The Rule of Thumb to Watch in This Market

In today’s Money Morning…why oil prices could be set up for a short term bounce…the most important statistic to watch, to understand commodities…how far could the Aussie market correct?…and more…

The Aussie stock market is set to continue its volatile consolidation period today, after another oil sell off overnight unsettled global markets.

The global benchmark, Brent crude, fell about 2% to US$46 a barrel. That’s the lowest it’s been since November 2016.

The apparent reason for the fall was higher production from Libya and Nigeria, two nations not bound by OPEC production quotas. As Reuters reports:

“The increasing August export programme in Nigeria and the jump in Libyan oil output should pressure oil prices further in the short term,” said Tamas Varga, senior analyst at London brokerage PVM Oil Associates.

“If we get bearish US oil statistics this week, we could see a test of $US45 on Brent,” Varga said.’

When prices are falling, it’s easy to become fearful. Perhaps prices will head to US$45 a barrel…or even lower. I don’t know. But in the short term at least, that could set the commodity up for a brief bounce.

Why?

Well, a really important statistic to watch when assessing the short term outlook for any commodity is the ‘commitment of traders’ report, released by the CFTC (Commodity Futures Trading Commission) in the US.

That’s because the futures market sets commodity prices. While some traders watch the fundamentals, others (I would say most) watch the traders watching the fundamentals. Because of this, price setting for commodities is a mix of supply and demand factors and market psychology.

And if you look at the commitment of traders report, you can see the ‘psychology’ of the market pretty well.

For example, earlier this year, the speculators (a category that largely represents the hedge funds) were net long a record 413,600 crude oil futures contracts. That’s huge, and reflects a very bullish psychology about where oil prices were headed.

However, the latest report, showing positions as at 13 June, shows net long positions in crude oil had fallen to 195,300 contracts. The psychology is certainly shifting.

Given the recent weakness in crude prices, you can be sure that the net long position will have fallen further when the next report comes out at the end of this week.

In other words, hedge funds have bailed out of their bullish bets on oil since the start of the year. You can see this in the chart below, which shows the sharp fall in speculators’ net long positions.

Source: Thompsonreuters.com

Click to enlarge

Of course, I have no idea how far oil prices will fall from here, but my guess is not much further before you at least see a short term bounce.

Anyway, for now the oil price slide is unnerving the market. The S&P 500 index fell 0.7% overnight, while the Dow Jones declined 0.3%.

That means Aussie stocks are set for further falls today, led by resources. But in the scheme of things, it’s just more of the same.

As I mentioned, the Aussie market peaked in early May and has since entered a correction period. How far could the correction take us?

A good rule of thumb is that markets often retrace as much as 50% of a prior rally while remaining in a long term bull market. This is important information to know because to the uninitiated, such a correction could cause fear and the desire to sell, at precisely the wrong time.

Let’s have a look at this rule in relation to the ASX 200, Australia’s benchmark index. As you can see in the chart below, I have marked the start and finishing points for the rally from November 2016 to May 2017. To mark the low point, I ignored the extreme volatility brought about by the US elections.

Source: Optuma

Click to enlarge

The rally took the ASX 200 from 5,179 points to 5,954 points. A 50% retracement of that rally would mean the index could easily fall back to 5,567 points with the bull market still intact.

This level also matches the tops reached in 2016, so I would at least expect to see support kick in here if the selloff continues in the weeks ahead.

But it would be surprising to see a deeper sell-off given the Aussie market continues to lag bullish global markets and given that interest rates will remain low for a long time.

Having said that, there are no obvious factors to drive the market higher right now. Banks are under regulatory pressure and resource stocks are dealing with corrections across a range of commodity markets, including oil and gold.

Speaking of gold, it’s correcting again after making a run at US$1,300 in recent weeks. Gold has made a decent move higher since hitting the panic low in December 2016. However the chart (see below) looks indecisive.

I really don’t have much conviction when it comes to gold right now. I don’t think it’s going up too much…or down too much. With the Federal Reserve on a slow but steady interest rate raising path, there isn’t a strong catalyst to push gold higher.

That could all change with a negative economic surprise from the US or China, but it doesn’t seem likely at the moment. That’s why I’d guess that gold will continue to trade in a broad range between US$1,200 and US$1,300 an ounce for some time to come.

Source: Optuma

Click to enlarge

Which is good for the quality (low cost) Aussie gold producers. With current Aussie dollar gold prices around $1,640 an ounce, the good operators are still making decent cash margins on their production.

But to ignite a revival of investor interest in the sector as a whole, you really need to see the US dollar gold price move above US$1,300 an ounce. Such a move would see serious capital move back into the sector.

While a move like this may be some time away, it’s worth keeping an eye on.

Regards,
Greg


Greg Canavan is a Feature Editor at Money Morning and Head of Research at Fat Tail Investment Research.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors.

And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand.

When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases.

Greg puts this philosophy into action as the Editor of Crisis & Opportunity. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis.

Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy.

With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the basic, costly mistakes that most private investors do every time they buy a stock.

To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Money Morning here.

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