After more than a decade of rallying and constantly making new highs, Commodities still remain in a secular bull market. However, if one was to watch CNBC or Bloomberg on a regular basis, majority of the the pundits are still talking about how stocks will have massive bull market any day now...
The truth is, since the US equity markets topped in year 2000, the best equities have done is pretty much go sideways and create no return over the last decade. If adjusted for inflation, equities have actually lost between 30 to 50 percent, depending on the index tracked. On the other hand, during this time commodities have continued making all time new highs and every one of the corrections has produced a higher low. This is typical behaviour of secular bull markets.
One of these lows has just occurred in December of last year, according to the equal weighted Commodity Index (chart above), so investors focus should once again turn to raw materials. However, just like the stock market has sectors and sub-sectors, so too does the Commodity Index. So the question here is, which sectors should one focus one as of today?
Just like the S&P 500 or Nasdaq Composite, Continuous Commodity Index (CCI) is also one big giant Titanic ship, which takes time to navigate. A huge ship cannot just turn around like a speed boat can. It takes time and the various components of the ship have to be placed in the right position or direction, for the turn to eventually take place.
The same concept applies to sectors of the CCI. These include Energy; Agriculture with three sub-sectors which are Grains, Softs and Live Stock; and finally Metals with two sub-sectors which are Industrial and Precious Metals. Major sectors of focus should always be Energy, especially focused on Crude Oil, and Agriculture as they hold the largest weighting. As we can see the in the chart below, CCI finally bottomed in December 2011, but Energy was first out of the blocks in October 2011. The final low came as Agriculture bottomed in middle of December. Titanic has now turned, so does that mean we should go out and buy all commodities?
While the answer could be yes, I prefer not to purchase Energy right now. As we can see in the chart above, it was Energy that bottom first within the overall broad Commodity picture, together with S&P 500 on October 04th 2011. Since than, Energy Commodities, excluding the Natural Gas sell off, have rallied very hard. For example, West Texas Crude Oil has rallied from $75 a barrel to almost $110 a barrel in the last couple of days. That is a rally of almost 50%, which makes me very uneasy to consider it as anything even remotely close to a good entry point.
Energy sector as a whole, now reads the highest cumulative net long positions in the history of weekly COT reports. In other words, when we add up all investor bets in Crude Oil, Gasoline, Heating Oil and Natural Gas, investors are now the most optimistic they have ever been. Main reasoning behind this occurrence is the large number of bullish bets on Crude Oil and Gasoline as the possibility of Iran War increases.
Furthermore, Daily Sentiment Index on Crude Oil has now reached 94% bulls as of late last week. These type of bullish extremes have only been reached a handful of times over the last four years. What eventually follows is either a major pullback (5% to 10%) or a serious correction (10% plus). So if Energy is not the sector to buy right now, what is?
Bull In Agriculture
I'd say it would be Agriculture. It is important to break Agriculture into two different sub-sectors: Grains and Softs. The chart below shows the Dow Jones Grains Index, which experienced a panic sell off in September, similar to many other commodities. I usually call this a selling climax.
What I mean by selling climax is the peak in selling pressure within a downtrend. It is a signal that majority of the selling has exhausted itself. While prices can go lower afterwards, all we are going to be doing is diverging prior to the actual low. It is quite similar to what occurred with S&P 500 in October 2008 (selling climax), followed by March 2009 (actual low). That is precisely what occurred with Grains in 2011 on a smaller scale and the low placed in December was bought by our fund (Article: Portfolio Update - Long Agriculture).
From here onwards, Grains have created the first higher low, which negates sellers ambitions to push prices further down. That lets us know the bear market has been stopped for now. What we need to see going forward, is a first higher high and a break above the resistance line I drew in the chart above. This will signal that bulls have returned and the price trend has entered a new bull market.
When it comes to Grains, personally I am the most optimistic with Wheat. This view I personally hold is quite contrary to the belief to almost every other trader, investor and media outlet out there. As a matter of fact, fundamental news continue to be extremely awful for Wheat investors - a perfect recipe for a contrarian investor! Here are some of the stories that have been doing the rounds in the media over the last few weeks:
- Wheat Shipments From Australia Seen at Record as Harvest Gains on Weather - Bloomberg
- Large Global Wheat Supplies Pressuring Market - South East Farm Press
- World Wheat Supply Tops Record as Harvest Gains - Business Week
- Grain Production To Touch Record High Of 250 MT This Year - The Financial Express
Media reports on Wheat have been amazingly bearish not only in the last few weeks, but to be quite honest, since October 2011. The price, however, refuses to go lower and has not closed below $6 per bushel in serious fashion. Usually news of excess supply occur around bottoms, while news of shortages and panic buying occur near market tops. A wise investors needs to do the opposite.
It was Marc Faber who first taught me long time ago, that when a price of an asset fails to make a new low on unfavourable news, it could be starting to price in more favourable conditions. The same is true for an asset that fails to make a new high, under very favourable conditions.
As we can see in the chart above, investors hold close to record high net short positions in the Wheat futures market, while we consolidate just below the 200 MA. Grains, and Wheat in particular, have failed to make new lows on various bad fundamental news, which means current record selling has discounted the present conditions and I believe the price is now ready to start discounting future conditions, which will be more favourable. Those who read the blog on regular basis, should also remember that one of my main outlooks for 2012 is for Wheat to surprise everyone with a super rally to the upside.
Soft Commodities on the other hand still remain depressed and in a bear market. No one is 100% sure if the bottom has been witnessed during the December low when CCI itself bottomed together with Grains and Metals. We haven't witnessed a powerful move out of the lows, which usually signals strong buying interest. Having said that, this sector remains a major laggard and therefore a good opportunity because equities, junk bonds, high yield currencies, energy, metals and other risk assets have rallied in recent months, while Soft Commodities remain oversold and pretty much flat.
Looking at the long term chart of Coffee, a major component of the Softs Sector, we can conclude that the cyclical bear market over the last 12 months is now getting quite oversold. On top of that, quite contrary to the Crude Oil, Daily Sentiment Index on Coffee currently stands at only 9% bulls as of last Friday, while COT report shows investors are close to shorting Coffee futures - a very rare occurrence which usually signals bottoms. Sentimentrader's Public Opinion is also depressed and at levels where long term bottoms usually start to base out.
Sugar is also showing signs of improvement after a long bear market, which topped in February 2011 at 36 cents a pound. You might recall last year that I bought Sugar futures at the May bottom around 21 cents and than sold them again in August at 30 plus cents (Article: Portfolio Update: Profit Taking On Sugar). That was all part of an oversold bear market rally. What we have now is the refusal by the bulls to let the prices lower than 23 cents and at the same time, a long drawn out base formation in progress. This is a very favourable occurrence, from which prices could stage another leg of this secular bull market. Sugar is probably the most depressed commodity in both nominal terms as well as in inflation adjust terms when compared to its historical highs in 1970s and 1940s.
Energy has had a super run since October 04th 2011, so I think we are due to for a correction around these levels or slightly higher from here ($115 resistance on Crude Oil). Currently, the sector as a whole displays signs of greed as speculators place bullish bets to record highs, while expecting tensions between West and Iran to rise. I have never been a fan of buying assets when majority are bullish, so I recommend adding no new exposure to energy as of today.
On a completely different note, Agriculture is where the true opportunity exists. In coming sessions, Grains have an above average chance of breaking out into a new uptrend from a basing bottom. Wheat especially looks very good here, with close to a record net short position. On top of that, Softs still remain oversold and probably represent the best opportunity for fresh money to be deployed in coming weeks. Similar to what occurs within the typical Equity Index sector rotation, we could now see sector rotation also occur within the Commodity Index, where Agriculture takes the pole position away from Energy and Metals.
Disclosure: As of the recent cyclical bear market lows in commodities, my fund holds exposure to index of all Agriculture as of middle of December of last year; and exposure to Physical Silver as of late December of last year. The fund has no positions in Energy Commodities. My own personal trading account, also holds Silver futures on COMEX with a high leverage as of late December and I have recently bought both Grains and Softs as a trade too.