The DeCarley Perspective...
The DeCarley Perspective Trading Newsletter
The DeCarley Perspective November 16th, 2008
This newsletter was emailed to clients on November 16th, 2008
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. If you are receiving this, you will also be receiving trade recommendations distributed by email should we identify what we believe to be opportunities.
You will find that due to market conditions we have temporarily scaled back the trading recommendations in terms of both quantity and risk.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.
** In regards to seasonality references and/or speculations made in this newsletter, past results are not indicative of future results. Seasonality and supply/demand factors are currently priced into the market and may not influence future price moves.
** All included charts are courtesy of Gecko Software, Track n' Trade.
In recent issues of the DeCarley Perspective, we have focused on the unprecedented uncertainty surrounding the financial markets. While I can't claim that there have been any improvements in the predictability of the economy, geopolitical tension and government policy there seems to have been minor strides toward investor confidence. Although recent selling pressure has been fierce, it hasn't had the same panic element to it as that seen in October.
With the Presidential election behind us, a small amount of political uncertainly has been wiped away. However, there seems to be a persistent curiosity on Wall Street in regards to the actual policies that President elect Obama will implement. From a trading standpoint, whether you support them or not isn't important but the market's interpretation and subsequent reaction makes all of the difference.
After declaring a democratic victory, the equity markets experienced the largest two-day drop in terms of percentages since the 1980's. There were obviously alternative issues at play, but one could argue that the fear of higher capital gains taxes and the possibility of revoking retirement account tax benefits could take its toll on Wall Street. The million dollar question is whether or not the market has fully priced in the possibility of changes in tax policy. Based on current price/earnings ratios and other market multiples it seems like a majority of the consequences have been accounted for.
Keep in mind that a significant amount of cash is sitting on the sidelines as investors and mutual fund managers are waiting for their queue to get back into equities. Analyst estimates are valuing this sidelined cash at approximately $50 trillion. This is a phenomenon that can, and seemingly has, added to market volatility.
The only thing scarier than being in the market is being left behind when the rally ensues. This is made evident by the massive "bear market bounces" that have been witnessed in recent months. We have repeatedly noted that picking an absolute bottom is nearly impossible but as investor confidence returns so will the bull market; the transition will likely be dramatic. If you are a stock market bear, you should always remind yourself of the possibility of a fierce reversal and as a bull you must be patient and look for opportunities to "bottom fish".
All of the major indices reached our technical targets (as published on The Stock Index Report) and then some. However, after overshooting technical support levels the market was catapulted higher on Thursday November the 13th as the bulls went shopping on the discount racks and the bears rushed to cover short positions. We like the prospects for higher equities in the coming weeks and project that the S&P 500 will see above 1,000 in short order. The Dow could easily see 9,660 by month's end and should resistance levels break may make a run toward 10,500. This would translate into 1150 in the S&P 500. The NASDAQ futures may find resistance near 1390 but could see prices as high as 1640 should a short squeeze ensue. Optimistic? Yes, but realistic given the overly bearish sentiment which often signals that all of the sellers are in.
If you have been following our newsletter, The Stock Index Report, you have likely noticed that we have reduced the risk involved with our trading recommendations. Instead of being net option sellers, we have temporarily converted our strategy to long option plays and have had some success thanks to the volatility.
As we become more comfortable with a short option strategy in this evolving environment, it will be business as usual. Watch for updates in The Stock Index Report.
Treasuries
Unprecedented amounts of market supply and an astonishing deflationary environment has kept a cap on what could have been a much larger bull market in Treasuries. U.S. backed fixed income securities has undergone one of the most significant flow of bullish fundamental news in history. Although economic slowing typically puts upward price pressure on safe assets such as bonds and notes, the market has struggled to reach the September highs.
Demand for Treasuries has remained very healthy in light of a lack of confidence in substitute asset classes such as equities and the corporate bond market. However, the government's relentless pursuit to raise the money needed to fund government bailout packages such as TARP (Troubled Asset Relief Program) has managed to keep the balance between supply and demand relatively tame. In other words, the unimaginable magnitude of the economic slowdown actually worked against bond prices as the ultimate outcome was dramatically increased bond, note and bill auctions. As a result, the Treasury market has avoided the massive volatility witnessed in recent months on Wall Street.
Also at the forefront of the lack of Treasury reaction to the quickest and possibly most extended economic slowdown this century is the pace of deflation. While the causes of the commodity rally (inflation) can be argued from many angles, the reality is that it did occur and it did have a temporarily profound impact on the costs of goods and services in our everyday lives. However, in the last 8 months we have seen the largest reversal in inflation concern ever witnessed.
The mixed fundamental picture of the Treasury complex tempts me to focus on seasonal and technical factors. The long bond and the 10 year note tend to trade moderately higher going into December. Likewise, the weekly charts suggest that this rally still has some steam left.
The recent rally in the U.S. dollar supports the idea of higher bond prices in the near term. After all, as the dollar has become the flight to quality currency foreign investors will be looking to park their funds on U.S. backed assets. Stocks and real estate may be a beneficiary for funds allocated to risky asset classes but the safety of Treasuries will likely attract a considerable portion of the capital.
There seems to be a short window of opportunity for Treasuries on the long end of the curve to rally. However, at major resistance levels near 121 in the long bond and 118 in the 10 year note I will likely be an advocate of bearish strategies such as selling calls and selling futures. Stay tuned to the Bond Bulletin for details.
Grains
Commodities have fallen victim to the global equity plunge and economic recession. Despite being driven by bullish demand side factors in 2007 and much of 2008, the story has become over supply and plummeting demand. Producers were anxious to capitalize on inflated grain prices and market prices have been shifted lower accordingly. Interestingly enough, while grain prices look to be weighed down by lower stock prices they don't seem to benefit from any upticks in stocks.
There seems to be a general consensus that grains have become "cheap". When looking at current prices relative to those seen earlier in 2007 the theory seems logical. However, if you look at the historical price envelopes of the major grains it is easy to see that we are still on the higher end of the range.
Corn
Perhaps the fact that the corn harvest is delayed relative to last year has something to do with the delay in the so called "harvest lows". According to a recent progress report, 71% of the corn acreage has been harvested as opposed to 92% a year ago.
Weekly export numbers are half of what were being reported a year ago. For example, the numbers released on Monday November 10th revealed that the weekly export inspections were at 24.7 million bushels of corn compared to 59 a year ago at this time.
"Farm talk" suggests that producers are disenchanted with the recent corn plunge and will be holding new crop supplies in hopes of prices closer to $5.
I like playing it safe given uncertain fundamentals. Rather than speculating with futures, or even an option spread, I think that going back to the basics is the best call. It is possible to buy a March corn 550 call for about $300. Time value erosion will be minimal due to the amount of time to expiration and this purchase gives you over 3 months in the market with limited risk.
Soybean Complex
In last month's newsletter we called for an oversold bounce in soybeans, which turned out to be a correct assumption. However, where we went wrong was underestimating the lack of momentum that the mini-rally would demonstrate.
The fundamental picture in soybeans isn't quite as dismal as that of corn, but the trend is decisively lower and the market is always right. There is still relatively strong demand for soybeans from China and South American supplies are mostly sold out. Additionally, domestic stocks of soybeans are not noticeably large.
The demise of soybean prices has been tied to the global recession but most profoundly by the rally in the U.S. dollar. Should the greenback fall out of favor, bean prices stand to benefit. With that said, beans tend to trade lower from the beginning to middle of December and may see January futures prices as low as $7.00 per bushel before finally triggering the short covering rally in grains that many are hoping for.
Wheat
In our opinion, wheat was among the most irrationally impacted commodities in 2007. Hedge fund money poured into the long side of wheat bringing the commodity to levels that were blatantly unsustainable based on fundamental supply and demand. As a result, the market has become highly unpredictable in our eyes.
This can be made evident by the counter-seasonal trade seen throughout the later part of 2008. As you can see in the chart provided, wheat prices spent September and October trading violently lower despite tendencies for higher prices. We are approaching a very bearish time of year in this market, but our confidence has been negated. Downside projections suggest that March wheat could be headed to $4.14 should support near $5.14 fail to hold. I wouldn't recommend taking on excessive risk in this market, but if you are itching to trade you can purchase the December $4.50 puts for about $250.
Energies and Metals
Crude Oil
Despite the amount of opportunity provided on the surface (a $100,000 move per contract since July) crude oil and other energy complex futures and options products can be the most challenging markets to trade profitably in. Where there is risk, there is reward and these markets aren't short in either department.
In last month's newsletter, we were calling for a possible short covering rally in crude oil but we now know that was an incorrect speculation. The market has been in perpetual free-fall and that may be the case all the way down to about $49 per barrel, which is where the2007/2008 rally originated from. Should prices fail to hold $49, $40 will likely be seen in short order. If you recall, $40 per barrel was considered to be the ceiling for crude oil for many years; it should now act as a floor.
To the surprise of many the precipitous decline in prices has occurred in the face of OPEC production cuts and can be directly attributed to the global slowdown. Demand has fallen off of the proverbial cliff and traders are fearful to be on the long side of commodities as the market grants very little mercy to those that are wrong.
If you have the margin and the fortitude to trade energy futures I commend you; however, I feel that the average retail trader would be much better off using limited risk option spreads. This can be done through the use of an Iron Butterfly spread (if you are unfamiliar with this strategy, be sure to read about it in the Option Trading e-Book located in the premium content section of DeCarleyTrading.com). If you would like to play the upside or the downside in this market and would like help putting a limited risk spread together, give us a call.
Gold and Silver
Even more so than Treasuries, gold and silver prices seem to be largely unaffected by what would normally be the largest wave of bullish news in history. Perhaps the flight to quality buying in metals was seen months and even years before the actual economic meltdown. You have likely heard the adage' buy the rumor and sell the fact'; this is the most extreme example of such that I have witnessed.
Plummeting stock prices, the credit market freeze and a global recession were all fundamentally supportive factors in recent months. However, signs of an implosion of inflation (deflation) and a rally in the U.S. dollar offset the bullish fundamentals and have kept precious metals out of favor.
Government action to stave off another depression is long term inflationary; also the U.S. Dollar may be due for a correction lower. These assumptions combined with seasonally supportive tendencies lead us to believe that the metals markets may be finding a temporary low soon. With that said February gold looks to be setting up for another move lower before the rally can occur. If this is the case, we could see prices as low as $670 but this should be considered a buying opportunity for the bulls. Near term resistance lies at $776.
Currencies
If a year ago you would have told a currency trader that the U.S. dollar would become the flight to quality target in 2008 they would have likely laughed. However, the tides have turned and they have turned quickly. The recent run from all time lows in the Dollar index is similar to the move seen in the early 1980's which came on the heels of a dramatic inflationary period. However, we can't help but feel as though a correction is near.
88.56 looks to be relatively heavy resistance and strong support can be found just under 84. Assuming a break down under 86.30 my models are pointing toward a retest of support and maybe a much larger correction. This may bring the index to levels as low as 79 in the near term.
Seasonal tendencies suggest that the greenback is in store for a significant decline beginning in the third week of November and may extend into the first week of January.
Euro
We believe that the Euro will ultimately be at par with the dollar, but are looking for a digestion to ensue that would bring the value of the Euro back to the 138 area before continuing to make its way lower. Keep in mind that the move may not occur until later in the month. In the meantime, the December Euro should find resistance near 131.80 and support at 123.72.
British Pound
Softs
Sugar
Our prediction was slightly pre-mature, but the market did recover to 13 cents only to succumb to selling pressure once again. However, our assumption that the subsequent selling could bring prices below 10 cents has been adjusted somewhat. We now expect the March sugar contract to find a low near 10.50 with 10.00 being a possibility but not an expectation.
Sugar prices are highly dependent on crude oil in the near term. As mentioned, we expect crude oil to continue lower in the immediate future and in turn we expect the same of sugar. However, seasonal pressures, rising demand in Brazil for ethanol along with declining ethanol stocks could mean that a low is looming.
Perhaps a dollar cost average strategy is appropriate. A trader may look to either buy futures or call options once the market reaches 10.50 with the idea of adding on should the market see 10 cents. I like the March 1450 calls for about $350. This gives you 3 months in the market with limited risk
Coffee
Keep in mind that there is a strong potential for a retest of $1.10 before the rally ensues and beware of incredible resistance near $1.40. 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
Lean hog futures have been confined to a range between 50 and 80 cents since 2003 and the closer that prices get to the 50 cent mark the higher the odds of buyers finally stepping in to stop the "slaughter". With December hogs trading near 55 cents and supportive seasonal tendencies looming the market may be in store for a recovery. Buyers should be patient as the trend is clearly lower and better prices are likely to be seen in the coming sessions. The first level of support will be seen near 53.30 but 50.50 looks to be a likely downside target.
Don't be fooled into assuming that oversold indicators are bullish. The meat markets can and do stay overbought or oversold for extended periods of time. Therefore, it isn't recommended that bulls begin considering aggressive trading strategies at current levels.
Cattle
Nonetheless, the seasonal "bottom" in meat prices typically occurs in the middle to end of November. We don't feel as though seasonal tendencies alone will be enough to turn the market around but should the financial markets stabilize the commodity markets may follow suit and cattle prices may benefit considerably.
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.
