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A Short-Term Correction in Commodities?

(September 7, 2009)

Dear Subscribers and Readers,

Let us begin our commentary by reviewing our 9 most recent signals in our DJIA Timing System:

1st signal entered: 50% short position on October 4, 2007 at 13,956;

2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

3rd signal entered: 50% long position on January 9, 2008 at 12,630;

4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;

5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;

6th signal entered: 50% long position on June 12, 2008 at 12,172, giving us a loss of 2,730.73 points as of Friday at the close.

7th signal entered: Additional 50% long position on June 25, 2008 at 11,863, giving us a loss of 2,421.73 points as of Friday at the close.

8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;

9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points.

In last weekend's commentary, we discussed the reasons why the US stock market was ripe for a correction.  Specifically, the major US equity indices have been trading in very overbought territory since early August – and most importantly, were losing momentum.  In addition, the NYSE ARMS Index – an overbought/oversold indicator that has aided me immensely in calling peaks and troughs (although it has historically been more useful in calling short-term troughs) was also close to historically overbought territory, as its 21-day moving average hit its most overbought reading since October 2007.  From a liquidity standpoint, equity mutual fund cash levels declined to 4.2% at the end of July – its lowest level since the end of April last year.  We also expected the Federal Reserve to slow down its asset purchases last week, given its $106.7 billion purchase of Treasuries and agency securities for the two-week period ending August 26th. 

Our suspicions in the Fed's reluctance to expand its balance sheet in the short-run was confirmed last Thursday when the Federal Reserve announced that it only purchased $11.7 billion of Treasuries and agency securities for the week ending September 3rd.  While both the Federal Reserve and the European Central bank have announced their intent to run a relatively loose monetary policy for the foreseeable future, neither one announced any new liquidity or easing facilities to boost global liquidity.  In the meantime, the Chinese government has committed to a relatively tight monetary policy for the rest of the year.  Combined with the psychological reluctance to invest during the historically bad month of September (this held true in spades last year), we reiterate our belief that the US stock market will continue to correct over the next several weeks.

Many of these same arguments could be extended to the commodity markets – in particular base metals, crude oil, and natural gas prices.  For example, and as shown below, the prices of base metals have generally retraced one-third to two-third of their declines during the 2008 bear market:

Daily Cash Prices of Selected Metals at the LME (January 1, 2003 = 100) (January 2003 to Present) - With the exception of aluminum prices, base metal prices have generally retraced one-third to two-thirds of their bear market declines during 2008. Since early 2009, the rally in base metal prices have been due to two factors: 1) Speculators betting on a reinflationary play based on a revitalization of Chinese and global economic growth, and 2) genuine inflationary concerns among investors. We believe that base metals and other commodity prices are ripe for a correction, given their overbought conditions and the rise in metals/energy inventories over the last three months.

In the short-term, base metals are definitely overbought.  Moreover, speculators bid up the prices of base metals over the last 6 to 8 months in anticipation of a revitalization of Chinese and global economic growth, as well as because of general inflationary concerns.  With the Chinese government now restricting credit creation for the rest of this year, and with no positive surprises from either the Federal Reserve or the ECB, commodity prices are definitely sailing into a liquidity headwind.

More ominously – and as shown below (courtesy of Kitco.com) – LME inventory levels of all base metals, with the exception of copper and zinc, have risen to decade highs:

Even though LME copper inventory levels have come off its March highs, it has been on an uptrend over the last three months.  Moreover, copper inventory levels in the Shanghai Futures Exchange (not shown) are now at a two-year high, while zinc inventory levels on the Shanghai Futures Exchange rose to an all-time high.  Furthermore, it has been reported that ship congestion at Brazilian and Australian ports have declined over the last couple of weeks, suggesting that the Chinese have continued to reduce their commodity purchases.

The inventory headwind is also applicable to crude oil, as OECD commercial oil inventories rose to 61 days of forward cover at the end of 2Q2009, which is well above average levels and the five-year maximum for this time of the year:

Days of Supply of OECD Commercial Oil Stocks

In addition, the above inventory numbers do not include crude oil and refined products held in floating storage, which are estimated to be about 140 million barrels, or an additional three days of forward cover.  Unless a regional war breaks out in the Middle East, or Federal Reserve commits to an easier monetary policy at its September 23rd meeting, commodity prices should correct over the next several weeks.

Let us now discuss the most recent action in the U.S. stock market via the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from January 2007 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 2007 to September 4, 2009) - For the week ending September 4, the Dow Industrials declined 102.93 points, while the Dow Transports rose39.59 points. The action in the Dow Industrials and the Dow Transports diverged again this week, with the Dow Transports rising while the Dow Industrials dropped. This latest confirmation suggests that the market is still indecisive, although we are still leaning towards a short-term correction over the next several weeks.  This *correction* scenario is further supported by the still-overbought condition in the market and the shakiness of the European banking system. For now, however, we will maintain our 100% long position in our DJIA Timing System, as all indicators suggest that the the intermediate uptrend remains intact (we will not shift to a more defensive position unless the market gets more overbought from current levels).

For the week ending September 4, 2009, the Dow Industrials declined 102.93 points while the Dow Transports rose 39.59 points.  Similar to the previous week's action, last week's “non-confirmation” in the two popular Dow indices suggests that the markets remain very indecisive.  However, with the stock market still at very overbought levels on both a short and intermediate term basis, and with the continued shakiness of the European banking system, we expect a correction in the stock market over the next several weeks.  That being said, the strong upside breadth and volume since the early March bottom suggests that any upcoming correction will be quick and relatively shallow.  However, should the market continue its rally on relatively weak breadth, we will then shift to a more defensive position in our DJIA Timing System (such as a 50% long or even completely neutral position).  For now, we will maintain our 100% long position in our DJIA Timing System.

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The latest four-week moving average of these sentiment indicators decreased from a reading of 8.4% to 7.4% for the week ending September 4, 2009.   Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending September 4, 2009, the four-week MA of the combined Bulls-Bears% Differential ratios decreased from a reading of 8.4% to 7.4%. While this latest decrease corrects for some of the overbought condition in bullish sentiment, it does not mean the ongoing correction in the stock market is over just yet. Again, while the strong upside breadth in the stock market since early March suggests the intermediate uptrend remains intact, there are many signs suggesting that the market is now tilting towards the downside in the short-run. For now, however, we will maintain our 100% long position in our DJIA Timing System but would shift to a more defensive position should the market or this sentiment indicator get much more overbought lin the short-run.

While this reading is not at an overbought level, its “spike” since early March suggests that we should now be mindful for at least a short-team peak in both bullish sentiment and the stock market.  That is, while there is still enough “fuel” for a longer-term rally, I believe the market will correct before doing so.  Moreover, while the “Bernanke Put” is still alive and well, I do not believe the Fed will expand its balance sheet in any meaningful way over the next several weeks given its whopping purchases during the last two weeks of August.  For now, we will remain 100% long in our DJIA Timing System, although we will likely shift to a more defensive position should the stock market rally further over the next several weeks.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator for the stock market.  Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:

ISE Sentiment vs. S&P 500 (May 1, 2002 to Present) - For the latest week, the 20 DMA declined from 123.8 to 119.4, while the 50 DMA actually made another 6-month low last week! While this sentiment indicator is now somewhat oversold, subscribers should keep in mind that (with the 20 DMA below the 50 DMA) this is now in a confirmed downtrend. Combined with the significant obstacles that the market needs to deal with - including the systemic risks emanating from the European banking system - we believe the correction in the stock market will continue for the next few weeks. For now, however, we will remain our 100% long position in our DJIA Timing System.

The 20 DMA declined from 123.8 to 119.4 last week, while the 50 DMA made another 6-month low!  While this sentiment indicator is now somewhat oversold, subscribers should keep in mind that – with the 20 DMA now below the 50 DMA again – this sentiment indicator is now in a confirmed downtrend.  Combined with the short-term liquidity headwinds and the troubles in the European banking system, we thus believe the stock market correction will continue for the next several weeks.  For now, we will remain our 100% long position in our DJIA Timing System.

Conclusion: While we believe the intermediate (6 to 9 months) uptrend remains intact, there are many fundamental, technical, liquidity, and sentiment indicators suggesting that the US stock market is now tracing a short-term top.  In addition, we now believe that any correction in the stock market will be accompanied by a correction in commodity prices – as commodities face a stronger headwind in the form of a tighter Chinese monetary policy and the substantial increase in warehouse inventories over the last few months.

Despite our aversion to the stock market in the short-term, subscribers should keep in mind that short-term tops and corrections are notoriously difficult to time (and most importantly, are typically quick and shallow) during a cyclical bull market (this author believes that a new cyclical bull market began in early March of this year) – and thus we will continue to remain 100% long in our DJIA Timing System.  By the time we come close to a major peak in this cyclical bull market, my sense is that retail investors will be much more bullish again and the liquidity headwinds will be much stronger.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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