Panic Grips The Commodity Markets May 17th 2012

 

Bond Markets
Nothing new to report.

Currency Markets
Commodity Markets
Recommandations

 

Market conditions are extremely oversold in all risk assets right now. Some assets have entered a four standard deviation price range away from their normal mean. Sentiment is super bearish across the board for many global stock indices and major commodities, to the point where an inflection point could easily occur. Certain commodities and European equity markets are slaughtered. Numerous assets are down 8, 9, 10, or even 11 weeks in the row. Other assets are down 8, 9, 10 or even 11 days in the row. These are extreme historical statistical events dating back decades. Something has to give soon...

It all points to a possibly of a major bottom occurring eventually and a massive buying opportunity. Having said that, if we continue down this selling road and we do not get a rally in risk assets soon, which drags us outside of oversold conditions, than we could crash from these oversold level. That is right... we could crash from here! Markets tend to crash when fear and panic spreads, while the technical conditions refuse to exit oversold readings. With no buyers coming into the market,  prices just sink lower and lower until full blown panic takes hold of all market participants.

 

Greece seems to be the catalyst yet again. If Greece leaves the EU and completely defaults on its bonds, banks from all around the Eurozone (even globally) will incur huge losses. Since majority of these EU banks are leveraged anywhere from 20 to 1 towards 40 to 1, liquidation in risk assets will take place to square off the balance sheet and reduce banks overall leverage. Some banks might even blow up. Even if the event lasts only for a several days, price levels could sink really really quickly. Similar type of event occurred In September and October of 2008 during Lehman Brothers bankruptcy. A more mild version occurred during MF Global liquidation just several months ago.

Personally, the current market conditions have certain type of Lehman II resemblance. On the other hand, technicals, sentiment and price data seems to point to an inflection point buying opportunity. I am not sure which one it is going to happen, the market will decide for all of us very shortly. Strong price action reversals could / should be bought for a rally, while further breakdowns could / should be major warning signals. 

 

Therefore, I would advise all to be very careful and take necessary precautions to protect yourselves in coming days and weeks. Hedge your core holdings in portfolios and reduce leverage. Leave cash on sidelines for a buffer. Finally, for those die hard contrarians out there... they should use this post (and the current market sentiment) as a signal that maybe it is time to buy right here... right now! Good luck.

 

It is Sunday afternoon, the 13th of May here in Asia. This week in the US one of the more important data factors I noticed was the fact that consumer confidence continues to improve towards a four year high. In my opinion, this is a contrarian signal, which will eventually be negative for the business cycle. Upturns start at consumer confidence troughs while company earnings are depressed, while recessions occur as confidence starts to peak and company earnings reach record high. We are at the latter, not the former.

In Europe, Spanish IP collapsed further than expected by -7.5%, French IP weakened by -0.9%, while German Factory Orders and IP surprised on the upside (up 2.8% while economists expected 0.8%). Swedish and United Kingdom IP remained quite flat, while Italian IP came in at better than expected figure of 0.5% positive. BoE kept its interest rate decision unchanged, with no further QE, helping the Pound outperform. In Asian, South Koreans kept their interest rates unchanged as well. There are signs of Asia slowing further. Malaysian IP and Indian IP showed a serious slowdowns. But the real focus was China, with major economic data being released on Friday, which included IP, Retail Sales and Inflation.
Chinese Industrial Production was very slow compared to expectations, coming in at 9.3% versus 12%. Chinese retail sales also disappointed and their CPI came in below expectations, giving the officials more room to ease. Chart above shows that during periods of slow growth and negative surprises, China still has plenty of room to ease. As the economic data disappointed, I've debated the possibility of China cutting their reserve ratio by this weekend, and before I even finished this write up, PBoC has already acted with a 50 basis point reduction. The impact should be felt in the asset markets, but before we turn our focus there, let us see what the credit markets are saying.

Credit lines within the economy are like the arteries of a human body. During any turbulent panic sell off stage in the financial markets, the first thing I like to do is check if the credit risk is rising to the point it could possibly create a systematic lending freeze and choke off global growth, like in 2008. After all, we are still in a de-leverging environment and the banking credit lines pose one of the biggest risk to the world economy.
Since I believe the worst is still not going to occur immediately, than we could rule out a crash from current oversold conditions (markets can crash from oversold conditions). Therefore, Chinese rate cut could be the perfect news event to kick off a rally from an oversold readings that the commodity complex finds itself in. In the chart above, we can see that the technical picture of the Continuous Commodity Index (equal weighted) is very depressed. We are also over-stretched on the downside away from a 200 day MA. The price has now declined ten days in the row.
Many individual commodities are extremely oversold too. In the chart above we can see that every single commodity is now trading close to or outside of 2SDs range apart from Natural Gas. That means, as a worst case scenario, at least a rebound is in the cards very shortly. Commodities are not the only oversold assets either. I believe global equity markets have also suffered quite a setback in recent months as well. Looking at S&P 500, one would be saying that the damage was minimal and that the VIX did not jump enough, but that is a very US-centric view. Global equity market correction from the 2012 peak currently stands at following % readings:
Traders with shorter term outlook should definitely note that there are number of bullish divergences occurring within the internals of the equity market. These include: % of Stocks Above 50 MA, McClellan Oscillator and 10 day Advance Decline line amongst others. This should make even the biggest perma bears hold back on pessimistic activities, for the time being. The chart above shows that despite S&P 500 making a lower low, a lot of breadth indicators do not confirm this move and have now setup a bullish divergence. In other words, it seems as if the market is willing to go higher from here and even take out previous peak at 1,422. I won't be participating and instead would rather be looking for a short at higher levels from here.
Two main pieces of the puzzle need to fall into place, if we are to have a risk rally occur. First would be stabilisation of the Euro and the second would be a Treasury Bond sell off. Let us focus on the Euro first. In the chart above, we can see that the outlook on the Euro keeps deteriorating closer towards extremely bearish levels again. This week up to Tuesday, hedge funds increased their net short exposure on the Euro by one third and all of this despite Euro still trading close to the $1.30 level. I think that up to Friday, those net short positions increased even further, even towards record highs. US Dollar is now up 10 straight sessions in the row too, which is overdone. All of this could setup a mother of all short squeezes!
The second piece of the puzzle is the sell off in the Government Bond safe haven assets. Money coming out of Treasuries could boost risk assets, if only temporarily. I say that because systemic risks still remain in place and not everyone will get out of bonds. In the chart above, Tom McClellan talks about a possibility of a Treasury market top as majority of the bad news becomes discounted for now. On top of that, German 10 & 30 Yr Bunds yields have dropped to record low yields for six straight sessions. Sentiment here is now very bullish according to theGerman Animusx Survey. Finally, the US 10 Yr Note rally is now way overdone and overbought. Bloomberg recently reported that:

U.S. 10-Year Notes Add to Longest Gain Since ’88 - Treasuries had the longest streak of weekly gains in more than 13 years after elections in France and Greece added to concern governments may struggle with deficit- cutting plans used to combat the region’s debt crisis. If these two assets move in the right direction (Euro bounce and 10 Yr Note sell off), than I definitely think risk on rally could ignite as the conditions are very ripe for it. These are: extreme bearish sentiment, oversold technical readings, constant weekly outflows and overall general news / media fear.

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Finally, as an aside note, I would like to focus on Gold here: Running the chart from left to right, we can see that Gold went slightly vertical for awhile and peaked around $1,920 on 06th of September 2011. Sentiment was extremely positive with 97% bulls according to DSI and fund flows extremely bullish. The price corrected into 26th of September and fell to the intra day low of $1,535. Sentiment reached 16% bulls, price moved outside of its 2SDs range and fund outflows showed record panic selling. A counter trend rally started and Gold amazingly still managed to finish the year on the upside, clocking its 11th annual gain in the row (I'm very nervous about this).

 

I do not have a lot of time to write today as I am busy with work outside of financial matters. I will be summarising the business cycle, economic data and the progress of the markets properly on the weekend. In the meantime, recent market action deserves a few words. Since quite a few readers have commented that fundamental articles, business cycle data and credit markets tend to be boring, they are wondering why I do not post about technicals setups and other timing tools (why study demand and supply, when one can just scribble lines on a  chart right? *cheeky smile*). So today, I just got charts with some scribbly lines on them.
Let us start of with S&P 500. The question I am wanting an answer to, is weather or not the break above 1,350 / 1,370 resistance earlier this year was a real bull market break out or whatever it will end up being a bull trap. A failure to sustain the price level above 1,340 to 1,350 could end up being quite negative, in my opinion. However, since majority of the selling has already occurred in various other indices around the world - GEMs are down 8 weeks in the row and IBEX 35 (Spain) is testing March 2009 lows - I believe there is a good chance we will hold this level.
Furthermore, almost every single major global index is down about 10% or more from their peaks earlier in the year. We have corrected quite a bit and fear has now returned. From the short term perspective, the prevailing consensus outlook is for equities to decline even more. Majority of the traders are positioned in Puts over the last few days, as reported by Bloomberg. Therefore, from a contrarian point of view, I wouldn't just blindly go and short equities right now.
Furthermore, Dow Jones is now down 6 straight days in the row. Over the last three years, streaks like these occurred in late June 2010, late May 2011 and early August 2011. All of those dates marked intermediate bottoms, which were proceeded by either a decently strong rally for at least a few weeks or by bottoming pattern where downside was limited. Obviously, this time around Dow Jones and S&P 500 have not fallen a lot, so this type of a signal might not be as useful.

Speaking of 6 day in the row, a decline for Crude Oil also meets this merit, which we have not seen since June 2010. Crude Oil is the main component of the CRB Index so it is one of the most important assets to follow. First of all, in the chart above we can notice that technically we are oversold and more importantly we are on two support levels at the same time. As I always say, when an indicator performs a same signal twice in the row, that signal is usually much more powerful. Also to note is that when two or more indicators signal the same outcome at the present time, it is also usually much more powerful. In this case, Crude Oil has a horizontal support at $95.50 as well as a 200 day moving average support at a similar level. There is a much higher probability this level will now hold.

Moving onto the currency market, we can see the US Dollar is still stuck in a  triangle without a major decision. A reader of this blog wrote an interesting comment where he stated that the US Dollar has been up 8 days in the row. Market trading, as opposed investing, has a lot to do with probabilities (investing has a lot to do with patience). Personally, I would never consider buying anything that has been up for 8 days in the row, even if it is for a trade. While that could be completely wrong and the USD could now move up another 8 days in the row on top of the current move, nonetheless it is just my own style of execution. Majority of you who read this blog regularly, already know that I am super bearish on the US Dollar and remain short since the middle of January 2012.

Staying with the theme of safe haven assets, we can see that the US Treasury 10 Yr Note is now up 8 weeks in the row and is edging onto making new highs. I think the Bond market is discounting another round of bond purchases. It is not that we are deflating and it is not that the economy is about to enter a recession... it is just that bankers are bidding up bonds for an easy trade from the Fed. Furthermore, the 30 Yr Bond does not confirm the move to new highs and I think a correction is now in order, if and when risk assets rally.

Technically, the picture has started to improve somewhat. Last night we posted a huge outside reversal on absolutely massive volume. Actually the volume was even bigger in Gold Mining Juniors (GDXJ). All of the indicators are oversold, while selling momentum is lacking, all of which means that a bottoming process could be starting. I always think that V trough bottoms are very rare, so do not be surprised if we retest $40 level or something similar, but all in all, I think the crash had ended around these levels. Great value for long term investors can be found in this asset class.

 

It is Monday evening here in Asia and the new week has started.... you guessed it... with more selling, but this time with huge gap downs, which could mark a potential bottom, at least from a shorter term perspective. We are now oversold. Before I get to the rest of the post, let me just outline the following simple facts about the current market conditions:

 

Etc etc etc... the list goes on, to be honest. While I do think we are very close to the end of selling, I will not be commenting on the direct technical market action today, but rather will focus on fundamentals. After all it is fundamentals that always drive the price, mainly supply and demand. After all, that is capitalism.

But before we start, let me just say that the above points listed are amazingly oversold statistics from the short to medium term outlook, especially when we consider that most of the damage is coming from the commodity asset class complex even after a strong bear market, which has been on-going for about 12 months already. So let us cover the recent global events and how they connect to the commodity market fundamentals.

The major report out on Friday was the US Non Farm Payrolls, which disappointed once again. The data came in at 115,000 jobs created, which was below economists expectations and is now the third decline in the row - a negatively developing trend, which has a lot of traders wondering if the Federal Reserve will step in as Operation Twist comes to an end. Obviously, the worse the jobs data gets, the bigger the chance Federal Reserve will act with more money printing, which of course shows that fundamentals for Precious Metals and all other commodities will continue to improve, while fundamentals for Bonds and Currencies do not, as they will be diluted and debased.

French Election took majority of the media attention over the weekend and so we have now found out that François Hollande has taken the leadership post away from Nicolas Sarkozy. The main difference between two candidates is the focus of pro-growth policies that Mr Hollande promises to French people, whom seem to be celebrating in the same manner as if France won the Football World Cup... again. We can all agree this is a Global Debt Crisis and we are in a de-leverging environment. There are only three ways that an economy can fight a Debt Crisis. These three are to either service the debt by decreasing spending via austerity (and possibly increasing taxes), to default on the debt altogether by the way of bankruptcy or partial bond haircut, and finally to inflate the debt away through the method of currency debasement.
Let us think about this for a second. The French voters have already signalled that austerity, for the sake of debt servicing for a prolonged period of time, is not the most popular option, so Mr Sarkozy has been booted out. Western governments have also signalled to us on many occasions since the 2008 Lehman Bankruptcy that another major institutional default will definitely not be allowed (but of course it will happen eventually). So that leaves us with debt inflation, which perfectly links to the pro-growth policies Mr Hollande is talking about. So it is my opinion that, for the new French government to keep their promise, we will need to see more borrowing via bond issuances and more money printing via ECB bond buying programs. Nothing new right? Once again, fundamentals for Precious Metals and all other commodities continue to improve, while fundamentals for Bonds and Currencies do not,  as they will be diluted and debased.
I recent articles I have been pushing forward an outlook that China is entering a recovery mode. This is evident by: (A) new upturn in the credit cycle, (B) new upturn in the liquidity cycle, (C) cement & steel demand rebound, and (D) a turning focus on infrastructure projects as opposed to real estate. The charts above are compiled by me, but all come thanks to a great investor by the name of Frank Homles, who I have much respect for. Also many thanks to Bank Credit Analyst for great data in all the charts.
At this point of the article I most likely lost majority of the perma-bears, doom sayers, deflationists and High Hendry's / Jim Cahnos's of this world. Fair enough. I do admit that there is a very high chance China will eventually experience a hard landing. The question in the investment world always comes down to one basic factor: will the Black Swan happen when everyone is expecting it to happen? Or to say it in another way: how can an event occur when everyone already expects it to occur? Since it is well "advertised" than most likely majority have taken the necessary precautions to protect themselves from it. As this blogs title states... when it is obvious to the public, it is obviously wrong! All I will say is that "Chinese Hard Landing" is media's favourite term as a blame whenever any sell off occurs here in Asia and has most likely pushed everyone who wanted to sell to already sell any asset connected to the Chinese growth story (e.g. commodities).
With all the fundamentals lining up for a Chinese economic recovery story, I think from a contrarian point of view, investing in Chinese shares is a wise strategy into 2012 and possibility even 2013. After four years of under-performance within the Global Emerging Markets space, Chinese stocks are set to recover back towards a pole position, where they belong (chart above). I definitely recommend an overweight position for those that constantly hold GEMs within the portfolio. As already mentioned in previous articles on this blog, Shanghai Composite is currently breaking out on the upside. This should be a very positive development for the commodity prices as well,as Shanghai Composite has a strong correlation with commodity prices. Once again, commodity fundamentals just keep improving here as well.

Investors constantly ask me why I still believe in the commodity story, with such an awful performance over the last year. First of all, a lot of other investors recommend shorting or selling out of commodities precisely because they have not performed well. Second, I receive emails from people telling me that the commodities, especially Gold and Silver, are in a bubble and that it has now burst so I should sell. Let us look at both of these concerns.
Finally to answer the other question, commodities - including Gold and Silver - are not in a bubble. It is really that simple. Gold has a long way to go before it comes close to the euphoric levels reached in late 1970s and close to the euphoric levels S&P 500 or Nasdaq Composite reached in the latte 1990s.
Everyone was gambling with the Gold price in late 1970s, everyone was searching for Crude Oil around the world during late 1970s and everyone was gambling with Nasdaq stocks in the late 1990s and everyone was a property developer / real estate agent in 2005 and etc etc for previous bubbles. How can something be in a bubble when hardly any major institutions or retail investor owns the asset? One day soon, commodities will also enter a mania similar to that of 1999 we saw in stocks, but that day is not even close yet.

Summary
We have now reached a major polarity support level, which was a previous major resistance. In my opinion, based on the fundamentals as well as sentiment, majority of commodities including Agricultural and Precious Metals sectors are a great buying opportunity around here. We could still have a shake out lower by a few percent, but in the grand scheme of things, that is nothing. A wise thing to do is to use the current price decline as a gift, so that you won't need to chase prices higher, once the rally starts. Remember... always try to buy sound fundamental assets on a low and than sell them high!