Commodities have gotten white hot in a very short window. The sheer amount of headlines around inflation and raw material pricing is insane. I don’t have a nifty little Google Trends chart to show you but I’m pretty sure I already know how it looks.
Every other financial article or analysis is about inflation or commodity pricing.
Commodities are on top of everyone’s mind right now, which of course means a reversal is imminent. Which in turn should drive the buck upwards as commodities are priced in dollars and heavy amounts of short-term capital will have to hide there while steam is let out of this commodities rally.
Have a look at DBC. You can see when recent capital started jumping in enmasse as a result of commodity price action and the narrative heating up around inflation.
It’s all a bit too much, too fast. A correction may have already began last week and I wouldn’t be surprised at all to see DBC come off 15%. However, there are a ton of Calls outstanding on this ETF compared to the Put total with tons of theta purchased out to January of next year.
Gamma sways everything.
Still though, my gut tells me the narrative around oil and copper is simply too hot. I’m probably a bit early here, so if one were intending to go short on select commodities, be sure to purchase enough theta on one’s own Puts.
Just look at the raw YTD performance of the energy complex! And copper is easily outperforming the S&P 500 and NASDAQ.
A couple months back, I thought a harder selloff in the commodity complex might trigger selling action in the equity markets. Instead, equities took their own little breather in September as volatility rose.
But I don’t think we’re quite out of the woods with equity volatility. This “buying of the dip” has a delicate feel to it, as if fear was not properly washed out last month. I continue to stand by my hypothesis that commodity weakness will lead to general equity weakness.
Of course, the commodity weakness will be transitory along with any equity weakness. I expect to have a solid end of year rally in stocks.
Assuming my hypothesis is correct, oil and copper should be the triggers. Copper’s decline has probably already begun with last week’s 5% selloff (and more to come).
Oil would be the real trigger for overall weakness across markets. Observe this bit of backtesting on oil, courtesy of SentimenTrader. If the trend over the last 30 years holds true, then we should expect a rocky month in oil regardless of narratives and “shortages.”
Couple this with some end of month historical tendencies towards equity weakness, and we have the makings to pull the rug out from recent dip buyers.
One historical fact is that, at the close today, we will be entering the worst historical week of the year. The October 21st close through the October 27th close has a tendency to show weakness. Before I show you the numbers, keep in mind that the 19th through 25th of EVERY calendar month has produced annualized returns of -8% on the S&P 500 since 1950. So this October weakness is really nothing new. It just happens to be the worst of the bunch. Below are the annualized returns by calendar day (since 1950) on the S&P 500, followed by the NASDAQ:
But then these annualized returns are immediately followed up by historical strength in the S&P 500, so any weakness should be relatively short and shallow, but very scary. It is Halloween, folks. Observe the next 9 days of annualized results (since 1950) for the S&P 500:
Summing up: The inflation narrative and commodity pricing are too hot. Expect weakness there. This would then catalyze weakness in equity markets with overall weakness driving capital into the USD.
All sound far fetched? Have a look at the USD and performance when CoT shows Large Traders at a wide disparity to Commercial Hedgers.
Some hefty rallies noted. I don’t expect a monster run; just enough for a short-lived rally while capital hides. It’s only a hypothesis, but one has to trade their beliefs and manage risk accordingly. Can’t reiterate that enough.