Tag Archives: futures markets

American Investors Safe from Nickel’s Boom and Bust

There’s good news on the horizon for the average U.S. retail investor. There’s a bubble coming and for once, Joe Investor is going to miss out on the boom and crash. Two primary stories create the potential for a short-term meteoric rise in prices only to quickly plunge as macro economic forces and political issues sort themselves out. In a world full of financial instruments, global exchanges and products ranging from weather derivatives to technology indexes to silkworm futures, the base metal nickel is inaccessible to the average retail American trader.

Continue reading American Investors Safe from Nickel’s Boom and Bust

Equity Market’s Race to the Top

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.

Short Covering Spike in the Sugar Market

The sugar market is currently displaying a number of characteristics that truly define what trading in the futures markets is all about both long and short-term as well as trend and countertrend strategies. Looking at the sugar futures market from a long-term trading perspective it is easy to see that short traders have been in control of the market since the last upward spike in prices last July. The sugar futures have steadily declined under the growing certainty of a large Brazilian harvest as well as declining demand in a slow global growth economy. These factors have combined to push sugar to its lowest traded prices since December of 2010.

All the telltale signs of a solid trend have accompanied the sell off in sugar. For example, open interest has skyrocketed from approximately 70k to more than 350k since the July 2012 high. There are two reasons that open interest swells as the market moves directionally. First of all, the market allows the people who are early to put on the correct position to stay in that position. I know this sounds simplistic but traders with profitable positions can rest easy and let the market do its own work. Secondly, the increase in open interest is attributable to more people climbing on the trend. Other than a minor spike last October, most anyone who has initiated a short position in the sugar futures market has been rewarded with profits quite readily. These two factors work hand in hand inviting more people to board the gravy train of easy trend riding profits.

The downward trend in sugar futures is well founded due to the expectations of a huge 2013 harvest that should be led by a record Brazilian harvest. This is news that everyone is aware of and this fundamental information has attracted good traders to the sell side of the market. Technical traders have also had an easy go of it since what rallies there have been have been capped nicely by the 90 day moving average. In fact, the last time the 30-day moving average crossed under the 90-day moving average was in August of last year. Finally, technical traders on the short side have collected profits due to the orderly decline of the market thus far rather than getting stopped out on any spikes in volatility.

This brings us to the current situation and our reasoning for looking for a buy signal in a downward trending market. First of all, the ballooning open interest happens to occur as the market has begun to stall. The market has traded between 16.69 and 19.25 since February 1st. This is a pretty tight range considering open interest has more than doubled since then. This means that there are more than 150k new short positions in the market over the last six weeks. Furthermore, none of these new short positions have had the chance to accrue much in the way of profits.

Technically speaking, these new short positions should be sweating. The sugar futures made a new low for the move last week, trading down to 17.56 and followed it up with a new low this week down to 17.55. Last week’s trading range was merely 22 points. The last time the market traded that tightly for an entire week was in September of 2010. Furthermore, this week’s new low, by one tick, has now been followed by a breach of last week’s high at 17.78. This creates an outside bar on a weekly basis. This is typically a good reversal signal for the next couple of weeks.

The new short positions will have protective stops placed relatively close to the market since risk should always be the number one consideration when determining a trade’s appropriateness. This week’s action clearly showed that the market has run out of people willing to create new short positions under 17.55. Markets always run to where the action is. The declining ranges combined with this week’s reversal bar lead me to believe that the next move is higher.

I expect the market to make some type of bottom here. However, it is always important not to sell a rocket or, buy a falling knife. We will enter the market through the use of a buy stop order. This means we will only buy the market if it can climb high enough to trigger our entry stop, which will be placed at 17.85. We expect this to begin triggering buy orders all the way up as traders take their profits or losses, accordingly. I expect the market could trade as high as the 90-day moving average at 18.74. More likely, it will stall out between the trend line dating back to July that now comes in at 18.47 and the 90-day moving average, now at 18.74. If our buy stops are filled, we will place a protective sell stop at 17.59, which should limit risk to just under $300 per contract.

Rarely do we find a contrarian play so clearly set up and with such a high risk to reward ratio. If we are right, the market will get us in on the long side just as 150k contracts are washed out on the short side thus creating a technical bottom in line with the seasonal tendency of the New York July sugar futures #11 contract.

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.

Cause of Commodity Volatility

Last week I suggested that the blame for the sell off in
silver was incorrectly placed on the small speculators’ direct participation in
the futures markets and further added that the volatility we’ve experienced is
going to be with us for quite some time to come. This week we’ll explain the
effect of Commodity Index Traders (CIT’s ) and Exchange Traded Funds (ETF’s) on
the commodity markets.

Commodity Index Traders are a relatively new phenomenon in
the futures markets. They began to gain notoriety as Exchange Traded Funds
based on commodities and started to make inroads with equity investors.
Commodity Index Traders have the same goal as mutual fund managers. They
attempt to mirror the index their fund is matched to. A mutual fund manager of
large cap stocks may try to match the S&P 500’s performance as their
benchmark. A Commodity Index Trader may try to mirror the Goldman Sachs
Commodity Index (GSCI) or, as it was known on the trading floor the, “Girl
Scout Cookie Index.”

The important similarity between these two types of
investment is that they are both, long only. People who invest in these funds
have bought the basket that the manager has acquired. This has, historically,
been a niche vehicle in the commodity markets and gone largely ignored until
the easy money policies following September 11th and the economic
crisis of ’08 devalued the dollar and sparked inflation in hard assets.

The oldest and largest commodity based ETF is GLD. As you
might have guessed, this is the gold ETF. It went public in 2004 and now holds $55
billion dollar’s worth of gold. Since the fund physically owns the gold, they
are responsible for holding more than 36 million ounces of gold at its current
price of $1,500 per ounce. This is the equivalent of more than 7,000 gold
futures contracts. They must adjust for their holdings as necessary to meet
investor redemptions as well as the demands of new subscriptions.

Mutual fund, ETF and CIT managers all have a tough time
beating their benchmarks. They are all bound to act on behalf of the public and
therefore, are subjected to the same shortcomings as the individual
participants’ human psyches.  In
practical terms this means that people, the individual investors, are most
anxious to buy at the top and sell at the bottom. When management fees are
factored in, it’s no wonder that gold futures have out performed the GLD since
its inception by more than 5% in price alone.

Furthermore, because an ETF’s trading strategy must be made
public in its prospectus, the managers’ trades are subject to market
manipulation by traders who know what action GLD must take in the markets and
when. The potential for manipulation is directly addressed in their prospectus.
“Other market participants may
attempt to benefit from an increase in the market price of gold that may result
from increased purchasing activity of gold connected with the issuance of
Baskets. Consequently, the market price of gold may decline immediately after
Baskets are created.”

Commodity based ETF’s have exploded in popularity over the
last few years. There are now more than 100 publicly available funds with a
combined net asset value of more than $110 billion dollars invested.
Furthermore, at the market highs in 2008, Commodity Index Traders held more
than 40% of the total commodity futures markets’ open interest, which was worth
an additional $60 billion. This is the money that has created the current price
floors that we are all calibrating ourselves to as the new normal.

The new money added to the commodity markets has roughly
doubled the size of the commodity markets’ capital base and indirectly, brought
untold numbers of new investors to commodity futures products. Considering that
this money is almost exclusively individual investors on the buy side, it’s
easy to see how general human psychology will exacerbate the highs and lows of
each rally and decline. The new normal will be higher volatility on the greedy
path to new highs as people climb on board followed by higher volatility on the
down side as individuals abandon ship.

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.

Trading the Coffee Market

Is the price of that morning cup of coffee doing more to wake you up than the coffee itself? Lost among the commodity headlines of gold, silver and oil prices, the price of coffee has risen to a thirteen year high over the last three months. Starbucks, Millstone, Caribou and others have all been forced to raise their prices to account for the increased price of their raw materials and the rise in prices has not been confined to high- end purveyors. Both J.M. Smuckers and Kraft Foods have been forced to raise prices on their Folgers and Maxwell House brands respectively.Currently, McDonalds is the only outlet able to hold their prices steady.

Coffee prices have risen 45% since the beginning of June due to serious production issues in multiple geographic locations. The extended length of the Asian monsoon season has affected the harvest of India, Vietnam and Thailand. These countries are responsible nearly 30% of global coffee production. While an extended rainy season has delayed the Asian crop, Brazil’s has been hampered by lack of rain. Brazil is the world’s largest producer and according to the Brazilian Coffee Council, the drought they’ve suffered through could cut production levels to the lowest output in four years.

The fact that retailers have been able to keep their prices reasonable, raising their prices around 11% on average is a testament to the necessity of the futures markets and their role in the economy. The futures markets were originally designed to allow producers and end line users of commodities to create binding contracts that specified the delivery date, price and quantity of the given commodity. Coffee retailers have been able to stay ahead of the rising prices by hedging their price risk in the coffee futures market. Contracts that were purchased prior to June have the benefit of the stable prices that coffee had been trading at for nearly two years.

Trading agricultural commodities entails an understanding of the price risk associated with each individual market. Broadly speaking supply and demand are the two types of risk that need to be accounted for. Agricultural commodities have a supply risk factor factored in to rising prices. This protects against any setbacks created during the growing season by the weather as well as accounting for any labor unrest during the harvest season. This is exactly the opposite of the risks associated with investing in the stock market. The fear is on the downside and there is a built in risk premium to the downside. The stock market deals with demand based risk.

Commercial traders are made up of two groups, the commodity producers who control the supply of a commodity and the end line consumers who create demand for the given commodity. These two groups are responsible for the battle to create value. When a market gets over valued, commodity producers come into the market and sell the crop they expect to produce within a given time frame. Conversely, when the price of a commodity falls below a perceived fair value, end line consumers like Kraft Foods and J.M. Smuckers will come into the market and stockpile the commodity to meet their future production needs.

This is the battle that’s currently unfolding in the coffee market. Coffee retailers are being forced to pay higher prices to ensure their raw materials for future production while coffee producers are taking advantage of the higher prices to make up for their lack of output. Tracking the movement of commercial trader positions through the commitment of traders report shows that end line consumers were large purchasers of coffee futures beginning at the end of June. We can also see that their buying appears to have peaked in early September. This cycle ensured delivery of the necessary raw materials through the end of the year.

Right now, the producers still have control of the market and we will continue to look for opportunities to buy selloffs in the coffee market. This allows us to put the purchasing power of major retailers behind us as well as the seasonal strength that tends to accompany the coffee market harvest period and into January. Our opinion will change when we begin to see the coffee producers rush to get their future crops sold. Whether the rush comes at higher prices or lower prices isn’t as relevant as the fact that farmers believe they won’t be able to sell their crops at these prices in the near future.

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.

Don’t Pay Up for Precious Metals Diversification

Gold and silver have exploded in recent years. The contributing factors of low interest rates, economic uncertainty, global fear and pending inflation have done their share to boost precious metals’ outsized gains relative to the stock market. Gold has rallied more than 150% over the last five years while the broad stock indexes are all flat to lower, depending on the day. Silver, for its part, has nearly doubled in the last five years. Given our still historic low interest rates and the growing economic trouble overseas as well as our ballooning governmental budget deficit, it’s reasonable to believe that the forces behind this trend continue to remain intact. The question has changed from, “Should I be invested in precious metals,” to “What’s the most cost effective way to maintain a presence in precious metals.”

The boom in the precious metals market has brought with it the familiar hype of the gold bugs. It has also fostered the invention of precious metal Exchange Traded Funds (ETF’s) and cash for gold TV commercials. Commodity futures markets have also benefited from the added attention being paid to gold. Each of these has a place in the marketplace and each has a vested interest in hyping their product as the one that’s best suited to your needs. However, if you are ascribing to efficient portfolio theory and seek to include precious metals ownership as a part of your portfolio diversification plan, the best bang for your buck is through commodity exchange traded contracts which are regulated by the Commodity Futures Trading Commission (CFTC) and guaranteed by their appropriate exchange.

The market sectors mentioned above can be lumped into two categories: small speculators and investors. Gold bugs and cash for gold are for people with left over jewelry, some family heirlooms and gold coins like American Eagles or South African Krugerrands. Typically, this type of gold ownership sell side biased. This means owners of small pieces or collections are keeping an eye on price and hoping to sell when they think the market has peaked. When they bring their physical collections to market, they will end up at the coin shops, pawn shops, cash for gold, or their local jewelry shop. The willing buyers are always waiting and ready to pay below market value for collections that may have taken a lifetime to accumulate. Upon recent survey of the available outlets, prices to be paid were typically $40 per oz under market value for gold and $.30 per oz under market value for silver. Those on the buy side of this equation, looking to add to their private physical collections will find themselves paying up $30 – $50 per oz over market value in gold and up to $1.20 over per oz in silver. Therefore, small speculators in the physical precious metals market may lose more than 10% of the value of their collection in the buying and selling process.

Passive investment in the precious metals can be done in two ways, ETF’s and commodity exchange traded products. The benefits of ETF’s are that the amount to be invested can be determined beforehand and the investor can pick their own allocation, even if that amount is less than the price of one ounce of gold. The downside is these ETF’s typically underperform the actual market they are designed to track. Typically, one would expect a dollar for dollar rise and fall between the price of the metal and the value of the account. However, due to administrative fees, expenses, incentive fees, cost of acquisition, advertising, etc, the longer the ETF trades, the further behind the actual price they fall. Therefore, it is possible to lose money in a flat market, or realize a smaller return than one would expect in a rising market.

Finally, exchange traded commodity contracts like those listed with the Chicago Mercantile Exchange Group are the actual proxy to which ETF’s and local dealers tie their prices. Perhaps the single biggest drawback to these products is their preset size. There are about half a dozen precious metals products listed ranging in full cash value from $18,000 to $125,000. These contracts have several benefits for passive portfolio diversification. First, these are standardized products fully assayed and certified by the appropriate exchange. This assures the investor that their 100 ounces of gold is 24 carat and their silver is .9999 fine and that the value of your holdings can be found 24 hours a day, rather than being quoted by the guy in the shop down the street.  Secondly, there are no administration fees, advertising costs, or incentive fees. The only charge is a one- time commission to your commodity broker, typically, around $50 per contract. Also, you will control the actual metal and not find yourself invested in mining sales or land right options because you didn’t read the prospectus thoroughly. Finally, the biggest reason exchange traded products are so much more cost effective is the use of margin and the amount of cash it frees up for the individual investor. The $18,000 contract mentioned above requires a cash deposit with the exchange of $1,150. This allows the individual investor to use the remaining $16,850 in excess cash for a money market account and earn interest on top of any return produced in the actual market itself. Therefore, those wishing to pursue efficient portfolio theory and diversify their holdings can most efficiently implement this process through the use of commodity futures markets.

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 in investing in futures.