We’ve been discussing the turmoil in the financial markets for the last three weeks both literally and figuratively. We’ve discussed the massive flow of money headed into the short-term rates in, “Expected Turbulence in the Financial Markets.” We noted the rotation from industrial to precious metals in, “Re-shuffling the Metals Markets.” We’ve caught both sides of the equity market volatility between, “Equity Rally Waves a Caution Flag” and “Hidden Strength in the S&P 500.” The final piece of the confusion was addressed timely enough in, “Bottoming Action in the Euro Currency” which we wrote the night before the Dollar turned. The point of all this review is that today’s action in the copper market further reinforces the increasingly negative attitude that the commercial traders are taking towards global output. Taken in total, the signs are negative. Taken individually, they are good trading opportunities.
This week, we took a step back and looked at the markets in groups. We focused on the metal and meat markets in general while only discussing specifically, a soybean meal trade.
Re-Shuffling the Metal Markets which we wrote for TraderPlanet focused on the growing commercial trader position in the precious metals. There’s no question they’ve been big buyers on the recent decline and their total positions are controlling a larger percentage of open interest with each additional contract they buy.
See our mechanical Soybean Meal program’s Equity Curve
We ended the week with a broad outline of the interaction between commercial traders and seasonal analysis in hogs and cattle. We featured the current seasonal charts by Moore Research and combined them with our own Commitment of Traders charts to demonstrate effectiveness of these tools when combined.
See all 9 charts and commentary in Hogs and Cattle Bottoming Out.
See the equity curve for the Meats Sample Portfolio.
I’d like to begin this week’s recap with last week’s primary piece, Commitment of Traders Report Returns S&P 500 to 1900. Also note that we we alluded to this setup as early as last Tuesday in our piece for Equities.com when we first discussed the shift in commercial trader bias while we were still sitting at 1975 in the December S&P 500 futures. Read more in, Commercial Selling Tips S&P 500 Bias.
Our piece for TraderPlanet this morning focuses on the developing metals picture. Quantitative Easing in Europe has clearly contributed to the deflationary tone along with China’s unwillingness to fill the global demand gap. However, these macro issues carry little weight in our day to day trading.
This morning’s issue comes down to two things. First, the Commitment of Trader Report has shown tremendous commercial buying on this decline and secondly, platinum and gold hit parity. As I said in our piece for TraderPlanet, “Given the same price, would you rather own an ounce of platinum or, an ounce of gold?”
We’ll be following up on this in detail later in the week.
Copper is often referred to as, “the economist of the metals markets.” This is because of its use in all things that make the economy go round from electronics to commercial and residential construction and general infrastructure. When economic development is robust, copper prices follow suit. More importantly, because copper is a base ingredient in this mix, the price of copper typically precedes any moves in the general economy. Based on the current conditions of the copper market, we expect prices to fall and with it, overall economic activity in general.
The Federal Reserve Board announced its intentions to begin tapering off economic stimulus on June 19th. As a result, Interest rates have soared. Since the Fed’s announcement we’ve seen mortgage rates rise by nearly a full point from May’s low to multi-year highs. This is a 15% increase in two months. The effect on mortgage applications is already taking hold as we’ve seen a decline in mortgage applications of more than 7% in the last two months. This has led to a 13.4% decline in new home sales for the month of July, the biggest decline in three years. Rising interest rates are slowing the economic recovery that has been led by the housing market.
No copper scenario is complete without discussing China. China is the world’s largest copper consumer, taking around 40% of the annual mining total. Unfortunately, separating the governmentally supported information handouts from the man on the street’s first hand economic observations is a difficult task in a country where information is so heavily monitored and controlled. The major news events this week are twofold. First, a group of Chinese investors are stalling on a $3 billion copper mine investment in Afghanistan. Their reasons are many but the five-year delay they just inserted into the talks suggests that the investors aren’t comfortable with current, physical demand levels. Secondly, Chinese manufacturing data, though signaling signs of expansion last month, appears to have done so through inventory reduction more so than actual production. This was seen in the contraction of new export orders, stocks of finished goods and employment.
Funneling the macro data into something tradable leads us to further bearish scenarios. Commercial traders were actively listening to Bernanke’s discussion signaling the end of the monthly injections of $85 billion into our economy. Commercial copper traders clearly see this as a negative as they’ve been net sellers in five of the six weeks since the announcement. Perhaps more importantly, this comes after they had accumulated a very large position around the $3 per pound level we’re currently trading at. This suggests that they were locking in future deliveries based on continued economic expansion prior to the Fed’s announcement. Their actions since clearly state their change of attitude going forward and perhaps most importantly from a trading standpoint provides the potential serious selling if they decide there is no longer a reason to own copper at $3 per pound.
Finally, moving to the technical side of the market it appears that copper’s strength over the last three weeks may have more to do with speculative short covering rather than the creation of new long positions. Copper volume reached its highest level since December of 2009 on June 28th. This coincided with the lowest prices seen since October of 2011. Expanding volume coupled with declining prices is indicative of a strengthening downward trend. This becomes even more obvious in light of the rapid decline in volume and open interest over the last three weeks as the market bounced off its lows.
We feel that the slowdown in domestic construction that has been brought about by the Fed’s actions coupled with a large and now, unnecessary commercial long position will force the copper futures market to follow its typical seasonal path and decline through the end of October. This should certainly lead to a test of the psychologically important $3 per pound level. Violating the $3 per pound level leaves only the 2010 low of $2.90 as support before bringing into question the economic crisis low of 2009 near $1.50. Remember that commodities are not corporations. The world can live without another corporation but copper’s base necessity will serve to put a floor under the market. Therefore, a violation of $3 and even $2.90 is possible however, the market will find waiting buyers at bargain prices.
The recent selloff in the metal markets has broken the sideways trading range they’ve been in for more than a year. We’ll begin by briefly recapping their recent history back to the 2011 high water marks. Copper was the first market to peak. An expanding Chinese economy and a low interest rate environment drove this market. This led to large end line consumers purchasing forward contracts to meet future demand. Finally, copper peaked at $4.65 per pound in February of 2011. The silver market peaked in April of 2011 at nearly $50 per ounce. This was by far the most speculative of the metals markets and we’ll get into the ramifications of a speculative rally, shortly. Platinum made its high in August of 2011 at $1,918 per ounce. Gold was the slowest to peak finally reaching $1,923 per ounce in September of 2011.
The recent declines have come amid a backdrop of rising interest rates. The language coming from the Federal Reserve Board suggests that they are looking to tighten money supply and withdraw some of the excess cash that has been pumped into the system beginning in September 2001.
The recent lows mark very important Fibonacci points. The Fibonacci sequence originated in 13th century Italy by Leonardo Pisano, nicknamed Fibonacci. The mathematician found the pattern of 0+1 = 1, 1+1 = 2, 2+1 = 3, 5+3 = 8, 8+5 = 13, etc. This pattern is found throughout nature to include flower seeds, shells, pineapple segments, etc. Their adaptation to trading financial markets came through the use of wave analysis and the energy released in the action and reaction of those waves.
The trading adaptation converts the Fibonacci sequence into ratios. The ratios are then used in conjunction with peak and trough analysis to determine not only potential support and resistance levels but also, the energy required to turn the tide and begin a new sequence in the opposite direction. The two primary Fibonacci ratios used in trading are .38 and .62. These are rounded for the sake of simplicity. A trip to the beach will explain their importance in that wave one and wave two typically encroach upon the beach by a third of normal shoreline measurement while the third wave may advance nearly twice as far prior to its retreat.
Putting these ratios to use in the metal markets we can see that gold, platinum and copper have all retreated by approximately 38% from their all time highs made in 2011. Platinum has retreated by a third, copper by 36% and gold by 39%. Silver, as the outlier has retreated by 63%, almost stopping exactly at the .62 ratio. The depth of silver’s decline also helps it hold its crown as the most speculative and volatile of the metals.
The Fibonacci numbers don’t possess enough voodoo to generate trading action on their own. However, when combined with the considerable commercial buying we’ve seen on this decline these retracements must be viewed in the context of a pullback within a longer term upwards trend. Beginning with the recent biggest loser we see that commercial traders have been net buyers in the silver market for 19 of the last 23 weeks, nearly tripling their net long position within that time. Gold, copper and platinum are also getting strong support by the commercial traders on this decline. Their actions tell us two things. First, they don’t expect the end of cheap money to be the end of strength in the metals markets. Secondly, this decline is a buying opportunity.
Specifically, we view platinum as the most attractive buying opportunity. This is based on its industrial use as well as the escalating mining cost of platinum going forward. Currently, platinum is trading below its cost of forward production. The mining cost is about $1,500 per ounce while the futures market is trading around $1,350. Furthermore, platinum is the primary component in catalytic converters of diesel engines. Diesel engines continue to take market share in Europe, India and China. This leads us to believe that in the wake of the metal markets’ declines; platinum is most likely the safest one to buy.
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.