Gold, interest rates and the stock market have a very interesting relationship. Normally, declining interest rates are good for business and bad for gold. Post 9/11 and housing bubble, zero interest rate policies (ZIRP) created an artificial situation that fractured this relationship rendering it virtually useless over the last decade. This began to change last summer when the Federal Reserve Board stated that they would begin slowing the stimulus they’ve provided to the economy thus allowing interest rates to gradually rise. These relationships have begun to sort themselves out over the last three quarters and may actually be telling us something about the current pricing in the gold market.
Trading the grain markets has always been tricky, especially during the planting and harvesting periods. Historically, this has placed us at the agricultural epicenter for global grain trade. Obviously, tension in Ukraine and the corresponding 15% spike in wheat prices have reminded everyone that even the agricultural markets are now a global game. In this respect, it’s no longer enough to keep an eye on domestic weather patterns to determine the success of our winter crops or anticipate spring wheat seeding. Now, it is imperative to focus on global production issues and World Trade Organization (WTO) agreements, as well.
The cattle market has reached new highs repeatedly this month. We’ve known for years that the U.S. cattle herd has been steadily declining. It currently stands around 89 million head, which is the lowest it’s been since 1952. This hasn’t mattered much as the decades long decline in US beef consumption has wilted domestic demand. Furthermore, the impact of modern animal husbandry techniques have significantly increased the final weight of the cattle that hit the slaughterhouses, thus supplying the market with more total beef on fewer total animals killed. All of this bearish information begs the question, “Why are cattle prices so high and where do we go from here?”
The recent bout of record breaking low temperatures has led to an obvious increase in the demand for natural gas and pushed delivery prices up to $4.40 per million metric British thermal units (mmbtu). These are the highest prices we’ve seen since the heat wave and drought from the summer of 2011. In fact, the Energy Information Administration reported the largest natural gas draw for the week of December 13th since they began tracking it in 1994. Furthermore, many analysts expect to break this record yet again with this week’s report. However, in spite of the recent strength in the market, I believe that there are several structural reasons why this rally won’t last and that the pricing of forward natural gas will head lower from here.
Actively participating in the markets comes with the understanding that the trader’s gut will be checked frequently and deeply. The primary cause of this is the trader’s degree of certainty in an uncertain world. It’s been proven over and over again that once an individual feels that they have enough information to make a decision, they will. Additional information provided after the fact typically raises the degree of certainty that the correct decision was made, rather than raising the degree of accuracy. So, I sit in front of the Federal Reserve Board’s announcement this afternoon involved up to my eyeballs in the US Dollar, Euro currency, 10-year Treasury Notes and the Russell 2000 stock index.
Each one of these positions is the result of mechanical trading programs that I’ve developed, tested and traded. Therefore, there are no arbitrary decisions or adjustments to be made. This leaves me in front of the screens sitting on pins and needles waiting for a range of possibilities to materialize. Given my experience with the markets, I expect the outcome to be somewhere in the middle. Rarely does it turn out one sided either positively or, negatively.
Let’s review the possible outcomes and the gut wrenching turmoil that comes with sitting on several large positions as I try to close out the books for 2013. My oldest position on the books is short the Euro FX. I stand to profit if the Euro currency weakens against the US Dollar. I’m short the market near the top of its range based on my research into the Commitment of Traders Reports. I know that there’s about a 60% chance the Euro will back off these highs by about a penny and a half. However, the market’s continuing consolidation near these highs puts me in a position where I could be stopped out of the market with a loss even before the Fed announces its decision this afternoon. The market’s proximity to my stop loss order contributes greatly to my angst.
The opposing position to the Euro is my long US Dollar Index position. Again, I’m long the US Dollar Index against a basket of currencies, which is dominated by the Euro. If the Fed suggests that they will begin to taper quickly, the Dollar should rally. Pulling stimulus out of the economy will place fewer Dollars in future circulation thus, increasing the value of the Dollars already in the market. The Dollar would rally and the Euro would fall. Both of my currency positions would be profitable.
Tapering by the Fed would most likely crush my 10-year Note position. Frankly, the discretionary trader in me can create the strongest case for owning 10-year Notes and betting against taper talk. Based on my analysis of the commercial traders in the 10-year Note I fully expect any decline in Treasury prices to be short lived. Commercial traders have accumulated their largest net long position in the 10-year Note since April of 2005. Commercial traders have dominated the big moves in the Treasuries with uncanny accuracy. If they’re right about no taper talk this afternoon, Treasuries will rally substantially and I’ll profit from my position….while losing on my currency trades.
This leads to my final position. I use a pretty fancy program for developing my day trading systems. Whereas my swing-trading program is based on the fundamental data inferred from the collective positions of the markets’ participants, my day trading programs are strictly technical. Knowing that the markets will unfailingly put a man to the test, it should come as no surprise that my day trading programs now have me long two units of the Russell 2000 stock index heading into this afternoon’s announcement. Furthermore, while I have some expectations of how the currencies and Treasuries will react to the Fed’s decision, the stock market’s reaction is far less predictable. If the Fed tapers, the stock market may rally further based on the assumption of a strong economy leading to further gains. However, the collective reaction could very well be violently lower as tapering could signal the end of the free money that many believe has fueled the rally to this point.
Discretionary traders face conflicting data like this all of the time and pick and choose which markets they’re in and when they’re in them. Systematic traders follow the signals generated by their programs without question. The cruelest aspect of trading is the market’s uncanny ability to seek out a traders’ weak spot and twist agony’s knife. I’ve been actively trading for more than 20 years and the trepidation of a pending report never goes away. This is where the classic line, “Plan your trade. Trade your plan” has the most value. Remember, additional information acquired after the fact doesn’t increase the odds of being right, it simply tricks the mind into greater certainty of the existing thought pattern.
The equity markets have just been rip roaring strong. Companies like FedEx, Google, Morgan Stanley, Walt Disney and Boeing have all gained more than 40% this year. The equity markets have made new all time highs, eclipsing the pre-crash highs from 2007 with hardly a shudder and soldiering on past the tech bubble highs of 2000. Recently, the technical analysts at Merrill Lynch came up with a four-year target of 2300 in the S&P 500. This is based on their analysis of the long-term pattern that was triggered by the new highs. The S&P 500 has climbed more than 150% since March of 2009. While I’m the first to admit that I’ve left a lot of money on the table by not sticking with the long side of equities, I’ve been doing this long enough to know that there’s always another trade. Therefore, I will not be committing new money to the long side of the equity market at these levels in 2014.
The way I see it, there are two opposing forces at work here. First, we have the Federal Reserve Board that keeps pumping money into our economy. The Fed continues its easy money policies indefinitely. There are seven voting members of the Federal Reserve Board of Governors. Six of them have been broadly categorized as dovish, in favor of easy money/stimulus. There are four more rotating members from the national Federal Reserve Banks. This is where things may get a bit interesting. Three of the rotating members gaining a vote in 2014 are centrist to hawkish. While the doves are still clearly in control, especially with Janet Yellen expected to assume the Presidency of the Board, the dialogue in the minutes of their meetings could change substantially.
The easy money policies have favored the equity markets in a couple of different ways. The artificially depressed interest rates have forced investors to accept more risk for returns that used to be outside the scope of retiree investing. The stretch for yield has driven a boom in riskier corporate bonds as investors move down the ladder in an attempt to maintain their portfolio’s value. This has caused a surge in lower credit bond prices reminiscent of the sub prime mortgage debacle of the mid 2000’s. Investors’ lack of satisfaction with the governmentally manipulated yield curve has led them to seek returns in the stock market specifically, through high yield investments like Real Estate Investment Trusts and utilities. What has gone unnoticed is the disappearance of nearly half of the companies listed on U.S. exchanges. Therefore, there’s more money than ever chasing a smaller number of stocks in the last 25 years.
Secondly, we have reached valuations that bode poorly for long term investing. Research abounds on the usefulness of long-term valuation models. Very simply, expecting these returns to continue through long-term investment at these valuations would set an historical precedence. Anything can happen in the world of markets but the odds clearly show that bull markets do not begin when the P/E ratio of the S&P 500 is above 15. The S&P 500’s P/E ratio currently stands above 19 and Nobel Prize winning Yale economist Robert Schiller’s cyclically adjusted price earnings (CAPE) ratio is over 25. Both of these will continue higher as long as the equity markets continue to climb. Neither is sounding the, “Everyone to cash,” alarm bell. Their history simply suggests that it would be foolish to expect these multiples to continue to climb and climbing P/E ratios are necessary for stock market growth.
Closing in on 2014 has left many money managers whose performance is benchmarked against index averages scrambling to catch up. There are two ways a manager can do this. First, wait for a sell off and try to buy in at a discount. This is part of the reason that the weakness in July, August and October was so quickly recovered. Second, apply leverage so that the manager’s fund gains more than $1 for every $1 the market moves. Leverage seems to be the move of choice. This year has seen a huge inflow into equity mutual funds, which have to be benchmarked to their index. By comparison, each of the last two years saw net equity mutual fund outflows. The added influx of cash has led investment managers into the futures markets, specifically the S&P 500 futures. The most recent Commodity Futures Trading Commission’s Commitment of Traders report shows a 10% growth in leveraged longs as well as a 5% decline in leveraged shorts. Finally, margin debt on the stock exchange itself has also reached an all time high.
The case I’ve laid out says nothing about where we’re going. Liken this presentation to a new home survey. The place has curb appeal. The neighborhood is growing. The government is supporting its growth. Each new home sells for more than the last. What could be wrong with buying now? Well, the inspector may inform you that everything you believe to be true is resting on a shaky foundation. The house may stand for years or, not. Personally, I’d rather be in on the ground floor than looking for a window to jump out of having climbed in at the top.
The United States is crawling into 2014 with the Federal Reserve Board doing everything it can to stave off deflation. Years of zero percent interest rate policies along with the current $85 billion per month in stimulus have failed to generate inflation in anything but the stock market. This leaves GDP well below 2% and unemployment remains stubbornly high. Meanwhile, the European Central Bank just cut their rates in half, now at a .25%, to spur any kind of economic growth of their own. Typically, two thirds of the world, North America and Europe mired in economic doldrums would lead to a generally soft commodity outlook. However, China’s growth continues to be the real story and this is best explained by the inner workings of the copper market.
China’s growth rate continues to exceed 7.5% and is expected to register a third consecutive quarter of growth, which may top 8% for Q4. The vast majority of this growth is in building. Industrial infrastructure and residential construction continue to boom. China’s arcane domestic investment laws are partly to blame for this as their residents have very few open channels of investment other than real estate. Further muddying the waters is their version of the loan qualification process, which now accepts hard assets, like copper as collateral. This has put China in the top spot in global copper consumption. In fact, they consume approximately 40% of the world’s copper shipments.
We often refer to copper as, “the economist of the metals market.” The logic follows the line of copper as a base need for economic expansion, which we view as building stuff – houses, electronics, buildings, cars, etc. It appears that the Chinese growth story is bigger than old world economic malaise. The copper market has seen renewed interest in commercial buying since Bernanke’s tapering talk in August signaled an, “everybody out of the pool,” moment. In fact, cash copper prices are trading above the copper future’s price and copper miners are negotiating just how high they’re going to set their premiums for 2014.
The current spot premium is around $.05 – $.07 per pound which reflects the highest premium since the collapse of ’08. The surge in demand is prompting premium increases of 50% and higher as producers negotiate with Europe, Asia and America. Codelco, the world’s largest copper producer has announced planes to raise Chinese premiums by 41%. There are similar increases of 50% for the U.S. and up to 75% for the European Union. These price rises come in the face of an expected surplus of 200, 000 tons (less than 2% of total market) after experiencing a three-year supply deficit. In spite of the projected surplus, Codelco has openly admitted that they’ve hedged none of their forward production.
Commercial traders in the copper market were what tipped me off to the market’s increasingly bullish outlook. I was so busy looking at our domestic economy that I didn’t see the rebound in their buying after initial talk of tapering, which pointed to slowing growth and declining demand created the bearish scenario I outlined in Augusts’, “Copper Points to Slowing Economy.” Clearly, the cash market premiums are leading end line users to hedge their future needs through the purchase of forward copper futures contracts.
The largest net long position I can find for commercial traders in the copper market is near 40,000 contracts. This was made during the July sell-off. Previously, the largest net long commercial position I could find was in February of 2009 when copper was trading at $1.75 per pound and we were coming out of the major market crash. What the market is seeing now is a greater willingness to own copper at much higher prices. This buying support is putting a floor in the market around the $3 per pound level and is prolonging the sideways market direction that has persisted throughout the year. The longer this occurs, the closer we are to breaching the downward sloping trend line that originated at the 2011 highs around $4.80 and now comes into play around $3.36 per pound. Obviously, a move above this would confirm the move for 2014.
We see two potential concerns in this 2014 scenario. First of all, China has always been an opaque marketplace where the economic statistics produced by the government must always be taken with a grain of salt. There is talk that end line demand is nowhere near as strong as Chinese imports suggest. However, for our purposes, it is pretty irrelevant if China is using their copper imports or, storing them. Either way, supplies are being taken off the market. Secondly, much of the mining that’s counted in moving us to surplus is in new mines whose production is only estimated. Therefore, their production numbers aren’t yet solidified. Finally, all things considered, copper may be one of the best physical assets to own as we approach 2014.
The wheat market is a primary staple in human diets as well as global trade. This causes the wheat trade to be affected nearly as much by geopolitics as it is by price and weather. Therefore global trade prices have to factor in sanctions, duties and taxes as well as transportation fees. The simplest way to understand this is by looking at the surplus produced by the primary growers like Canada, Ukraine, Russia, Australia, Argentina and the European Union as well as us and then trying to determine why each one of those countries are also wheat importers. Due to the conflagrated nature of global trade negotiations, I find it easier to focus on the primary players here in the U.S. and plan my trades accordingly.
First, I screen the markets’ traders and their eagerness to participate in any market by reviewing the Commodity Futures Trading Commission’s weekly Commitment of Traders Report. This report breaks the markets’ participants into a few primary categories – index traders, non-commercial traders, commercial traders and non-reportable. Briefly, Index traders manage the long only allocation portion of the fund they represent. Non-Commercial traders tend to be the money managers within the futures industry. They trade from both the long and short side as they see fit. Commercial traders are either the producers of the commodity or, the end line users of it. Their trading is based on managing their costs from the production side and maximizing their profits on the producer side. Finally, the non-reportable category is left to small speculators, producers and end line users who are too small to qualify for a larger group.
Hedge funds fall into the non-commercial trader category and their movement finally began to be tracked by the CFTC in 2006. The last three weeks has seen the largest jump in their short position since their trading has become a matter of public record. There are three important factors at work here. First of all, most of this selling took place prior to the November 8th USDA crop report. Secondly, commercial traders in this case, the end users, have absorbed every bit of selling the speculative money has thrown at them. Finally, this dynamic shift in market participant makeup comes near major support near $6.50 per bushel in the March Chicago Board of Trade contract.
This sets the stage for a climax. Our bet is that most of the price decline has passed. Commercial traders are value players. We are looking at the end line wheat consumers locking future delivery prices in order to generate their business models for 2014. Cereal and bread producers are fully aware of what their input costs are and they clearly view this as a bargain. The non-commercial traders who’ve taken the short side of this market are typically trend followers and pay little attention to price. They’re simply riding the wave….until it crashes.
I believe their wave is about to crash. First of all, wheat hasn’t been this cheap since July of 2010. Secondly, in both June of 2010 and May of 2012 commercial and non-commercial traders squared off in a similar manner. These market imbalances strongly favor an outcome in favor of the commercial traders. In fact, most solid wheat rallies start by commercial traders putting a floor in to support prices and lock up future inputs. Conversely, every trend trader trades the trend until it’s over then, they give back a chunk of their profits on the ensuing market turnaround. Finally, open interest peaked in September and has begun a much earlier decline than normal into the December futures expiration cycle. This means the market is failing to attract new players at these depressed levels.
The daily chart shows a solid basing pattern that is holding just above major support. The December wheat futures rapidly approaching expiration means that anyone who doesn’t intend on delivering wheat of the appropriate standard to an approved collection site as well as those who aren’t fully prepared to take delivery of the contracts they’ve purchased must offset their position. Obviously, end line consumers are looking forward to their delivery of cheap wheat. Meanwhile, none of the non-commercial speculative money will be able to make any deliveries. Therefore, I believe that the buying from non-commercial short covering will begin to fuel a rally in the wheat futures market.
You can find more on our application of this strategy at COTSignals.com.
The United States has tripled its balance sheet since 2008 and Great Britain has quadrupled theirs in the same time frame. Theoretically, the growth in the currency base should be accompanied by a corresponding decrease in the purchasing power of our Dollars and Pounds. Many of us who’ve worked diligently for years trying to manage our personal budgets and build up our personal stores of wealth find the governments’ actions downright criminal. This is the scenario that’s drawn billions into the gold market. We’ve been taught that gold is the first choice alternative investment for fighting inflation and maintaining the value of our savings. This week, we revisit an alternative to gold as a hedge against inflation and currency debasement – the Bitcoin.
I published a piece on the Bitcoin in June of 2011 titled, “The World’s Strongest Currency.” Many viewed this as a passing novelty at best or, the next .com bubble. At worst, people saw it as the international street criminals’ Swiss bank accounts. Bitcoin is an Internet currency that is traded globally for goods and services and can be cashed out in the physical currency of your choice. It is, “mined” on individual computers that are placed, by anyone, on the network. The mining is basically using your computer to solve an equation. The equations get harder and harder through time. This ensures that the supply of Bitcoins grows at a stable rate. The publicly validated equations place more Bitcoins into circulation by the people who’ve mined them. The number of Bitcoins currently stands near 12 million. The next equation and number of coins in circulation are all publicly available in real time.
When we published the first piece in June of 2011, Bitcoins were trading near $14 per Bitcoin with 6.6 million Bitcoins in circulation for a market cap around $92 million. The Bitcoin mining equation is public information. It’s always known how many are in circulation as well as the growth rate. Furthermore, the total number of Bitcoins will be limited to 21 million by the equation itself. These are the currency controls lacking in today’s global economy. The proof lies in the adoption and acceptance rate of Bitcoins, which is growing exponentially. The current Bitcoin market is 12 million Bitcoins at $400 each for a market capitalization of $4,800,000,000. This places it between Exxon Mobil and Apple in market value.
This leads to the .com bubble argument. There’s no question this market is extremely volatile. Let’s put the volatility in context before Bitcoin is dismissed and demonstrate why it isn’t a fad. The S&P 500 declined by more than 50% in four months during the housing crash and has more than doubled, reaching all time highs since. The European Central Bank just cut their interest rates in half and gold is nearly 40% off of its highs. The world we live in is a volatile place. I’d argue that we haven’t seen this much change in the political/economic/social aspects of this world since World War 2. I’d argue further that it is precisely this volatility that has made Bitcoin a globally accepted alternative form of payment at both the retail and business-to-business levels.
Bitcoin has clearly passed the novelty stage. EBay as well as Amazon accept them. They’re even beginning to show up as an ATM. The first ever Bitcoin ATM was recently installed in Vancouver and it processed more than $100,000 in transactions in its first week. This is no ordinary ATM. There are financial controls on Bitcoin just like normal currencies. In Canada for instance, they are only allowed to exchange $3,000 per day without filing anti-money laundering documents. I recently visited Mt. Gox.com, the leading Bitcoin exchange and found their registration requirements to be every bit as stringent as the ones we face in the commodity futures markets. This degree of regulation continues to add validity to the Bitcoin system rather than hindering its growth.
We live in a world of fiat currencies subject to monetary adjustments or downright manipulations that many of us have no say in. Frequently, the decisions that are made for us negatively impact the very foundation that we’ve worked so hard to build. Bitcoin is a known quantity in a world full of unknowns. It travels globally without the processing fees of PayPal, Western Union or the banking industries. In fact, the current banking systems’ loss of processing fees is both a boon to Bitcoin business as well as the reason for the most vocal arguments against it. After all, JP Morgan has to recoup the $8 billion they’ve received in regulatory fines over the last two years somehow, right?
The government shutdown has passed and the markets are still here. The stopgap measures that kicked the can into early next year merely provided a buying opportunity in the interest rate sector for the top 1% while providing the catalyst for the final leg up in a bubble that makes the housing issue of ’07 look like an appetizer. Recent reports suggest that two separate papers presented at the International Monetary Fund meeting this week highlight the potential for a serious revision and extension of the fiscal stimulus plans already in place. Given the current nature of our markets, it’s hard to see how this doesn’t turn sour in the long run.
The Federal Reserve Board has two primary objectives; fostering full employment and stabilizing market prices. Historically, market prices referred to those things in life, which affect all of us like, milk, gasoline and farmland. This perspective has increasingly shifted towards the stabilization of more esoteric prices like the stock markets and interest rates. This shift in focus was originally designed to prop up a swooning stock market as well as getting capital flowing again during the heart of the economic collapse of ’08. The markets came roaring back with equities more than doubling and reaching all time highs this year and interest rates have bumped along at historic lows ever since.
The Fed achieved their goal of stabilizing prices ages ago and it has been proven that each additional increase in Quantitative Easing has been exponentially less effective than the previous one. This path will be followed for the next four years as Janet Yellen is handed the reins of the Fed next year. Why would the smartest minds ignore the data that so clearly illustrates these points? The simple answer is that, “and in other news, the Dow Jones Industrial Average reached another new high today,” sounds like a win to the average John Doe. The truth is that the average John Doe has never participated less in a stock market rally. Furthermore, the headline unemployment rate of 7.2% does not take into account that the labor participation rate is at a 35 year low. Therefore, the unemployment rate as published fails to include 90 million Americans who’ve simply given up looking for work and are drawing no unemployment assistance, thus no longer counting as unemployed.
Recent talk of tapering off the $85 billion per month Fed bond buying programs spooked the equity markets and sent the bond market plummeting, and rightly so. There’s no question that the excess capital created by the Fed must end up somewhere. We’ve seen a full rotation out of stocks and interest rates and into commodities and gold. Now, it’s out of commodities and back into interest rates and equities. The government shutdown created the mother of all buying opportunities in the interest rate sector. You can see the commercial trader buying surge as the Fed’s suggestion in May scared the market. I believe this could lead to the final phase of an interest rate bubble that dwarfs the housing bubble because the big money knows the Fed is too scared to take their foot off of the accelerator and has backed themselves into a corner due to their willingness to manipulate prices on the open market.
We’ve already seen some of the smartest bond money in the world step aside with Bill Gross of Pimco choosing to exit the 30-year bond bull. However, like most smart money, he’s probably early on the way out and will probably miss the last leg up. Although, he was recently quoted about buying the bottom of the shutdown that it was like, “picking up pennies on the street. Somehow, I think he’ll survive. His pennies are not the same as my copper pennies. Banking analyst Dick Bove said on CNBC that the US balance sheet shows us at $16 TRILLION in the hole. Most of this is coming due between 2018 and 2020 as the Fed has taken advantage of lower yields across the board to increase the average length of maturity from 4.1 to 5.4 years since 2009.
Finally, the two papers presented this week will suggest that we EXTEND the length of the QE programs from the original goal of 6.5% unemployment and 2.5% inflation to perhaps 6% or even 5.5% unemployment as inflation is yet to rear its head. The Fed has increased its monetary base from less than $1 trillion prior to the economic implosion to more than $3.6 trillion. If the economic stimulus is the cause of the decline in unemployment from 10% to 7.2%, not counting a quarter of the US population who’ve quit looking for work, then a linear equation suggests that another $1 trillion would get us to 6% unemployment.
Current bond market expectations suggest the 10-year Treasury Note may close the year near 2.25%. That’s approximately 60 basis points above our current price of 126^27. The market would have to reach a new all time high of 133^13 for yields to decline this far. This represents a $6,500 rally per contract in the 10-year Note futures. Given the nature of the bond market, I expect to be able to get this market bought around the 125^00 level and would risk the trade to the 16-day government shutdown low around 122^00. This would provide a risk to reward of $3,000 to $8,400. While we fully intend to trade the bond rally, our primary concern remains focused on what happens once it’s over. The big question remains, “How can the Fed weasel its way out of a situation that they created for themselves while continuing to suggest not only its continuation but, its continuation beyond the original scope of its design?”
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