Commodity Producers: Make or Break Time

The stock market is in good shape. It’s commodities and the commodity producers that have given back some. While silver and gold bullion have been capturing headlines in the great sell-off as of late, the producers have been in decline weeks before. In fact, many have been consolidating in a trading range since December last year. Looking at the energy sector, many industry groups have also shown the same consolidation patterns after a great run in the second half of 2010; such as coal, natural gas, and service providers. The charts are either consolidating or putting in a top here. Basically, it’s make or break time on the charts for the producers.

Before looking at a whole list of producer charts, let’s first talk about the U.S. dollar and the euro. These currencies are important to commodities because of their relationships. When the U.S. dollar index rises, commodities priced in dollars typically fall, and vice versa. There are three ways that the U.S. dollar has rallied amidst incredible bearish sentiment over the past three years; they are:

1. Safe Haven play - when markets search for liquidity, the U.S. Treasury market is their man. Example: 2008 credit crisis.
2. Weakness in the euro (57.6% of the dollar index). Example: December 2009 to May 2010 over Sovereign debt default risk in Europe.
3. Strong U.S. economic data. Example: also in December 2009.

Right now, I don’t see any impending crisis except for rising commodity prices due to accommodative policies in the U.S. combined with rising world demand for resources. Rising margin requirements by regulators are taking some of the hot steam out of commodities now, and it isn’t the first time they’ve done it. Margin requirements have been raised on silver a few times since December 2010. It’s likely we’ll continue to see the very “visible hand” of government actively intervening in our markets going forward. Traders and investors will need to learn to adapt to this. While these interventions greatly affect the short to intermediate-term, they cannot affect the long-term trend which is based on structural foundations such as greater world resource demand.

The euro is the most significant currency in the dollar index with a 57.6% weighting. Events that effect Europe such as interest rate policy, economics, and political upheaval affect the U.S. dollar, which affects commodity prices, which then affects company profit margins and discretionary income. Everything is interrelated at some level. So over the past week, an interest rate pause and a threat to leave the European Union have corrected the euro, thus causing a rally in the U.S. dollar. As a result, commodities have sold off. The question is whether this change in trend will shift from short-term to something lasting? I think charting can give us some indication, or at least give us some parameters to watch that would signal such a lasting change is taking place.

Let’s start off looking at a chart on the credit default swaps (a form of insurance on default) for Greece debt and some of the other ailing economies like Ireland, Spain, Portugal, and Italy. As you may have recalled a few weeks ago there was discussion from Germany that a debt restructuring wouldn’t be a bad idea; however, it certainly was a bad idea to creditors and so they obviously took action as seen in the chart below. While the credit default swaps skyrocketed in April, they’re starting to level off as Greece and European finance ministers discuss restructuring the bailout or adding a second one.

Currency and futures traders trade off of two inputs, news and the charts. We’ve previously talked about the news events affecting the euro. Let’s take a look at the second input, charts on the euro and the U.S. dollar. Almost the inverse of the U.S. dollar, we can see that the euro has broken above a key trendline just as the dollar has broken below a key trendline; however, there is a horizontal supply zone that I pointed out on my April 21^st Market Observation in the euro that is clearly exercising some influence on the price of the euro near .50.

Here’s the long-term chart:

And a clearer picture that shows how the long-term chart affected the short-term chart. This is why it’s critical to not only look at near-term trends, but also long-term trends.

Let’s also take a look at the U.S. dollar as changes in the euro will largely affect the broad outcome in the U.S. dollar. The long-term chart has been in decline since 2002. Since 2004 the dollar has been consolidating within a wide berth between 70 and 90 on the index. Many technical analysts believe that pattern to be complete with the break below 76 in March of this year (break below black triangle below).

However, like the supply zone in the euro, there is a long-term horizontal demand zone in the low 70s (early 2008) that can’t be ignored on the charts. Currency traders will not ignore this support zone despite the March break below 76.

So there’s been a bounce in the U.S. dollar, and a correction in the euro. Are they going to be the start of a new trend or are they merely short-term in nature? Let’s look at a technical checklist by focusing just on the U.S. dollar:

• Has there been a bottoming out process?
  • Momentum Divergence? No
  • Higher low or trough? No
  • Basing pattern? No
  • Flat moving averages now turning up?No
• Have any moving averages been broken?
  • Yes on the 20-day moving average (short-term)
  • No on the 50-day moving average now (intermediate-term)
• Have there been any traditional buy signals?
  • Short-term in an RSI that crossed from below 30, higher (trader signal)
  • Short-term slow stochastics from below 20, higher (trader signal)
  • MACD cross signal (trader signal)
  • MACD positive signaling positive trend? No (investor signal)
  • Shift in bearish to bullish mode in the RSI? No

So looking at all of the facts above, it’s clear to me that we’ve had a trading bottom in the U.S. dollar, but nothing of substance that should say the dollar is bottoming long-term. There’s not enough evidence to suggest a new bullish trend has formed or is forming in the dollar either. Does that mean that it can’t stage an intermediate-term rally here? No, I’m just saying it’s a little premature to say that the dollar has put in a bottom. The factors I bulleted off above should turn from “no” to “yes” if the dollar is going to put in a significant bottom. There was too much momentum going into the dollar’s decline and the euro’s advance to just shut off without a second attempt at recent lows and highs respectively; or at least to put in a failure swing (higher low in the dollar or lower high in the euro). Let’s now turn to some of the commodity producer charts that I said look like they’ve merely consolidated recently and are near supportive levels where one would expect buyers to enter. Because I may own some of the companies personally or in our managed accounts, I will stick with just the industry group funds:

Amex Gold Miners Index

Metals & Mining Select Industry Index

Coal Industry Group

Oil Service Group

Oil & Gas Equipment and Services Index

Oil & Gas Exploration & Production

Agriculture Fund

Looking at all of the commodity industry group charts above, there are many common traits:

1. A rising trend from summer 2010 until the 1^st quarter 2011.
2. Current clear and identifiable demand and support zones within a sideways trading pattern.
3. Volume peaking near the demand zone and not when price is in the supply zone. In bull markets, you buy the dips.
4. All have the possibility of becoming top formations should the demand zone fail to rally prices.

The forces driving commodity prices are numerous. Chart patterns, daily comments from finance ministers in Europe, economic indicators that are slowing (disinflationary pressure), and “visible hand” intervention in the commodity markets are a list of the major drivers. That’s a lot to cause many investors to just sit on the sidelines and watch the commodity market shake things out. From my analysis on the dollar, the euro, and the commodity producer charts, the sell off looks overdone for now. I see clear demand zones with volume to support that thesis. With ongoing talks over Greece’s debt issues, comments from Europe favor either another bailout or lengthening the term to the existing bailout. Credit Default Swaps are sliding from elevated levels as concerns begin to subside. Inflation around the world clearly indicates we’re likely see more interest rate hikes overseas while we continue to increase our central bank’s balance sheet. This should continue to weigh down on the U.S. dollar.