Copper Points to Slowing Economy

Copper is often referred to as, “the economist of the metals markets.” This is because of its use in all things that make the economy go round from electronics to commercial and residential construction and general infrastructure. When economic development is robust, copper prices follow suit. More importantly, because copper is a base ingredient in this mix, the price of copper typically precedes any moves in the general economy. Based on the current conditions of the copper market, we expect prices to fall and with it, overall economic activity in general.

The Federal Reserve Board announced its intentions to begin tapering off economic stimulus on June 19th. As a result, Interest rates have soared. Since the Fed’s announcement we’ve seen mortgage rates rise by nearly a full point from May’s low to multi-year highs. This is a 15% increase in two months. The effect on mortgage applications is already taking hold as we’ve seen a decline in mortgage applications of more than 7% in the last two months. This has led to a 13.4% decline in new home sales for the month of July, the biggest decline in three years. Rising interest rates are slowing the economic recovery that has been led by the housing market.

No copper scenario is complete without discussing China. China is the world’s largest copper consumer, taking around 40% of the annual mining total. Unfortunately, separating the governmentally supported information handouts from the man on the street’s first hand economic observations is a difficult task in a country where information is so heavily monitored and controlled. The major news events this week are twofold. First, a group of Chinese investors are stalling on a $3 billion copper mine investment in Afghanistan. Their reasons are many but the five-year delay they just inserted into the talks suggests that the investors aren’t comfortable with current, physical demand levels. Secondly, Chinese manufacturing data, though signaling signs of expansion last month, appears to have done so through inventory reduction more so than actual production. This was seen in the contraction of new export orders, stocks of finished goods and employment.

Funneling the macro data into something tradable leads us to further bearish scenarios.  Commercial traders were actively listening to Bernanke’s discussion signaling the end of the monthly injections of $85 billion into our economy. Commercial copper traders clearly see this as a negative as they’ve been net sellers in five of the six weeks since the announcement. Perhaps more importantly, this comes after they had accumulated a very large position around the $3 per pound level we’re currently trading at. This suggests that they were locking in future deliveries based on continued economic expansion prior to the Fed’s announcement. Their actions since clearly state their change of attitude going forward and perhaps most importantly from a trading standpoint provides the potential serious selling if they decide there is no longer a reason to own copper at $3 per pound.

Finally, moving to the technical side of the market it appears that copper’s strength over the last three weeks may have more to do with speculative short covering rather than the creation of new long positions. Copper volume reached its highest level since December of 2009 on June 28th. This coincided with the lowest prices seen since October of 2011. Expanding volume coupled with declining prices is indicative of a strengthening downward trend. This becomes even more obvious in light of the rapid decline in volume and open interest over the last three weeks as the market bounced off its lows.

We feel that the slowdown in domestic construction that has been brought about by the Fed’s actions coupled with a large and now, unnecessary commercial long position will force the copper futures market to follow its typical seasonal path and decline through the end of October. This should certainly lead to a test of the psychologically important $3 per pound level. Violating the $3 per pound level leaves only the 2010 low of $2.90 as support before bringing into question the economic crisis low of 2009 near $1.50. Remember that commodities are not corporations. The world can live without another corporation but copper’s base necessity will serve to put a floor under the market. Therefore, a violation of $3 and even $2.90 is possible however, the market will find waiting buyers at bargain prices.

Profitability vs. Responsibility in the Cattle Market

We’ve discussed at length the balance between feeding a growing population in a world of declining resources. These discussions have been primarily focused on the grain markets and the enhanced yields of genetically modified organisms (GMO) versus any applicable health and environmental risks. This week, we’ll focus on a major development within the cattle industry as it tries to balance concern for public and animal well being against the dual mandate of feeding the world while generating some profit.

Tyson Foods unexpectedly announced that they were going to stop buying cattle from feedlots that use Zilmax on August 7th. Zilmax is the brand name of Merck’s beta-agonist feed supplement. The FDA originally approved beta-agonists for the treatment of asthma in humans. One of the noted side effects during the drug’s development was consistently muscular weight gain in treated mice. Merck used this as an opportunity to expand their animal care services and received FDA approval of Zilmax in 2006 for use in cattle. The entire beta-agonist family has received various approvals as a feed additive since 1999.

There is no doubt that cattle fed beta-agonists gain weight quickly. The cattle production cycle typically sends cattle to feed lots for, “finishing” before being sent to slaughter or, “processing” in today’s politically, correct terminology. This is where feed additives come into play and the final pounds are added on. Kansas State has a widely respected animal husbandry division and their published research clearly shows that feedlot animals have grown much larger and more quickly than they have in the past. Cattle are gaining more weight per day than ever and are spending less time on the feedlots. The feedlots, in turn are sending heavier animals to slaughter. The result is that the U.S. is producing nearly 20% more meat from nearly 20% fewer animals.

Tyson’s concern is based on the health of the animals being delivered to their processing facilities. We all remember the video clips on the news during the mad cow scare. These included disturbing images of animals unable to walk or shaking with tremors. That is a neurological disorder. The current issue is strictly physiological. Animals are becoming so large, so quickly that their bodies are shutting down as they try to support the dramatically rapid increase in mass. Dr. Bryan McMurry states that cattle now average 1,350 pounds and have gained 300 pounds over the last 30 years. His primary concern is that 1,350 pounds is now the average, which means over half the animals are larger and the first standard deviation places 16% of the animals above 1,500 pounds. His analysis shows that these animals aren’t even able to reproduce effectively through lower calf weights and lighter weaning weights. The animals simply require too much of their bodies effort to sustain themselves and therefore don’t have enough in reserve to foster healthy calves.

Our society is constantly debating the battles between science and morality. We’ve grown faster technologically than we have ethically. Revenues drive research. Morality is not a revenue producer. Tyson’s announcement that they will not accept Zilmax fed cattle after September 6th is a major statement considering they control 25% of the meat industry.  However, they are a publically traded company and need to continue turning a profit. Therefore, they will still accept animals fed Ractopamine and Optaflexx made by Eli Lilly. Neither of these compounds has been as effective as Zilmax, which has been banned in over 100 countries but both are better financial alternatives to longer finishing times and lower weights.

The financial implications on the cattle futures market have been a chaotic glimpse into the dichotomy of public speculative action versus the cooler heads of commercial traders. Initially, the market rocketed to limit up. Speculative buying on the idea that the largest packer in the U.S. would have to buy more cattle at lighter weights going forward fueled this. The secondary reaction brought the market back to unchanged and lower as it digested the fact that there will be an initial glut of cattle coming to market to beat the September 6th deadline. Commercial traders meanwhile have been light buyers over the last week. I felt the important thing was to wait on commercial reaction to the news. This meant I had to wait for this week’s Commitment of Traders report.

The math behind lighter cattle means that another 90 million bushels of corn will have to be dedicated towards animal feed rather than ethanol or other crops or development land. We will also need to add about 10 million more cattle to the production chain to make up for lighter weights. That represents an increase of more than 10%. The balancing act comes down to the environmental strains of producing another 10 million animals and growing another 90 million bushels of corn against as well as higher processing costs at the slaughterhouses and extra finishing time at the feedlots versus profitability. This will lead to higher prices down the road in spite of a short-term glut of animals coming to market.

Natural Gas Finding Support

Natural gas prices have fallen by 25% since its April high, which in and of itself is not a big surprise. Natural gas is notoriously volatile to the point that the market doubling or, halving in price is a common occurrence nearly every calendar year. What interests us is that the current low happens to come near the typical late August seasonal low and also coincides with solid technical support as well as significant buying by commercial traders. Let’s see if we can build a case for a natural gas bottom that may hold through the seasonal low run through the typical end of October seasonal peak.

Three dollars per million metric British thermal units has generally acted as good support going all the way back to the 2008 highs above $20. Rallies meanwhile seem to be stalling around $4.50. Due to the large size of the natural gas futures contract this represents a swing of $15,000 per contract from the $3 support area to the $4.50 resistance area. Therefore, if we can carve out a chunk of the next move while limiting the risk, the reward should take care of itself. The recent action is becoming indicative of a reversal since August 8th when the market made a new low at $3.129, below last July’s low and quickly rebounded to generate the first upside reversal bar we’ve seen since last September.

The fact that the natural gas market appears to be running out of new sellers as we near $3 doesn’t come as a surprise. Using the Commitment of Traders Report (COT) to measure historical trading activity can be a bit misleading, however since there have never been more participants in the futures markets than there are now. The COT report is very useful in determining the mix of market participants, though. Commercial traders in natural gas have been building a substantial long position as the market has declined and their position is now near record levels. Furthermore, short commercial traders (natural gas producers) have trimmed their negative outlook on the market and their corresponding positions by 18% in just the last week.

Seasonally, the natural gas market has a primary peak from mid-May through mid-June. The market then tends to sell off through the end of August before making a secondary peak towards the end of October. The secondary peak is usually fueled by the need to generate electricity to run the air conditioners due to late summer heat, which we’ve had very little of this year. In fact, according to the American Gas Association we’re nearly 12.5% below our average number of “cooling degree days” through August 10th. In spite of the favorable climate the Energy Information Agency shows that natural gas in storage has not grown by the expected amount with reserves running roughly .5% above last year’s level.

The trade that is setting up has very little to do with the long-term price of natural gas which should continue to decline over time. However, the combination of technical action combined with the commercial trader positions coinciding with a seasonal low definitely puts us on the lookout for some type of reversal into higher prices as we head into the fall. Considering the natural gas futures have fallen by 13% since July 18th, we think that a move back towards $3.7 per million cubic feet is totally reasonable. Measuring this against current risk levels we think that it should be quite possible to find a trade risking less than $2,000 per contract and expect a reward of at least $3,500 while holding the position for a few weeks, at most.

Calling a Top in the Equity Markets

Back in the old days when the trading pits were full of people executing trades we had a saying, “The market always finds the orders.” This is quantified by the market through the comparison of volume and open interest levels against the price levels that generated the activity. The first rule of trend trading is that growing volume and open interest supports the market’s current direction. Last week we discussed the idea that the stock market may be establishing a late summer high with probable declines into fall from a big picture outlook. This week, we get technical.

Monday, August 5th, the S&P 500 futures traded approximately 850k contracts. Only one normal trading day in the last few years has done less volume than that. Typically, we’re looking for twice that much trading on a normal day with bigger days eclipsing the 3 million contract mark and big days reaching over 6 million like we did during the August sell off in 2011. Monday’s volume more closely matched the Christmas and New Year averages around 600k. Low volume is usually accompanied by low volatility and Monday’s trading range of was the smallest since August of last year and all the way back to April of 2011 before that. Thus, even the holidays of recent years generated more market movement.

Lower volume doesn’t always mean dying trends. There are times in a market’s trend typically, following the accumulation phase when volume will decline but open interest grows as the market begins its march in small orderly steps. Unfortunately, this is not where we stand within the equity markets’ current trend. The S&P 500 futures expire quarterly. Therefore, those who wish to maintain a position going forward have to re-establish it as their current contracts approach expiration. Those who do not may simply let their contract expire. Market participation in the futures markets is measured by open interest. Theoretically, open interest has no upside limit. As long as two new people come to the market and negotiate a trade, open interest will increase by two. One new person (long) is making a bet on higher prices going forward while the other new person (short) will profit from a falling market. Open interest in the S&P 500 futures is at its lowest levels in over a year. This means that the current market price is completely uninteresting to potential market participants.

This leads to the obvious question, “If the market is uninteresting, who’s trading?” We began to answer this question last week in our discussion of margin buying and human nature’s, “catch up” instinct. Margin buying in the stock market is borrowing money from your broker who charges you interest so that you can buy more stock than the available cash value in your account will allow. There have been four all-time highs in margin buying – 10/1987, 4/2000, 9/2007 and right now. The previous peaks all led to declines of at least one third within next 12 months. Remember the leveraged nature of the housing bubble? Leverage begets leverage…until it crumbles. Commercial traders and their large bank accounts have gladly sold all that the public wishes to purchase at these levels.

Finally, we have current technical and pattern analysis that clearly believes there is more money to be made on the expectation of downward pressure on the stock market rather than continuation of the upward trend we’ve been experiencing. One of the primary tools I utilize is the analysis of divergence. The idea is to gauge the market’s momentum by measuring various calculations against each other. The results are then plotted below the chart and we simply look for a market that has made a new high or low without a momentum confirmation. The all time highs made in the S&P 500 last week have not been confirmed by any of the popular indicators and their textbook, default settings. Meanwhile, pattern analysis shows that we have just created a broken cup with handle formation. This is a normally bullish formation gone wrong due to the currently overpopulated and leveraged speculative participation rate.

Owners of equities, mutual funds and their equivalent ETF’s should seriously take note of the warning bells. If recent history has taught us anything, we should know that six years of nowhere to new highs can be an emotionally traumatic interim. I’m not suggesting dumping the family holdings whose cost basis is now next to nothing. I am suggesting that those who’d like to sleep peacefully should look into the various ways of providing downside protection for their portfolios with advisors they trust. Insanity is doing the same thing repetitively while expecting different results. This time may be different but I’m not betting on it.

This material has been prepared by a sales or trading employee or agent of Commodity & Derivative Advisors and is, or is in the nature of, a solicitation. This material is not a research report prepared by Commodity & Derivative Advisors’ Research Department. By accepting this communication, you agree that you are an experienced user of the futures markets, capable of making independent trading decisions, and agree that you are not, and will not, rely solely on this communication in making trading decisions.

The risk of loss in trading futures and/or options is substantial and each investor and/or trader must consider whether this is a suitable investment. Past performance, whether actual or indicated by simulated historical tests of strategies, is not indicative of future results. Trading advice is based on information taken from trades and statistical services and other sources that

Commodity & Derivative Advisors believes are reliable.  We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades.

What’s Wrong with Equities

The economic black hole between the equity markets and the man on the street has never been greater. Earlier this month the media trumpeted about the all time highs in the Dow Jones Industrial Average. The President commends Congress for creating policies that “put Americans back to work,” and points to unemployment levels that are 25% below their 2009 peak. Meanwhile NBC News publishes the results of a new study, which states that four out of five of us will, “struggle with joblessness, near-poverty or reliance on welfare for at least parts of their lives.” Please bear with the following few paragraphs as we discuss the social issues that we all feel and use some correlational analysis to come up with a trading plan.

Anecdotal evidence of the government’s failed economic bailout plans to help the working class and small businesses abounds. Finally, we have some research that quantifies where TARP funds went as well as how much of the stimulus reached its intended target. We suggested five years ago that the major banks who were deemed, “too big to fail” were more likely to sit on the funds they received in order to shore up their own loan to equity ratios than they were to make those same funds that had been ear marked for small business creation and maintenance available to them.

The best summation of these events comes from John Mauldin, a republican economist from Texas. “We are watching the Fed employ a trickle-down monetary policy. They hope that if they pump up the banks and stock market, increased wealth will lead to more investment and higher consumption, which will in turn translate into more jobs and higher incomes as the stimulus trickles down the economic ladder. The kindred policy of trickle-down economics was thoroughly trashed by the same people who now support a trickle-down monetary policy and quantitative easing. It is not working.” Mauldin’s condemnation of trickle down economics is especially telling given his own personal background.

The government bailed out the owners of the large banks and their related business entities. Warren Buffet’s Berkshire Hathaway is a good example. When the financial crisis set in Mr. Buffet, who already owned a considerable position in Goldman Sachs, doubled down as the stock hit the skids. He was betting that the Goldman was, “too big to fail” and that the government would bail them out, which they did. Goldman Sachs received $10 billion in TARP aid. Berkshire Hathaway stock is 10% higher now than before the collapse and is up approximately 30% this year. The point is that those with equity ownership and the resources to increase their equity ownership by using the Federal Reserve as a backstop profited handsomely. Unfortunately, a Gallup poll shows that the percentage of Americans owning individual stocks and securities is at its lowest level since 1999 and has declined by 13% since 2007.

Human nature is a terrible trader. The scarcer something becomes, the more we want it. The more that’s available, the less we want it. When stocks were cheap, we were scared. We as individuals are never, “too big to fail.” Collectively, we rarely succeed. This is evidenced by the recent run up in margin buying, which just hit a new all time high. Margin buying is akin to buying stocks on leverage. Currently, investors are only required to put up 50% of the face value of a stock and the brokerage house, “loans” you the balance. The last recent highs were 2000 and 2007. Ring any bells? This is a significant indication that individual investors are doubling up at the top to catch what’s left of the rally they’ve missed. Conversely, When the Federal Reserve Board announced a possibility of easing back on the stimulus and bonds tanked, these were the same people pulling their money out. This is a clear, ugly and leveraged speculative rotation.

The markets themselves tell a different story. The Fed can’t afford to let off the stimulus gas just yet and the major market players know it. They also see the sucker top forming in the equity markets. The appropriate strategy we see is to tighten up equity risk and look towards the long end of the yield curve to regain some of its losses. Frankly, we think moving from equities to bonds should be the primary move between now and October. Take advantage of the access to information we now have and know that ignorance is a choice.This material has been prepared by a sales or trading employee or agent of Commodity & Derivative Advisors and is, or is in the nature of, a solicitation. This material is not a research report prepared by Commodity & Derivative Advisors’ Research Department. By accepting this communication, you agree that you are an experienced user of the futures markets, capable of making independent trading decisions, and agree that you are not, and will not, rely solely on this communication in making trading decisions.

The risk of loss in trading futures and/or options is substantial and each investor and/or trader must consider whether this is a suitable investment. Past performance, whether actual or indicated by simulated historical tests of strategies, is not indicative of future results. Trading advice is based on information taken from trades and statistical services and other sources thatCommodity & Derivative Advisors believes are reliable.  We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades.