The DeCarley Perspective...
The DeCarley Perspective Trading Newsletter
The DeCarley Perspective January 18th, 2009
This trading and commodity market analysis newsletter was emailed to clients on January 18th, 2009
Thank you for choosing DeCarley Trading. We are proud to offer the DeCarley Perspective as an informational guide to our clients and hope that you walk away from the newsletter with a better understanding of market fundamentals, as well as technical and seasonal factors.
The DeCarley Perspective is intended to give you a broad based view of the financial and commodity markets and provoke you to explore various market approaches.We appreciated any feedback that you can offer us in how to make this newsletter better. Please feel free to communicate with us regarding your needs and wants.
Throughout much of December, positive euphoria surrounding the financial markets in light of optimism over a new administration in Washington allowed equities to progress in the face of negative economic news. However, a never-ending flurry of dismal headlines and significant technical barriers eventually halted the rally that began in a light volume environment.
Failure for equities to carry the December rally into 2009 and what is predicted to be an unfavorable "January Barometer" seems to have market sentiment at bleak levels. According to Yale Hirsch, writer of the Stock Traders' Almanac, as the S&P goes in January, so goes the year. The indicator has produced only five major errors since 1950.
It is often said that the first five days of January can be a good indication of what to expect for the remainder of the year. According to sources, the last 36 up "First Five Days" were followed by full-year gains 31 times with an average gain of nearly 14% when considering all 36 years. The first five days of 2009, offered little guidance as the broad market was essentially unchanged. The March S&P came into 2009 at 900 and ended the first five-day time frame at 906. Nonetheless, after last year I think that we would all agree that unchanged isn't so bad.
The major indices have recently experienced sharp sell-offs but have yet to replicate the type of irrational panic trade that occurred in the fourth quarter of 2008. This bodes well for the markets in the long term but it seems as though the market turmoil could extend well into the second quarter of 2009.
The equity markets are cheap and seem to offer investors great values but it seems likely that there will be even better levels to be bullish in the coming months. Some of our contacts in the S&P option pit are calling for the S&P to see prices as low as 650 at some point in the first quarter. Our chart-work, points to the possibility of 670 and just under 7,000 in the Dow.
In last month's newsletter, we pointed out resistance in the S&P near 930 and that this level would have to be broken in order for a larger rally to ensue. After failing to make progress in the high 930's confidence dwindled and so did prices. We were overly optimistic in regards to the other indices, but the price action was similar and the results were the same, another failed rally.
While excitement over the new coming President may keep stocks afloat in the coming days, we have a hard time believe that any near-term gains forged will hold in the long run. It seems as though the bar has been set unrealistically high for the incoming administration and this may be leaving the market vulnerable to a "reality check". Even the most brilliant stimulus package and monetary policy combined wouldn't be enough to turn the economy on a dime.
Additionally, beginning in mid-January stocks are typically subject to dramatically weak seasonal tendencies. Thus, if the indices can't consistently close above resistance at 888 in the S&P, 8,520 in the Dow and 1,215 in the NASDAQ it seems as though we could be setting up for a rather large decline.
Treasuries.
As it turns out, the analysis provided in last month's newsletter turned out to be highly accurate. Unfortunately, the timing (over the holiday) and the quick nature in which the selling took place left many, including us and our clients, on the sidelines. Regrettably, as the month progressed we strayed from our original forecast. "the charts" suggested that there could be one more rally before heavy selling became a reality. Sometimes the charts lie. Here is a short excerpt from last month's newsletter:
With rationality out of the way, we are forced to look at technical patterns and market seasonality. December is known for being a turnaround month for bond traders. It is not uncommon for a large Treasury rally to come to a dramatic end in mid-December. However, my instinct tells me that the trend reversal will be a little late this year. With current prices "off of the charts" and outside of my previous scopes of possibility, I have a little less confidence in my analysis. However, I believe that the recent consolidation range was the market preparing for another move higher. My first target in the 30-year bond is 138, but I see the possibility for prices just under 140. The 10-year note could see prices as high as 129 before a long awaited reversal occurs. With that said, if my predictions become reality it will do so in the near-term and will likely be a relatively quick rise and even quicker fall from grace. Stay tuned to the Bond Bulletin for ideas on how to play this market.I often remind people that there is a big difference between being right and making money. The fact that we hadn't recommended being involved in this market at the time of the move, accordingly preventing most of our clients from benefiting isn't comforting.
Looking ahead, we are getting incredibly mixed signals from a technical standpoint and the fundamental picture isn't helpful either. After all, as bond friendly negative economic news pours in so do the new issues of debt instruments. The Federal Reserve as well as corporations are scrambling to sell bonds and notes in order to finance operations which has sharply increased the supply of fixed income products. It is no secret that the Fed has substantial obligations in which money will need to be raised and traders recognize this as a possible weight around the neck of bonds and notes.
Conversely, although speculation of the Federal Reserve purchasing long dated securities (including their own Treasuries) as a means of artificially lowering interest rates as been rampant, they have just recently begun admitting to their intention to do so. Many are making the assumption that they are and others that they will but the distinction is essentially irrelevant and the Fed knows that. Given the speculative nature of the markets, the mere mention of such a practice is often enough to do the trick.
While we feel as though yields are simply too low to be sustainable in the long-term, the looming vulnerability in the stock indices have been keeping a floor under Treasury prices. With that said, if our anticipation of a large decline in equities proves to be reality, bonds and notes will benefit greatly. In fact, with the help of a stock market plunge we could see the March 30-year bond trade near 144 and possibly 131 in the 10-year note.
If the stock market selling dissipates on swifter than expected government intervention, bonds and notes will be susceptible to a decline to 131 in the long bond (eventually as low as 118'10 in a much larger time frame) and 123 in the 10-year note (eventually 119 in a longer time horizon).
Grains
There is no denying the role that the U.S. dollar has played in the massive fluctuations in commodity prices; however, the relationship seems to have soured a bit. With the exception of the most recent dollar rally, beginning January 9th, the grain complex had been focused on alternative market forces. Nonetheless, it was the dollar devaluation that sparked the massive commodity rally in 2007 and it is likely that the negative correlation between grains and the U.S. currency will strengthen once again.
While the dollar is in the midst of a correction, it seems to us that the long-term path will remain higher for now. If this assumption is accurate, after a short-term continuation of the current rally we should see a continuation of the deflationary trade.
Along with eventual price pressures in commodities at the hands of a stronger dollar, the demand destruction for feed and a decreased interest in ethanol production should keep grain prices moderate. In fact, the decline in demand for feed and fuel led to the USDA to increase the 2008/09 ending corn stocks by 350 million bushels as stated in the December Supply/Demand Report.
Corn
In last month's newsletter we predicted that the short covering rally in corn would extend itself to resistance near $3.85 and possibly as high as $4.16. We underestimated the move a bit, but are still of the opinion that a stronger dollar will weigh greatly on commodity values as the year progresses. With that said, the U.S. dollar is in the midst of a correction and may see some temporary selling in which the grains will have the green light to move higher. However, corn will likely have difficulty breaking new highs above the $4.27 area.
While traders may benefit from bullish strategies in the very near term, it seems as though the better play is to the downside. An idea is to buy the March corn $4.25 call for about 11 cents in hopes of a retest of the high. At which point you can decide to use the call option as insurance against a short futures or play the call option by liquidating (hopefully at a profit) , holding on, or selling a call above the market to lower your exposure and convert it into a bull call spread. Aggressive traders may wait for higher levels to execute a bearish strategy such as a bull call spread with a naked leg.
Soybean Complex
Soybean traders seem to have forgotten all about the pending deflation resulting from nearly non-existent demand for many of the other commodities. As crude oil has declined tremendously, the bean products have managed to forge impressive near-term gains.
March Soymeal has rallied nearly a dollar from the December lows but analysts wonder if demand will be able to sustain the gains. The USDA has predicted domestic meal demand to be down nearly 2% from last year.
Much of the move has come on questions regarding South American weather, but some sources are pointing toward better conditions and note that the dry areas far outweighed those with ample moisture.
We can't rule out a rally to $350 in the March meal contract on speculation of tight supplies and a return of the inflation trade, but are leaning lower due to what seem to be bearish fundamentals.
Last month we suggested that the fundamentals for beans seemed much stronger than those of the other commodities. Therefore, we weren't necessarily convinced that our bearish technical analysis would work in the current market environment. We were right to be cautious. Soybeans broke their technical down-trend and soared above $10.00.
We can't help but feel that beans have made the majority of their move, at least for now. While we could see prices slightly above $10.60 in the coming days or weeks as the greenback temporarily falls off, we believe that we will see a swift retreat from such levels. Yet, traders should be cautious with trying to "pick a top", especially given the recent daily range of nearly a dollar in price movement. Selling a mini futures contract, or constructing a bearish option spread seems to be the way to go should we see prices above $10.50 again.
Wheat
Wheat prices have been difficult to predict in recent years. As one of the less traded grain markets, the light liquidity seems to have created a hot-bed of volatility. If you happen to have keen speculation, there is a lot of money to be made, but the risks are high and option traders can face large bid/ask spreads in the wake of explosions of volatility.
Wheat prices are normally in the midst of seasonal weakness during the month of January and for the most part that characterization has held true.
Like the other grains, we are expecting wheat prices to retreat in the coming weeks. However, highly net short speculation in this market seem to be a recipe for a quick rally to retest the January highs near $6.40 before succumbing to seasonal, fundamental and currency pressures.
Energies and Metals
Crude Oil
According to the Commodity Trader's Almanac, January tends to see continued weakness in crude oil and natural gas before finding a typical bottom in the month of February. Also, according to the almanac, traders should prepare for the strongest buy moth in each of the noted energy markets. It is noted that crude prices often suffer from year-end inventory liquidation, mainly because large producing states are subject to paying taxes on unsold inventories. End users of crude oil are said to postpone purchases of inventory until well after the New Year, thus the February "bottom". However, the buying pressure typically doesn't materialize until the later part of February, leaving energy prices somewhat vulnerable in the near-term.
A good friend of ours, Chris Jarvis (you have likely seen him on CNBC), is a well-known and respected energy analyst. When we asked him his opinion on the direction of the energy markets from here, his answer was simple; "The energy markets are a great buy at these levels, but you have to be careful because these markets will rip your face off before proving you right."
In our view, March crude will have to trade below $40 per barrel before becoming somewhat attractive. We see support in the March contract near $38. This prediction is based on the fact that the recently widening contango (the amount in which the front month is trading at a discount to the back months) has prompted suppliers to hold on to inventory for later delivery months. Also, economic news and a potential slide in equities should continue to keep the buying muted until later into February.
Gold and Silver
Our analysis in last month's newsletter happened to be relatively accurate. Here was our prediction:
We are looking for February gold to trade just under $900 in the coming weeks but feel as though the rally will fizzle out at such levels. Silver on the other hand, will face significant resistance near $10.80 but a move to $11.50 may be in the cards should the dollar weakness continue and the other commodities find footing.
This month, we are seeing conflicting seasonal tendencies and technical analysis and are facing considerable fundamental uncertainty. However, we have arrived at the following conclusion.
The fact that we are leaving the door open for a possible plunge in equities leads us to believe that the metals markets may temporarily benefit. Although late February seasonals point to lower gold and silver prices, the next two to three weeks could make way for some upside.
In the case of gold, our upside targets are relatively modest, we are looking for a climb to the top of its current trading range and a retest of the October highs near $940. However, we see potential for silver to see prices near $11.95 and in the "perfect storm" of fundamentals as high as $12.82 within the next month. Subsequently, we believe that seasonal tendencies will weigh on silver and dramatic price declines could be seen in late February.
Currencies
A month ago we were discussing the swift manner in which the U.S. dollar fell out of favor. However, since then the greenback has once again been the benefit of flight to quality trade. While there are clearly some instabilities in economies and governments worldwide, Federal Reserve debt is still rated a triple A by Standard & Poor's and is being given the benefit of the doubt. Other central banks are seen as being slightly less reliable by currency traders and, in our opinion, currency valuations are proof.
Faith in the quality of the debt has nearly erased any interest rate differential arising from the Federal Reserve's target overnight rate of nearly 0%. Additionally, foreign central banks are also being heavy handed when it comes to rate cuts.
Last month we were looking for continued weakness, which we deemed as a buying opportunity and that turned out to be accurate. This month it is much of the same. We are expecting a temporary correction, in the Dollar index due to technical trade but believe that the up-trend will continue. In fact, strong seasonal weakness in the Euro, which makes up about 60% of the index, should make way for the dollar to eventually trade near the November highs.
We see support near 81.00 and again near 80.50 but for now we expect these levels to hold. Options in this market are a little on the thin side, accordingly traders may want to stick with simple long futures plays at prices at or near noted support levels.
Euro
We were shocked by the magnitude of the short covering rally in the Euro. Although our analysis in the previous newsletter wasn't ridiculously off the mark ,we had no way of anticipating what was in store for the currency markets. Here is a recap of last month's analysis:
This time around, the move to what we believe will extend to about 138.00 in the Euro is underway (a little later than originally expected). We are looking for resistance levels to hold, and for the Euro to retreat into the mid to low 120's. However, if we are underestimating the fundamental climate and the amount of short covering that could take place, the next major area of resistance will likely be found near 143.30.
After retreating nearly 17 handles from its high, it is clear that the Euro is a little oversold and in need of a digestive bounce. However, we are assuming that any short covering rally that occurs will be followed by another slide.
According to the Commodity Trader's Almanac, the Euro tends to be flat during February and they recommend taking profits on any short positions by February 8th. Alternative seasonal data suggests that late January selling could occur.
With this knowledge, and the help of our technical tool-belt, we are anticipating a retracement in the March Euro to the 50% retracement of the last drop to 136.33. This technical rally may extend itself slightly higher to 136.80.
The Euro has been highly volatile in recent months, thus it is recommended that, unless you have a sizable account and risk tolerance, you trade via the mini-version of the contract.
Japanese Yen
Like the other currencies, the Japanese Yen has undergone significant amounts of volatility leaving the trading ranges wide and unmanageable for many traders.
We are leaning toward the downside of the Yen based on seasonal factors. Assuming a break of support near 110.60, we believe that a larger slide to 107.11 and maybe even 105.73 could become a reality. The Yen and the Dollar Index have been moving in tandem as of late, so it isn't farfetched to expect that they trade weaker together. If we are wrong, resistance will be found near 115.90.
Softs
Sugar
With short-term supply for sugar at high levels and discounted crude oil prices eating away at the demand for ethanol, sugar prices look to be under near-term pressure. Additionally, technical resistance should divert any rally attempts beyond the 12.50 level as long speculators liquidate on a failure to maintain momentum. Keep in mind that trend following funds were noted net longs in the last COT report and given the devastation that trend followers have experienced in the commodity bubble burst, they may be fickle in their holdings.
It is said that markets spend 80% of their time trading in a range and recent action in sugar futures supports this theory. Believers of the premise should assume that the market will continue to trade within the range until it is able to prove otherwise. Therefore, I would expect sugar to remain in the price envelope between 10.50 and approximately 12.50.
Longer-term fundamentals seem to favor higher prices making 10.50 attractive levels to be bullish. The recent trading range in sugar has allowed implied volatility, and thus option pricing, to become affordable. Those expecting sugar prices to make their way to the bottom of the range may consider purchasing 10 cent or 10.5 cent puts with the anticipation of possibly buying futures at such levels if these prices are seen. The 10 cent puts for May puts are running about $350 and expire on April 15th.
Bears may also consider selling March futures as they are near the upper end of the current trading range. However, we don't recommend doing it without some type of insurance given the amount of short covering that could occur on a breakout. Some ideas to mitigate the risk of a short futures are to purchase the March 12.50 call for about $500. This limits the risk entirely beyond the amount of premium paid and the distance between the strike price and the entry price of the futures position.
It may also be a good idea to use a bull call spread to lower the cost of the protection. For example, buying the March 12.50 call and selling the 13.50 call for a cost of $250. Keep in mind that this involves two transaction costs making it unattractive at higher costs. This spread, would fully hedge the short futures from 12.50 to 13.50 but leaves the position "naked" above 13.50.
Coffee
Unlike some of the other consumed commodities, coffee demand is known to remain high during tough economic times. Coffee drinkers tend to be loyal (or addicted), instead of frequenting Starbucks consumers are taking advantage of McDonald's new McCafe line. Others...are dusting off their home brewers.
The December/January seasonal rally has taken place leaving the market to face sagging tendencies through the middle of February. Our floor broker, Jurgens Bauer, notes that a break of support below 112.80 could "uncover stops from recent longs". Given the typical weakness during this time of year and the potential for sell stop running, I can't help but feel as though coffee prices are destined for lower prices in the near term.
Following the spike higher in recent weeks, the Commitment of Traders positions have become more normalized but large speculators remain short this market. While a retest of 118 in the March contract is a possibility, we expect coffee to make its way lower with the first area of support being 111.70 and then again near 108.50 and 105.20.
Coffee is a high stakes market, the options are expensive and the futures margins are high. Before entering this market, make sure that you are able to tolerate the risk involved.
Meats
Hogs
After undergoing a 30% plus price decline since the middle of 2008, hog prices are becoming attractive for long-term traders. The recessionary demand pressures have taken their toll, but fundamentals driving prices may shift from the demand side of the equation to supply. Although, there is some speculation that hog exports will pick up in anticipation of demand from Russia. This sentiment is based on a lingering deal in which Russia would agree to import as much as twice as much pork designated for a low duty.
Fundamentals and technicals seem to point to a positive year in the hog market. However, prices have been reluctant to find a low despite a recent attempt at a key reversal. While the absolute bottom may not be in yet, we are seeing evidence of a turnaround.
Last month we were predicting a slide in the February contract to the mid to low 50's and weren't too far off. This time around, seasonal tendencies and oversold conditions suggest that a 5-cent plus rally could be in the cards. Look for April lean hogs to find resistance in the high 60's. It doesn't seem likely that the rally will have enough momentum to pull hog prices out of the rut...odds favor a sustained rally deeper into 2009.
Cattle
Many analysts are of the assumption that cattle prices have already accounted for the recession and note that the dramatic fall in prices has resulted in a highly reduced supply. Thus, it is possible for cattle prices to appreciate long before demand ever does. Additionally, it is said that competitive meats such as poultry are also seeing decreases in supply, likely due to feed costs and an anticipated lack of demand as consumers shift to more affordable food choices.
While the longer-term outlook for cattle prices looks positive, prices may remain choppy to lower in throughout the remainder of January and beginning of February. With that said, seasonal pressures, technical trade may trigger a sizeable rally in the February time frame.
We see resistance near 89.45 and again near 91.56. The mid-91's are a likely probability given the Commitment of Traders (COT) data that suggests that small specs are rather short. You may remember in early June of 2008 when small speculators recorded the largest net short position on record in cattle and the subsequent 9-cent rally. Unfortunately, trading is a "dirty game" and the masses tend to be wrong.
DeCarley Trading
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**There is substantial risk of loss in trading futures and options. Past performance is not indicative of future results. The information and data in this report were obtained from sources considered reliable. Their accuracy or completeness is not guaranteed and the giving of the same is not to be deemed as an offer or solicitation on our part with respect to the sale or purchase of any securities or commodities. Any decision to purchase or sell as a result of the opinions expressed in this report will be the full responsibility of the person authorizing such transaction.
