In a free market, the best cure for high prices is high prices

For some years I have been reading George Slezak's analysis of the weekly Commodity Futures Trading  Commission's (CFTC) Committments of Traders  (COT) Report. George does the hard work I did myself for years. He was the first to do futures category summaries and total CRB summaries in addition to each individual futures contract analysis, with and without its own futures options volume. When CFTC started gettng data on commodity index fund activity, George was right on that long before that issue became "news". This is a guy who was a floor trader in Chicago. He knows his stuff.

 

George's release at the close yesterday is extremely important not only for the current state of physical commodities futures but also for the stock index futures.

 

I have no financial connection in any way with George or his websites or his business. I just think he's the best at an important type of analysis. His main site is here: http://www.cot1.com/

With his permission I am replicating most of yesterday's release. This is not an ad nor a recommendation. I simply like his work.

 

Tom Drake

 

 

WEEKLY COMMENTARY: 7-18-2008

 

In a free market, the best cure for high prices is high prices. 

 

What happens when there are high prices in a market that isn't free?

 

US oil production went from near 10 million barrels per day in 1970 to 5 million barrels per day in 2007. Obviously higher prices have no impact on US PRODUCTION because the US is NOT a free market. 

 

There are 36 million acres of land leased by the USDA farm program to control excess crop production. Now that prices are high and inventory is needed the land in the CRP is NOT available to meet the current needs because the USDA will NOT release the crop land back into production. (The birds want to keep it.)

 

So, does that mean higher prices DO NOT act as a cure for high prices.

 

But, some argue that we are better off with less pollution and more birds and caribou. Is that true?

 

If we don't produce more oil, won't other countries rip into their exploration and be far worse on the environment of the world in their production? Are the caribou in Siberia treated the way the caribou in Alaska would be treated if we increased our drilling? Aren't we forcing horrible treatment of the caribou in other parts of the world?

 

If Cuba drills for oil and pollutes the Gulf of Mexico, is that better than our drilling in an environmentally controlled way? Aren't we causing increased pollution of the Gulf of Mexico by letting others outside our control do what we would do more responsibly?

 

South America is cutting down the rain forest for farmland. Is that worth our planting grass in our fields for the birds to nest along our creeks?

 

See, free markets SOMEWHERE will find incentive in higher prices. 

 

AND THEN HIGHER PRICES WILL CURE HIGH PRICES. 

 

If $50 oil and $4 corn "should" have brought on more production to bring prices back down to $20 oil and $2 corn, will $140 oil and $7 corn only bring on a little production from other places in the world, or, will there be MASSIVE new production brought on stream in other parts of the world?

 

These higher prices are incentives for massive new finds of oil, for massive clearing of land for farming. Once new oil fields are found, like in Brazil and in India - both have gone from oil importers to oil exporters, will they turn off the pipeline if prices come down? Once land is cleared will they stop growing crops if prices come back down?

 

I believe these high prices will result in MASSIVE GLUT of new world production that will drive prices all the way back down to oil under $20 and corn under $2, and the environmental damage some will cause will be catastrophic relative to the minor disruption we might have caused by allowing responsible production in the US. 

 

Not only will our narrowly defined domestic environmental concerns result in far greater global environmental damage, but  the export of our capital to pay others for production we could have done ourselves has weakened our country and our future by increasing our debt and flooding the world with our currency.

 

I explained the above because this is the trading environment we live in. With 20 20 hindsight we should have known how this commodity bubble would ignite. The domestic drilling restrictions and the acres set aside set up the bubble over many years. But high prices WILL cure higher prices by increased world production. Bull markets can take many years of basing and foreplay until they eventually light on fire. But bear markets are BORN IN THE FIRE OF THE BULL EXPLOSION. Today we only hear about waiting for demand destruction to bring a pause in the bull, when we should also be focusing on the race to increase world supply and the commodity bear market that will result. The world is not merely bringing supply and demand in balance. This has been the greatest commodity bull market in history and in response the world is bringing the greatest increase in supply in history that will eventually overwhelm demand.

 

Remember the Beverly Hillbillies that found oil by shooting a bullet into the ground. Well, today, in the US you can't shoot at the ground and bubbling oil would cost you pollution fines. But in the rest of the world they are strip mining and shooting eagles and their chicks out of the trees to bring new supply to the markets.

 

Let's not talk about right or wrong! Let's not talk about who wins or who loses. Let's not talk about why or why not. Let's just talk about the markets.

 

So how are we going to know that the commodity bull has peaked and the new bear is on the way?

 

For the last few months I have recommended to be on the sidelines, out of the markets except for a few cheap long term puts. (see recommendations in the column at the right.) As of the July 11 close, however, I recommended going SHORT the commodity indexes in my Commodity Index Timing .com web site and long the stock market in my Stock Index Timing .com web site. The Commitments of Traders data was an important factor in both conclusions.

 

My "July 11 sell signal" on the commodity markets

 

To get to my sell signal on the commodity markets I have been saying in this commentary for months that the totals of the Commodity Index Trader (CITs) positions in the Supplemental Report covering the Ag markets could be used as an indicator of a change from accumulation of commodity index positions to distribution of the commodity indexes.  

 

(Click http://www.futuresemail.com/cot/cotp2.htm to view an explamation of the Supplemental Report.)

 

In the following chart the Commodity Index Trader totals are plotted as the BLUE line over the CRB. The Commodity Index Trader positions have been declining since last May. (The following chart, along with charts of 40 other markets, is updated for subscribers in the chart section of this web page each Friday evening after the issuance of the new COT reports.) 

 

 

You could have drawn a similar conclusion that the CIT's were reducing positions from the 12 week summary of CIT positions linked in one of the yellow buttons in the navigation bar at the top of the page. Following is a portion of the 12 week summary showing that the largest position of the last 12 months was on May 3rd at 1,781k contracts (bottom line in table below) and has reduced 5% to 1,689 in the report for July 1. 

 

 

 

My view of the totals as an indicator is that the positions of the Commodity Index Traders had dropped over 10% in most major commodities and that suggested I take a short on the indexes when I saw a technical reason for a short. The new highs in crude Oil not confirmed by the indexes was my primary technical reason for moving to a sell on the Commodity Indexes.

 

Further, I have been saying we should look for a $20 to $25 drop in crude in the first 3 to 5 days after the high to call a top. On July 11 the high in August Crude was 146.65. Today the low was 128.54. Do you think?

 

My "buy signal" on the stock market 

 

In my July 11 "buy signal" on the stock market, I also used information from this web site in making my decision. 

 

Since the beginning of the year I have often explained in this commentary that the commodity index trader positions in the supplemental reports are tied to structured investment notes issued to the commodity index funds. The firms issue the notes to the funds to contract for the return of the index. This way, the funds do not make actual futures trades, it is all covered by the note. But the issuing firm will buy futures to hedge their contract obligation. These are the positions represented by the Commodity Index Trader totals in the supplemental report. 

 

The supplemental report only covers the Ag markets. To try to gain a similar perspective of other markets like, Crude and Gold, I began publishing separate 12 week summaries with the one year, three year, and five year range of the data of the Commercial LONGS separate from the Commercial SHORTS. Each week I post those summaries on this web site for subscribers.

 

Based on these summaries, in past commentaries I explained that the gross commercial short position in Gold and in Crude were at the largest short position in history. Contrary to the mindless idea that the gold mines should be unhedged, the gold mines actually have increased production and increased their production hedging greater than any time in history.  

 

I used similar information in my stock index timing .com commentary to recommend a "sell signal" on the stock market. The table shows the commercial short positions in the stock index futures were near the smallest short position in the last three years.

 

 

 

In the past we would view the net commercial position in the stock index futures as an expression of value by the portfolio managers that use futures to hedge risk. When the net commercial position was at the smallest net hedge in the last year, I viewed that as a statement that the portfolio mangers viewed the stock market as cheap. When the net commercial position was at the largest net hedge in the last year I viewed that as a statement that the portfolio mangers viewed the stock market as overpriced.

 

The mutual funds use of structured notes to contract for the returns of the Commodity Indexes has obviously also spread to contracting for the returns of the stock indexes. The effect has been the firms issuing the notes are buying stock index futures to hedge the contract risk and those totals are included in the commercial category in the COT Report. The effect is as the stock market goes higher and retail adds to their fund investments and the funds have more structured notes, the firms buy more futures to hedge that obligation. As the stock market goes down and retail investors reduce their investment in mutual funds the redemptions result in less structured notes, and the firms reduce their contract hedges.  The structured note hedge has grown so much that it is far greater than the portfolio hedging by portfolio managers that use futures to hedge risk, so the effect is the stock index futures net commercial position in the cot report now increases as the market goes up and decreases as the market goes down.

 

I used the separate tables of commercial long positions and commercial short positions to view the commercial short position in the stock index futures as representative of the positions of the portfolio hedgers that use stock index futures to hedge risk and saw the the gross short position was near the smallest gross short position in the last three years! So even though the net position was declining because the structured note hedgers were reducing LONGS as the market declined, the gross short position was declining suggest the short hedgers that were hedging portfolio risk were reducing hedges to the point that it suggested they viewed the stock market as very cheap!

 

This was an important additional piece of information, combined with my technical analysis of the stock market, in bringing myself to go the a buy signal on the stock market as of the close on July 11.

 

Following is a portion of my table of "short" only commercial positions. Just a few weeks ago we had the SMALLEST "GROSS SHORT" STOCK INDEX FUTURES POSITION IN THE LAST THREE YEARS!

 

 

 

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I explained the above information I used from this web site in my market timing decisions on the Commodity Indexes and the stock Market Indexes to try to illustrate ways to use the information I provide to subscribers in my web sites. 

 

I have always found reviewing the COT tables and charts that I present in this web site as a great stimulant of market ideas that I just don't find in other data sources. More often than not, the ideas I gain from reviewing the data tend to be contrary opinion type ideas. ie everyone is bearish stocks and the portfolio hedger positions suggest the market is cheap so it is time to buy. or, ie, the commercial gross shorts in gold are the greatest in history so it is obvious the story that the producers are unhedged is probably false. Maybe some are, but the majority are aggressive hedgers and that suggests gold is grossly over priced.

 

I hope you subscribe and use the information provided in this web site in making your trading decisions. 
  Charts of Supplemental Report data         

 

NEW SHORTCUT TO THIS WEB PAGE www.cot1.com    

 

CURRENT OPEN TRADE RECOMMENDATIONS:

 

Following are the open trade recommendations in this free weekly commentary. Subscribers should see Commodity Index Timing .com (shortcut www.cit1.com ) for further commodity recommendations.

 

Hold the Long December 2008 $3.00 Corn PUT option bought for 3 cents or $150. If you followed the recommendation in this report, on 11/28/07, you purchased the December 2008 $3.00 Corn PUT for 3 cents or $150. Hold the position. Risk is the net premium paid plus commission. December 2008 corn option prices

 

Hold the Long May 2009 $4.00 Corn PUT option bought for 7 cents or $350. If you followed the recommendation in this report, on 3/31/08, you purchased the May 2009 $4.00 Corn PUT on a 12 cent or better recommendation for 7 cents or $350. Hold the position. Risk is the net premium paid plus commission. May 2009 corn option prices

 

HOLD the Long SEPT 90.00 Swiss Franc PUT for 40 ($500) or better.    If you followed the recommendation in this report, on 3/14/08 you purchased the Swiss Franc September 90 put for 40 or better (about $500.)  Risk is the net premium paid plus commission. Sept 2008 Swiss option prices

 

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Good luck and good trading!

 

George

 

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