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.
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.
This is the third cautionary report I’ve written on the stock market in six weeks. The last time I focused this heavily on the stock market was in early 2009. Back then, I was making a point to everyone who’d lost their shirt on the way down that employing the leverage provided by stock index futures contracts would be a great way to recoup some of their lost funds when the market bounced. This week, we’ll discuss the same strategy only in reverse. I’ll explain how to use leveraged futures to protect your equity portfolio ahead of time in case you haven’t taken the appropriate actions.
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 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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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.
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.