The commodity markets have been unkind to long only funds and indexes in 2014. Most of the commodity markets have been sideways to lower with a couple of exceptions like cocoa and cattle. This week, we’re focusing on the broader commodity landscape due to an article published on Bloomberg by Debarati Roy in which she stated that open interest in gold had slumped to a five year low. We’ve expanded on this topic to include 27 general commodity markets and compared their current open interest to where they stood both one month and one year ago respectively. The purpose is to determine whether smart money is headed into or, out of the commodity markets in general as well as what affect this may have on the markets going forward.
John Mauldin recently wrapped up his annual Strategic Investment Conference and shared some insights from his illustrious speakers. In his world, the information he passed on in his summary was simply nuggets. In my world, I had to go digging for context to put it all together. As a trader, I live in a day-by-day world. As such, it’s easy to lose track of the big picture and at times, the proper context from which to view the macroeconomic landscape. Reading the notes from Mauldin’s speakers clearly illustrated two main points for my own trading.
The United States is awash in domestically produced crude oil. U.S. crude oil inventories just hit a 26-year high. Heck, just last year North Dakota passed Ecuador’s production and Ecuador is a member of OPEC. Furthermore, the U.S. is expected to takeover the crown as largest global oil producer from Saudi Arabia as early as 2020. The questions that keep coming up are two-fold. “Why hasn’t the price of oil fallen and why are gas prices still so high.” The answer is simply, politics and logistics.
It’s been more than a year since we’ve discussed the cocoa futures market in any depth. Last February we discussing the seismic changes in the Ivory Coast’s political landscape and the paradigm shift in cocoa farming practices this would facilitate. African politics being what they are, it should come as no surprise that two years later there’s been less hope and change than was originally sold to the country’s people. The result may cost First World cocoa consumers a pretty penny in 2014.
Five years ago the financial world was coming to an end. The stock market tanked and interest rates went negative due to the unsurpassed flight to safety in U.S. Treasuries. Most of this was due to greedy lending practices that claimed to be championing President Clinton’s thesis that everyone in America should be able to own a home. Lax lending requirements that were intended to get lower income earners into their own homes travelled up market and allowed upper middle and upper tier earners to refinance their houses at artificially low rates to buy second homes and Harley’s. Once again, misguided bureaucratic endeavors have been perverted by greed. The roaches in China are beginning to surface and the banking system stress tests in Europe are uncovering the depth of this five-year-old issue and once again, the primary beneficiary of these actions will be the U.S. Dollar.
Removing the politics of the Russia-Ukraine issue and focusing on the economic implications of Russia’s bloodless annexation of the Crimean peninsula puts some trading opportunities on the table as global risk premiums jump. In order to do this, a couple of suppositions must be declared. First and most importantly, the United States will not actively engage Russian troops. In many ways, this is a replay of the Georgian conflict in 2008. Georgia was in revolt against Russia and wanted closer ties to the European Union and the US. Their cause was quickly championed by Western leaders until it became obvious that neither the European Union, The United States nor, NATO would take any military action to defend Georgia against Russia. This episode set the precedent for the current situation.
I thought taking a vacation at the end of 2013 might allow me to come back to the markets with a clear head and new viewpoint. My hope was that a little detachment would bring the forest back into the picture at 35,000 feet. I’ve now caught up on my reading and research and find the markets just as schizophrenic as they were when I left. While the markets remain as confusing as ever, our trip did provide me with the sense of awe that comes from physically standing in the presence of thousands of years of history. One thing is for certain; mankind always finds a way.
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 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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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.