Commodity Bull Market on a Knife Edge

After having its best run in months last week, the Aussie market is set to start this week on the back foot, thanks to a retreating US stock market on Friday.

The S&P 500 finished down 0.57%, while the Dow fell 0.71%. Oil was the biggest loser, with Brent crude down 3.7%, thanks to a disagreement over output quotas between Saudi Arabia and Iran. As the Wall Street Journal reported:

Saudi Arabian and Iranian oil officials have clashed this week over production limits, people familiar with the matter said, as OPEC struggles to iron out differences ahead of a meeting next week in Algeria where output controls will be discussed.

The disagreements highlight the chasm that still separates the two geopolitical rivals on economic issues as they stand on opposite sides of the civil war in Syria and the violent conflict in Yemen.

Yes, these two countries are major rivals. Why would anyone assume that they would agree to curb production together? The market had either priced in some sort of OPEC agreement, or it was just a convenient excuse for the heavy selling on Friday.

While the oil selloff was a sharp one, there’s no need to be too concerned just yet. The important level for oil bulls is just under US$42 a barrel, as marked in the chart below. That’s the early August low, and if Brent can hold above these levels and then move higher, it increases the probability that the final low for oil occurred at the start of the year.


Source: Optuma
[Click to enlarge]

If, however, the August low gives way in the coming weeks, it will confirm that oil is in a bear market, and it would increase the likelihood of prices falling back to the lows of January 2016.

That’s also a risk for the broader commodities sector. The chart below shows the Thompson/Reuters CRB Commodities Index. Since bottoming at the start of the year, the index rallied into June and is now going through a corrective period.


Source: Optuma
[Click to enlarge]

As long as the index remains above the green line, the odds are in favour of the young commodities bull market continuing. But a break below there would bring the bear back into play. Given oil’s dominant effect on this index, much depends on its performance in the weeks ahead.

The fact that an interest rate rise seems likely in the US soon will weigh against the commodities sector. But if higher rates come with an increase in economic activity, commodities will benefit.

The market will tell you which way things are going before the headlines do, so keep an eye on the support levels above.

Another potentially bearish development for commodities comes from a recent decision by the Federal Reserve, as reported by the Financial Times:

Banks will have to carry billions of dollars in extra capital if they trade hazardous materials such as oil and natural gas under a proposed US regulation meant to lessen the risks of liability from spills, explosions and other catastrophes.

The Federal Reserve on Friday released a proposed rule governing Wall Street’s involvement in physical commodities that would stiffen capital requirements, tighten limits on trading activity, remove banks from the business of running power plants and restrict their activities in the copper market. Banks that stay in the market despite the restrictions would have to reveal their commodities holdings to the public.

It’s hilarious what regulators will do to try and lessen the risks to financial stability. It’s not as if years of easy money and quantitative easing created so much liquidity that ALL assets benefited from increased activity.

And it’s not as if all of this liquidity flowed through the banking system, encouraging banks to get involved in areas that they wouldn’t normally be associated with.

This is just another example of the Fed trying to put out a fire it started years ago. It really is comical.

But it’s not about to end. This week, we get another barrage of Fed speakers ready to manipulate the market to their own particular whim. Notably, Janet Yellen and Vice Chairman Stanley Fischer have speeches lined up.

Following the market’s disrespectful response to their flimsy commitment to raise interest rates last week, it will be interesting to see whether they try and talk a little tougher.

But their words seem increasingly weak in the eyes of the market. The credibility of the institution is on the wane as they play into the market’s hands.

Ian Verrender captures this nicely in an ABC News article this morning:

Credibility is an elusive ideal; difficult to attain and deceptively easy to squander.

Janet Yellen, the head of the world’s biggest central bank, the US Federal Reserve, last week shredded what remained of hers and the organisation she chairs.

Once again, she hesitated when decisiveness was required. Once again, she capitulated to fear. Rather than face the wrath of financial markets she instead chose to bow down before them. In so doing, she has made a looming problem even worse.

The looming problem, as I see it, goes something like this: The Fed commits to a December rate hike and feels like they really need to move in December. Economic data comes in weaker than expected, but, not wanting to look weak in the eyes of the market (too late for that!), the Fed decides to move in December anyway. As a result, the wind comes out of the economy AND both the market and the Fed are left stranded, too proud to backtrack on the rate cut.

The final result is that the Fed comes out of the experience with an even lower level of credibility than what they went in with!

That’s just a guess, though. A lot can happen in the space of a few months. The more important thing is to see how the market reacts over the next few days. Last week, you saw the standard Pavlovian response to central bank stimulus. This week’s price action will tell you whether that response was indeed the correct one, or whether it was just a ‘head fake’.

For now, you have to give the bulls the benefit of the doubt. But that could all change very quickly. This week will be a crucial one.

Cheers,

Greg Canavan,
For Markets and Money


Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

 


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