The crude oil market has declined by approximately 45% since this summer. The massive decline has surpassed most analysts’ expectations including those who advise sovereign nations on international foreign trade issues. The biggest problem most of us face is determining the difference between falling oil prices and gasoline being a good thing at the personal, micro level compared to the damage that falling oil prices have had on equity and currency markets at a macro level. Unfortunately, the answer lies on a continuum rather than an easy black and white answer or a single numerical value. This week, we’ll look at differences in the economic makeup of the major players and determine where they stand in terms of currency and budgetary risks due to oil’s precipitous decline.
This has been a tumultuous week in the equity markets as news events and political leveraging have sent markets in China and Greece down by more than 5% and 11%, respectively. Here in the US, Wednesday’s action attempted to mimic the global markets but was met by a solid bid in the S&P 500 and Dow Jones Industrial Index around the Thanksgiving lows. Meanwhile, the Russell 2000 found support near the critical 1150 level that has propped it up since late October. We published a short take in Equities.com earlier in the week projecting expected weakness in the equity markets due to the shift in the commercial traders’ position over the last couple of weeks. This has led many to ask exactly how we use these reports to forecast trading opportunities in the commodity markets. We’ll use this week’s piece to explain our approach in detail within the context of today’s equity markets.
We frequently describe the discretionary portion of our COT Signals advisory service as a three step process. First of all, we only trade in line with the momentum of the commercial traders. It has long been our belief, three generations worth, that no one knows the commodity markets like those who whose livelihood’s rest upon the proper forecasting of their respective market. This includes the actual commodity producers like farmers, miners and drillers along with the professional equity portfolio managers using the stock index futures to hedge and leverage their cash portfolios. Tracking the commercial traders’ net position provides quantitative evidence of both the long and short hedgers’ actions within an individual market. The importance of their net position lies in the collective wisdom of this trading group. Their combined access to the best information and models is summed up by their collective actions. The final part of the commercial equation lies in tracking the momentum of their position. Their eagerness to buy or, sell at a given price level is equally important as the net position. We only trade in the direction of commercial momentum. Finally, commercial trader momentum is the bottom indicator on the chart below.
The second step of this process is how we translate the weekly commitment of traders data into a day by day trading method. Commercial traders have two primary advantages over the retail trader. First of all, they have much deeper pockets and they have the ability to make or, take delivery of the underlying commodity as needed. Secondly, they have a much longer time horizon. Think, entire growing season or their fiscal year on a quarter by quarter basis. Therefore, we have to find a way to minimize risk and preserve our capital. We do this by using a proprietary short-term momentum indicator on daily data. The setup involves finding markets that are momentarily at odds with the commercial traders’ momentum. If commercial momentum is bearish, we are waiting for our indicator to return a short-term overbought situation. Conversely, if commercial traders are bullish, we wait for a market to become oversold in the short-term. The short-term momentum indicator is labeled in the second graph.
Once we have a short-term overbought or, oversold condition opposite of commercial momentum, an active setup is created. The trigger is pulled when the short-term market momentum indicator moves back across the overbought/oversold threshold. Waiting for the reversal provides two key elements to successful trading. First of all, it keeps us out of runaway markets. Markets are prone to fits of irrationality that catch even the most seasoned of commercial traders off guard. News events, weather issues and government reports can all wreak havoc unexpectedly. Waiting for the reversal also provides us with the swing high or low that is necessary to determine the protective stop point that will be used to protect the position. Everywhere there is a circle, red or blue, was a trading opportunity in the S&P 500 this year. Within each circle, the highest or lowest value was the protective stop point. It is imperative to know the protective stop prior to placing any trade. This allows the trader to determine the proper number of contracts to trade relative to their portfolio equity. Risk is always the number on concern of successful trading. Currently, the protective stop levels are 17980 in the Dow, 1189 in the Russell 2000 and 2079 in the S&P 500.
Currently, the Dow, S&P 500 and Russell 2000 all contain this same set of circumstances. Given the lofty valuations, the speed of the recent rally and recent global economic developments it seems prudent to expect a retreat from these highs. Clearly, that is what the commercial traders, who were MAJOR buyers at the October lows believe is about to happen. We’ll heed their collective wisdom as they’ve successfully called every major move in the stock market for 2014.
The commercial traders have been on fire when comes to predicting the stock market in 2014. I suppose this makes sense since they’re the ones with access to the best information and modeling available. This explains the huge moves we’ve seen in their net positions based on the Commitment of Traders reports. Somehow their neural and social networks have put them in the right position for nearly every trade this year as you can see on the chart below.
This week started off with our Chicago wheat futures analysis for TraderPlanet in which we discussed looking for a selling opportunity near the 50% retracement level at $6.05 just through the resistance at $5.80. Tuesday, the market traded to $6.10 before selling off down to $5.70. Tuesday’s reversal also triggered the entry for our COT Signals Mechanical system.
The wheat trade came straight from our nightly discretionary COT Signals which has a 30-Day Free Trial.
Tuesday we discussed the growing glut in the crude oil futures market because we noticed how actively commercial long hedgers are locking in future supplies. We still see this as a trading opportunity.
Finally, our main piece focused on the Diminishing Effects of Global Quantitative Easing. This is where we left off in Hand Quantitative Easing to Germany. We did not expect Japan and now, China to come in and throw gasoline on the fire the way they have but the fact is, we now have three major regions kicking in QE programs since late September compared to the US enacting three programs over the course of four years.
More specifically, this piece should be titled, “Diminishing Effects of Global Quantitative Easing in a Long Only Portfolio,” but that seemed a little long. Have we returned to an era where bad economic news guarantees the action of sovereign nations to prop their markets up? Does bad news make front running the Bank of Japan’s direct equity purchases a sure thing? Have we globalized the, “Bernanke Put?” The European Central Bank, the Bank of Japan and the Peoples’ Bank of China have all enacted accommodative interest rate policies since September 8th. Since then, the various global equity markets had all sold off and are now at or near new highs.
The crude oil market has been under pressure on all fronts. It’s been pounded by declining global growth numbers and diluted by growing global production. Structurally, this market must work its way lower over time. However, the 5.5% decline over the last week or so may be a bit overdone.
Monday’s corn analysis for TraderPlanet couldn’t have been more timely. Our mechanical swing trading programs picked up the highs being made in the grains as a short selling opportunity that bore fruit right through yesterday’s exit. We discussed the Commitment of Traders report’s importance in determining resistance levels as defined by the commercial traders’ volume and execution prices.
Read, “Corn Rally Stalls Short of $4.”
The S&P 500 has rallied more than 12% in 24 trading sessions. This isn’t a terribly rare occurrence. Writing up a quick indicator shows me that there have been 18 observances of rallies traveling more than 10% in any rolling 24 day period. Restricting the filter to 12.5% still provides us with 9 observances while bumping it to 15% drops the return to 5 examples. The last 10% rally was in January of 2012 and the last 15% rally was in November of 2011. These last two observances were clearly during the churning process as the market had not made new all-time highs, yet.
The 18 total examples gained an average of .92% in the S&P500 futures one month later. The largest gain was 6% while the largest loss was 10%. Finally, the market ended up higher one month later exactly half of the time.
Cocoa shortage news seems to be going viral when the fact of the matter is that cocoa prices will structurally decline in the coming years due the modernization of an industry that’s been marginalized for more than 20 years. The Ivory Coast which, is the number grower in the world is undergoing full on paradigm shift due to President Allasane Outtara.
As we said last year, “President Ouattara, who was educated here in the U.S. at Drexel University, is quickly modernizing the Ivory Coast’s cocoa markets. There’s been rapid development in soil reclamation, fertilization and education. Most cocoa is grown by individual farmers on small plots of land and is harvested by hand as it has been for hundreds of years. The application of modern agronomy techniques will cause the Ivory Coast’s cocoa production to increase rapidly over the coming years. The combination of infrastructure improvement and political stability supporting free trade and as well as modern farming practices will increase yield and depress prices once the changes are fully implemented.”
Read more – Paradigm shift in the Cocoa Futures Market.
See our past cocoa futures articles.
Read the rest of today’s piece, Cocoa Fear are Overblown at Equities.com