- 1997: Volume 6, No. 5 What's Hot and What's Not

The number of "hot" markets declined dramatically during the summer doldrums. There were, of course, some big moves, but not the type of sustained trends that many traders depend on. The financial markets turned shaky, T-bonds, stocks and the U.S. dollar fell sharply. However, due to mixed economic fundamentals it remains to be seen whether those markets have entered major down phases. The grain markets registered a few big up moves due to, what else, weather. But negative fundamentals (big corn and soybean crops are likely) have kept a lid on prices, preventing sustained trends. Similar action occurred in the petroleum markets and livestock. The most impressive trends have occurred in natural gas, which rallied sharply due to low supplies, and copper, which fell due to rising supplies.

What's Hot?

Natural Gas—This market has been in a steep uptrend most of the summer, boosted by good demand for electricity generation. Even though temperatures across the northern tier of the U.S. have been moderate (actually downright cold at times), temperatures across the South and Southwest, including southern California have been hot-hot-hot, keeping air conditioners operating at full blast. The net result has been a slower than normal buildup in underground storage stocks of natural gas. High prices have finally attracted gas into storage; AGA weekly injections averaged 93 billion cubic feet over the past two weeks compared to 60 to 70 bcf previously. But in spite of the increased storage pace, relatively low stockpiles probably set the stage for significant price spikes this winter during any sustained period of much colder than normal temperatures.

What the winter weather will be like is anyone's guess, and the strong El Niño weather phenomenon (warmer than normal surface water in the equatorial Pacific Ocean) further confuses the issue. Some forecasters say there's an association between El Niño and a warmer than normal winter in North America; others expect El Niño to cause a big buckle in the Arctic jet stream causing it to drive down into the central U.S. (which has regularly occurred this summer) resulting in a harsh winter.

Copper—Large increases in exchange copper stocks (London Metal Exchange stocks more than doubled) and disappointing demand (which has been slow to begin a seasonal increase) have kept copper prices in a major downtrend since early summer. A stronger U.S. economy (favoring copper demand) has been offset by weak economies in Asia (except for China). Also, world copper mine production continues to rise. That leaves it up to China to save this market from further declines. China previously was expected to make major purchases during the second half of the year, more than 200,000 tons according to some, but those ideas have been scaled back. However, China's economy isn't likely to slow so they'll undoubtedly reenter the market, and when they do it should establish a bottom. Until then, lower prices are favored.

Currencies—The U.S. dollar has fallen sharply versus the D-mark and Swiss franc; but since much of the selling has come from speculative longs, and the fundamentals aren't particularly negative, it remains to be seen whether the dollar has entered a major down phase. The main bearish fundamental argument is the potential for Germany to raise interest rates to head off an uptick in inflation. However, not only might a German rate hike hurt the German economy, which is saddled with record high unemployment, but it could cripple Germany's efforts to meet the strict fiscal requirements for European Monetary Union, i.e. a slower economy would cut tax receipts, keeping Germany's budget deficit to GDP ratio too high to quality for EMU. We have a feeling the Bundesbank would rather live with a small rise in inflation than risk slowing the economy, meaning hints of a rate hike are merely a ploy to shore up the D-mark. In addition, the dollar is likely to remain firm versus the Japanese yen. In spite of the "usual" U.S. complaints about Japan's export driven economy and high trade surplus, the outlook for a weak Japanese economy (hurt by troubled economies and currency turmoil elsewhere in Asia) and potential for a Japanese interest rate cut (Japanese long-term bond yields are at an historical low) favor the dollar. Finally, not only should the U.S. economy outperform Europe and Japan, but there's a reasonably good chance for a U.S. rate hike which would keep interest rate differentials in favor of the dollar. We think the dollar is likely to stay in its major uptrend.

What Might Get Hot

Corn-Direction hinges on U.S. crop size; production below 9.3 billion bushels tightens the supply/ demand balance significantly and probably warrants a rally to the $3 level; output in excess of 9.4 billion bushels would most likely leave prices somewhat weak but in a trading range around current levels. At this stage, it appears an early frost (if it occurs) won't come soon enough to cause significant yield losses.

Stock Market—The recent sharp break in the Dow and S&P once again raised the possibility of a major top in the stock market. However, the decline was mitigated somewhat by continued strength in the broad market; the Russell 2000 index scored new record highs as investors rotated out of high cap stocks into "undervalued" low cap issues. In addition, nothing has surfaced to change the long-standing bullish rationale of a moderate, sustained U.S. economy with low inflation and relatively low interest rates. Obviously, a continued sharp decline in the U.S. dollar or bonds could push stocks into a bear phase but there's nothing in the fundamentals that would spell an end to the bull move, notwithstanding the usual concern that stocks might be overvalued. That concern hasn't stopped the market from getting to record highs over the past two years. From a trading standpoint, we'd take a cue from the technicals; a close under 890 in the December S&P futures would be a sign of a bear phase. Barring that, higher prices are still favored.

T-bonds—This market has settled into a trading range, waiting for opinions on Fed policy to crystallize, i.e. will they or won't they tighten monetary policy? The bear camp says that a stronger than expected second and third quarter economy (it's growing "above trend") and concerns of rising wage and price pressures will cause the Fed to raise rates 25 basis points before year end. The bull camp says that a stronger economy and inflation aren't linked (inflation is a monetary, not economic, phenomenon) and that the Fed will tolerate higher growth as long as inflation remains under control (the old "opportunistic disinflation policy"), particularly since continued gains in productivity and three-year low unit labor costs should reduce price pressures and keep inflation well behaved (even Fed officials admit they really don't understand why inflation has been so subdued). Basically, Fed policy is a coin toss, but tradingwise, we'd take a cue from the technicals. A close outside of the recent trading range in bonds would probably signal a strong shift in sentiment and the direction of the next major move.

Heating Oil—It's the time of year when spec longs pile onto the long side of heating oil in anticipation of a "seasonal" rally. And in many years that's not a bad play. However, unlike 1995 and 1996 when distillate stocks were low going into the peak winter demand season, which set the stage for significant price spikes in response to colder than normal weather, the situation is just the opposite right now. U.S. distillate stocks have been climbing at a strong pace and have already reached the low end of what is considered a "normal" level (i.e. between 130 and 150 million barrels). Should supplies continue to climb at the current pace, they might reach a burdensome level prior to the November 1 start of the heating season. While that certainly wouldn't preclude rallies in the event of much colder than normal temperatures, it should greatly reduce the probability and duration of price spikes. In addition, continued stock increases could also drive prices lower over the near-term with any downmove possibly exaggerated by liquidation of the distressed speculative positions. Bottom line, this doesn't appear to be a good year for playing the long side of heating oil.