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And now the excitement really begins. Having observed the financial markets for – ahem, a while now – there are times when things “look familiar."  This is one of those times. Many traders and investors live for good trends to develop so that they can ride them to large profits. That scenario has been on display for quite awhile now. The stock market has been for the most part trending lower since last October. And on the commodity side things have been steadily moving to higher and higher ground. The grains, energies, metals, softs, you name it, are all far above the level at which they stood a year ago. And we have now reached – or appear to be reaching – the “everyone knows” stage. As in, “everyone knows that crude oil and grain prices and metals, etc. will continue to rise in price.”  And well they might. But here is where the familiarity part comes in. I’ve seen this scenario before. “This time it’s different."  This time it really will turn into a sustained long-term trend. The expansion of the economies of China and the India virtually “guarantee” a prolonged demand for commodities, thus price will continue to rise. And well they might. But here’s the part that has me a bit concerned. Even the greatest bull markets occasionally pause and correct. And in the process, a lot of hard-earned “trend-following profits” get handed back in a hurry.

The Trend is Your Friend, But Not So the End

A long time ago, I started out like a lot of traders do. Testing trend-following and moving average based trading systems. These were pretty “raw” systems. Nothing fancy – not a lot in the way of profit targets and/or trailing stops – just find a trend, get in and ride it, and let the market take you along for the ride. For a long time this was a very viable trading technique. In fact, a careful reading of Jack Schwager’s Market Wizards (an absolute must-read for all traders and investors) reveals that one thing a lot of those profiled enjoyed was that they were in the right place at the right time. That statement is not to denigrate anyone’s skill or accomplishments in any way. The traders profiled in that book had to adapt to the way the markets were at the time they earned their fortunes. That is, grab the tiger by the tail and, a) hold tight, and b) know when to let go. Nevertheless, the point is that over the past several decades and prior to the past 12 to 18 months – the number of prolonged trends that traders could latch onto were not of the same size and duration as those experienced in the late 1970s-early 1980s.

As inflation soared and then peaked during that time, commodity prices swooped and soared. As inflation declined steadily over a long period of time, price fluctuations were never quite as great. As with most things financial, the pendulum has now swung back the other way, and commodity prices are once again enjoy large, prolonged moves. But to borrow another well-worn market axiom, “trees don’t grow to the sky." 

A lot of those systems I followed way back when all ended up generating roughly similar equity curves. Large increases in equity while the markets where trending, followed by large drawdowns as the market would subsequently whip back and forth – often in large trading ranges, in a very violent and volatile manner. It was not uncommon to see all of the profits gained during the “trend” get wiped out during the subsequent “trading range."  And that type of action is a very real possibility in the near future.

The Markets Today

As you can see in Chart 1, many markets have experienced extremely sharp run ups in value in the past year or so. Some have also showed signs of experiencing a “blow off” top and some have experienced indicator divergences and sharp declines

off of recent highs.

Chart 1 – Big advances in the commodities and futures markets

If history is an accurate guide, this could be the start of a very volatile period for commodity prices in general. Despite the headlines that suggest that continuing multi-year advances in commodity prices are a foregone conclusion, it is typically about the time that this consensus builds that things start to head in the opposite direction, at least for a while.

Now if you only trade stocks you might assume that such a development would not affect you. However, because the stock market hates uncertainty above all else, such a development would not necessarily be a good thing for the stock market. Stable and/or declining commodity prices are what make the stock market happy. A bunch of commodities whipping around in large trading ranges leaving everyone to guess whether the next major move will be to the upside or the downside, is not what we need at the moment. But it may very well be what we are about to get. Should this scenario transpire, we may see the stock market rally sharply when the commodities market fall (as on Tuesday 7/9) and vice versa.

Turning From Commodities to Stocks

Speaking of the stock market, the jury is obviously still quite clearly “out."  So many cross currents are buffeting the market at the moment that it’s almost impossible to keep up. Still, given the deeply oversold levels reached by some of the rate-of-change, advance/decline and new highs/new lows indicators that I follow – not to mention that overwhelming sense of “gloom and doom” purveyed daily by the mainstream media – there is hope yet for the stock market.

I am still waiting however, for a catalyst. The “Big 4” are:

1) A retest of early year lows for the major stock market indexes – The S&P 500 and Russell 2000 Index just completed successful (at least for the moment) retests of their yearly lows before bouncing higher on 7/9. This could produce a meaningful advance.

Chart 2 – SPX and RUT bounce off of retest lows

2) Crude Oil and Energy Prices – As of 7/9, crude oil was about $10 off of its all-time high. Whether this is a pullback or the start of a meaningful decline is one of the most important questions anyone can ask at the moment. Unfortunately, while one can speculate as to the answer, for now we simply have to wait and see how it plays out. Per my earlier comments, I would look for some big fluctuations both up and down, with some fairly wide daily ranges. Nevertheless, pay close attention, because a meaningful break to the downside would be very helpful for the stock market.

3) Grain Prices – July and September are typically the two weakest months for corn and soybeans. Both have declined sharply in the past week. A continuation of these trends could ease inflation fears and prove to be a bullish catalyst for the stock market.

Chart 3 – Long advance in grains – but where to from here?

4) The VIX Index – The VIX “sorta, kinda” spiked on 7/7. Some of the key sentiment indicators that I follow are posed to give buy signals if the VIX and the CBOE put/call ratios trend lower from. Still, the one real “nagging feeling” I have is that the current decline in the stock market will not end without some good old-fashioned “fear”, such as the kind indicated by a sharp spike by the VIX to higher ground.

Chart 4 – Was the latest upmove in VIX enough of a sign of fear?

Conclusion

Hold on tight.  

To search for previous articles written by Jay Kaeppel, please click here.


Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site

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