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May 12, 2006

Trading the CRB Index
by Adam Hamilton

What an amazing week in the commodities markets! The combination of the first $700+ gold closes in over a quarter century, all-time-record platinum highs above $1250, copper soaring over $3.75, and renewed oil strength led to a very welcome surge in mainstream interest in this powerful secular commodities bull.

While the fearless contrarians have already earned fortunes since this bull stealthily started galloping higher in 2001, all the increasing commodities exposure in the mainstream financial media is bringing legions of new traders to the table. Many of these new investors and speculators cut their teeth trading in tech stocks in the late 1990s.

These stock traders, naturally, like indexes that act as proxies for a sector. If you owned ten tech stocks in 1999 and wanted a quick read on how they were likely doing, all you had to do is take a quick look at the NASDAQ Composite index. Indexes are really valuable since they distill quite a lot of important price data down into one easy-to-follow number.

While not yet anywhere near as popular as the headline stock indexes, the CRB Commodities Index is the most widely followed index today that acts as a proxy for this general commodities bull. If a trader is in a hurry and doesn't have time to check gold, and silver, and platinum, and copper, and nickel, and oil, and natural gas, and whatever else, then he can take a quick look at the CRB to see if commodities are generally strong or weak.

There are several critically important attributes of the CRB that are well known to veteran commodities investors that newcomers to this realm really ought to be aware of. The CRB index, now in its 10th major revision since it was launched in 1957, is comprised of 19 key commodities. These commodities are not equally weighted, either individually or by sector, and are arithmetically averaged and rebalanced monthly.

The CRB's 4 energy components, which are crude oil, heating oil, unleaded gasoline, and natural gas, make up the largest proportion of this index by far at 39%. Crude oil alone accounts for 23%! This large energy weighting is a double-edged sword. Since the energy sector is so strong it is great for the CRB's performance, but if you are looking for equal exposure across commodities the CRB no longer does this.

You probably don't want equal exposure though. I sure don't. The greatest gains in this commodities bull by far have been in the very capital-intensive hard-to-produce commodities, like metals and energy. Metals account for 20% of the CRB's weight and once again energy is 39%. The remaining 41% is soft commodities like wheat, coffee, sugar, and livestock. The supply/demand profiles of these soft commodities are generally suboptimal.

Producing metals and energy is extremely hard. It requires hundreds of millions to billions of dollars of capital to sink a mine or drill a well after years of lead time to find economical deposits. As such, metals and energy prices can easily stay high for a decade or more before the free markets are able to adjust and bring considerable new supplies online. Investors and speculators can reap fortunes during this long, slow high-price adjustment period.

In contrast soft commodities adjust much faster. If wheat prices had more than quintupled like copper prices since 2002, every farmer in America would be growing wheat today. Soft commodities have low barriers to entry, anyone can produce them, so they adjust far more rapidly to price increases. An additional huge problem they have is governments often subsidize their production, leading to persistent oversupplies and hence chronically low prices.

Finally, today and increasingly in the months and years ahead, you will hear that the CRB is at all-time highs. This is technically true but quite misleading in real terms. If you adjust the CRB for inflation, it would have to soar near 800 to exceed its early 1980s highs and above 1000 to achieve a new all-time real high. Thus, adjusted for inflation, the CRB and most commodities remain relatively cheap today with the majority of their bulls likely still ahead of them.

Unfortunately the CRB is not particularly easy to trade. To the best of my knowledge there is no CRB ETF trading in the United States so American stock investors have no way to access a CRB tracking proxy directly. The CRB can be traded via futures accounts, but I am not sure why an individual speculator would want to do this. If you already trade futures why buy the CRB futures diluted by lower-potential softs when you could directly trade high-potential individual metals and energy contracts?

At any rate, whether you want to trade CRB futures directly or use the CRB as a secondary indicator to give you a quick read on the prevailing sentiment for this general commodities bull at any particular moment in time, understanding the CRB technicals should prove useful. I like the CRB for the latter purpose, to offer additional insights into individual commodities sectors I happen to be trading.

As an example, imagine you were trading oil stocks or gold. Your primary technical tool on buy and sell timing would be oil and gold respectively. But the CRB technicals can provide a useful secondary confirmation of your current trading thesis, or undermine it. If gold was looking toppy at the same time the CRB appeared to be near a technical top itself, this would increase your confidence in the probabilities that a gold correction was likely drawing nigh.

While individual commodities don't always move with the CRB, over the long term these commodities are definitely highly correlated with it. So just as the NASDAQ's technicals won't always accurately predict the next move in Cisco Systems, more often than not Cisco will move in sympathy with its sector's flagship index. This same general rule applies to commodities. While they don't have to move in unison with their sector, more often than not their major swings are correlated.

Thus as an investor and speculator deployed in both commodities and elite stocks of commodities producers, I like to follow the CRB technically to grant me some perspective on the prevailing sentiment in the commodities markets at any given time. I am using the same methodologies here that have proven very successful for us in gold and oil, analyzing the secular CRB rhythms and the Relative CRB.

The basic underlying premise for this analysis is that all bulls flow and ebb, experiencing dramatic uplegs followed by corrections necessary to rebalance sentiment. In order to optimally time their trades, investors only want to add positions during these periodic corrections. And speculators want to buy low in these same corrections and sell high near the post-upleg interim tops that follow later. The best way to understand when probabilities most favor major interim highs or lows is to analyze the underlying bull to date.

Our first chart takes a look at the commodities bull to date as represented by the venerable CRB. For such a diverse commodities index, the secular uptrend channel of the CRB has remained remarkably consistent. This is even more impressive considering the radical revision of the CRB structure that just started trading last July. Such consistency yields some excellent secular-rhythms data to analyze.

For a nearly five-year-old bull, this CRB uptrend is probably the most consistent I have ever seen. The very same support and resistance lines that were established in 2002 and 2003 are still pretty spot-on today. During this time frame the CRB has had six major uplegs and subsequent corrections. I defined major uplegs as the index powering up to fresh new bull-to-date highs and corrections as the periodic falls towards the CRB's 200-day moving average that inevitably happen after these interim highs.

These six uplegs have had gains running from 12% to 29%, with a bull-to-date average near 19%. This happened over 142 trading days on average, although this trading day statistic is probably not as predictive here since the duration of these major uplegs is all over the map. But the 19% average gain is certainly a useful metric to consider in future CRB uplegs. When this index is up 19% or so in its latest upleg, then the odds are turning against it and the probability of an imminent correction looms.

As of May 10th, the data cutoff for this essay, the CRB was only up 13% so far in its seventh major upleg, so it isn't yet particularly close to the point where secular rhythms suggest that caution is in order. When it does hit a 19% upleg-to-date gain, I would be really hesitant to add long commodities positions due to the ballooning probability of a general commodities correction in the weeks immediately ahead.

The secular rhythm of these CRB corrections so far has been even tighter than its uplegs, with much lower variances between individual major corrections. The six so far have averaged 8% losses in the CRB over 41 trading days. Thus, when the CRB has corrected off a major interim high and is down about 8%, I would be looking to buy since the probabilities would then be shifting in favor of the next major upleg launching.

Now since the CRB is a composite of so many disparate commodities with their own individual supply and demand profiles, applying secular rhythm analysis is riskier here than in an individual commodity. For example, the CRB is now dominated by oil so it will usually be on the high side when oil is high. Yet at the same time copper might be relatively low, close to its own 200dma (unlike today). In this case adding copper positions would probably prove really profitable even though the CRB was technically high. This is one of the major reasons why I only consider the CRB technicals useful enough to be a secondary indicator.

There are a couple more CRB-unique issues that demand we take CRB rhythms with a grain of salt when launching trades in individual commodities. While the CRB uptrend has been remarkably consistent so far in its bull to date with one primary channel, odds are this will soon change for two important reasons.

First, all secular bulls tend to have at least several major uptrend channels over their lifespans, and each subsequent uptrend channel has a steeper upslope. This is readily apparent today in oil and most of the base metals. Sooner or later the CRB is going to jump out of its current uptrend and start carving a newer steeper one. Interestingly this will still happen even if the CRB upleg gains remain roughly the same. Constant gains over time mathematically carve a continuously steepening uptrend on a conventional non-logarithmic-scale chart.

The second reason why these secular rhythms may be changing is the 10th major CRB revision of last July. Until that point, the 17 CRB components of the time were equally weighted and geometrically averaged which greatly smoothed out volatility and helped generate an orderly uptrend. Today the 19 CRB components are neither equally weighted nor geometrically averaged which will ensure more volatility. And with the CRB's heavy crude oil exposure today, going forward this index will mirror oil far more closely than ever before.

This is already apparent above. The latest major uplegs in the CRB since mid-2005 are accelerating in frequency, technically mirroring what we have seen in oil over the past year or so. With oil alone accounting for nearly a quarter of the weight of this index, oil's uplegs and corrections should be more than enough to keep the CRB bull unfolding at an oil-like pace. This will definitely oil-ify the CRB's secular rhythms.

So I suspect it will still prove useful for investors and speculators to watch for CRB bull-to-date average upleg gains of 19% and average correction losses of 8%, but realize that these probability metrics will continue to evolve and change going forward. Thus it is probably not too prudent to consider the CRB technicals as anything more than a secondary indicator, especially if you are not trading CRB futures directly.

Another technical tool that will probably prove more useful is the Relative CRB, or rCRB. Based on Relativity, the rCRB is calculated by dividing the CRB by its 200-day moving average. As bulls like the CRB flow and ebb, over time they tend to advance a certain distance beyond their 200dmas in uplegs before retreating back to their 200dmas in corrections. The rCRB quantifies and charts this relationship over time.

Think of the red rCRB line below as what the CRB would look like if its 200dma was flattened along the 1.00 line of the horizontal axis and then the CRB was expressed as a constant multiple of this 200dma. Interestingly this analytical approach tends to create a horizontal trading band. And since this rCRB is a multiple rather than an absolute CRB level, this technical tool is much less affected by new steeper-sloped uptrend channels as this bull marches on.

The same six major upleg tops flagged in the first secular-rhythms chart are marked here. These major CRB interim tops occurred at an average rCRB level of 1.116, when the CRB was trading 1.116x as high as its 200dma. And if the first major interim top in early 2002 is excluded, which it probably should be since the CRB bull was just starting out then, the rCRB average interim top rises to 1.125x.

This observation is very useful for trading the CRB directly or using it as a secondary general commodities indicator. When this index advances more than 12% over its 200dma, the odds are growing high that a healthy correction will soon be necessary to rebalance sentiment. Conversely when it nears its 200dma, the odds are growing high that the correction is over and a new upleg is about to erupt from the ashes.

Investors and speculators alike can benefit tremendously from monitoring this effective CRB probabilities band. All traders want to buy low, and when the rCRB falls under 1.00 the CRB is about as low as we can reasonably expect it to go in the midst of a powerful secular bull market. So if the CRB is under its 200dma, the odds of success for adding new long trades in any CRB commodity are relatively high. But when the rCRB stretches over 1.12x, the odds favor an imminent correction so no one ought to buy and speculators should prepare to sell or be stopped out.

These horizontal relative trading ranges form a continuous analog probabilities band. It is not like the odds of a correction suddenly get high the moment the rCRB crosses 1.12x. The higher the rCRB gets the greater the odds for a correction become in a continuous manner. And the farther over 1.12x the rCRB travels the greater the chance the inevitable correction to follow will be sharp and extreme rather than a nice sideways consolidation. When the rCRB meanders in the middle of this channel, near 1.06x, there are even odds for it to move higher or lower next.

As of market close on Wednesday of this week the CRB, even though it hit all-time-record nominal highs, was only trading near 1.095x its 200dma. So while the odds for a correction are growing higher than those of its upleg continuing, the CRB still remains underneath its 1.12x neutral zone where the odds for an imminent correction start getting really high. In rCRB terms it looks like the CRB may still have some room to run yet in its seventh major upleg today.

If you want to follow the rCRB regularly to use as a secondary indicator for your own trading, we are now updating a large high-resolution version of this rCRB chart on our website weekly. It is posted in a private charts area of our website reserved exclusively for our subscribers. If you are a current subscriber and haven't seen our subscriber charts for awhile, you ought to log in and check it out. We recently radically updated this section and more than doubled our regularly updated charts offered.

At Zeal we have been watching the rCRB for some time now and I have found it to be a useful secondary indicator for our trading. While most of our research efforts are concentrated in analyzing individual commodities so we can optimally time trading recommendations into individual stocks of elite commodities producers, it is nice to use the CRB to get a general read on overall commodities sentiment.

If you are interested in continuing to ride this awesome commodities bull higher with us, then please subscribe to our acclaimed monthly newsletter today. In it I integrate all of our trading tools and individual stock research into a coherent whole to help you better understand the ebbings and flowings of the bull markets in key commodities. And when the odds look to be wildly in our favor, I recommend high-potential stocks for investors and speculators to buy to ride the next major upleg to potentially fantastic gains.

The bottom line is the venerable CRB Index remains the best proxy today for the general commodities bull as a whole. While the diversified CRB is not precise enough to be a primary indicator while trading in individual commodities, it is certainly very useful as a secondary indicator to gain an understanding of the current sentiment season prevailing in commodities.

And while the CRB Index just hit new highs this week on the fabulous gains in key high-potential commodities, neither the secular CRB rhythms nor the Relative CRB suggest that a correction is imminent. While the odds of a periodic correction are certainly increasing rapidly, based on bull-to-date precedent the CRB may still have room to run yet in this upleg.

Adam Hamilton, CPA
Zeal LLC.com

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If you have questions I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/financial.htm for more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I WILL read all messages though, and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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