Since the euro crisis hit full swing, we have seen a major depreciation in the Euro, and a corresponding rise in the dollar, which is inherently bearish for commodities.  Crude saw a major selloff as the situation in Europe deteriorated, falling nearly 25% on July contract.  This makes sense, given the Euro’s approximately 12.5% depreciation.  What did not fall, however, was natural gas.

Natural Gas, the Euro, and Crude Oil

While Crude oil and the Euro fell, natural gas held within a constant trading range that it has recently broken above, in large part due to the likelihood that we will not be drilling for oil offshore and will instead use natural gas.

It is worth noting that the way contracts are created for trading at the NYMEX (see my earlier post about Crude contracts), the Henry Hub natural gas contract probably isn’t that natural gas that would be used in Europe and thus not reflect their demand decrease as much as international LNG would, but this does not eliminate the fact that the depreciation in NG prices due to a supply glut has mostly been priced in, and the supply glut removed due to a surprisingly cold winter, making nat gas a possible value here.  Nat gas’ BTU equivalent spread with Crude oil (ie the dollar value/unit of energy equivalent for nat gas and crude oil) is at the widest its been in a long time, also implying there is value in nat gas.

July Nat Gas

Looking at the current chart of natural gas, it appears we have broken above prior resistance around 4.500, but have begun to fill in the gap.  As for an outright play on natural gas, it is possible that if one waits for confirmation at the 4.500 level, gas could take off and never look back, and an opportunity would be missed.  On the plus side, if one chose to get long here, there is a clear level of support that if broken would make for an excellent stop-loss.

Another alternative is MLPs, Master Limited Partnerships.  Rather than being companies, these stocks are linked to specific assets, usually gas pipelines, and issue dividends in the range of 5%-15%, depending on where you look.  Examples that I own are LINE, EPB, EPD, and PAA, which all have > 5% dividends and decent looking charts.  Rather than just owning those outright and risking oil-sector exposure, a possible strategy could be to buy these and sell XLE, the energy ETF, and remove energy market exposure, just leaving the dividend collection as a strategy.

Gold Double Top

On an unrelated note, Gold failed to break through and hold the 1250 level the past two days, creating a double top pattern that is bearish for gold unless it can break through, certainly not worth going short gold in this volatile environment, but worth reducing positions if you have them.

Happy trading

However, upon inital backtesting, there is a definitely problem with a drawdown occurring in Mid-2009, starting in March and continuing the August.  This is really not surprising, given that March-June, we were experiencing a rally in the S&P 500 that was occurring under its 200-day moving average.  Because the probability of a major selloff is approximately 4x more probable under the 200-day SMA (my own calculation, supported by Larry Connors of TradingMarkets.com’s research), my systems only go long above the 200-day SMA, and short only below.  Naturally, this would cause a problem in a turnaround (both like the bottom we saw in March 09, but also at a hypothetical market top, the system has been underperforming lately), as every time the market rallied under the 200-day SMA, the system would sell it short, and take a loss.

This does make sense in theory, given that if one subscribes to mean reversion as the major market driver, there should really be no major tops or bottoms; the market should just remain choppy.  Obviously, we have never seen this to be the case, and there in lies the problem.

The way I see it, there are several possible paths to take this:

1) Don’t use the 200-day SMA, it’s too loose- use a tighter MA filter, like a 50-day or 100-day.  Definitely possible, although that would significantly increase the whipsaw nature of the system.

2) Lose the MA filter altogether, and let long and shorts both occur at all times.  This would definitely increase the volatility of the system, as well as the number of trades.  Probably to risky, you’re failing to address the chance of a major collapse.

3) Diversify the system into more securities.  Ideally, if you’re using the system for ETFs, stocks, FX, futures, etc, you’ll have a mixed bag in terms of whats above its 200-day SMA and whats below, giving you trades in both directions across different securities, differentiating yourself sufficiently.

I’m not sure if any of these will work, but they’re all worth thinking about addressing in the future.

Rather than talking about the current Israeli crisis, which I’m not nearly qualified to discuss, I’m going to post CNN’s link as a surrogate for US Media, the BBC’s article for the UK Media, and Debkafile, the Israeli Military news service’s article.

CNN

BBC

Debka

This is obviously very scary stuff, and the fears of retaliation from extremist groups is definitely something I’m concerned about, both for Israeli citizens as well as the citizens of the US, Israel’s most prominent ally.  With rising Middle East political tension, gold and oil come to mind as suitable safety investments (although the US Equity futures are up about half a percent, the dollar is down, and oil is only up 50 cents- hardly a strong reaction from the markets).

Meanwhile, Zerohedge has done its best in the past 48 hours to terrify me as well, posting links about Israel positioning nuclear subs off the cost of Iran, a guest post about impending hyperinflation, and another guest post about a deteriorating Chinese economy (although this post talks about oil and base metals taking a hit, which makes sense, but I still think there’s more upside there than not).

Between all of this, BP’s lackluster efforts to control the oil spill, currently reading Roubini’s book, and having the book Game Over still lingering in my mind, all I can say is: I’m terrified, and want to own as much oil, gold, copper, water- whatever people need to survive, because it all sounds like bad news these days.

The first three are all obvious, but I believe that the last one requires some more explaining.  I’m predisposed to being a bull on China, having read Jim Rogers early on in my financial education, as well as having a great deal of respect for the man generally, and he’s generally always long-term bullish on China.  Which makes sense, given their cash surplus and buying power.  They have the money to throw around, and it’s always best to follow the smart/big money, and even get ahead of it if you can.

The Chinese have agreed that buying energy and base/industrial metals (remember, tangible, usable, non-replenishable) is a solid investment, buying copper, aluminum, steel, oil and energy-yielding land in Canada.  Today, their was a report stating China would continue to hold onto their European debt (a report that was denied by China, but investors, well, ignored that), and the market saw that as a signal that the Chinese government believed that the debt crisis would be contained in Europe and wouldn’t deteriorate substantially further.

China holds $630 billion worth of euro-zone debt, compared to compared to $772 billion that it holds in US debt.  Judging from these numbers and the relative size of the various PIIGS, its unlikely that China is holding an uncomfortable amount of truly dangerous debt, and most of it is probably in the larger economies like Germany or France, who, although hurting, are certainly not in the same situation as Greece.

Thus, while the report from China drove the market up 300 points, well above Dow 10k and S&P 1100, I’m not sure that was entirely deserved.  The report was not confirmed by the Chinese, and even if it was, its holding enough European debt that it would not be in its own interest to outright say its going to sell its European debt- that would trigger a sell off hurting its own holdings.  Furthermore, the report wasn’t all that bullish- the report said that they weren’t going to sell their current debt/weren’t reviewing their current holdings, it said nothing of buying more/rolling over their current holdings when they mature.  I think that this was a case of the market looking for something to rally on, and it did so on little volume. Tomorrow’s volume will be even less than today (people have been knocked out by daily 300 points swings, its memorial day Monday so everyone on wall street will already be heading to the Hamptons), and you better be sure no one is going to want to hold any positions over the three-day weekend, so expect some moves on the close tomorrow.

Instead, I made it more difficult to enter, requiring a value below .3 to enter, and you had to be trading above the security’s 200-day moving average (Larry Connors, of TradingMarkets.com, does an excellent job of explaining why this is the case, in either of his books).  Also, CSS does not outline an exit strategy, so for my backtest, I chose a simple 5-day SMA cross, exiting a long position when the price crosses above its 5-day SMA, and visa versa for shorts.

The results of the backtest, from Jan 2000-present, are below:

GAMDO

There are not a lot of trades, only 140 over the course of almost 10 years, and majority of the gains occurred more recently.  However, the steady upward slope from 2000-2008 is a good sign, and shows significant repetitive positive returns.  The drawdowns aren’t particularly bad, a max drawdown of 8% of total asset value at the time, which is definitely a value I can live with.  An excellent value is the average return over variance, a value of about 20, higher than most RSI2 mean reversion strategies.

This isn’t a formal backtest: I left no recent time for forward testing, and this is the first set of parameters I chose.  In terms of entry thresholds and exit strategies, there is still a great deal of work to be done before this is ready for execution.

With front month crude below $70, I think there is a lot of value in oil and general commodities.  Given the current slowdown, it makes sense that oil would sell off, but it also raises the probability that we will see a continuation of low interest rates, which should help to set a floor for oil prices.  Furthermore, the oil spill situation does not seem to be resolving itself anytime soon, not only costing us oil in the present, but is definitely hurting the chances that we will see increased oil drilling in the Gulf of Mexico in the future, constraining future supply more than people realize.

The problem for average investors investing in oil via USO or a weighted commodity index like GSG or DBC is that these securities lose money when the ETFs roll the crude contracts.  Another possibility to play these current lower energy prices is to buy the Canadian dollar, which has fallen off substantially but still has value, given still relatively high crude prices and a strong banking sector.  One can also choose to play this oil value by buying oil providers ETFs, such as OIH or XLE, who will benefit from rising oil prices as well, but do not suffer from the roll.

6-month Chart With Fibonacci Lines

Looking at this 6-month chart with the fibonacci lines, measuring the rally from the February low to the late April high, its clear that the 1111 level we’re floating around is serving as support/resistance. Should we begin to recover, the Fibonacci retracement doesn’t show much before 1175, but on the other side, should we take out the 200-day SMA, there doesn’t seem to be much support before the February 1050 low.

2-Week Chart of S&P Mini, 30 min bars

Looking at the S&P again, this time over the last two weeks, it appears that the 1150 fibonacci line, as well as the 1130 50% retracement, and the current 1111 level are all serving as respectable support and resistance.  The 1087 level has not really been tested, in the current downslide, although it served as support for the previous rally in the S&P around the end of March.  However, if the S&P takes out the 1111 level, and then the 1100 200-day SMA, it is unlikely it will hit major support around 1087, and instead return to that 1050 low.  Should it break that, I believe seeing an S&P with a 900 handle is possible.

S&P With RSI2 and Bollinger Bands

Looking at the RSI2 and Bollinger bands at the close (the market is up in after hours, relieving some of the oversold conditions), the market is primed for a short term bounce.  Sitting at support in oversold conditions, in this case an RSI2 of 4.4 and a %b of .17, the probability of a short term bounce is significantly high, although the quality of the bounce may not be substanital.  If it takes out today’s high of 1122, it also appears to set up an inverted head-and-shoulders formation, suggesting a reversal around the 200-day SMA which makes sense.  From here, a possible play could be to get long the S&P, either through the June emini futures contract ESM0, or the ETF SPY.

Why is this relevant? Well, the value of crude oil in Cushing may not be relevant to people in the middle of Europe or Asia.  This is similar to what Mark Fisher discusses on page 165 of his book, The Logical Trader. Ideally, the conditions in crude oil would be similar across the world, so the supply conditions in Cushing would be a good reflection of crude oil elsewhere.  However, it is suggested that at times, such as now, this is not the case.  This inconsistency was the reason the Saudi’s dropped WTI and NYMEX’s contract for oil as their benchmark- it really wasn’t relevant to the rest of the world.

At present, the reason the NYMEX contract is down so much is because of a major supply glut at Cushing, which has pushed the NYMEX price $6.42 below the price of Brent Sea crude, an ICE crude contract that actually represents a lower quality of crude oil.  This raises the skepticism over any validity of the WTI contract.  This supply glut also appears to be an abnormality, given that the July NYMEX crude contract is trading $3.60 above the June contract, a very large contango gap, and implying this current oversupply will resolve itself soon.  However, these extreme price gaps based on supply of crude oil at one location in Oklahoma prove how weak of a benchmark WTI actually is.

Finally, another indication that WTI is being disregarded as a valid benchmark is that the crude derivatives, heating oil and RBOB gasoline, have not moved down as much as oil, increasing the crack spread and increasing margins for oil refiners.  If this price of oil were the true price, the derivative products would also move down accordingly, and the refiners would not have the benefit of increased margins that we have been seeing lately.

Ultimately, because of how widely its traded, its hard to imagine that Brent or another standardized oil price would become a worldwide benchmark for crude prices, but the current inconsistencies highlight the problems that we must be aware of.  Because investment is often a self-fulfilling prophecy, my only concern would be that this temporary condition in the price of crude oil would scare people away from its fundamental soundness and measure of an economic recovery, causing capital and liquidity to be removed from the markets out of fear, and hurting our chances for a successful recovery.

——————————————–

Article from Friday on the subject, with similar themes to what I suggest:

http://www.businessweek.com/news/2010-05-13/wti-at-15-month-low-to-mars-on-cushing-supply-energy-markets.html

Third, the erosion of the equity culture, with many pension funds switching from equities to bonds after the two back-to-back crashes in equities in the past decade, is likely to be reconsidered, as investors rethink the safety of government debt. It could rekindle the equity culture, but is more likely to lead to a further surge into EM and real assets.

Then, compare this with what I wrote in response to the Greek riots, 11 days ago:

What I think the major lesson of the credit crisis was is that most of what we trade is synthetic.  It is manufactured by banks for the purposes of speculation, and quite often there is little substance behind it.  If the systemic trust is lost (which I suspect a great deal of it was), a phenomenon known as disengagement would occur, and people would literally stop trading.  We saw a little bit of this as liquidity dried up, but I think in the long run, we will see fewer people trading synthetic securities.  Maybe not the people who are currently trading, and are too far invested to change now, but the people just getting ready to enter the market- they will see that equities, CDS, derivatives don’t really have substance.

What people thought may have had substance is now being called in question as well.  If there was anything that had value, it was the faith in governments that they would pay back their debt.  Even outside of the US, there was always a general feeling amongst investors that most sovereign debt was without major default risk, and serves as a baseline as a “risk free” rate of return.  I think that opinion is thoroughly disregarded, as people are waking up the fact that even sovereign debt carries risk, especially in countries that have nationalized institutions.

So where does that leave us? The value of derivatives are suspect, as is the debt of sovereign nations.  Where is the true store of value?  I believe that people will eventually realize that the only true store of value will be hard assets, commodities.  Fiat currencies, debt, and equity all are just pieces of paper with no tangible value.

I don’t have much to add on the subject beyond what I’ve already written, but this, in conjunction with Jim Rogers’ comments about hard assets and arable land, seem to indicate a trend among the “smart money” that commodities are going to be the place to be in the long run.

However, the short-term uptrend has not been broken, as this 3 month low has not broken the 70.75 low made in the June contract in February.

2-year Chart of June 10 CL: Recent Low Not Broken

Until this Februrary low is broken, the general uptrend will not be over, and as we approach this level, the risk/reward ratio for entry will move further into bullish favor.  The higher-high-higher-low trend has begun to slow along with the economic recovery, but a recovery in the price of crude should challenge the 87.50 high, and if it breaks through, the 90-100 range will be possible within 2010.

If the situation in Europe is of primary concern, buying crude oil in euro terms will hedge out most of this risk.

Crude performing better in EUR than USD

This 6-month line chart (created by dividing June CL futures by June Euro futures) clearly shows better performance of CL in euro terms.  In Euro terms, crude prices are not yet challenging the February low.  As the bull market in crude’s primary risk is the deteriorating situation in Europe, buying crude while selling the equivalent dollar value of EURUSD will substantially mitigate this risk.

UPDATE: NPR is reporting that the Crude Oil in the Gulf of Mexico is 10x worse than thought- I cannot see President Obama allowing for increased drilling legislation; this, compounded with the amount of oil we are losing at the present, will only serve to create a floor under the price of crude oil.