Softening Commodities Ahead

Louise Yamada, a very well respected technical analyst was recently on CNBC discussing the case for a, “death cross,” in the commodity sector. While I agree with the general assessment that commodity prices as a whole could soften over the next six months, I take issue with the market instrument she chose to illustrate her point, the CCI as well as the general uselessness of this instrument as an investment vehicle. Therefore, we’ll briefly examine why we agree with the softness of the commodity markets and what I believe will follow shortly thereafter as well as a useful tool for individuals looking for commodity market exposure.

The CCI is the Continuous Commodity Index. This index originated in 1957 as the CRB Index as named by the Commodity Research Bureau. It’s been revised and updated many times over the years to generally represent an equal weighting of 17 different commodity futures contract and is continuously rebalanced to maintain an equal 5.88% weighting per market. This really was the pioneering commodity index contract and was traded at the Chicago Mercantile Exchange actively until the early 19990’s. The proliferation of commodity funds and niche indexes since then has rendered the CCI useless and untradeable. In fact, the Intercontinental Exchange that held the licensing for this product delisted it this past April.

Louise Yamada’s point that the commodity markets may be softening is worth noting. She attacked it from a purely technical standpoint. She used the bearish chart pattern that was setting up on her hypothetical contract to illustrate the waning nature of the commodity markets’ failed rally attempts over the last year to suggest that there is more sell side pressure on the rallies than there is a willingness to buy on the declines. She further illustrated her point using the “death cross” of declining moving averages to suggest further bearishness was in store for the commodity markets cleverly noting the frown pattern made by the highs over the last two years.

I’m a big proponent of technical analysis as well as chart pattern recognition (Our Research) however, my reasons for generally bearish commodity behavior over the coming months has far more to do with the sluggish nature of the global economies. China is still the primary source of global economic expansion. Their economy is both large enough and strong enough to buy the world time to work through the overexpansion and corresponding crash of the housing/economic bubble that hasn’t been completely digested, yet. Furthermore, the unabated quantitative easing has lost its ability to boost the economy as a whole and is simply fueling an equity market bubble as the world’s largest players seek parking spaces for the ultra-cheap money that only they have access to. Therefore, until Europe turns the corner and we begin to reconcile the difference between the doldrums of our economy and the exuberance of our stock market, the end line demand for commodities will remain soft.

The flip side to the waning demand story is that once the tide turns, all of the liquidity that’s been pumped into the global economic system will finally trigger the next massive commodity rally. The first leg was fueled the Federal Reserve and Mother Nature. Massive quantitative easing in the wake of the housing collapse fueled massive speculation in gold, silver and crude oil markets. This was followed by one of the worst droughts in U.S. history sent the grain markets to all time highs. Clearly, we’ve gotten a taste of what happens in the commodity markets when there’s a rally to be had. Money attracts money and that’s why we saw the evolution of the Continuous Commodity Index from a single to contract to every conceivable niche market in futures, ETF’s and index funds.

Some of these niche markets have developed a strong enough following to make them tradable. The most liquid commodity futures index contract is the Goldman Sachs Commodity Index Excess Return contract. This is based on the Goldman Sachs Commodity Index (GSCI) affectionately termed the, “Girl Scout Cookie Index” by floor traders when it came on the scene in the mid 1990’s.

This market currently has an open interest of more than 25,000 contracts. The bid/ask is relatively wide at approximately $100 per contract difference but the liquidity is solid with a total of more than 100 bids and offers showing on the quote board. This index, like the old CCI is still heavily weighted in the energy sector with Brent crude and West Texas Intermediate crude accounting for nearly half of the weighted index. The bright side is that this index only has a margin requirement of $2,200. Ironically, a half size mini crude contract requires $2,255 in margin. You can find all futures market hours and point values here. The balance of the index is weighted 15% towards growing commodities like wheat, corn, coffee and sugar. Livestock comprises another 4.5% and metals makes up about 10.5%.

This fall and winter should provide time for the markets to finish digesting some of the previous boom cycle’s excesses. We’ll also have lots of global data coming from Japan, China, India and Germany as well as a new Federal Reserve Board Chairperson of our own. The trillions of Dollars that have been poured into the economy will eventually end up chasing returns. That will be the point when inflation begins to creep in. Weaning the economy off the monthly doses of funding is becoming harder and harder with each dose administered and the major players won’t be happy about it. Therefore, it’s sure to continue for too long and will only be reigned in once it’s too late.

Energy in the U.S. and China

The global energy market recently passed two milestones. First, China passed the US as the number one importer of crude oil in the world in September. Second, the US passed Saudi Arabia as the largest fossil fuel producer in the world last week. Neither of these incidents came as a surprise. Both trends have been progressing roughly as expected. However, now that we’ve reached critical mass in forcing the evolution of the global energy markets, it’s time to take a look at some of the longer-term changes that will arise as a result of these events.

China was destined to become the number one energy importer due to its population growth, economic growth and geography. While we are concerned about whether the effects of the government shutdown may trim two percentage points off of our third quarter GDP of less than 2%, the Chinese have been chugging along at GDP near 8% and haven’t seen their Gross Domestic Product drop below 6% since 1991. The economic boom in China is still in full swing. Speculative phases like warehouse space or production facilities may have been overbuilt just like their housing markets but the infrastructure buildup remains in full force. The governmentally sponsored projects continue to redefine the Chinese way of life through the addition of roads, bridges, trains and power plants.

The growth in China comes as we isolate ourselves here in North America. China is still our second largest trade partner. Most of our trade with them is at the cheap manufacturing level. Meanwhile our number one trade partner has become Canada. Our trade with Canada is much nearer to equal than our Chinese trading relationship. According to the July, 2013 US Census, our trade with Canada occurs at a 7% deficit while we import 280% more goods from China than we export to them. Our growing isolationism can be confirmed since Mexico is our third largest trade partner.

This brings us back to Saudi Arabia and energy production. There are two main reasons for our declining ties to Saudi oil. First of all, American vehicles have become more fuel-efficient. The University of Michigan tracks average fuel efficiency of all new cars sold on a monthly basis. There has been a 20% increase in the fuel efficiency since 2007. Furthermore, the, “Cash for Clunkers” program took approximately 700,000 inefficient vehicles off the market further adding to the overall efficiency of our current fleet. Secondly, fracking and tar sands production have vaulted the US into the leading petro-chemical producer in the world. Saudi Arabia and Russia still produce more oil but our total distillate output has surpassed them.

These major trends will continue for many years into the future. The US is expected to become fully energy independent by 2020. Meanwhile, China will become increasingly dependent on world supplies. We used the following example in describing the growth of the Chinese hog market a few years ago and the comparison still fits. The Chinese story is all about developing a new middle class and putting newly disposable income into new hands. The first new expenses are better food, clothing and shelter. Moving up the ladder, the new middle class expands into luxury goods like cars and vacation travel. The average Chinese person uses about 3 barrels of crude oil per year. The average US citizen use more than 21 barrels per year. Clearly, this gap has room to close as the new Chinese middle class continues to westernize.

The growing demands of the Chinese middle class will change the way China conducts itself in global politics. Energy analysts at Wood McKenzie expect China to claim as much as 70% of the global oil imports by 2020. Therefore, at the same time the US becomes energy self-sufficient, China will become even more energy dependent. This will place them in a different role regarding global peace, especially in the Middle East, as unrest there will affect their country more than anyone else. This should cause China to continue to grow their military, especially their naval power and should have the unintended benefit of allowing us to scale back our military investments. Hopefully, the politicians here won’t spin this into another cold war as an excuse to renew domestic military investment

China’s growing need to purchase oil on the global market will force their hand in freeing up their currency to float.  Trade partners will not do business in a currency that can be manipulated at the drop of a hat. Opening their markets and allowing their currency to float will encourage investment flows in both directions. Big picture analysis suggests that this could be the catalyst towards pushing China into the dominant super power role. They have the demographics and capital necessary to generate the need for currency reserves and open markets. The last thing to develop will be the political ties towards the Middle East oil producers and finally, armed services to guarantee their trade routes remain open.

Day Trading Currencies to Avoid the News Cycle Chop

The debt ceiling debacle and government shutdown have affected our normal trading operations in several ways. I’ve been a stock index trader since the early 1990’s when I began working and trading at the Chicago Mercantile Exchange. The news cycle lasted at least 24 hours before newspapers and television morning shows would revise or alter the political landscape and issues of the day that may affect market behavior. Furthermore, the U.S. financial markets closed for business at 4:15pm and didn’t re-open until the following morning. This forced all of the market participants into a, “time out.” Finally, this allowed the markets’ participants to digest the day’s events and adjust their trading plans accordingly.

Fast forward to 2013 and the news cycle is delivered 140 characters at a time by anyone who thinks they may have something newsworthy to say. This all noise, no signal news environment is then transmitted via every conceivable electronic gadget, TV, and satellite radio to completely overwhelm the markets’ participants.

Fortunately, we live in a world where everyone is entitled to anything they want. The sellers of, “want” support this by providing access to the markets nearly 24 hours a day. Furthermore, the same sellers of access to open markets, the brokerage houses and government regulators have decided that 24 hours a day isn’t enough. We’ll stay open on several bank holidays as well. Our clients won’t be able to transfer funds if they get in trouble but the odds are, it won’t be our margin call and the commissions will cover any punitive damages if there’s a joint action against the brokerage industry.

The previous sarcasm is securely based in the trading world in which I exist. There are times when the only truth in the market is the market’s last traded price. This is where the rubber meets the road and the best bids meets the best offer, the contract is sealed. The noise can be tuned out. The TV can be turned off. The strategy shifts from big picture investing and turns to technical analysis and day trading. Based on my experience, the exchange traded currency markets can be the best option due to their volume, contract size and responsiveness to technical analysis.

Successful day trading in any market requires the proper degree of volatility and contract size. These are the determining factors of whether a given market has enough Dollar based movement to be profitable. The simplest method of figuring this out is to multiply the average daily trading range over the last several days by the tick value in the market you’ve selected. The Euro Currency has an average daily range of about $.0077. That doesn’t sound like much but the Euro Currency has an exchange listed contract value of $125,000. Therefore, the average movement is $.0077 X $125,000, which is an average daily dollar movement of $962.50. Another way of looking at it is that the Euro has a tick value of $12.50 and has an average range of 77 ticks.

We’ve determined that the market has enough movement and a large enough contract size to provide opportunity to profit from its daily movement. The next step is to determine if the market has sufficient liquidity to handle our trade size without losing too much in slippage. Continuing with the Euro Currency as an example we can look at the depth of the market on nearly any popular trading platform. Market depth provides us with a live look at the number of contracts attempting to be bought or sold near the market’s current price. The Euro is currently trading around 1.35 to the Dollar. There are 50 buyers at 1.3499 and 32 sellers at 1.3500. Moving a few ticks up or down shows that there are hundreds of contracts waiting to be bought and sold within a couple of ticks of the last traded price. This is clearly enough volume to handle a day trader’s volume efficiently.

Finally, we come to technical analysis. One of the beautiful things about the currency markets is the global trade that they represent. Rarely do we see the currency swings or volatility like we see in the S&P 500. The S&P 500 futures have had 30 days in 2013 where the market moved more than 1% compared to 11 days in the Euro with a 1% move or more. Market movement is important in determining potential profits but, volatility based on news events that change throughout the day will most likely lead to more protective stops being hit as well as more false breakouts in pattern recognition and the corresponding failure of the setup.

Day trading the currency markets like the euro can be a more stable way to grind out profits when the news cycles have turned the stock indices into a yo-yo. The added depth of the currency markets as they relate to global trade brings international conglomerates to the marketplace when the swings get out of hand.

A large portion of my trading, whether day trading or, position trading is focused on following the what the major players are doing and attempting to align myself with their viewpoints. The government shutdown has halted the Commodity Futures Trading Commission’s weekly Commitment of Traders report, which allows me to track what the commercial traders are doing in all of the markets I trade. In its absence, I find the added depth and global viewpoint of the currency market’s participants a good proxy. Therefore, I will shorten my horizons until better opportunities present themselves and I’m once again provided with signal rather than noise.

Market Reactions to Debt Ceiling Changes

The ongoing budget and debt ceiling issues have arguably become as contentious as the Trayvon Martin case in social media. This is as vocally divided as I’ve seen my social media feeds. The left claims that the Republicans are solely to blame for our issues while the right insists we cannot spend forever what we haven’t got. Personally, I think both sides have their heads shoved very deeply up a warm and dark bodily cavity. While Congress argues about how to spend our money and money we haven’t got, they receive a lifetime’s salary plus benefits for 4-6 years of work yet have the nerve to use the term, “welfare state,” in public.

Whether you agree with the left, right or somewhere in the middle is irrelevant in the world of managing finances and trading. What matters is empirical data, not conjecture. A quick survey clearly shows that the economy is starting to slow due to the government shutdown. Consumer confidence is plummeting along with Congress’ approval rating. Government loans are being stalled for small businesses. Mortgages are stalling because government guarantees can’t be secured. Customs is turning into a choke point for global trade as inspections can’t be done and clearances can’t be granted. These are all quantifiable drags on our economy and will be reflected in lower GDP numbers.

The previous points are all uselessly valid. We don’t trade US Customs volume and our assets aren’t invested in Brazilian oranges left rotting at a dock. Our assets are directly placed in the US financial markets. I’ve spent the last week compiling a spreadsheet of debt ceiling negotiations and raises (there haven’t been any decreases) from the last twenty years and compared it to the most likely assets to be affected: interest rates, the US Dollar, gold and the S&P 500. Professors always say that economic choices are made, “at the margin.” Our philosophy has always been to stay ahead of the margin calls in the first place.

The debt ceiling has been raised 18 times since 1993. I chose this start date because it gives us 20 years worth of data during the most politicized portion of our history. Furthermore, the past twenty years have participated in the boom of the information age where the average person on the street has had more and more access to more and more information than ever. This allows all of us to make investment decisions based on fully formed opinions on events as they unfold. Therefore, the data set should be representative of the current investment climate.

Based on what has happened in the past, how can we best position ourselves for the future? Unfortunately, the data is mixed, at best. Because I’m old school and still do charting and modeling by hand, I chose a simple premise. “Where did the markets close the day before the debt ceiling was raised and where were they trading ten days later?” The range of results varied little by direction. The most predictable asset class is the interest rate sector by using the 10-year Treasury Note as a proxy. Ten year Treasury Notes traded lower (higher yields) 11 out of 18 times. This seems logical as raising the debt ceiling should force us to pay more in future obligations. It is worth noting that the declines in the 10-year Note came against the backdrop of a 25-year bull run in the interest rate sector.

The S&P 500 was the second most bearish market as it was lower ten days after the announcement in 10 out of 18 instances by an average of 1.6%. The S&P also retained its typical character of panic sell-offs. The largest gain was only 4.82% in May of 2003 while there were four occurrences of losses greater than 5%. Two were greater than 10%. The largest 10-day loss was a whopping 22.7%. Therefore, raising the debt ceiling and conducting government business as usual is not always a positive for the stock market.

The lone bull in the markets examined was the US Dollar. The slight bullishness in the US Dollar surprised me. The Dollar was higher in 10 out of 18 instances by an average of 1.3%. This is where multiple types of analysis really work together. Last week, we suggested that the Dollar is setting up for a downward trending run. I stand by that analysis. Monday, October 7th, Trader Planet published a piece I wrote on the counter trend bounce typically found in the US dollar after multiple moves to new 30-day lows. The Dollar situation as a whole confirms this theory. I expect the Dollar to rally short-term but fall over the course of time.

Gold was the final market we went into. I didn’t expect to find much here and I didn’t. Perhaps, the biggest point to be made here is that anyone trying to talk you into buying gold because the government is failing, inflation is coming, the Dollar is dying, etc must have a hidden agenda. The data simply doesn’t support the sales pitch. In fact, the biggest moves in the post debt ceiling adjustments in gold were to the downside. The general direction however remains a coin toss as the gold market moved up and down with equal frequency over the last 18 instances.

Finally, there’s one last point to be made of historical proportion and I have to credit my brilliant nephew, Erik VanDootingh for tipping me off to it ahead of the news curve. The markets are scared. Big, BIG money is scared. This can best be measured by the difference between the interest rates that the US government is paying for loans versus what international banks are charging to borrow from each other. Technically, this is the spread between Treasury Bill rates and LIBOR (London Interbank Overnight Lending Rate). For the first time in history, including the 2008-2009 implosion, our government is being charged a higher interest rate to borrow money than banks are charging each other. Interest rates are based on risk. The higher the risk, the higher the rate charged. Let that sink in awhile as you ponder, “too big to fail.”

Insidious Effects of the Dollar’s Decline

The United States is home to the largest and most liquid investment markets in the world. There’s hardly a market one can think of that isn’t exchange listed. This has made the United States the primary destination for excess global capital placement whether it has gone towards the relative safety of government bonds or been more aggressively allocated towards stocks, ETF’s or even the futures markets. The final destination of the investible funds is less important than the singular characteristic that all these investments have in common. They’re denominated in US Dollars and the Dollar’s value may be more meaningful than the underlying asset class.

Investment securities are not protected from the vagaries of their underlying currencies. Therefore, globally allocated investments owned in US Dollars can lose money in a flat market if the Dollar declines. The Dollar peaked in early July and has since fallen by more than 6%. Therefore, if your US equity portfolio hasn’t gained more than 6% since July, you’ve actually lost money. The Governmental shut down has accelerated the recent slide and pushed the Dollar to a new 30 day low for the second time this week. This is only the second time since May of 2011 that we’ve made multiple 30-day lows in the same trading week.

Perhaps more troubling to global investors than the currency-based loss is the fact that the traditional safe haven investments, even in Dollar terms, have not behaved as expected. The primary relationship between the Dollar and the US equity markets since the financial implosion of 2008 has been negative. This has been embodied by Dollar rallies on stock market declines. Very simply, foreign capital gets converted to US Dollars and placed to work through buying declines in the stock market. Conversely, when foreign investors take profits in a rising stock market and convert back to their base currency, the Dollar falls.

We also see this relationship play out in the gold market. Economists on TV tell us to buy gold as a defense against a declining US Dollar. Sensationalists point to the overwhelming debt being created by our country and tell us to buy gold because our country is on the verge of implosion and our currency will become worthless. Speaking of correlations, it’s amazing how many of the people saying this are the ones selling gold investments. Astute investors would notice that the correlation between these two markets has been trending upwards since early June. This means they’re moving in the same direction more frequently rather than opposite each other as expected.

Foreign purchases of US goods have always been Dollar dependent. Every nation and agricultural enterprise within every nation is forced to tie their commodity purchases accordingly. Therefore, it becomes especially disturbing when a weaker Dollar fails to attract foreign purchases of global staples. Beginning in August of 2012 we started to see the commodity markets decouple from the US Dollar. Wheat was the first market to be sated. Corn followed suit in October of 2012 and hogs joined the new normal last November. This means that even base foreign needs have been filled. Therefore, they are more likely to trade in the same direction as the Dollar going forward rather than the typical negative correlation that we’ve seen from bargain hunters looking for inflation in the commodity markets.

The International Monetary Fund (IMF) stated that world Consumer Price Index (CPI) came in at 3.2% year over year for August. This is down from 4.9% a little over a year ago and ties in rather neatly with gold’s last run at $1,800 per ounce early last October. The US unemployment rate is generally believed to be artificially low in the as reported number of 7.3% and Gross Domestic Product (GDP) here in the US came in at a very tame 2.5%. These statistics, combined with a low global industrial capacity usage number suggest that inflation is nowhere near. Furthermore, the Federal Reserve Board’s recent decision not to implement a tapering of the $85 billion per month in economic stimulus reinforces the notion that their primary concern is deflation, rather than inflation.

Many economists believe that we may be near a tipping point in the bull run that has followed the economic meltdown of 2008. The obvious concern now lies in the protection of the wealth that’s been garnered during the recent run. Clearly, the ownership of alternative investments isn’t going to play out the way the pundits have suggested. Therefore, investment vehicles that will profit from a decline in both asset value and currency depreciation should be seriously considered. These include inverse ETF’s as well the futures markets, which will allow the seamless execution of short trades including currencies. Equity futures spreads selling small caps like the Russell 2000 and buying big caps like the S&P500 are also a good idea when expecting volatile, downward markets. Remember that cash is only king as long as the King’s throne isn’t sinking.