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February 09, 2007

Continuous Commodity CRB
by Adam Hamilton

Commodities investors have faced major psychological trials over the past several quarters or so. Back in early May the flagship CRB commodities index hit an all-time nominal high, but then it started grinding lower into the summer. Not long after it plummeted, crashing through its key support zones like a meteor.

In August and September, the plunging CRB led to a widespread perception that commodities in general were falling off a cliff. Some, like the perpetual commodities bears on Wall Street, rejoiced. To them the utter technical failure in the CRB was prime evidence that this pesky commodities bull that has been competing with their mainstream stocks for capital was finally finished. They were smug in their apparent triumph.

To others including many long-time commodities bulls, the technical devastation in the CRB wrought proportional psychological devastation. For every investor there comes some inflection point when prices have fallen so far technically that they overshadow any bullish fundamentals. Eventually everyone has to cut their losses if a damaging price cascade lower continues unabated. There is simply no other rational choice.

And there is nothing that breeds negative psychology faster than falling prices, so it is not surprising that bearish theories on commodities have flourished in the last six months or so. It is just human nature to want to understand why events are happening around us. We are all the most receptive to theories that explain and justify whatever happens to be transpiring at the moment in our own immediate environments.

A key case-in-point is global warming. Regardless of whether these theories are true or false, they only gain traction among the general populace during unusually warm conditions like this past winter. There is no doubt that if our winter had instead been anomalously cold and bitter, barely anyone would have been talking about global warming. This innate psychological need for explanation intimately affects the markets as well.

When prices are rising fast, bullish theories abound to explain them. Remember all the New Era bullish theories surrounding the NASDAQ in late 1999 and early 2000? And when prices are falling fast, bearish theories gain traction and prominence. If the CRB had been strong rather than weak over the last six months, almost none of the bearish theories so popular today would even exist. Prices drive explanations.

Well, believe it or not, the CRB actually really was strong over the last six months! All the bearish theories based on the cratering CRB are founded on nothing more than an illusion. Every single bearish theory you've heard lately that draws strength and credibility from the falling CRB is simply not valid. An epic misunderstanding, or deception depending on your perspective, has just taken place. The CRB is not as it seems.

If you have been following my research thread on this, you know exactly what I am talking about. I wrote essays about this critical issue in October and January and have discussed it in our newsletters. I believe it is extremely important to properly understand because the crumbling CRB is the foundation of countless bearish theories, and if the CRB is not really falling apart then these theories are instantly rendered void.

In a nutshell if this is new to you, the composition and calculation methodology of the venerable CRB commodities index radically changed in July 2005. The equal weighting of components and geometric averaging of prices that had defined the CRB for its first 48 years of existence were thrown out the window. An entirely new never-before-seen beast was created. A couple weeks ago I wrote an essay with much more detail on this if you need some background. Today's essay assumes you have read this earlier one.

Oil and two of its refined products now account for one-third of the weight of this new CRB revision, the tenth in its storied history. So the index widely known as the CRB today is the radically different tenth revision, or CRBr10. When the anomalously warm winter eroded oil demand across most of the northern hemisphere, oil had no choice but to correct aggressively. Of course the CRBr10, effectively 33% weighted in oil, fell in sympathy.

When the CRBr10 bled with oil, it broke a crucial years-old secular support line as well as the index's 200-day moving average. My controversial contention was that the CRBr10 breakdown was not an indication of a general commodities problem, but merely of a new oil-dominated CRB being led by the nose by a brutal oil correction. The trouble lied in proving this thesis as reconstructing the old ninth-revision CRB, or CRBr9, would be extremely difficult as I explained a couple weeks ago. But if it could be done I wrote...

"So I would love to see what the ninth CRB revision would look like extended to today. I hope someone out there can build it. I know this for sure, the CRB breakdown would either be vastly smaller, a minor dip under its long-term support, or it would not exist at all."

Well, it turns out I was not only right, but I was actually seriously understating the bullish case for the historical CRBr9 extended to today! As a student of the markets I am always seeking new knowledge. One of the great benefits for me of sharing my research in these essays is people far wiser than myself graciously write in and help me better understand issues I am grappling with. Their insightful feedback helps hone my knowledge, just like the famous Proverbs verse says... "As iron sharpens iron, so one man sharpens another."

After my last essay on the CRB two weeks ago, a handful of folks wrote in and set me straight on the CRBr9. I was trying to figure out how to reconstruct it, but they let me know that it still exists as a futures contract! The answer to comparing the CRBr9 to the current CRBr10 was far easier and more elegant than I had dared to hope. If you were one of the people who wrote in to help me with this issue, thank you so much. You have my deep gratitude for your time and wisdom.

So all I needed to do to test my controversial theory that the bears hate and ridicule was to secure some CRBr9 data. This is available in a NYBOT-traded futures contract known as the Continuous Commodity Index, or CCI. The NYBOT describes its neat product as "The Continuous Commodity Index (CCI), represents the ninth revision (as of 1995) of the original Commodity Research Bureau (CRB) Index."

I felt like a kid on Christmas morning when I was told about the CCI and then secured the data. Now all I had to do to compare what has happened in the CRBr10 to what would have happened in the CRBr9 without the tenth revision was to chart both series. After you digest these charts, you will agree that all bearish theories based on a secular CRB breakdown are garbage. The difference is that striking! This commodities bull is very much alive and well.

In these charts, the CRBr9 that made the secular trend in question is charted in blue. The accompanying moving-average and standard-deviation technical lines apply to it alone. Starting just before the actual tenth revision began trading in early July 2005, today's CRB (the CRBr10) is charted in red. This chart is like cool, fresh, pure water to the parched throat of a traveler who has been wandering for months in a scorching desert!

It is best to start at the beginning. The CRB hit its brutal multi-decade bear-market bottom in late 2001 and then started gradually climbing. Over the subsequent five years or so it carved one of the most beautiful and tight secular uptrends that you will ever see. The geometric averaging inherent in the CRB really smoothed it and contributed to a precise uptrend within very-well-defined support and resistance lines.

This uptrend was without a doubt the most important technical foundation underlying the perception of a general commodities bull market. Every time commodities corrected prior to Q3 2006, investors would look at the CRB with hope and trepidation. If the CRB held above its secular support and/or 200-day moving average, then all was well as the commodities bull remained intact technically. A decisive break in this critical support would be devastating for sentiment, and that is indeed just what happened.

In July 2005 the brand-new red CRBr10 line became known as "the CRB". Almost all technical analysts, including me I am embarrassed to admit, just grafted it on to the old CRBr9 data. Most analysts were not aware of the radical tenth CRB revision so they considered the CRB continuous and comparable out of ignorance. Some, like me, were well aware of it but didn't yet know of a viable CRBr10 alternative. And I suspect a few, probably Wall Streeters, knew about the CCI yet deviously still ignored it in favor of the CRBr10 since it supported their perpetually bearish case for commodities.

So after this tenth revision, the new CRBr10, grafted onto the old CRBr9, continued along higher within the CRBr9's well-established secular uptrend. The CRBr10 was entirely different and not comparable, but due to rising oil prices in 2005 and early 2006 it continued along in its predecessor's path out of pure coincidence. Then in Q3 of last year the CRB suddenly broke down with a vengeance. Its secular support failed, its 200dma failed, and there was great wailing and gnashing of teeth leading to flourishing bearish theories.

The critical problem here was that it was the CRBr10 that had broken down, the new oil-dominated one, not the traditional CRB that had originally made the uptrend in question in the first place. If the same ninth-revision CRB is charted up to today, which is now known as the CCI since July 2005, there was no breakdown! In fact, exceeding my wildest hopes, the CRBr9 actually broke out of its secular uptrend to the upside in early 2006 and has traded above its old trend channel since. This is incredibly bullish, not bearish!

This next chart zooms into the last couple years which set the CRB record straight once and for all. The blue line and the accompanying technicals are from the ninth-rev CRB until July 2005. After July 2005 the CCI, calculated by the identical CRBr9 methodology and component weightings, is grafted on. Meanwhile the red line is the new tenth-rev CRB that is unfortunately known as "the CRB" today. By focusing on it instead of the perfectly comparable CCI, we have all been terribly misled.

The true CRBr9 and the new CRBr10 weren't that different in the first quarter of the latter's introduction. But ever since, they have been increasingly spreading apart and taking their own individual paths. For the second half of 2005 these differences weren't great, but they really started accelerating in impact and importance in 2006. If people considered the CCI today and not the CRBr10, commodities perceptions would be far different from what we've seen over the last six months.

At the dawn of 2006 the CRBr9 was actually breaking out above its secular resistance line while the CRBr10 was merely in the middle of its predecessor's technical uptrend. The strong rally in the metals last spring drove both CRBs up to new bull-to-date highs, but the CRBr9's rally was much more impressive. This true CRB we've all learned to love over the years nearly broke 400. Man I wish I had known about the CCI back then!

In the latter part of Q2 2006 both CRBs corrected, a necessary and healthy reaction after the greedy euphoria that drove them to new highs in the weeks before. Up until Q2, the CRBr10 was not all that different from the CRBr9 performance-wise. Yes it was already understating the bullish technical case for commodities by languishing in a lower range, but at least these two indexes were usually moving in the same direction. But their harmony abruptly ended in Q3.

In the middle of Q3 2006, the headline CRB was already weakening down near the center of its trend channel. But soon it started to really fall with oil. Oil itself retreated from its highs soon after the Prudhoe Bay oilfield problems weren't as bad as feared and traders started growing concerned about the conspicuous absence of any hurricanes approaching the Gulf of Mexico. On top of that, energy traders were spooked after a major hedge fund blew up and decimated the natural-gas market as the fund's trades were unwound at fire-sale prices.

With such a tremendously heavy oil weighting, the CRBr10 started freefalling. It made a valiant attempt to rally at support, but this only lasted a week or so before it started plummeting lower again. Since almost everyone was not aware that the CRBr10 was not comparable to the CRBr9 that had originally carved the breaking uptrend, technically-oriented traders started getting really scared. In light of this erroneous assumption that the current CRB was comparable to the past, their fear was rational.

But in reality, just as the CRBr10 was starting to slide with oil, the CRBr9 was actually making fresh new all-time nominal highs! On May 11th the CCI closed at 398.56, compared to just 365.35 on the CRB. But on August 9th the CCI closed marginally higher at 398.87, a new high. Meanwhile the CRB had already fallen considerably to 353.70 and it was headed a lot lower. So just when people were starting to get worried, the true CRB was near an all-time high!

As oil dragged the new headline CRB lower, the CCI fell too since it also has oil and heating-oil components. But when the CRB initially bounced at dismal deep-sub-trend lows near the end of Q3, the ninth-rev CCI had actually just merely fallen back down to its own upper resistance. Thus in early October when bearish theories really started to germinate in the fertile fields of fear and worry, in reality the CRBr9 was at the very top of its trend channel in a very bullish state. If only the CCI had been widely known then!

In Q4 2006 the spread between the ninth-rev CCI and tenth-rev CRB widened considerably. While the CRBr10 recovered slightly into late November at still very-low levels technically, the CRBr9 was actually making fresh new all-time nominal highs in the midst of the carnage! The CCI closed at 408.79 on November 30th, a whopping 27% higher than the headline CRB's close that day. Instead of listening to the goofy bears, we bulls should have been dancing in the streets.

In reality not only was there no CRB breakdown, but the true historical CRB index was hitting new highs despite the isolated weather-anomaly-driven weakness in oil. And we are still nowhere near a breakdown today. As of this week, the CCI remained a good 12% above its long-term secular support line as well as above its 200dma. And speaking of 200dmas, the CCI's actually rose during the last six months unlike the CRBr10's which nosed over and meandered south.

In all my years of studying the markets and speculating, I have never seen an index change as radically as the CRB did in mid-2005. And on top of that, I have never seen a situation where pretty much everyone, me included, just kept on watching the new index as if it was comparable to the old. The irrational behavior of the masses, even the ones trying to pay attention, never ceases to astound.

At Zeal we strongly suspected that the CRBr10 was not faithfully telling the story of commodities, but we had no way to prove it until I was told about the CCI last week. Despite this, since the October lows we have been aggressively buying elite high-potential commodities stocks in our newsletters to take advantage of the low prices and rotten sentiment. Most of our new trades since then have been gold-stock trades since we feel gold's young upleg has particularly exciting potential.

If you invest in or speculate in commodities stocks, you ought to subscribe to our acclaimed monthly newsletter. In it we are always working hard to try and understand the trends. When the technicals seem wildly in our favor, we recommend great stocks with excellent fundamental prospects to ride the next surge higher. The CRB confusion has created a rare opportunity where perceptions and realities don't match. Please join us today before this great chance to buy vanishes.

The bottom line is the Continuous Commodity Index, an extension of the old ninth-revision CRB's calculation methodology, components, and weighting, decisively shatters the false notion that there has been some catastrophic commodities breakdown. It is a myth. A new never-before-seen "CRB" index was driven lower by oil, but it wasn't the same index that made the secular uptrend in the first place by a long shot.

All bull markets climb an endless wall of worries and this one is no exception. Some worries are valid, others are not. Next time someone tries to get you to buy into a bearish theory based on the CRB breakdown, realize that it is utter nonsense. The true CRB never broke down and instead broke out to achieve new all-time highs recently. There is nothing remotely bearish about the ninth-revision CRB's behavior over the past six months.

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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