The Daily Trading Report

Yes the bad joke continues! The bearish commentary continues to pile up against Natural Gas and yet day after day the futures fall in what appears to be a “controlled and regular” fashion. In the last month alone near dated futures have fallen by some 25%! We like contrarian trades but this one sure does feel like catching the proverbial “falling knife”! We don’t want to get involved in arguments regarding the ratio of crude to natural gas and all the fundamental reasons as to why natural gas is falling and about to go materially lower (storage levels etc). What we do want to highlight is the high correlation between electricity futures and natural gas futures and the “potential” bottom forming in the electricity futures. Obviously this raises another issue and that is whether or not electricity futures lead natural gas futures or is it the other way around? Of course the exciting part is that we are about to find out!

The graphs below give the price series of the Mid Columbia Electricity Futures Contract and the Near Dated Natural Gas Futures Contract.

Oh yes patience is certainly a virtue if you are a natural gas futures/UNG holder!

Our wealth creation portfolio is up 14.6% since the beginning of the year with approximately 40% of the volatility of the S&P 500. This portfolio is not leveraged.

Subscribers to our paid service are privy to our portfolio, sector weightings, and trade history.

Our attention as of late has been drawn to the advance of forestry and rubber stocks in particular International Paper (IP) and Goodyear (GT). IP and GT are up just on 100% this year so far (and by in excess of 400% since the low in March. OK we are not so consumed by the price performance of IP and GT but rather are more interested in the implications of the powerful advances. Note the performance of the “underlying” commodity of each stock. Pulp and Rubber futures have advanced dramatically over the last 8 months and are essentially trading at multi-week highs. Pulp and rubber futures are not exactly the easiest things to trade and players in this market are essentially professional hedgers rather than high school speculators…..so we take the behavior of these commodities somewhat more seriously than those commodities which can be traded via ETFs. As far as we are concerned rising rubber and pulp prices are inflationary. It is a brave man who doubts the advance in the CRB index when three of the biggest commodities in the world which are not constituents are advancing with gay abandon!

Pulp Futures (CME)

Rubber Futures (Osaka)

But wait there is more…….take a look at another commodity which is part of everyday life but rarely talked about – wool. Greasy wool futures (from the Sydney Futures exchange) are also advancing even in Aussie dollar terms!

Greasy Wool Futures (Sydney)

As far as we are concerned rising industrial commodity prices like rubber, pulp and wool prices are inflationary in nature. It is a brave man who doubts the advance in the CRB index when three of the biggest commodities in the world which are not constituents are advancing with gay abandon! And still there are folk around who figure that the world is in a deflationary environment, clearly they have not looked hard enough!

We think that everything is in place for higher commodity prices over the coming weeks (including natural gas).

Our wealth creation portfolio is up 16% since the beginning of the year with approximately 40% of the volatility of the S&P 500. This portfolio is not leveraged.

Subscribers to our paid service are privy to our portfolio, sector weightings, and trade history.

Is the inflation trade really a “crowded” trade? Well a number of commentators are leading us to believe that this is the case. However, inflation really depends on where in the world you are sitting/living/being paid and having to pay…….i.e. it is a currency “thing”. What is good for the goose (e.g. Americans) many not necessarily be so good for the gander (say Australians). That is, what may be inflationary to Americans may not be inflationary to Australians…….if commodity prices are rising in USD terms but falling in Aussie dollar terms. We think that right now inflation from a global perspective is still a localized phenomenon (actually it is not us thinking but the market telling us). Yes commodity prices are rising in USD, EUR, JPY, CHF, GBP, & CAD terms but they are not doing so AUD, NZD, BRL, and ZAR terms. It is not until (if) commodity prices have experienced an extended period of strength against all other paper currencies that will we conclude that the commodity/inflation trade is a crowded one.

The graph below gives the performance of the Goldman Sachs Commodity ETF in Aussie dollar terms. Yes it appears that the Aussie is now struggling to outperform and given the behavior of the Rate of Change indicator, the next big move is likely to be to the upside.

Yes we know that the Goldman Sachs index is heavily weighted in favor of energy (something like 70%) but even so look at the performance of a more broad based index like the Rogers International Commodity index…..more specifically look carefully at the behaivor of the Rate of Change indicator. It is rather suggestive of an immanent bullish breakout!

So here we go again………the inflationary path is opening up before our very eyes, but it is taking its time about it. Does this ultimately mean that that we are in for an ultra long period of inflation, that is, commodities being the strongest currency in the world? We would like to think so but of course the market cares little for what we think……..let the market be your ultimate guide!

Our wealth creation portfolio is up 17% since the beginning of the year with approximately 40% of the volatility of the S&P 500. This portfolio is not leveraged.

Subscribers to our paid service are privy to our portfolio, sector weightings, and trade history.

Bloomberg reports today:

Aug. 24 (Bloomberg) — The global economy is showing “clear” signs of a rebound and central banks are unlikely to raise borrowing costs for many months, the International Monetary Fund’s No. 2 official said.

“The signs are clear — if still tentative — of renewed growth,” John Lipsky, the IMF’s first deputy managing director, wrote today on its Web site. “With inflation threats distant, there is little doubt that central bankers intend to keep policy interest rates very low for some time to come.”

We find that the IMF is rather lagging in everything it does and says and the comments above regarding inflation are certainly no exception. We wonder if Lipsky has paid any attention to the two graphs below which are commodity prices in USD and non-USD terms. Rising commodity prices are inflationary because it suggests that the value of paper currencies are depreciating relative to hard currencies – that is, things that hurt when you drop them on your foot!

But wait there is more, the world bond market continues to send a clear signal that inflation is coming sooner rather than later:

If you are not convinced try looking at the behavior of the large inflation protected bond portfolios relative to the US 10 year:

Perhaps the behavior being depicted in the charts above is hardly surprising given the growth in the money supply………… Since the start of this global economic crisis, the U.S. government has been injecting massive amounts of new currency into the financial system to prevent deflation and stimulate economic growth. All that money is going to find a home. We think that this phenomenon is already devaluing the dollar and pushing price inflation higher.

We take careful note of what the IMF “says” because they have proved to be rather good contrarian indicators.

Our wealth creation portfolio is up 17% since the beginning of the year with approximately 40% of the volatility of the S&P 500. This portfolio is not leveraged.

Subscribers to our paid service are privy to our portfolio, sector weightings, and trade history.

Financial markets continue to tell us that the “inflation trade” remains strong. There has been no breakdown in the leading indicators of inflation, which transpires to leading indicators of commodity prices. Inflation protected treasuries remain in an uptrend against non inflation protected treasuries both in the US and internationally. Growth indicators such as emerging markets vs. developed equity markets and coal stocks vs. the broad market continue to suggest that growth is likely to surprise to the upside. Finally commodity currencies continue to advance against both the USD and the Euro. So without even looking at commodity charts we are able to deduce that commodity prices are more likely to rise than fall over the coming weeks. The only real drag on commodity prices so far has been the behavior of the food group not the base metals group which has been a much better indicator of inflation and world growth in the past.

Our wealth creation portfolio is up 15% from the beginning of the year with approximately 40% of the volatility of the  S&P 500.

Subscribers to our paid service are privy to our portfolio, sector weightings, and trade history.

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When someone talks about gold the first thing that comes to mind, after a picture of a heavy shiny thing, is the word “inflation”. The ordinary average investor/economist looks to gold as a barometer of inflation because price movements of gold in the past have been a reasonably accurate indicator of the level of inflation. Given the degree to which the price movements of gold are analyzed/scrutinized we believe that this is a rather futile exercise. Financial markets are a strange phenomenon where often the harder we look for something (having observed it in the past) the less likely we are to find it occurring in the future. We believe that this time around the gold price will be a lagging or “coincidental” indicator for inflation. Furthermore, gold also suffers from the fact that it is relatively easy to manipulate. Compared to paper currencies it is quite illiquid and easy to store. So if you had the backing of a government balance sheet you could manipulate its price (we are not saying that it is being manipulated we are merely saying that it could be).

Anyway, for those of you who are looking for a leading indicator of inflation we suggest that you look no further than the behavior of the industrial metals group. From a relative perspective it is considerably difficult to manipulate industrial metals individually and even more so as a group (copper, aluminum, nickel, lead and tin). To get straight to the point, if industrial metals are rising on a rolling 100 day basis, it is highly likely that it is because of a change in fundamentals (albeit perceived). Specifically it is due to demand outstripping supply and indicates a rise in world industrial activity and inflationary conditions. Yes it is that simple, and it is the simple things in investing that make all the difference.

Why not the energy group or the food group? Yes the energy group certainly does have merits as an indicator of inflation but we find that it is often subject to price movements due to political “activity” rather than pure economic fundamentals. Agriculturals are not so subject to political actions but rather are very subject to climatic conditions which at the best of times have nothing to do with underlying economic fundamentals.

Anyway, getting straight to the point – industrial/base metal prices are rising and doing so in unison and in a rather linear fashion. This suggests that the move is very real and there is considerable more upside. These strong trends suggest that world growth is picking up rapidly and we are moving into an inflationary environment and one in which is likely to surprise many. Accordingly it is only a matter of time before gold breaks above $1000.

How far will the advance in industrial metals go? The action of the market suggests that the up-trend is just getting into gear and that the upside is likely to be “considerably material”. If you are looking for the next “TMT” bubble to ride, it is probably staring you straight in the face – believe it or not!

Our wealth creation portfolio is up 13.3% from the beginning of the year with approximately half the volatility of the S&P 500.

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Is world growth in trouble? The action of industrial commodities suggests not. While one can argue about the merits of manipulation of oil, gold and silver few would argue that pure industrial commodities like copper, lead, nickel, and cotton are subject to price manipulation or flamboyant speculation. All four of these key industrial commodities remain in healthy up trends with a series of higher highs and higher lows. The action of these commodities suggests that either world growth or inflation or some combination of the two is for real(very).

In addition to the behaviour of the four industrial commodities themselves is the confirming behaviour of relative trends in equity markets. One of our favourite confirming indicators for the behaviour of industrial commodities is the performance of steel stocks relative to the broad stock market. The graph below confirms the action of industrial commodities and suggests that yes the world is pulling out of the worst recession since the 1930s

Watch the chart above closely, we have found that it leads even the behaviour of Dr Copper. If the charts above are anything to go by we have already seen the bottom of the commodity market. Monkey See Monkey Do!

Commodities should form part of any “balanced” long term portfolio, of course the trick is to figure out just which commodities to invest in at any particular time.

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Isn’t the ‘winner’ clear by now? Given the behaviour of the commodity market as of late it appears that there is considerable confusion out there. Let us revisit the inflation/deflation debate again and be careful not to overlook the evidence that has been in place for the last 6 months at least.

Before we look at the evidence being put forward by the market let us look at what Jim Grant has been saying in his latest issue of Grant’s Interest Rate Observer. He makes the following points that we find very interesting:

Grant starts off by quoting the Bureau of Labour Statistics regarding the fact that May’s 1.3% drop in the Consumer Price Index was the largest decline since April 1950:

“It’s a funny deflation, though. Deflation, to us, is too much debt chasing too little income. One symptom of deflation is falling prices. In a proper deflation, prices fall broadly, not narrowly. Seventeen months into the Great Depression, the CPI had fallen by a cumulative 8.1%. This time around, December 2000 to date, it’s risen by 1.8%.”

Grant then notes that although the steel industry is operating at a capacity utilization rate of below 50%, AK Steel was raising prices for the second time since May. “If deflation it be, it’s deflation light,” he says. Grant’s colleague Ian McCulley points out, “If we are truly in a sustained deflation, price decreases will eventually spread.” Jim notes:

“It hasn’t happened yet. Core CPI, which includes food and energy, is 1.8% higher than it was last year. Though its rate of rise has slowed (a year ago, it was rising at an annual pace of 2.3%, it continues to hold above the level to which it sunk during the great deflation scare of 2002-2003.”

McCulley proceeds to observe that the Cleveland Fed has its own alternative measure of CPI and that by virtue of its calculation methodology, “it is thus a less volatile price index than headline CPI, and is currently rising by 2.4% year-over-year.” Yet there is more. Many believe that with the economy operating so far below its potential output and with high levels of unemployment, inflation can’t possibly happen. Grant says:

“that would be a perfect theory, if not for the existence of so many countervailing facts. Bolivia recorded a monthly inflation rate as high as 120% in 1984-86 with unemployment rates in the mid- to upper teens. Bulgaria recorded a monthly inflation rate as high as 242.7% in 1997 with unemployment rates ranging between 12.5% and 13.7%. The greatest hyperinflation of them all was not the 1920-23 German affair but the Hungarian calamity of 1945-46, which occurred in a war-ravaged economy operating well below pre-1939 levels of resource utilization.”

So Jim Grant sees inflation as a very real threat…….what are markets telling us? The commodity market is certainly looking decisively weak with the broad based CRB CCI Index (an equally weighted index of 17 commodities) having fallen by 9% since the start of June. However, that 9% fall only takes the CCI back to early May levels. Significant support lies at the 375 level which is still some 3.4% away from current levels. We can’t expect commodities to go up in a straight line as much as we would like them to do so. I guess the question is how much “slack” do we give them…..when do we stand up and say we are wrong? I would say that if the CCI falls below 350 (which would be a lower low) then we would have to stand up and eat humble pie! From a confirmation perspective we believe that one cannot get too bearish on commodities (by looking at the price charts of commodities in isolation) in general unless there is bearish confirmation from industrial metals. From the graph below it does not appear that industrial metals are in trouble….albeit they have got considerable room to fall before confirming a bear trend.

From a “fundamental” perspective what are bond and currency markets telling us? In terms of inflation expectations (inflation being a primary driver of commodity prices), the bond market is suggesting that the “inflation” trade is still on. Inflation protected treasuries are outperforming non inflation protected treasuries not only in the US but also in other developed markets. Although TIP has underperformed IEF since mid June it is not enough to warrant us getting concerned about a change in “trend” of outperformance. Notice how much TIP outperformed IEF in May (inflation expectations from the bond market perspective). We think that the weakness we are currently observing is merely a correction of this. Note that the inflation protected developed (ex-US) market treasury ETF WIP did not dramatically outperform its non inflation protected counterpart BWX in May and it has managed to hold onto all its gains (for now that is). We believe that the bond market is more efficient than the commodity market and place more emphasis on the signals generated in the two charts below.

Is the world “growth” or economic recovery story still on? From our observations it still appears that way. Highly economically sensitive emerging markets are continuing to outperform developed markets. In addition small caps are outperforming large caps…..which confirms the action of emerging markets relative to developed markets.

Economic growth conditions also suit the performance of junk bonds and emerging market debt relative to US investment grade debt. We do note some weakness in high yield and emerging market debt relative to US Investment grade. However, for the time being at least it is not “out of the ordinary” behaviour. So for the time being at least we will have to give the bullish trends below the benefit of the doubt.

And finally, currency markets are not confirming the short term bearish break in the CRB CCI index. We won’ put the charts in here because of space constraints……but do youselves a favour and look at the performance of the Brazilian Real ETF “BZL”, the South African Rand ETF “SZR”, and the emerging market ETF “CEW”. A holding pattern maybe, but definitely not a clear breakdown that you could translate to the start of another bearish phase……or bullish phase for the USD!

It is always hard to hold your positions when the enemy is coming straight towards you (and is rather fierce looking)……..like right now in the commodity market. However, one can take “comfort” that so far at least none of the bulls’ lines of defence have been breached. Until the bulls’ lines are breached (and we are confident they won’t be) we remain commodity bulls……and take the heat like a seasoned trader!

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Two dogs of the commodity “family”! It is difficult to find any commodities that are engaged in a bear trend these days. The only two we can find is livestock (hogs and cattle) and natural gas. However, every dog has its day……..and these are commodities we are talking about not Bear Sterns, Lehmans, Wachovia, AIG, Freddie, Fannie, Washington Mutual, National City, Citi, ML……i.e. commodities don’t go to zero (although a few have gone close). The fundamentals for both UNG and COW are “bad” but then again if they were “good” both ETFs would be 50%+ higher from where they are currently trading. From a technical perspective at least it does appear that someone has been willing to put their neck out (we take our hat off to those ultimate contrarians) and buy. Expect significant buying to come in once COW breaks above 30 and UNG breaks above 18.

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Emerging Market Bonds…….you don’t buy “risky” emerging market bonds unless you are genuinely bullish. We believe that the strength of emerging market currencies is being supported by the strength of emerging market bonds. The performance of emerging markets (both equities and bonds) are a reasonably reliable indicator for the performance of commodities. This is due to the sensitivity of emerging markets to world growth. Most emerging markets are heavily involved in the extraction of resources (agriculture, mining, and energy).

The charts below relate to two of the larger emerging market funds available to investors……..both look bullish to us

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