However, a false break could arise where the price fails to move quickly and reverses to fall back inside the triangle. This would signal that a sharp move could be forthcoming in the opposite direction of the false break.
In my experience, a well traced out triangle pattern in a widely followed market such as palladium often leads to false breaks. Sure enough, the Russian invasion of Crimea in 2014 led to a breakout, but the price failed to rise much and made only a marginal high before falling back below the lower trend line of the triangle.
I believe that palladium has experienced a false breakout and shorted it on Friday at an average price of $742. The beauty of this trade is that I can stop myself out if the price rises back above the trend line to approximately $775 on a weekly closing basis and take a small loss. Alternatively, I may add to my short position if the price breaks the downward sloping support line at $700.
I will be tracking the trade here.