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Historic Commodity Deflationary Declines

Using the Research Engine, we are able to look at the various historic precedents of historic deflations similar to what we have seen in our market; however, given that this has been the greatest commodity decline in history, and the fact that there is variability on how previous historic deflationary declines occurred, it is important to note that the 200 year history, while it seems like a long period of time, does not give us many reference points since we are looking at something and dealing with something that we have really only seen a handful of times in history.

We do have some limitation, and I say that to maintain a sober outlook in the market. I want to make sure that when I make recommendations to you that it is based upon probabilities; it is based upon history repeating. There are times when we are simply lost in the markets, and I don’t view that as a negative in any way because it doesn’t make any difference what we think in the markets until we commit money. At the point at which a forecast converges with our trading signals, that is the point at which we commit money. We are in this to make money, not to be right in the markets.

Projections for Overall Commodities – Goldman Sachs – Commodity Index

With respect to what is taking place, we are going to be looking at the chart in the Goldman Sachs again, which is this chart (see video), and make a couple of observations.

We had overlaid what took place after the great deflationary declines in 1974, 1979, 1920, and 1980. In 1980, the initial liquidation, the major waterfall liquidation was followed by a bear market rally and a resumption of the bear market. This was also true of both the 1815 market and the 1864 deflation after the Civil War. There were three instances when declines similar to this, and there have only been six in history, so this is the seventh-when declines of this magnitude resulted in bear market rallies like occurred in 1980 and then resumption of the bear markets.

Now three other of the waterfall declines were followed by culmination points and bull markets. That occurred in 1974, 1949, and 1920. I am at this point aligning myself to the belief that we are going to be following a pattern where we’ve probably got a culmination in final low in overall commodity prices, and we are in the midst of what will be a first leg up in an overall long term bull market. You can see (see video) that in 1949, our most important cycle, the 60-year cycle, the retracement of the preceding decline initially was rather modest. After that first leg up there was a correction, and then the market moved to a new high and then continued up in a bull market.

There is an observation that I do want to make with respect to this, particularly the geometry of markets like this.  I would say the decline after the July 2, 2008 high is the equivalent of a nuclear bomb going off in the financial markets. The markets are catching their breath. That is what I believe is taking place right now. A tremendous amount of wealth destruction occurred, and the markets have to digest all that is taking place in the economy. No one has a perfect prescience as far as what is taking place, and so there is a lot of guesswork being done.

Writing Options: A Strategy in Response to Volatility Premiums

That is why conditions are choppy and why I still view this environment as ideal for strategic writing of options. I believe that we are in a trading environment. This was a huge historic downtrend leg down in overall commodity prices, and what we know from history is that typically we can see a move like this and yes, there is the law of action and reaction where there could be a violent reaction to a move down like that, but then the markets tend to, over time, slow down and quiet down.

By virtue of the volatility that we have had in the market, option premiums have been very high, and we have a premium advisory service called The Strategist where we have actually been writing call options. We have been selling options in the S&P, selling options in the silver, and that has been working out very well because the option premiums are so high because the fear factor in volatility premiums, which are eroding because of basically trading range conditions, and the time factor in the options is working in that favor. It just so happens to be a season where, I believe, option writing may be the preferred strategy, one of the best strategies. It is certainly not as exciting from the standpoint of risk – reward as other strategies in the market, but it is very valid, and it is one that we are utilizing in The Strategist service.

Commodity Market Trend Continues to Point Higher

That being said, in terms of expectation as far for commodities, at this point in time we do believe that the trend is going to be up, but the carrying charge premiums are really high, so that diminishes rates of return on potential longs in many of the commodities, particularly in the energy complex. That diminishes rates of return, so there are certain factors that in a sense inhibit the ability for the markets to move significantly and yield high rates of return; I should say multiples of risk reward.

We want to obviously be approaching the market with the right mindset based upon where the market is historically, and so I believe we are in more of a trading type situation and will continue to be so.

* Please comment on the video at the bottom of the page *

We’ve experienced a very sharp decline in terms of velocity, and we’ve had five days where the market has done some backing and filling. That is actually a very healthy thing in that the market was getting a little ahead of itself, so profit taking and backing and filling is a very healthy process. Nothing goes down a straight line even though these are the greatest legs down in history.

These are the greatest legs down in history in the stock market (the red lines and target points on the lower right), and yet you do see that there is backing and filling on the way down, as one would expect. A couple of observations: other than the correction after the first leg decline on the 29th, all five bear market rallies were complete by February 7th.

Here’s our target zone (the red box). This was the last of the bear market rallies to complete (U 1930). You can see that we are well off that February 7th date, so the probabilities are very high, that this is a bear market with extremely high probabilities that the January 5th high is the high for this bear market leg.

The other side of the equation is if this market did continue to go higher and continued higher beyond the February 7th high, then the probabilities would go up that we have an important low in place. That being said, these target zones tell us a great deal about whether the market is conforming to historic norms because as soon as it stops doing that, then we have to say, “Okay, something else is going on here.”

But right now, this market is conforming beautifully to what we would expect for another leg to the downside. Now the other thing is, if the current decline has started another leg down, it is running pretty hot relative to the legs down during the Great Depression. That was what I said at the recent low, but now we’ve had five days of consolidation, so the market is in a healthier position here, healthier in advance of what we would expect to see as a breakdown into new lows below 797 with a break of the 737 low with follow-through to the downside.

At the 797 low, this is what we were telling subscribers. We have a buy pattern. If I was looking to go long, the reversal higher after breaking the 813.50 low by 16.50, which is what we did; we broke this 813.50, dropped down to 797 and ran into a ton of sell stops down there and panic sell orders. But the reversal from there actually issued a buy signal if we were looking to be a buyer, but since we believe we’re in a bear market, in bear markets you don’t take buy signals, and in bull markets you don’t take sell signals. We go with the trend, but we did get a buy signal, and we have to respect that.

A break of 797 would increase the probability we are in the midst of a leg down and an overall bear market. A break of this low would indicate follow-through. This is particularly true in light of the last five days of trade, so if we break this 797 low, we have trade action, trade recommendation for subscribers on what to do in anticipation of follow-through to the downside.

This is the setup in the March S&P. The last was at 839.80 and I believe that we closed a little bit higher today, as I’m coming to you just before the close on Tuesday afternoon.