The Daily Trading Report

We keep belting out the merits of the CRB Index and how close it is to breaking to a multi-week high. We believe that the CRB will break to a multi-week high over the coming days and then move quickly to the 300 level over the coming weeks. We only have to look at the broad based strength in commodities, the continued weakness in the USD, the strength of shipping rates (as per the Baltic Dry Index) and the reduction in supply (as a consequence of unavailability of credit to increase supply).

The Baltic Dry Index is very close to breaking to a multi-week high. Granted strength in the Baltic Dry Index is not, on its own, bullish for commodities but its behaviour taken together with the behaviour of other commodities it is a very powerful confirming indicator.

We have been watching four ETFs representing the various sectors namely DBE, DBA, DBB, and DBP. Take a look at these ETFs yourself and note how close they are from breaking out! Also note the strength of Natural Gas. The natural gas tracking ETF “UNG” was up again last night and is very close to breaking above resistance at 18. Natural Gas was the last commodity (in the commodities that matter) to break-out of a bear trend……

Also note the strength of Cotton – a very important industrial commodity.

Our preferred instrument to obtain exposure to commodities is the ETF “DBC”

One of the most reliable indicators we have of the mood of the market is the behaviour of high yield (also known as junk grade) corporate bonds relative to investment grade bonds. We have found, almost without exception, that high yield corporate bonds begin to underperform investment grade bonds well before the stock market turns down. We have also found that stock market rallies do not come to much unless they are accompanied by outperformance of high yield bonds relative to investment grade.

We use the Vanguard High Yield Corporate Bond fund as a proxy for the high yield corporate market. We use the ETF “AGG” as our proxy for the investment grade market. Note, how a strong sell signal was generated in July last year with the relative line falling below the moving average(and perhaps a “weak sell signal before that)…..and a strong buy signal was generated in early April this year. We use a 90 day moving average as our indicator, depending on one’s time frame a longer or shorter moving average could be employed.

 If one did not want to trade an open ended fund then there are two high yield corporate bond ETFs available “HYG” and “JNK”. We like JNK. Notice how JNK closed higher yesterday even when the Dow closed down by almost 2% and AGG (less risky investment grade corporate bonds) closed only marginally higher. This is very bullish behaviour. Up until mid March at least whenever the Dow fell JNK followed……now it appears that buyers of Junk grade bonds want nothing to do with the equity bears.

Whilst junk grade corporate bonds continue to do well in their own right and relative to investment grade bonds it is reasonable certainty that there is more upside left in equity markets. We remain bullish equity markets.

In the forefront of our minds are the consequences of the “reflationary” efforts by the FED and US Government. We are fully aware that the FED’s balance sheet has been increased dramatically (to put it politely) in a very short period of time. The charts above suggest that the reflation efforts are working (albeit from the market’s perspective) but that inflationary forces are likely to surprise on the upside. Our preferred trade to take advantage of inflationary pressures is long positions on the ETF “DBC”. It is the most liquid of commodity ETFs in both the physical and option market.

The CRB is now just 2% below a multi-week high. Given the broad based strength in commodities and the material weakness of US Treasuries we are confident that the CRB will break above resistance at 245 over the coming hours. We have been waiting for Natural Gas to break it’s down trend and it now appears to have done so (albeit in the process of). We are placing an order to buy UNG tonight via long term call options.

There is one stock, Chesapeake Energy (CHK) that has a big exposure to natural gas and we see significant upside in CHK over the coming months:

The strength in Gas and Oil last night pushed the energy ETF “DBE” to a multi-week high. Now we have both energy and base metals at multi-week highs. All we await on now is Agriculturals (DBA) and Precious Metals (DBP) to break to multi-week highs.

We continue to believe that a significant rally in commodities is about to get into gear. There are lots of ways of getting exposure to commodities, we prefer the ETF “DBC”

Rarely does everything come together like clock-work! Equities, junk grade corporate debt, and high yield/commodity currencies are registering multi-week highs, US Treasuries are making multi-week lows, and now the US Dollar Index is only a few percent from breaking to a multi-week low……and the CRB Index is a mere 3% away from breaking to a multi-week high.

When everything lines up like this experience tell us that “there is a lot more where that came from”!

Looks as if the upside in commodities is just getting into gear (DBC the best way of playing the broad commodity group)

A higher CRB index should be preceded by a strong Aussie Dollar. The AUD stands at a multi-week high

The performance of high yield or junk grade corporate bonds suggests that a risk taking mood has beset markets

It appears as if the USD and US Treasuries are reversing the gains made since July last year.

The current environment is poor (but that is already factored in), and the outlook is far from being clear (also factored into prices/valuations). It remains popular to forecast economic weakness, but numerous “green shoots” suggest improvement. The list of important positives is long, including lower oil prices adding discretionary income to household budgets, massive inventory liquidation in manufacturing, declining and low inventories of housing (except in a few distinct markets), large government fiscal stimulus packages, low interest rates, and ongoing recovery in credit markets. These positive developments are already reflected in small increases in consumer spending and an end to the decline in new home construction and sales. Unemployment claims appear to have slowed. Consumer confidence has increased. It is a good start.

If the recent gains build, economic growth should resume by summer, which is implicit in the recent stock market rally. Indeed, the market rally implies that investors, collectively, believe that an economic recovery lies ahead (even with more projected job losses). What is one sector that we should watch that would suggest an economic recovery is underway? If we had to pick one sector it would be shipping. Look no further than the ETF “$SEA“. If SEA continues to advance and outperform the DOW on a relative basis a strong case can be made for the market factoring in a “sustainable” global economic recovery:

The graphs above are rather interesting. It appears that $SEA is about to break to a multi-high in its own right and also relative to the Dow. A very powerful “world growth” signal is suggested if SEA breaks to multi-week highs. We like the following shipping stocks: $DRYS, $CHK, $DSX, and $TDW

The market gets a whiff of bullish news and stocks rocket like there is no tomorrow. We are now stating the somewhat obvious now that stock markets are looking bullish…..perhaps what is not obvious is that there is still considerable more upside in the offering before we have to worry about any bearish moves of significance.

We will be worried about bear moves if there is a divergence between the Value Line Index and the Dow, High yield corporate bonds underperforming investment grade, the USD Index and US Treasuries strengthening, and the ETF DBV falling. Let us have a look at these key indicators of risk:

It does not take a rocket scientist to figure out that the broad market is much stronger than the Dow. This suggests that the font-line troops are feeling much more confident than the generals (that is exactly the situation that we are after).

High yield bonds (junk bonds) continue to outperform investment grade bonds. You don’t buy illiquid junk bonds in preference to liquid investment grade bonds unless you are genuinely bullish (because of the illiquidity in junk grade bonds you don’t want to be selling in a down market because your sell orders will push prices down themselves). Perhaps that is why junk grade bonds turn down well before investment grade when problems in the equity market strike.

US Treasuries have clearly (at least from our perspective) entered a bear market, albeit reconfirmed the bear market that they have been in since the start of the year.

It now appears that the USD (as per the USD Index) is on the verge of breaking below the 83 level which would confirm a material bearish break down. We continue to believe that the USD Index will break below 83 over the coming days and then break below 78 over the coming weeks.

One of our favourite ETFs “DBV” which goes long high yield currencies (out of the G10 currency universe excluding the USD) and by default short low yielding currencies continues to appear as if it is in a bottom formation and that the next move of significance will be to the upside.

We include one more chart as well…….the performance of emerging market small cap stocks (we use the ETF “DGS” as a proxy for emerging market small cap stocks). If you are bearish on the prospects of world stock markets you don’t go and buy emerging market stocks and secondly you don’t go and buy even riskier emerging market small cap stocks – but look at what is happening here, emerging market small caps are taking off, in fact momentum to the upside is accelerating. In our experience one first picks up problems in world equity markets first in small cap stocks particularly in emerging market small caps.

From the charts above we conclude that there is no threat to the upside of the stock market…..everything is confirming each other and that rarely happens!

US Treasuries continue to collapse. On Friday not only did the long dated US Treasury ETF (TLT) fall but the medium term (IEF) and short term US Treasury ETF (SHY) also fell by rather significant amounts. Falling US Treasury prices (higher yields) suggest that the market is factoring in higher interest rates, higher economic growth rates and inflation. This has very important ramifications for equities in general, commodities and high yield currencies.

We could see this relationship unfold on Friday with the Value Line Index closing another 0.75% higher, The CRB index 3% higher and the USD Index lower by 0.20%

The equally weighted Value Line is now at another multi-week high. Furthermore, there does not appear to be any breakdown in upside momentum. A multi-week high (in fact a 7 month high) suggests that fundamentals are improving, or at least not as bad as everyone was expecting:

Note how the USD Index is starting to break down. For some 8 months the USD acted like a gauge of fear. Every time equity markets took a dive the USD advanced….now that is all starting to unwind. We see considerable downside in the USD over the coming weeks/months.

Finally commodities are starting to react the way we thought they would. The broad CRB Index almost closed above the 1^st line of resistance at 230 on Friday. We believe that the CRB Index will break to a multi-week high (245+) over the coming days:

We now have a clear breakout to a multi-week high in commodity related stocks as per the Morgan Stanley Commodity Related Equity Index below:

On a sector level we have bullish break-outs in; Agriculturals (MOO), Steel (SLX), Coal (KOL), Metals and Mining (XME), Oil Services (OIH), and Timber (CUT). We believe that the breakout in commodity stocks has just begun. Over the coming weeks we should see commodity stocks claw back all their losses in sustained in late Sept/early October last year (another 40% upside before year end).

How long will the rally in commodities, commodity stocks, and equities in general last? We don’t know (seriously). We are riding the risk-seeking mood of the market. While high yield bonds, emerging market small caps, and high yield currencies continue to advance and US Treasuries fall, expect more upside in “risky” assets.

It is one of those “poetry in motion days”. Stocks were strong along with commodities, high yield bonds, high yielding currencies and emerging market stocks and bonds. These movements were supported by a weak USD and US Treasuries. It seems like there is a shift out of safe haven securities and into high yielding securities

TLT closed down another 1% confirming, beyond reasonable doubt, that US Treasuries (and by default world Treasuries) are in a bear market. We believe that the behaviour of the US Treasury market is the “king-pin” to the behaviour of other asset classes. The USD Index also broke down again and it looks increasingly likely that it will break below the 83 level….and if it does that then we will see it at 78 within a few weeks…….we continue to be positioned for US Dollar weakness.

The multi-week low in TLT coincides with a multi-week high Value Line index and another high in the Vanguard High Yield fund.

We are not particularly interested in the reasons as to why this behaviour is occurring, we are traders not economists and paid to make money rather than merely sound intelligent. We are trading with the mood of the market…….and right now it is bullish, and we will not be surprised to see continued bullish behaviour given the strength of high yield bonds and the weakness of US Treasuries and the US Dollar.

We think the best places to be in the equity market are commodities and IT. Have a look at the ETF KOL, it is poised to break to the upside over the coming days and it should be a dramatic upside break!

Over the last few weeks (since late March) we have noticed commodity prices slip more or less across the board. This brings us to the “million dollar” question – are we still bullish on commodity prices? In short yes…..we believe that a cyclical low in commodity prices has already been made and that they are now in the process of hammering out a long term bottom which may well involve one more retest of the Feb/March lows. In order for a sustainable rally to form a solid foundation must first be built, generally the longer the market hammers out a bottom the greater and more sustainable the upside potential. We have already noted on previous occasions that the CRB Spot Indices have already broken to multi-week highs and we believe that the futures indices (and commodity ETFs which are based on futures prices) will break to multi-week highs over the coming weeks.

From an inter market perspective there is a lot of support for higher rather than lower commodity prices over the coming weeks:

1. The break-down in the US 30 & 20 year Treasuries
2. Out performance of emerging markets relative to developed markets
3. Out performance of small cap stocks relative to large caps
4. Out performance of junk vs. investment grade corporate bonds
5. The strength of commodity currencies like the Ruble, Rand, Real, Aussie & Canadian (in USD terms)
6. Dramatic supply cut backs of energy and mining companies.

The breakdown in TLT is perhaps one of the most significant break-outs this year and is strongly suggestive of inflationary conditions in the not too distant future….which is very bullish for commodity prices in general (DBC)

Junk grade bonds are now outperforming investment grade (JNK relative to AGG is at a multi-week high)

We believe that any weakness in commodities should be seen as a buying opportunity rather than selling, that TBT (the inverse to TLT) should be bought in weakness or strength as with JNK.