Commodities Risk Trade

By: Adam Hamilton | Fri, May 20, 2011
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Commodities prices have been exceptionally volatile in recent weeks, with big daily rallies and plunges intermingled. Seemingly without rhyme or reason, commodities surge one day as traders crave riskier bets but then fall the next as they flee risk. While this commodities risk trade often looks capricious and schizophrenic, it actually has a logical and consistent driver. The state of the stock markets.

This perpetually frustrates countless commodities-centric investors and speculators. They want to believe that their favorite commodities' fundamentals are what move their prices. While certainly true over the long term, many years, on a day-to-day basis sentiment usually trumps fundamentals. How traders feel about commodities leads them to buy and sell. Thus pure emotion drives most short-term price action.

And nothing is more important for global financial-market psychology than how the stock markets happen to be doing. When the stock markets are rallying, traders all over the world involved in every possible market feel optimistic. They interpret the stock-market strength as a sign the global economy is improving, hence demand for commodities will continue growing. So they eagerly deploy capital into commodities, engaging in what Wall Street now calls the "risk-on trade".

Conversely when the stock markets are selling off, universally traders feel pessimistic. They read this as an omen of slowing economic growth, and hence weakening global commodities demand. So they exit commodities-related positions, now popularly known as the "risk-off trade". Thanks to this strong psychological link, stock-market sentiment spilling into every other market including commodities, these prices are highly correlated to the US stock markets.

Almost without exception, the big risk-on up days in commodities coincide with sizable stock-market rallies while the big risk-off down days mirror significant stock-market selloffs. So though it may seem counter-intuitive, the stock markets often dominate commodities sentiment! Commodities-centric traders cannot afford to ignore the stock markets if they hope to thrive by buying low and selling high.

This critical causal relationship of stock-market sentiment bleeding into commodities is easy to empirically verify. All we have to do is compare the post-panic performances in commodities and the stock markets and this psychological link becomes blindingly obvious. The best measure of the US stock markets' performance is the mighty S&P 500 stock index (SPX). This broad market-cap-weighted index tracks 500 of the biggest and best companies in America.

The flagship commodities index is no longer the CRB as many believe, but the old-school Continuous Commodity Index (CCI). After being around for nearly a half-century, the CRB was butchered in its tenth revision in July 2005. Its traditional calculation methodologies including equal weighting of all component commodities were trashed in favor of a new crude-oil-dominated index. Today's CRB is no longer the classic CRB, which was renamed the CCI. Confused? Read one of my essays on it.

For today's purposes, the incredible causal link between stock markets and commodities is readily apparent in an SPX and CCI chart. This one covers most of the post-panic era, the ongoing SPX cyclical bull. As you can see visually, the price action between these two wildly-different indexes is uncannily similar. Other than one major yet short-lived divergence, you could pass the CCI line off as the SPX and vice versa!

SPX and CCI 2009-2011

And the hard math underneath this relationship shows it is far beyond superficial. Over this 2009-to-2011 span, the CCI and SPX had such a stellar positive correlation that their r-square ran 86.6%! This is stunning in case you've forgotten your college statistics classes. It means nearly 87% of the CCI's day-to-day price action since early 2009 is mathematically explainable by the daily moves in the SPX!

Almost 7/8ths of the behavior of commodities as a group in this post-panic era mirrors what has been happening in the stock markets. So investors and speculators who fail to consider what the stock markets are doing before buying or selling commodities, commodities ETFs, or commodities stocks place themselves at an insurmountable disadvantage. Everything outside of the stock markets combined, including individual-commodity fundamentals, only account for about 1/8th of the price action!

The best times for investors and speculators to buy positions in any ongoing bull market is immediately after a correction, right? That's when prices are the lowest within their uptrends. When do commodities as a group experience these selloffs? Exactly when the stock markets do! In this chart I highlighted every major SPX pullback (less than 10%) and correction (greater than 10%) of this entire cyclical bull in red. Check out how the blue CCI line performed during these material episodes of stock-market weakness.

Without exception in the last couple years, every time the stock markets sold off significantly the commodities followed them lower. As the percentages above reveal, sometimes the CCI matched the SPX's decline, sometimes it was milder, and occasionally it even amplified a stock-market selloff. Not only did the CCI always follow the SPX lower, but all of commodities' material selloffs of this entire cyclical bull only happened during SPX selloffs.

If you carefully examine the blue CCI line above, you'll note that the CCI never sold off meaningfully except in those red-highlighted spans where the SPX was experiencing a major selloff. And most of the time when the SPX was rallying between its own pullbacks and corrections, the commodities happily followed it higher. The one major exception happened in early 2010, when the SPX surged but the CCI ignored it.

This was a peculiar divergence that hadn't happened before and hasn't since. In January 2010 the SPX entered into what would become the biggest selloff in this cyclical bull at that point (and the biggest pullback to this day). The selling was fast and furious as this flagship stock index fell 8.1% in less than 3 weeks. Commodities were naturally crushed in this abrupt selloff. The falling stock markets spawned much pessimism among futures traders who worried the global economy was weakening, so they sold.

When considered as collective groups, futures traders are much more sophisticated than stock traders. Though the SPX soon bounced into a secondary melt-up rally that persisted into April, the futures traders were very skeptical of this move for all kinds of technical and sentimental reasons. So commodities weren't bid up with the SPX in that particular episode. And since they ignored the last surge of that SPX upleg, they weren't overbought and didn't have to correct hard with the SPX in the summer of 2010.

But since then, the CCI's relationship with the SPX has grown even tighter. This current SPX upleg was born in deep despair in late August, as I predicted at the time despite the silly Hindenburg Omen crash scare. Over the 9 months or so since, the correlation r-square between the CCI and SPX has surged to 93.4%! For all intents and purposes, the commodities have become a leveraged extension of stock-market action in this upleg. Almost 19/20ths of their daily price action is directly attributable to the SPX!

From writing about this in our popular newsletters, I am well aware this irritates commodities-centric traders. I hear over and over again how people don't want to hear about the stock markets, but instead solely about fundamental developments in their favorite commodities. But as a lifelong speculator, my primary mission is to multiply capital through profitable real-world trading. So if the SPX happens to be driving commodities' prices these days, then the SPX is what we are going to watch to trade commodities.

All that matters in the markets is what is moving prices, not what we want to move prices. Countless silver traders were just slaughtered in its brutal post-parabola near-crash, foolishly ignoring dangerously-overbought technicals and sentiment to myopically focus on to-the-moon fundamental arguments. Fundamentals are indeed super-important for long-term secular trends, great for investors to consider. But for short-term speculators, sentiment is the entire game. And the fortunes of the SPX dominate it universally.

This is so readily apparent if you take the time to look. Next time the SPX has a big up day, carefully observe how the financial media reports on it, what commodities prices do, and how you feel about things. The news coverage is going to be bullish and optimistic, commodities are going to catch a big bid on an improving economic outlook, and your own heart is going to be happy and glad. And of course the exact opposite is true on a big SPX down day, pessimism abounds and you are going to feel worried.

The state of the stock markets drives the commodities risk trade, beyond any doubt. When the stock markets are rallying traders everywhere feel great and thus plow capital into commodities, risk-on. When the stock markets are falling traders all over the world get nervous and therefore pull capital out of commodities, risk-off. If you take the time to understand this dynamic, and carefully apply it by studying the state of the stock markets before you make commodities-related trades, your realized profits will soar dramatically.

One more observation on this relationship. Over the past 6 months or so as commodities grew more overbought, they plunged whenever the SPX suffered any down days big enough to spark meaningful fear. This trend will likely persist whenever the SPX's next big down days arrive. And realize that the CCI's 17 component commodities are equally-weighted and geometrically-averaged. This has a huge smoothing effect, so any given percentage move in the CCI is a far-bigger deal than that same percentage in the SPX.

Provocatively commodities and the stock markets have been so joined at the hip in recent years that their technical indicators even look like Siamese twins. This next chart shows the Relative CCI, or the CCI divided by its own 200-day moving average. Charted over time, this indicator creates a horizontal trading range. If the black 200dma line was flattened to horizontal, and the blue CCI line rendered as a perfectly-comparable-percentage multiple relative to it, the light-red rCCI line would be the result. If you aren't familiar with my Relativity trading system, it can greatly improve your understanding of market timing.

Relative CCI 2009-2011

Considered as a broad sector, the best time to buy commodities is when they are down near their 200dmas. The last time the rCCI was low, below its relative support line of 1.00x (meaning the CCI was at its 200dma), was during the summer of 2010. And look at the massive rally in commodities since! But when the CCI was overbought, near 1.20x its 200dma, it was the time to sell in anticipation of a correction. And indeed we saw such selling events in early 2010 and probably now again in mid-2011.

While individual commodities often diverge from their equally-weighted geometrically-averaged index, in general it is prudent to heed the state of CCI technicals. When this index is oversold, which only occurs after serious stock-market selloffs, buy commodities (and commodities stocks) aggressively while they are cheap and out of favor. And when this index is overbought, which only happens after major stock-market uplegs, realize your profits in commodities and hold cash for the inevitable correction. Buy low, sell high, and grow rich!

While commodities prices have plunged rather sharply in recent weeks, they still aren't oversold as measured by the Relative CCI. So we're not down to a high-probability-for-success buying zone yet, but it is likely coming. Its catalyst? An overdue stock-market selloff, of course! For a variety of technical and sentimental reasons I've detailed in recent essays, the SPX is overdue to correct. This selling will drag down commodities as usual, as it leads to general pessimism and the desire to flee risky trades.

Once you know how overpowering and dominant the stock markets are in driving sentiment over in commodities-land, you can adjust and harness this for your own benefit. While it is still very important to look at technicals and sentiment in the specific commodities critical to your trades, also look at the broader stock-market picture. Are the stock markets overbought, highly-complacent, and likely to correct? Then your individual commodities and their related stocks will almost certainly be dragged down with them.

And if you are looking to buy and deploy capital, after considering your specific commodities' technicals and sentiment take a look at the broader stock markets'. Is the SPX oversold and out of favor enough that it is unlikely to fall farther and drag down commodities with it? Is a stock-market rally probable? Then your individual commodities and their related stocks are likely to rally and thrive with the SPX.

With the SPX action directly explaining 87% to 93% of commodities performance since the panic, you just can't afford to ignore the general stock markets. And I really suspect this powerful sentimental relationship is likely to persist and even strengthen throughout the remaining years of these secular commodities bulls. Why? More mainstream capital is chasing commodities, engaging in this so-called risk trade.

Every secular bull market starts out small, emerging out of horribly-oversold conditions where no one will touch it with a ten-foot pole except a handful of hardcore contrarians focused on fundamentals. These are true believers who aren't the least-bit concerned about the stock markets. In a secular bull's earlier years as contrarians continue to dominate, the stock markets are irrelevant. More and more capital gradually flows into the still-undervalued market regardless of what the stock markets are doing.

But eventually the young bull's performance becomes so impressive that mainstreamers can no longer ignore it. So they start gradually deploying capital. And along with their capital comes their worldviews and biases. With most investors stock-centric, it is only natural that rising stock markets will make them feel good while falling ones frighten them. The more mainstream capital that flows into commodities, the greater the effective influence of the stock markets on commodities-trader sentiment will grow.

At Zeal, our mission is profitable real-world trading. All of our hard work and research supports this singular goal. So we will heed whatever happens to be actually driving the markets we are trading. Figuring out when markets move, and what drives them, is critically important. The net results of this highly-focused approach have been spectacular. Over the past decade or so, all 583 of our newsletter stock trades have averaged annualized realized gains of +52%! Growing your capital at 50%-a-year rates is hard to beat.

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The bottom line is the stock markets dominate sentiment in commodities. The entire risk-on, risk-off dynamic that defines commodities price action these days is the direct result of stock-market action. Rallying stock markets create optimism which drives capital into commodities and buoys their prices. Falling stock markets do the opposite. For better or worse, commodities are psychologically joined at the hip with the stock markets.

The hard correlations in this relationship are stunningly high, with almost all of commodities price action directly explainable by parallel stock-market action. Thus commodities and commodities-stock traders who refuse to heed stock-market sentiment and technicals before making individual trades are doomed to frustration and failure. The commodities risk trade has become a leveraged extension of the stock markets.

 


 

Adam Hamilton

Author: Adam Hamilton

Adam Hamilton, CPA
Zeal LLC.com

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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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