The Commodity Bull Market is Alive and Well

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Sally Limantour

As most of you know, commodities went through an overdue correction last week. This shouldn’t have been a big deal. Here’s the problem though. As a result of that correction, some folks are making assumptions that don’t make sense. In fact, some of these assumptions are downright dangerous.

For example, the media and others are giving Fed Chairman Bernanke credit for “putting an end to commodity inflation” with his brilliant strategies.
On March 21st, Bloomberg stated that “the biggest commodity collapse in at least five decades may signal Federal reserve Chairman Ben Bernanke has revived confidence in financial firms.”

Or how about this: Ron Goodis, a trader with the Equidex Brokerage group, tells us that “Bernanke took care of the commodity bubble.”

This is faulty thinking. To imagine that Bernanke deserves credit as the commodity dragon slayer, even as he lowers interest rates and continues to stoke inflation, is mind-boggling.

Sources of the Sell-off

So what exactly caused the vicious sell-off in commodities? When all was said and done, by last Thursday’s close, gold had its biggest weekly loss since August 1990. Oil had plunged almost $10 over three days. The corn market was off by 9%. There were a number of things that contributed to the sell-off. First, the commodity markets had gotten ahead of themselves, and were in a classic “overbought” situation. Second, derivative trading losses and shrinking credit lines were forcing hedge funds to liquidate their winning trades – many of those trades in commodities – in order to free up capital.

There was also fear that the CFTC (Commodity Futures Trading Commission) was on the verge of raising margin requirements for commodity positions. This is what happened at the end of the last big commodity bull market, when the Hunt brothers were forced to liquidate their silver positions. (I was on the trading floor at the time… it wasn’t pretty.)

Furthermore, the dollar was oversold and ready for a bounce. All these factors combined to create a swift break, which has now taken many commodities back to more attractive buying levels.


Facing the Facts

To say the commodity bull market is over is just, well, a bunch of bull. Let’s take a look at the facts. Energy prices, precious metals, agriculture prices, and other commodities have been in a bull market trend since 2000. The UBS Bloomberg Constant Maturity Commodity Index has gained 20 percent every year since 2001. For 2008 the index is up over 10%.

The big picture has not changed. We still have central banks pumping money like mad into the global financial system. This is obviously long-term inflationary. Helicopter Ben is not going away. Nor is his one-trick strategy to save the world – running a printing press. This is long-term bullish for gold and silver.

In regard to agricultural commodities, the 2008 crops are not even in the ground. Demand issues are pressing and widespread. There are still record high rice prices (a global food staple) in Asia. Egypt is in the midst of a serious “bread crisis” for lack of grain. An outbreak of “sharp eyespot disease,” or SED, now threatens 4.83 million hectares of wheat in major producing areas throughout China. Water is increasingly scarce.

In regard to energy, no major new finds have been tapped in recent memory, North American natural gas demand is set to outpace supply over time, and the global supply-demand situation is still supportive of high oil prices. (That said, crude oil’s parabolic move from $85 has been enormous, and a trading range may be in order for crude.)

Three Billion Strong

In the macro picture, we still have the incredible growth stories of China, India, Brazil and Russia under way – not to mention many other fast-growing countries that get less attention in the headlines.


While there is talk of “recoupling” (the tongue in cheek opposite of decoupling), it is hard to argue with the fact that 5.6 billion people currently consume just one third of the world’s raw materials. That 5.6 billion grows more successful, and more hungry, every day.

As my good friend Clyde Harrison (www.brookeshirerawmaterials.com) says ,“the industrial revolution involved 300 million people. The emerging nation revolution involves 3 billion.”

When discussing the general supply-demand imbalance for commodities, I am referring to a very, very big trend. In fact, we now have two “megatrends” that are colliding. Thirty years of restrained and neglected natural resource supply are coming face to face with three billion people intent on discovering capitalism. Irresistible force meets immovable object? We haven’t seen anything yet.


Reversing the Reversal

Monday’s trading action in commodities saw a “reversal of the reversal,” with solid moves higher in many different areas. Today we are seeing follow through on the upside. Soybeans have tacked on $1.00 per bushel since the Thursday’s lows and are limit up today.. Wheat is up over 10% and corn has rallied 8%. The metals are recovering as well with gold, silver and copper all gaining between 3-5%.

The commodity bull market is alive and well. Last week’s correction let some much needed air out of the balloon, that’s all. It would be healthy at this point to see some consolidation, but we might not get it. Already it looks like commodities could be off to the races once again.

Financial Sector and this Fed

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Sally Limantour

The biggest question over the weekend was whether the engineered discount rate cut by the Fed was enough to safely say the lows were put in last Thursday. There are reasons to be skeptical in looking at the market players and the Federal Reserve.

We have been witnessing the phenomenon of deleveraging and if history is any guide this rarely occurs smoothly, or without some effect on the wider economy. It is hard to imagine that what took years to create is over in a few weeks. The ability to slice and dice risk and spread it around has us questioning the vulnerability of the economy.

In addition, there are clear signs that the pain is spreading from hedge funds to banks. The total amount of rescue financing has placed tens of billions of dollars at risk for many of the biggest banks. Most charge nominal fees for the guarantee of liquidity and some banks did not properly reserve for the risk since the prospect of default seemed remote.

Citigroup (C) and JPMorgan Chase (JPM), for example, have guaranteed more than $90 billion of liquidity, or about 5 or 6 percent of their total assets, according to a recent Banc of America Securities report.






State Street(STT), a custody bank, guaranteed about $29 billion, or 23 percent of its total assets.


That has ignited fear that the subprime contagion has spread to the global banking system — and, some suggest, caused the Federal Reserve Board to take action yesterday.

“The Fed is concerned because of the banks’ exposure. The banks are on the hook for potentially tens of billions of dollars,” said Christian Stracke, an analyst at CreditSights, a fixed-income research firm. “That could tighten credit conditions significantly if all that paper is tied up in things that none of the banks want to hold."

Bernanke’s Fed

The perception that the Fed will bail us out is still in the background for many, but if Bernanke turns out to be more like Volcker than easy Al as I wrote on August 13th, then the current Fed will inject liquidity when needed but may quickly remove it when markets stabilize.
Mr. Bernanke may not follow in the footsteps of the former Fed chairman and provide what fondly became called the “Greenspan put.” Under that philosophy whenever a crisis brewed Greenspan would slash the fed funds rate and provide cheap money to those who needed it as well as those who used it to add on layers of derivative speculation.

The Greenspan put helped during crisis such as the 1987 stock market crash and the 1998 Long Term Capital Markets hedge fund fiasco, but it also built up a huge speculative fervor and added on layers of risk that would not be there if cheap money had not been available.

Friday’s move by the Fed to lower the discount rate – not the Fed Funds rate made liquidity available to banks and depository institutions. They could borrow against collateral, such as asset-backed securities but the important distinction is that this discount window is not available to the more speculative group such as hedge funds and in this sense is quite different from the insurance that Greenspan provided.

We are going forward confronted with decisions to make both with our portfolios and with daily trading. I am approaching the markets as if I am still walking in a minefield and highly alert as to where I step. Listening for further news from institutions holding subprime debt as well as the language and actions of the Fed will be paramount as to how we navigate this treacherous terrain.

During the day I am trading “light and tight” meaning small positions with tight stops. I still believe we are at the beginning - not the end of a volatile time in many asset classes and we should not get lulled into complacency if markets are calm for a week or two. That said, my other twin always reminds me I am too close to the game and I am reminded of the words from Julian Jessop of Capital Economics as he puts it rather directly: “People in financial markets always think they are more important than the real world.”

Ouch!

Sovereign Wealth Funds, Volatility and Markets

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Sally Limantour

The recent correction in the stock market has many worried that liquidity will dry up as private equity deals diminish from their torrid pace. While this may be true the new darlings of investment – the “sovereign wealth funds” may pick up the slack. Sovereign wealth funds (SWF) are basically pools of money derived from a country's reserves and set aside for investment purposes that will benefit the country's economy and citizens. The funding for SWF comes from central bank reserves that accumulate as a result of budget and trade surpluses, and even from revenue generated from the exports of natural resources.

Government investment funds have been rising and China’s recent investment of $3 billion into Blackstone and the purchase of Barclay’s by the CDB (which also came with a board seat) shows how they want to develop their economies and will give China access to operations in emerging markets.

The numbers are staggering. For perspective it was only five years ago governments were sitting on $1.9 trillion in foreign currency reserves. This has grown to $5.4 trillion which is more than triple the amount in the world’s hedge funds. This excess cash is being moved into sovereign wealth funds and will change the landscape going forward.

A number of ramifications will emerge from SWF and currently concerns from protectionist measures to financial stability are being discussed. The US government has stated that the spread of sovereign wealth funds could create new risks for the international financial system.

One theme running through the SWF story is the idea that countries are diversifying from US dollars and placing their funds in other more tangible higher yielding investments. They want to diversify their holdings and this is not bullish for the US dollar. This adds to the move by other countries that are beginning to accept other currencies for purchases of oil and other products.

I have long held the view that we will see increased volatility in many asset classes going forward. The growth of SWF could be a factor in this as Mr. Lowery of the US Treasury has warned that SWF could fuel financial protectionism and has said “little is known about their investment policies, so that minor comment or rumors will increasingly cause volatility in markets.”

We all know markets do not like uncertainty and we are entering a period where “deep opaque pockets” will be making bigger and more ambitious purchases through state owned companies such as Gazprom and the China Development Bank (CDB).

My focus with regards to SWF is the natural resource sector. It is well known that China is basically resource poor and needs to import many of commodities to feed, house and mobilize their 1.2 billion people. With China set to move up the food chain it is only natural that they would use the SWF to secure their commodity needs by directly buying into companies that produce natural resources.

In a recent interview Marc Faber was stating that China will have to import most of their commodities and he looks at the price of coffee as an example and says, “If the Chinese just go to the per capita consumption level of say the Taiwanese or South Korean, they will take up the entire coffee crop of the world.”

As both China and India grow the demand for commodities will increase. The voracious appetite for commodities should continue and I would expect the next 5-10 years will see continued advances in many of the natural resource prices and the related stocks.

Water stocks, food, timber, mining and oil should continue their bull market and look for these SWF to move in this direction as well to secure their commodity needs for the future. Remember, 1 billion people currently use 2/3 of the world’s natural resources.
5.6 billion people use the other third. Meanwhile 3 billion are discovering capitalism and want “stuff.”

During this time while the stock market is taking some heat I am gathering my list of names in each sector and will share these with you going forward each week.

Water, oil and energy, food and metals are still in bull markets and I expect another leg higher in many of these will occur sooner than later.

Takeover Mania, Uncle Ben and Earnings Season

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Sally Limantour

Another strong week on Wall Street and the focus continues to be on takeover activity and stock buyback news. Vodaphone is considering a $160 bn takeover bid for Verizon which would rival AOL’s takeover of Time Warner and Vodaphone’s earlier acquisition of Mannesmann.
The FT this morning is quoting Stephen Jen, Morgan Stanley’s currency strategist on major emerging market economies. He is saying that while cheap credit may be drying up the emerging market economies are flush with cash and their growing interest in establishing sovereign wealth funds could well drive equity and other capital markets around the world to new heights. ”Major emerging market economies currently have a collective $1,500bn worth of excess reserves, - defining “excess” as official foreign reserves exceeding the amount needed for liquidity purposes, based on their “conservative rule-of-thumb”. http://ftalphaville.ft.com/

Dr. Bernanke is to appear before the House and the Senate this week. Those appearances which occur Wednesday before the Senate and Thursday before the House will dominate the discussions for the week. The market will be listening for any mention of inflation concerns as well as thoughts on the economy and housing.

The news is of better-than-expected earnings reports thus far, and 2nd quarter reporting is in full swing. Expectations for further upbeat earnings will support the market, but at what point does high energy prices, weak consumer spending, subprime problems and higher interest rates come into the picture? I am still looking at mid August for this market to correct, but blow off phases can be much longer and stronger than we can imagine.

Commodity prices are strong lead by the metals and crude oil. The gold ETF (GLD) rose 60% over the past two years while stocks such as Barrick has risen 30% and Newmont +14%. Perhaps it is time for the gold mining stocks to play catch-up. Attention will be paid to future earnings from gold mining operations.

Energy is on a tear as I pointed out the spreads weeks ago were starting to show the tightness. The market is showing demand is so strong that crude oil is not being moved into storage, but brought to market. That is bullish and should keep prices firm.

Good Trading to All

SubPrime Worries Persist

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Sally Limantour

Last week the main focus was on the subprime mortgage mess, hedge fund blowups and widening credit spreads. The contagion effect is making folks nervous and the S&P closed under the 50-day moving average for the first time since March. Whether this is a pause, a consolidation or the beginning of a big correction remains to be seen, but higher interest rates are definitely not supportive. As the technical analyst John Roque recently wrote when looking at the 10 year yield and seeing that it has moved above the 50 and 200-day moving average, “It’s a trite line, but if the yield were a stock we’d be getting long.” A black cloud hanging over the bond market creates a vicious circle – more subprime downgrades increased counterparty risk, potential belly up hedge funds and liquidation which can feed on itself.

Bank stocks are vulnerable as Bank of America is breaking an important trend line and has been under the 200 day moving average since May. Wells Fargo, Wachovia and JPMorgan are also technically weak and looking as if they are struggling under the 200 and 50 day moving averages. This does not bode well for the market in general. Adding to the list of negatives Friday 14 Democrats from the US House of Rep. proposed a bill that would raise taxes on “carried interest.” This would double the tax rate for this type of income and take billions away from private equity chiefs.

While everyone cheered the $4.1 billion Blackstone IPO, on Friday, Andrew Barry ponders in Barrons this weekend if it “could be a high water mark for the private equity business.” He is concerned with higher rates, more conservative lending standards, tax changes and increased competition for the buyout business.

The week coming up we will be focused on the FOMC meeting starting Wednesday and any hints as to the direction in interest rates. The bulls are hoping they will remove that annoying inflation language, but I doubt we will hear that. Friday will report the core personal consumption expenditure deflator which is an inflation gauge the Fed likes to watch and the consensus is for an advance of 0.2%.

Speaking of inflation, Pizza Hut is forced to raise its prices on our favorite American food due to a 55% increase in the price of cheese. The signs are everywhere and I am afraid that producers cannot contain price increases and it is popping up in the food you buy and the places you dine.. Now, when you go to order your large cheese pie they will charge what it costs to purchase a large cheese and pepperoni pizza, but you won’t get the pepperoni.
It will be interesting to see what ConAgra Foods and General Mills has to say about commodity prices this week as they report earnings.

The week is full of economic reports with Friday being the most active day. Traders will be watching oil prices, subprime news, hedge fund fall outs and interest rate wording from the meeting. Technicians will be paying attention to the 50-day moving average, the percentage of Dow stocks above their 50-day moving average and the number of new highs at the NYSE which has been constricting lately. We will also be monitoring volume which was large on this last downdraft. In market profile terms 1528.00 is an important level and if we are unable to capture that early the market should stay on the defensive. Trades that worked well last week were shorting opportunities as failures at the previous day’s value area low were rewarding. Once the market failed there it was typically a fast run down.

This morning we are coming in with the Shanghai market off 3.7 % and most commodities down with gold off $4.00.

Finally, A psychologist/trader I admire has this to share about a health crisis and trading lessons: http://traderfeed.blogspot.com/2007/06/three-life-and-trading-lessons-from.html

Pork n’ Bonds

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Sally Limantour

Various commentaries over the weekend point to many reasons why interest rates rose recently. Bill Gross throwing in the towel; massive duration hedging required by portfolios; a 12.5 billion reduction in foreign holdings of US Treasury and Agency securities, and yes pork prices climbing 43 percent in the first three weeks of May from a year earlier.

Bloomberg reports: “China's inflation probably accelerated in May as pork prices soared, increasing the likelihood that interest rates will be raised”. http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aNDCG3kLYQqg

Seriously, we have pointed out here that food prices together with rising money supply (around the globe) and recent labor price increases have lead to bond yields increasing.

On a technical basis I have been charting two things – the pattern of lower highs on the weekly 30 year Treasury futures and the 50% level from the highs on 6/20/03, of 122 27/32, to the lows on, 6/18/04 of 10228. That 50% level is 11300 and we continue to reject it.

While Mr. Gross of Pimco “capitulated” last week this was something in the making as he was beginning to get uncomfortable with his bond positions the summer of 06. I quoted his discomfort at HamzeiAnalytics.com from an interview in the WSJ back on August 23, 2006:
“The Bond King, Bill Gross, of Pimco, who had bet on the economy slowing, was so stressed from positions going against him that he took an unplanned vacation. “I just had to leave for 9 days, I couldn’t turn on business television, I couldn’t pick up the paper, and it was just devastating.”

So what now? My guess is we continue this pattern of lower highs and I will continue to sell decent rallies. Bond yields are not high by historical standards and typically once a trend change in bonds is started it continues for years.

Higher rates remain a long-term theme.

Food accounts for a third of the consumer price index and meat alone for 7 percent. ``The size of gains on stock markets, as well as the likelihood that food prices will keep consumer price inflation high in coming months has depressed bond prices in anticipation of rate hikes,'' M2, the broadest measure of money supply in China, probably jumped 16.9 percent in May from a year earlier, exceeding the government target for a fourth month, according to the Bloomberg News survey. The central bank may release the figures as early as today.
China's producer prices may climb 3 percent in May from a year earlier after increasing 2.9 percent in April, the survey showed. The statistics bureau will release the figures today.

Trade Sanctions & Commodities

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This morning we have a slew of more buy out news but so far the market is ignoring this and yesterday’s action was telling as we quickly gave up the previous day’s (Friday) value area which indicated a trend day down. Has anything changed other than Richard Russell who has been bearish for years has now turned bullish?

One thing bothering me in the background is potential protectionist measures. We need to watch the upcoming Chinese delegation on May 22nd to see if there is any rhetoric in this direction. Morgan Stanley’s Stephen Roach believes the US Congress has bipartisan support for trade sanctions against China and possibly Japan. In front of a tripartite Congressional hearing on trade issues last Wednesday he said, “My worst fears were realized. At the end of three hours of grueling give and take, I left capital hill more convinced than ever that the protectionist train has left the station.”

Today in FT there is an article titled Globalization’s losers need support which also hints at protectionist measures: http://www.ft.com/cms/s/3e39c1ca-022b-11dc-ac32-000b5df10621.html

Commodities were bashed across the board yesterday after their recent rally and this has a feel of across the board liquidation. Gold has the upcoming rollover from June to August which typically sees selling pressure. Physical demand is strong and any trade back to $655-660 should be supported. If not, this will be telling. Keep in mind that gold was nailed last year during this time frame and bottomed in mid June.

Gold

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Sally Limantour


The metals sector was strong last week despite the Asian holiday, a stronger dollar and weaker oil. Copper jumped 7.2% and surged through key resistance while nickel (+10.6%) and lead (+4.3%) made new highs. This time of year is traditionally supportive to the metals as Chinese demand tends to recover following its New Year celebration and construction typically picks up in Europe and North America as the weather turns warm.

All eyes are on the gold market as we approach the $700 resistance area. Currently there is talk of a Peruvian gold mine going on strike which would threaten supply and overnight AngloGold Ashanti posted a $97 million profit for the last quarter ending in March. In a bigger picture there are other supportive factors occurring.

More and more gold mining companies are limiting their hedging practices and last week the Grand Daddy of them all, Barrick unwound a large hedge and took a loss on the position. Prior to this Barrick had been active in hedging - selling much of its production at pre-determined prices. Now, however they spent $557 million to get out of their hedging contracts and this allows them to take full advantage of rising gold prices.

The Yen continues its slide and reached a record low in Europe and this combined with a weaker US dollar continues to support gold. In Tokyo gold is challenging 26-year highs and traders are buying gold as a hedge against the weaker yen. What I find interesting is that while many investors/traders look at the stock market in terms of value relative to gold or euros, the “public” traditionally does not. Recently, however the media is highlighting these dynamics and people are starting to see that “value” is not necessarily what it appears to be. In the NYTimes last Saturday an article titled, A Comeback for the S&P (If the Yardstick is Dollars) speaks volumes. These articles are raising the awareness of gold as a way to measure value and more importantly, that it is rising relative to stocks, bonds and other asset classes.
http://www.nytimes.com/2007/05/05/business/05charts.html?_r=1&oref=slogin


China and India continues to be buyers of the yellow metal and even with tightening measures in China this does not seem to put a damper on demand. Money supplies are surging and while inflation numbers appear under control we cannot ignore the fact that 18 of the top 20 central banks have double-digit increases in their money supplies.


One inhibiting factor to the price of gold has been persistent legacy central bank selling. This has been a consistent theme where the legacy banks agree on an amount to be sold within a given year. As of the end of April 2007 the tonnage remaining of the announced sales will be down to 617.5 tonnes. Julian Philips of the Gold Forecaster writes that this may be ending soon. He emphasizes, “If sales continue at the rate we have seen over the last two months at around an average of 10 tonnes these sales will last just over a year before they are complete and will terminate. (http://www.goldforecaster.com/)

Finally, the technical picture looks healthy with gold consolidating above $675 and unable to go below $670 during April’s break. As you can see on the chart the trend remains up and corrections are becoming smaller.

Gasoline

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Sally Limantour

Gasoline prices are on the rise with prices up another 2.46% today. Nigerian rebellions are increasing and threatens to destabilize the region’s sole source of oil. In addition we have more US refinery problems, threats to European gasoline supplies, talk of Belgium union oil workers going on strike in early May (Belgium accounts for 4% of Europe’s refining capacity) and the current stocks-to-consumption ratio at 21.0 days. This is more than 2.0 days below the seasonal average and below levels that typically follow summer’s peak demand season.

Keep this on your radar - on May 21st Iran will begin rationing gasoline domestically, and shall raise the price of gasoline to the public by 25%. This will undoubtedly get interesting as Iran sits on 10% of the world’s proven oil reserves and yet after 5/21/07 the Iranians will be allowed to only buy less than one gallon of gasoline per day. What will those people do in Tehran and other cities? We can be sure the black market for gasoline which is already a “thriving market” will become more active.

Outlook for the US Dollar

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Sally Limantour

The dollar was at this level back in the 1978.. We have tested this area a number of times and there are two predominant perceptions right now.

The dollar will be supported down here. Going back to charts in the 1970’s there have been 4 times we have tested this level and bounced – 1978, 88, 92 and 05.

Here is the logic:

Foreigners currently own roughly half of our Treasuries and securities and are Buying over a trillion dollars worth every year. It is in their best interest to not let the dollar fall much further.

The other idea is that many other countries have interest rates that are higher than the US and their currencies are more attractive.. Britain, Germany, Australia and others are all higher and their ministers of finance are talking more about concerns over inflation and raising rates to control it. The US, however is still hinting at lowering rates in the future to offset a weak housing market.

So this is the dilemma and we have to watch this closely as it will have repercussions for many markets.

While I hold CD’s denominated in different currencies ( as a way to be short the dollar), I am eyeing a potential short term trade of going long the dollar. On Friday morning, looking at the Market Profile chart we had a high level of trade occur at 81850 and I went long. It took off and I aggressively moved my stop up and captured a good part of the move and am now flat.
(see Market Profile chart – look at 4/13 and see where the horizontal line is longest at 81850. It then gapped up and traded crazy before settling at 81950.) This technical set up together with the chatter getting loud on dollar bashing while talking up the Euro (German exporters calling for 1.4000 in the euro) made me get a bit contrary in the morning).

Options may be the way to play this as a way to get long with a good risk/reward strategy. I am still bearish the dollar in the big picture, but it may be overdone and the first perception mentioned may move the market higher.

The following charts are:


1. Long term chart of US Dollar

2. 30 minute chart of US Dollar

3. Market Profile of US Dollar

Bond Market

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Sally Limantour

Friday’s non farm payrolls number was a bit of a shock and has dashed any hopes of a rate cut in the near future. Revisions of the past two months were strong and the unemployment rate fell to 4.4% matching a low back in May 2001. Interesting too was the strong leap in construction employment in an industry that has negative headlines on a daily basis. Remember that February’s number was quite negative and the 56,000 new jobs created in March construction is most likely an adjustment. The important thing is the trend and the direction for the past three months in construction employment is still down.

As of April 3rd the COT report showed the spec and fund combined net short position of
126,351 bond contracts. We have to assume this position is larger as the market is a full point lower now and it will be important to see the COT report this Tuesday. The 109 level I have been looking for in the Treasury bond futures (USM7) is close at hand and although the COT reflects a large short position amongst the spec community, bond prices can still go lower before a good bounce. In fact, many times I have seen bond prices move an additional 3-4 points even with an extreme COT position.

Talk of interest rate cuts will now be on the back burner as the Fed will remain on hold. Inflation is ticking up and having just returned from the Bahamas where I attended the Natural Resource Summit of the Americas, I am still convinced we are in a major bull market in commodities and this sector will outperform. It is both a supply and demand issue in many of the raw materials and we should see opportunities ahead in the base metals, precious metals, molybdenum (try saying that word three times fast) uranium, energy, alternative energy, water supplies and food. This is a theme I will continue to cover and focus on both in futures and the natural resource stocks.

Looking ahead in bond land this is a slow data driven week with the biggest news coming on Wednesday as the FOMC releases the minutes from March 21. Following this we have Chicago Fed Moskow speak about the US economy, then Thursday’s chain store sales and Friday’s report of the PPI, the Uni. of Michigan Consumer Sentiment and the international trade numbers for February. It is not inconceivable for the 30 year Treasury bonds to trade back to long term support at 108.00.

Crude Oil, VIX and S&P-500

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The relationship between oil and stock prices is on the front burner again as prices skyrocketed with May crude oil trading to $68/ barrel. “Oil surged $5 in 7 minutes late yesterday on speculation the U.K. would mount a rescue attempt.” (Bloomberg)

As the situation between Iran and the UK gains attention and concerns over the stability of the Persian Gulf and the Straits of Hormez move to center stage we now have concerns over the US naval forces there. This many ships in the Persian Gulf are of great concern… but should we be surprised?

Back in late January I voiced concerns over the changing “guard” in the Middle East. For the first time President Bush was putting in a US Navy Admiral as the US Central Command Commander-in-Chief. Admiral William Fallon was appointed on January 30, 2007. That seemed suspect to me as what had been up until now a protracted land war was soon, in my opinion, “going to see water - lots and lots of water. Can you really have a navy admiral running things and not have some ships in the picture? The geography of this war may be shifting.”

Stocks are acting defensive. We have geopolitical concerns, a slowing economy and inflation in some of the commodity prices. My favorite trade is long gold/short stocks right now and will continue to hold this.

The VIX is still relatively low when looking at a monthly chart and I wonder how long the VIX will find support in the 12-13 area. Will it soon have a higher low – 15-18 as its support line as we move into heightened concerns in the Middle East and inflation kicks up?

The next two are market profile charts for S&P-500 and Russell 2000 e-minis . The long horizontal letters represent supply above the market.

Commodity Prices

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Sally Limantour

Commodity prices have been moving higher as all three indices are up. While many of the markets are higher, the grain prices are lower. Many of you have emailed me asking why in last week’s class I was liquidating all of my grain positions. What technical indicators were telling me it was over? Other than RSI being over bought and trading near the top of the BB it was really a money management decision. All of these markets – corn, wheat and soybeans are up exponentially since first accumulating long positions in September and with the USDA report looming ahead of us on March 30th, I felt it was prudent to say “Thank You” and stand aside. It is not often that prices double in a matter of months as we saw in the corn market. A lot is riding (both politically and economically) on this report, so why be a hero? We can always get back in and hopefully at lower prices.

The energy markets are all moving higher and crude oil is 1.0% higher, while RBOB gasoline is 3.4% higher. The world is watching the situation with Iran and the UK and concerns over the Persian Gulf and the Straits of Hormuz are moving to center stage.

The weather is getting warmer and driving season is upon us as the nation’s refineries are low on gas! The spreads are reflecting this tight supply as the nearby spreads are trading to a premium to the deferred spreads. This does not look like a tight situation that is going away anytime soon.
Any breaks into last week’s range I would be looking at buying. Also the May/ June spread at 8 cents/gallon looks possible with stops under 5 cents. (note you can look at the mini contract and the symbol is QU).

Finally with commodity inflation heating up it is looking more and more to me like the bonds could trade to the 109 area. I will be looking for set ups to go short.

Inflation Update

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Sally Limantour

The Chinese rate hike over the weekend initially scared traders as last night the market opened lower. Initially, the dollar fell and the metals came in unchanged to a bit higher.

The Shanghai index proceeded to gain 3% which defied the typical stock market reaction to a rate hike. Are we out of the woods? Are the sub prime woes behind us? Two things that disturb me are that unlike the sell off in May/June ‘06 the break from the recent highs has been lead by the financials. One has only to look at the chart of the bank index to see the weakness.

The other issue is inflation. With US core CPI now at 2.7% y/y (well over the Fed’s 2% cap) it is hard to imagine the Fed cutting rates. I think this is what is meant when people say the Fed is between a rock and a hard place. There still seems to be a predominant belief that the Greenspan put will be adopted by Bernanke and the Fed will, once again, save the day. I think we have to look at the reality of inflation and realize the importance of food prices in particular.

Food prices are reaching high levels, particularly the category of ‘food away from home’, such as restaurants, take away food and so on. This component alone has reached its highest annual rate since April 1991. In addition food at home prices are also picking up. After reaching a low of 0.8% in May 2006 prices have now accelerated to almost 3% annual inflation. Corn prices alone have doubled and this has caused problems ranging from run away tortilla prices in Mexico to beer producers raising their prices. No longer are producers able to contain prices and have to now pass it onto the consumer.

Another aspect of the inflation picture is that whereas last years sub component prices were dominated by oil prices we now see a broader participation by other areas. Shelter remains at elevated levels, medical care inflation is back at its higher levels and apparel inflation is unusually inflationary at the current time.

In addition money supply growth is accelerating and the high level of asset prices around the world is now a problem for central bankers. Going forward
it appears we will be finding out where liquidity begins and leverage ends.

Tomorrow the FOMC begins a two day meeting and housing starts will be reported. Last January’s housing starts fell more than 14% due to the bad weather, so all eyes will be on February’s number. For today, next resistance is 1415 with strong R at 1418.75. Breaking the 1399-1401 level will clearly put the market on the defensive while rallies that hold above 1415 area should attract buying.

Japanese Yen

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Sally Limantour

After a break in the overnight market the yen is now holding firm above 86.00 level in the futures market. There was a piece about the yen in Market News. Apparently State Street developed an indicator called the, “Japanese Yen Foreign Exchange Flow Indicator, or FXFI that makes a point that over the last six months the average short yen position established was 119.70. They assess the majority of yen shorts were probably put on above 118.00 (86.00 level in the yen futures) and,

“Thus institutional investors are significantly underwater, even when one takes into account positive carry. We believe that these accounts will use any rallies in dollar-yen to reduce their short yen exposure and limit further losses.”

It is interesting that State Street only goes back six months. The carry trade has been something that has been going on for years and most likely the level is closer to levels from Jan 2005 at the 105 level (98.00 level in futures) as Barbara Rockefeller discusses in the March issue of Currency Trader Magazine, The Yen: Canary in the Currency Coalmine (www.currencytradermag.com). I also suggest an article published yesterday in the Economist magazine called, The Yen also Rises (www.economist.com).

Assuming this is true, we are not close to breakeven levels and we would most likely see massive liquidation prior to that. Keep that on your radar.

Long yen positions are held with the next target level coming in at 88.43 (Upper Bollinger Band on JY H7 Weekly Chart).

One Week Wonder?

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Sally Limantour

After the brutal reversal yesterday and closing near the lows we are coming into calmer asset classes this morning. The dollar is reversing across the board and every single currency has moved contrary to yesterday’s wild action which has a “turn around Tuesday” kind of feel to it. Some are trying to say the carry trade unwind is over and all was accomplished in one week.
I am not so sure about that as at 20 year lows on a trade weighted basis the yen seems undervalued while, on the other hand, the Australian and New Zealand dollar seem over valued and their growth expectations are moderating. More on this later.


Commodities continued their liquidation yesterday. Gold was off its recent highs of over $50 oz while silver had tumbled from a high of 14585 to a low of 12470. The base metals fell hard lead by nickel. However, after the close in the stock market my shortest term model went to a buy and as mentioned yesterday I expected a rally early in the week. Sensing a shift or possibly just worn out from going down, long positions were established in gold, silver, the mini S&P and mini Russell index. The market(s) are oversold on a short term basis as we had the 10 day moving average put to call ratio at a extremely high level. I still anticipate a sell off later, but for now I am testing the long side with break even stops. No hero here!

In the mini S&P today the 1379.00 is a pivot with 1389.50 my 1st resistance, then, 1392. A “point of control” which signifies the area where the most amount of activity occurred the prior day, is 1384.25. Support now is 1381.25, then, should we take out yesterday’s low, 1364.50 is the next support.

I continue to stay long the volatility plays established in mid February as I do not think the roller coaster is over.

Correlation or Contagion?

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Sally Limantour

The selling continues this morning as the Chinese government this morning has rekindled global slowing concerns. We have taken out last weeks lows and now are focused on China’s promise of increased regulation of banking and real estate as well as the possibility of additional interest rate hikes. We still have our usual suspects lurking in the background – carry trade unwinds, sub-prime home blues, and recession fears. With stocks, commodities and currencies falling across the board a question is circulating across the globe – is this a typical “healthy correction” where contagion kicks in as investors/traders liquidate positions across the board in all asset classes? Or does this have a different premise where the global macro backdrop of different asset classes is so highly correlated that a new paradigm is evolving which will threaten our beloved Goldilocks scenario?

“US demand has come in weaker than expected. Maybe the China story and the sub prime story are linked. The weakness in housing is going to cause real problems in the supply chain to the US consumer and that could be US small caps, or it could be in Asia. The saying these days is that the only thing that goes up when the market goes down is correlation.” --from FT.com article, Feb 28, titled: ‘Correlation rather than contagion’

People are now focused on concerns and until that changes, markets will stay under pressure. Now the hard questions are being asked concerning China and their murky accounting practices, their still stringent capital controls which defacto prevent an exit and the true rights and claims of so called Chinese shareholders (350 out of 500 of the largest listed Chinese stocks are still government owned). In addition questions regarding the private equity market (which is for the most part unregulated and unreported) and its size and risk to the overall banking and financial system are being asked. Not to mention the size of the carry trade unwind and derivative positions. I am not one to get to negative, but as I said last Wednesday we are trying to assess where real liquidity begins and leverage ends. It is a tangled web.

In the short term I expect a short covering rally perhaps early in the week and then further weakness in the equity markets. My shortest term model is getting close to a buy signal and we have the put to call ratio now at a high level. Intraday ranges should continue to be wider than what we became accustomed to and volatility will continue to move higher.

I watched Master and Commander (for the 3rd time) over the weekend and there is a classic scene when the ship is under attack and a small boy is crouching with fear. The Captain pulls him up and says, “stand tall in the quarterdeck,” meaning, be present and responsible. Heading into the week listen carefully to what the market has to say, respect the charts, preserve your capital and trade only with good risk/reward scenarios.

Market Gyrations

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Sally Limantour

An unexpected rebound in the Feb. manufacturing survey helped support the market after a swift move down. Personal income was also up 1% which was better than expected, but the embedded core PCE was up 0.3% in Jan. after a 0.1% in Dec., or 2.3% y/y. Remember, a reading over the Fed’s 2% is taken to mean no rate cut anytime soon. Construction activity was down as was single and multi-family building. No surprise there.

In Japan, the Nikkei lost 1.35% on its 4th day of a losing streak. It has now given back all of this year’s gains. The Yen continues to rally and is fast approaching my 1st target of 86.00.The strong yen, of course, plays into the fears of “the great unwind” but the question is whether this is actual unwinding of the buildup of carry trades or… a feeding frenzy of speculators trying to jump in ahead of a potential unwinding. If anyone has a good understanding or a way of measuring this to get a handle on it I am all ears. The important thing to realize is the dollar is rising against the Euro but crashing against the yen. I think it is challenging to fully comprehend the correlation of stock markets with currencies and perhaps this uncertainty alone is enough to keep the market jittery for a while.

Bloomberg reports that it is real unwinding (versus unreal?) and will continue as “carry-trades are inherently risky and everyone wants to dump risk these days.” Meanwhile EconMin Ota is saying the Yen’s rise will not effect the economy. This makes no sense to me as the weak yen is a boon to exporters and they are the key strength for the Nikkei. The yen is making its biggest weekly gains in over a year against many currencies – Australian $, New Zealand $ and the South African rand which are all high yielders and favored carry-trade plays.

Note too, these are the commodity related currencies which is important and something to pay attention to as we have witnessed a stampede into the commodity arena both for diversification purposes and to chase returns.

In my virtual training class last night we were looking at a chart of the continuous commodity index (CCI) which is a basket of 17 commodities. Open interest recently set a record and we have seen outsized gains in different commodities over the last few years. My biggest question and fear (and we always have to carry a worse case scenario to be prepared) is what are the chances of these supposed non correlated asset classes declining in unison coupled with an unwinding of the carry trade? This is something on my radar as I hunker down the way I do on a sailboat right before a storm. Batten down the hatches! As mentioned yesterday I tightened stops in commodity position to lock in gains and they did take me out yesterday. I will observe and monitor metals, grains, etc and will write more on this sector over the weekend. Stops are your friend.

Coming in this morning, we have a pivot of 1399.00 in ESH with 1st resistance at 1410, then 1417. Support comes in at 1386.50, then 1368.25. We need to get above 1404 early to get things moving up, otherwise I suspect, given its Friday with rattled nerves we could have a fast move lower. Stay nimble and disciplined.

Rest up and enjoy the weekend.

Volatility Squared

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Sally Limantour

Carry traders are in an option buying frenzy with implied volatility on a 1-month dollar-yen option moving to its highest level since Aug. Some are predicting a 10% move by month end. As mentioned here these last two weeks, volatility was a screaming buy in many asset classes – not just stocks and the VIX. Meanwhile, the 30-day statistical volatility of the volatility indices more than doubled overnight!

Yesterday’s Chicago purchasing manager’s Index for Feb. came in at 48.7 and anything under 50 is not particularly healthy. In addition inventories rose sharply to 54.5 from 41.9 which is bothersome as is the new home sales number in January, which fell 16.6%. With the medium/long term models still on a sell signal from last week and the short term model on a sell from Tuesday morning, my view remains the same as Monday – continued weakness with increased intraday volatility that will make day trading a fun job again. Witness this morning’s sharp break and rally, something nimble traders welcome. Until we get solid closes over 1429.00 in ESH7 and models turn at least neutral, I will stay defensive while taking advantage of intraday extremes.

Bernanke said he did not see a “real trigger” for the sell off on Tuesday. I wholeheartedly disagree as mentioned in, “the great unwind.” He also said he doesn’t see any real issue with liquidity. This statement is causing mixed interpretations. Some think he is communicating an ongoing “Greenspan put” (which refers to investor faith that the Fed will always combat market declines) while others think he means this is not the Greenspan Fed and we should not expect rate cuts if financial markets get wobbly. You choose, but remember it was Bernanke who in 2004 during a Q&A said, “I think it’s extraordinarily difficult for central bank to know in advance or even after the fact whether or not there’s been a bubble in an asset price.” (Note to self - watch the charts. They speak volumes without the ambiguity).

On dips, I continue to add to volatility positions in currencies and stocks and added to long positions in yen, gold and silver while moving up stops in the agricultural sector to protect profits. The metals and agricultural sectors have been outperforming and corn is up 90% since first writing about the bullish outlook.

Volatility Revisited

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Sally Limantour

The wave of risk aversion for most global equities finally broke yesterday as
rumors of a government crackdown in China on buying stocks with borrowed money and other dubious practices took hold. In our own backyard the continued concerns of higher margin debt, sub prime mortgage loans and geopolitical concerns now conspired to create fear. Up until today markets were so complacent that financial market contagion appeared to be a thing of the past. This complacency could be seen in the extraordinary absence of volatility that has been a defining feature of financial markets.
I wrote about this on 02/07/2007 stating that I was initiating long volatility strategies.

With stocks markets down sharply and exacerbated by problems calculating the DJIA index, stocks had one of its worse days in history falling over 540 points around 3:00 pm. Not all charts were plummeting however as the VIX, the CBOE volatility index shot up like a rocket closing up 64.22%. This was an unusual spike as looking back since the VIX was first introduced in 1993 there have been only 4 days in which the VIX spiked up 30% or more. It is interesting to note that the VIX has not made a 40% move to the upside since February 2, 1994 when the Fed shocked the market with its decision to raise interest rates.

This dramatic move up in the VIX still has the index at relatively low levels. Consider past events - in March 2003 when people thought the insurance sector was about to implode the VIX traded above 30. During the summer of 2002 when the telecom sector was threatening the VIX traded above 40.

So the question now is with the VIX closing at 18.31 does this mean the index is heading higher and stocks lower? Currently we are moving up from very low levels in the VIX so the percentage move up in one day is extreme. Markets revert to the mean (each way) so I would expect a short covering rally in stocks and a correction in the VIX back to lower levels in the short term. Typically VIX spikes last for a day and retrace on the second day.

Going forward, given that the market’s persistent and long running appetite for risk I expect volatility to trend higher and stocks lower in the weeks ahead. Also, my global volatility indicator that measures over a hundred global financial assets still remains at a low level and is far from signaling a buy on global stock markets. As mentioned on the post here on 2/12/07 (S&P and Currencies) my medium and long term model were warning of a “high wave risk aversion” (meaning a sell signal) and I was concerned about the unwinding of the carry trade and mentioned “we could see a bear trap rally in the yen.” All of this could lead to what was referred to in a FT article, “The Great Unwind is Coming.”

I will add that with the creative financial engineering we have witnessed leading to highly leveraged derivative strategies it is difficult to assess where real liquidity begins and leverage ends. This is something we will find out in the weeks ahead.