MP 5/19/08

Traders,

Friday was a flat day after the market had initially sold off in the morning, the rebound into the close seemed like no one wanted to go home long or short over the weekend. While the VIX certainly does not reflect concern – the action on Friday seemed rather uncertain as to the future. The dollar slide again on Friday and of course (like a well-oiled clock) oil rallied. More news of falling home prices last week and concerns of possible future write-downs continues to create a gulf between the market and economic conditions. The market (several sectors) are getting a solid boost by global markets – that is also being reflected in the commodity markets.

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Oil continues to rally

More reports trying to point a finger at someone to blame for high gas prices is becoming the topic of news articles and talking heads, but commodities, unlike equities – are a different animal. Many claim a bubble, but I would argue that while there IS large premiums in Oil (and possible other commodities) – we need to look at the bigger picture in commodities. First that are consumed and once consumed we cannot use or sell them again. That being said and global consumption is increasing (on all commodities) specially in the BRIC – well demand is a large part of fueling prices.

Additionally there is a shift as many companies (airlines, shipping, energy companies) that have traditionally do bulk buying in the spot market have increased OTC and LISTED future purchases to hedge against future price rise risk. Finally – the drop in the dollar is also contributing largely to the rally in Oil.

So is it a bubble? I would say no, but there is a rather large premium contributed to several factors – Pickens has clearly pointed them out.

1. Dollar risk – as the dollar falls against global currencies we will see commodities priced in dollars rise. How much ? I have heard between 5-15% dollar risk premium as the dollar has dropped. Thus – if the dollar rallies we should expect to see Oil prices decline.

2. Global Consumption Risk – while the U.S. oil consumption remains flat and in some areas may decrease – Global consumption is up at a rate of 2% compounded. China is increasing at 5-7% per year (compounding) – India and other emerging markets as well. Oil should not be measured in supplies, but rather extraction vs. consumption rate. Most reports on proven reserves show an extraction rate of 90-95%. That gives little room to increase extraction and as consumption continues to grow – extraction will have to rise to off-set prices. Otherwise prices will continue to go higher. If we see Global consumption slow or extraction on NEW reserves increase we will see oil fall off. How much premium is measured by this? I am not sure – I would say this has more to do with intrinsic value and not premium.

3. Political & Mother Nature Risk – the Middle East continues to be a hot bed, add in Venezuela, Sudan, Nigeria and there is non-stop risks to oil supplies. Add in a hurricane or other act of Mother Nature and BANG – oil prices shoot up. We just saw that happen to Rice prices with the cyclone that wiped out 2,000 sqr miles farm land and 600 thousand tons of rice may not be exported this year. The instability of supply premium fluctuates between 5-20% depending on circumstances.

4. Speculators? Well – this is the recent talk and many assumptions are being made that speculators are the ones driving up prices. While I will not argue that it IS a contributing factor – the money flow into the listed futures market is peanuts compared to what corporations (airlines, shipping, etc.) and nations (China, India, etc.) purchase in both the spot, listed, and OTC market. Speculators on any given day contributed to possibly 10% and sure they can create intra-day momentum up or down. But if we strip out speculative trading by Hedge funds – I believe oil would still be above $100 a barrel.

The Global market is going through a major expansion and contraction simultaneously and the US is caught squarely in the middle. We have lost buying power as our fiat currency drops, credit lines have dried up for local consumers, companies are shifting to exports to meet margins and profits, the BRIC (Brazil, Russia, India, and China) are going through MASSIVE growth as they face their industrial, service, and technology revolution simultaneously.

Cities growth and population booms in those cities require both HARD commodities (Steel, cement, copper, etc.) and Soft commodities (food and fuel) to sustain that growth. We in the U.S. have been the center of the world financial markets and economies for so long we become self-centered and still think of China as a 3rd world country. The shift is happening and they are growing – I am afraid that Protectionism in this country is going to be the next political agenda – regardless of party (but more so with the Democrats) that will only HURT the citizens in this country. We can NOT stop globalization and instead of fighting it we need to understand it and figure out how to be a part of it – otherwise the dollar will continue to fall and protectionist laws will push companies to move abroad more and more.

I think Rogers, Ross, Pickens, Bogle, and the rest are right – we are in a commodity bull market for the foreseeable future – unless the dollar strengthens, global demand drops, and many other factors come into play – but I don’t think ALL of those things will happen to curtail prices. Sure oil may come down – but don’t expect to see $30 oil again!

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Housing Slump hurts Lowe’s

Lowe’s reported 1st quarter earnings with a drop of 18% as the housing market continues to see pressure on all sides (construction, mortgage, commodity prices). The stock is getting hit in the pre-market and expect to see pressure across the board in the building sector and home services.

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Citi cut’s Goldman, Lehman, and Morgan estimates going forward

I guess Citi didn’t like being downgraded by the investment banks and are now punching back by downgrading them. Of course Citi is probably correct in their assessment in lower commissions due to lower volume, hedging margin risk will also take its toll, and of course valuing CDO and other structured products is going to see some pressure. No doubt the landscape has improved since the Bear bubble bursting, there is still credit problems and the housing market has not found a bottom.

At the end of the day Citi should be focusing on their own problems – which I think loom larger than the investment bank side.

Expect some pressure in the financials this morning.

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Futures Pre-Market

The futures are pretty flat going into the opening – bouncing above and below fair value. Expect ARB traders to remain sideline until the opening.

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Support / Resistance

We did see a significant pull back in the AM on Friday and a rebound into the close. However, the INDU is still below 13k and the rest of the indices after breaking resistance didn’t get the follow through legs of a strong market. Still uncertain at these levels.

INDU 13000 (This is the pivot point – resistance or support? Who knows.)

NDX 2000 (This is support and area that was tested over and over again last year and broke in Jan. We are now above it – will we continue to rally – there is no resistance at this point)

SPX 1400 (Again a new short-term support – the resistance – who knows at this point. As long as we remain this week above 1400 expect to continue to see strength.)

RUT 700 / 740 (The big support in the 4th qtr of 2007 was 740-750, which was broken in Jan. We are still shy of it, similar to the INDU. If the RUT can get above 740 or even better 750 – we could then see a broader support area for the market as a whole.)

The INDU is still below 13k and the RUT has not broken through and gotten above the 740-750 range YET – they could – which if they do will confirm market strength. Until then – I remain skeptical and suggest hedging all hard assets.

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Conclusion

This is a political year – so expect to hear spin from both sides. People are looking for someone to blame for higher gas prices. Last month it was OPEC, this month it is Speculators, who next. If we take a step back and look at the complexity of all factors involved (Dollar, import/export, consumption rate, supply issues, spot vs. future purchase, etc.) we see that it is bigger than OPEC or the Speculators, sure they contribute to the price – but it is WAY bigger than just one group. We need to stop pointing fingers and really understand the function and complexities of commodities.
We are in a commodity bull market and while it may come off some – I expect that we will remain in a commodity bull market for some time. However, I think the equity market will be more volatile as some companies will benefit on both the weak dollar and higher commodity prices – some will suffer. One thing is for sure consumers WILL suffer from higher commodity prices and weak dollar – this may unfortunately push forward a protectionist agenda and more socialism in this country – to the long-term determent to all.

For now – I remain skeptical as the disparity between the economic picture and the market separates. I expect the VIX to see 30 again – later this year.

This is the YEAR of Volatility and we have a long way to go.