Ending on a High Note

The market has stated repeatedly throughout 2010 that it’s good to own, “stuff.” Tangible assets with a finite supply have increased in value because they are known quantities. The United States and the European Union are devaluing their currencies through various forms of Quantitative easing and investors face growing concern that fiat currencies lack real meaning. The combination of low interest rates and limited supply has pushed the commodity markets to the front of the attractive investment sectors in 2010 and should continue to shine in 2011 as the U.S. economy falters under the weight of its own debt while reinventing itself as a global service provider rather than global manufacturer.

 

The commodity markets posted new investment interest highs in 18 markets in 2010. This means that almost half of all mature domestic commodity markets reported all time highs in outside investor interest. These markets not only include the headline leaders like gold, silver and oil but also cotton, which has doubled since August. Furthermore, investors are using the commodity markets to hedge their own portfolios in the face of uncertainty in the cash markets. Three commodity markets reached all time highs in investor interest on the short side. The S&P 500, 10 year Treasury Note and the Euro currency all set new records in 2010 for net investor short interest. These markets were sold in record numbers in anticipation of stock market declines in February, an expected rise in Treasury yields in April and a weakening of the Euro currency in May.

 

The stock and bond markets are unlikely to lure money away from the commodity markets in 2011. I think it’s very likely that we’ll see our economy slip back into recession by the third quarter of 2011 with unemployment climbing above 10.5% and moving past 11%. Generally speaking, the economy needs to create more than 100,000 jobs per month to hold the unemployment rate steady from the previous month. Eight million jobs have been lost since the recession began in December of 2007. Those jobs have not been replaced since the National Bureau of Economic Research signaled the end of the recession this past June. In fact, Princeton economist Paul Krugman states that the economy needs to create 250,000 jobs per month, every month, for the next five years just to get back to where we were before it all hit the fan in ’07. Finally, small business creation and growth is what drives the employment picture and the National Federation of Independent Businesses monthly surveys simply do not support a robust recovery picture.

 

This general picture is further supported by the most recent commitment of traders data commercial trader momentum in the S&P 500 turned negative to join the Dow and Nasdaq, which had already turned. Negative momentum across all three major indexes has been a reliable forecaster of topping action in the stock markets including the recent tops in April. When we combine this with the strong buying action across the short to mid term treasuries this past week, it’s clear that professional money is moving to safer bets to start the new year.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Coffee Topping Out?

Traditional agricultural commodity markets have always been subject to supply disruptions. Think about the mid-west flooding of the mid 90’s, mad cow disease, Florida orange crop freezes as well as labor strikes and political coups. Almost two months ago, we talked about trading the coffee market. We noted that the two major growing regions both had weather related problems and that’s what was driving up the price. There’s one other primary reason for commodity market supply shocks and that is the lack of substitute goods.

 

All commodity markets have very specific contract specifications that must be met in order for a producer to deliver their product to the exchange’s warehouses. The coffee market in the U.S., which is the by far the most dominant, accepts delivery on Arabica beans through 19 global warehouses. Arabica beans only make up about one third of the coffee crop and are the source for premium coffee blends. Robusta coffee is much more common. Robusta coffee is used in instant coffee and coffee blends because it grows quicker, is a hardier plant and has high caffeine content.

 

The coffee market has seen supply shortages before. In 1996, total warehouse stocks declined to 321 bags. This meant the New York Board of Trade, now the Intercontinental Exchange, had just over 42,000 pounds of coffee on hand to meet global delivery demands. Consequently, prices shot up to more than $3 per pound at the exchange. By contrast, the current supply, which is down 44% for the year, puts the exchange’s coffee stocks at 1.7 million bags for December. Arabica coffee producers in Brazil and Central America ramped up production in the wake of 96’s shortage. Those trees began to produce around 2000 and the coffee market bottomed in 2002 on the flood of their second harvest.

 

Much of this coffee has been sitting in storage for years and remained in the system through a loophole in which producers would take delivery of their own old stock and then resubmit it for certification. The bags then came in as new stock. Recently, this coffee has been making onto the market. Coffee roasters have taken delivery from the exchange only to find that the beans they bought were unusable. As a direct result of this, the Intercontinental Exchange has rewritten the delivery specification for their coffee contract to protect the integrity of the exchange and in doing so, created an interesting setup for a commodity trade.

 

First of all, they are now penalizing warehouse stocks more than 720 days old. This closes up the delivery and retender loophole. Secondly, they are going to begin accepting robusta coffee beans at a discounted value as deliverable against the Arabica contract. This will open up the delivery ports of the ICE’s 19 world -wide warehouses to a global supply of fresh, deliverable coffee. Furthermore, this develops multiple production centers and weakens Brazil and Central America’s ability to monopolize the prices by controlling more than 50% of global Arabica bean production.

 

Commodity traders will see these changes manifest themselves in increased exchange liquidity, which translates into lower volatility with fewer and milder price spikes. Volatility will also be eased as Brazil continues pour money into the development of its own infrastructure with more than 1 billion dollars currently earmarked specifically for coffee production.

 

When we last talked about coffee, we noted that commercial consumers had been buyers of the market to lock in end line production costs. Trend following commodity index traders as well as small speculative traders have climbed aboard coffee’s upward trend as it has marched to 13- year highs. However, general coffee market sources have priced in a balance of trade ceiling around $2.70 per pound, which is about 15% higher than the current market price. The bearish combination of the exchange’s rewriting of the contract specifications combined with the market nearing its pre-forecasted top leads me to believe that commercial producers will begin selling this market in earnest in order to lock in their forward production at these attractive prices. We will watch this development closely. It has the makings of a bull market climax.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Commodities Still Strong Amid Global Uncertainty

The Eurozone debt concerns have finally taken their rightful place as a daily front -page news story. Tuesday, Spain brought 2.5 billion Euros to market in 12-month bonds. The average rate for the auction was 3.45%. This is 45% higher than previous month’s auction rate. For the sake of comparison, it’s hard to find a 12-month CD over 1% here. Wednesday, 20,000 Grecians rioted in response to the latest round of austerity cuts. Finally, European Central Bank President Jean -Claude Trichet is calling for an expanded role of the bailout fund. These headlines all echo the same theme…uncertainty.

 

Uncertainty is a bigger impediment to fully functioning markets than fear or, greed. Uncertainty prevents planning and prevents action. While Europe digests their own financial crisis, we can take a look at the effects of our own actions here as well as what to expect in the coming months.

 

Throughout the late summer and into fall, many leading analysts suggested that the domestic stock market was a much better investment than the domestic bond market. This includes people like Warren Buffet, James Paulson and Alan Greenspan. Their general assertion was that the effects of the loose monetary policy put in place to provide liquidity and jump- start the economy was holding interest rates at artificially low levels.  Therefore, the risk premium, which compares investing in stocks versus bonds, had swung in favor of equities. The fourth quarter has clearly proven this to be correct with the stock market up 9% so far in Q4 while the 30yr. Treasury bond has declined more than 9.5% in price.

 

Most of this rally has been based on the unwinding of the fear and carry trades. Investors must constantly balance yield versus safety. Lately, the investment world has become virtually unmanageable to the individual investor attempting to figure out what the global leaders will put into play, how it will affect their portfolio and finally, what actions can be taken to capitalize on that analysis if it is correct. For example, it was generally accepted that the domestic stock market, metals markets and the U.S. Dollar could not simultaneously trade in the same direction yet, that has been the case of the fourth quarter. In fact, a decline in commodity prices combined with a rise in borrowing costs would put a real squeeze on the carry trades that have been placed over the last two years.

 

One solution to this puzzle is to focus on individual pieces. Sometimes, we don’t have to know what the final picture looks like. Eventually, if we keep putting the pieces in the right places, the picture will take shape. Therefore, some of the assumptions we will be working with are:

–       The U.S. is ahead of Europe in dealing with the financial crisis.

–       The U.S is still the largest safe haven economy.

–       Euro weakness will make the Dollar seem strong by comparison.

–       Developing Tiger countries are the engines driving global growth.

These ideas will continue place us on the long side of the commodity markets, while trading both sides of the Stock market and the U.S. Dollar. The markets should become less predictable and volatility should increase as the risk premium between the currency, equity and commodity trades continues to tighten. This will place many asset classes on equal footing and leave alpha to be gained only through the careful examination of the individual issues within those asset classes.

 

Out of the 36 markets that we track on a daily basis, 25 of them are facing negative commercial trader momentum. As we discussed a couple of weeks ago, some of these markets are near all time speculative limits. In fact, crude oil just set a new record for speculative long positions this week. This means that professional money managers are putting money to work buying crude oil while the people who produce it are selling all they can. The ability to follow the money flowing through the individual commodities provides a degree of certainty. This allows us to take action, using bottom up, micro economic analysis while the people at the top are still trying to figure it out on a macro economic basis.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

J.P. Morgan Locking in Silver Losses?

There’s an old investment saying that says, “Never marry a loser.” When the ego gets in the way, the trade becomes more about being right, than about being profitable. When J.P. Morgan used Federally backed funds to acquire Bear Stearns in March of 2008, it seemed like the steal of the century. They bought Bear Stearns at $2 a share and the Federal Reserve guaranteed Bear’s illiquid debt and counter party risk allowing J.P. Morgan to step in and take immediate control of Bear’s trading operations.

 

Apparently, part of Bear Stearn’s proprietary portfolio included a rather large short position in the silver market. J.P. Morgan, rather than liquidate the position at a loss, clean up their new balance sheet and pocket the profits decided they were smart enough to trade their way out of it using the profits accrued from Bear’s acquisition to sustain the ongoing trading losses. Thus, they’ve continued to add on to their short position selling more silver futures to increase their average price the entire way up. It has been reported by the UK’s Guardian that J.P. Morgan may now be short the silver futures market to the tune of 3.3 BILLION ounces. As a comparison, the total outstanding deliverable interest in the silver futures market is 320 million ounces and annual global supply is approximately 900 million ounces.

 

Short positions in the futures market can only be settled in two ways. First, the contracts can be repurchased at the current market price, which in J.P. Morgan’s case would be a losing trade. The second way out is to physically deliver the silver itself. This would make the people who bought the silver from J.P. Morgan, whole.

 

J.P. Morgan has the ability to hire some of the top minds in the trading game and over the last two years, they’ve been working hard to try and trade their way out of this mess. Their primary strategy thus far has been to take advantage of the limited trading in the overnight electronic markets to manipulate the market prices. The basic plan they’ve been following is to place large orders to sell more silver which make the overnight markets appear to have an abundance of sellers. When normal market players come in and need to get their own silver sold, their own human instinct takes over and they make their offer at a lower price than what they’re seeing on their screens. Once J.P. Morgan feels that enough sell orders have piled up under their own bluff of an order, they come in and buy up the lower priced offers and withdraw their large bluff sitting over the market. They have been under investigation by the Commodity Futures Exchange Commission for their manipulation of the silver market for the last year.

 

Clearly, J.P. Morgan has a problem. They owe the market more silver than the world produces and their previous attempt to unwind their position is under investigation. So, what’s the next logical move? They’re currently attempting to corner the copper market from the long side. They are essentially, creating a hedge. The idea is that they’ll make in the copper market what they’re losing in the silver market. Over the last three months as silver as silver has gone from $19 an ounce to more than $30 an ounce, J.P. Morgan has been managed to accumulate between 50 and 80% of the copper traded on the London Metals Exchange.  It’s no coincidence that they also announced their plans to offer an Exchange Traded Fund backed by physical copper. Clearly, they’re hoping to recoup some of their losses through price appreciation in copper while the generating a new revenue stream, as well.

 

Time will tell how this plays out on their balance sheet. History has shown that traders who lock into one idea, like selling the silver market, typically go broke before they are proven correct. J.P. Morgan’s dominant purchases in the copper market reflect their fear of outright loss in the silver market. Considering the notional amount (3.3 billion ounces) they are short relative to the size of the silver futures market and the global supply of physical metal, it will be interesting to see how they manage to divorce the loser they’ve inexorably hitched their wagon to.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Success Breeds Success

There are several sayings intended to keep us on the right path in our financial lives and in this day of data crunching, quantitative analysis, back testing and the never ending search for the best new method perhaps none is more true than, “Success breeds success.” When I first began my trading career in Chicago, I didn’t spend much time with new traders. Partly because many didn’t last long enough to get to know their last name and partly because I was married with a young child and a lot of bills to pay. I did spend time with as many of the grizzled veterans and established traders as I could. Early on, after what had been one of my worst days, I was full of self- doubt and felt the pressure of the world on my shoulders. I sat in the member’s break room, just off the S&P 500 trading pit with my head in my hands and an untouched cup of coffee in front of me. I hear a chair slide out at my table and a graveled voice of experience ask, “You bust out kid?” I look up to see Bill Katz who had been a member since the blackboard trading days on Franklin Street. I replied that I hadn’t and his point was that as long as you get to come back tomorrow, you’re still doing something right.

 

The point of this story is that many people ask me questions about why I follow the weekly Commitment of Traders Report (COT), what group I follow within the report and, why. The month of November has been a great illustration across multiple market sectors. This week, I’d like to explain how it all plays out.

 

The Commodity Trading Futures Commission (CFTC) tabulates the weekly Commitment of Traders Report based on the trading of several individual groups of traders. Over the last couple of years, in the interest of, “transparency,” the groups have been broken into several subsets as well. For our purpose, we can break it down into the following main categories.

 

Large Speculators – Any trader with an interest greater than the CFTC’s reporting level in any individual market.

 

Small Speculators – All individual traders with an interest less than the CFTC’s reporting level in any individual market.

 

Non-Commercials – Any organization trading in commodity futures with substantial reporting interest not tied directly to the production or consumption of the markets that they hold reportable positions in. These include Commodity Index Traders, Exchange Traded Fund managers and swap dealers.

 

Commercial Traders – Producers or consumers of commodities. These are the true hedgers in the commodity markets. These hedges can be directly tied to gold, corn and oil just as easily as bonds, currencies and stock indexes.

 

Following the commercial traders is, “Success breeding success.” This group of traders has a fundamental understanding of value either through the production of or, the end line consumption of the commodity market in question. These people make the calls on when to stock up on raw materials for future consumption or, when to sell forward production and base their livelihoods on their ability to ascertain value.  Furthermore, in the case of publicly traded companies like British Petroleum, Con Agra or General Mills, their research entreats themselves to the good graces of their shareholders and board members.

 

November’s trading was an excellent depiction of this mechanism at work. This month saw very strong rallies in metals, grains and the stock markets.  In these three market sectors non-commercial traders fueled the rallies. In fact, we saw soybeans, platinum and palladium either reach or, nearly reach record historical buying levels. The one thing these markets all had in common was momentum. These market sectors had all been in established upward trends. Many of the non-commercial traders represent commodity funds and exchange traded funds, which are obligated to maintain certain percentages of each market in their portfolios to match their disclosure documents. This forces them to buy more on the way up and sell more on the way down to maintain the proper allocation percentages. Their actions in the marketplace are mechanical and take little account of a market’s value when making their trading decisions.

COT Extreme Worksheet

Commercial traders played their hands like the World Series of Poker for the month of November. These same markets that rallied on the strength of non-commercial buying managed to reach their highs just as the threats of European solvency issues and a Chinese slowdown came in to turn the tide. The proactive analysis of the commercial traders throughout these recent market tops allowed them to position themselves favorably for the markets’ coming declines.  Their selling was quite obvious on the screens and reported by the CFTC in the COT report.

 

These reports also show us that the commercial traders have been active buyers of the energy market, decreasing their current net short position by more than 25% in the last week. This is representative of their perception of value in the face of the sell off early in the month in a market they’re expecting to be headed to new highs sometime in the near future.

 

There’s no shame in following the success of others. Following value driven trading actions by people whose livelihood depends on their successful analysis rather than the trading actions of someone following an allocation formula is my present day version of finding successful traders to guide me in the break room.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.