NEWSOM ON THE MARKET PARADIGM SHIFT
- Darin Newsom DTN Senior Analyst
It was late in the fall, 2003, and I was having lunch with DTN's Urban Lehner for the first time at a Cracker Barrel restaurant in Topeka, Kan. This was my initial meeting with Urban, my job interview for the position of Grains Analyst, and Urban's questions were quickly getting to the point of my core beliefs about the market.
Urban: "Can you describe basis in layman's terms?"
Me: "Simply put, the difference between cash price and futures price."
Urban: "Are you a technical analyst or fundamental analyst?"
Me: "My background is studying charts. I look at fundamentals from a technical point of view."
Urban: "In the end, are markets fundamentally or technically driven?"
Me: "Ultimately, fundamentals will decide direction."
I thought of this conversation Friday morning following a discussion on the social network Twitter. I was visiting with other analysts regarding the state of the grain markets, but in reality, the theme could be applied to all markets. The question: Have fund traders displaced fundamentals as the driving force in the marketplace?
The definition of a paradigm shift is "a change in the basic assumptions within the ruling theory of science." If fundamentals have become secondary to computer algorithms (including technical factors, and responsible for a large percentage of fund trading), then the science of analyzing markets has been turned on its head.
Over the last couple of months, my weekly columns have focused on the takeover of ag markets by noncommercial entities, a dynamic change that I've written about since late 2005 when position limits were changed, allowing traders to hold twice as many positions in ag commodities. Recent developments concerning expanded trading hours have created more interest in how the markets work. At the same time, the commercial side of the market (those traders actually involved with the underlying cash commodity) has strengthened its defense against large-scale noncommercial activity.
The ongoing downtrend in commodities comes at a time when some markets are showing increasingly bullish fundamentals. Much-discussed examples are corn, with the old-crop situation exceptionally tight and large question marks hanging over new crop; and soybeans' global short supply against the backdrop of increasing demand (regardless of global economic developments). Another market that has been flying under the radar is RBOB gasoline, with weekly stocks reports showing a 3 1/2-year low in domestic supplies continuing to decline. While demand remains in question following the most recent U.S. employment and unemployment data, if summer usage does pick up, the situation could get interesting.
For the record, I'm not ready to join the side claiming the paradigm shift has occurred. In fact, I would argue that we have seen this same scenario play out before, just in the opposite direction, in the not-so-distant past.
Two examples quickly come to mind: 2008 crude oil and Chicago wheat. In regard to wheat, early in 2008 noncommercial traders held a large long-futures position of more than 110,000 contracts as the nearby March contract established a new all-time high of $13.34 1/2. Meanwhile, the commercial side of the market was growing more bearish, reflected in a weakening national average basis. Ultimately, the national average cash price (DTN National SRW Index) would fall to $2.25 under the futures market, and the futures market itself dropped to $4.55 by the end of the year as noncommercial traders trimmed their long-futures position back to 53,000 contracts.
A similar situation emerged in crude oil, where frothing fund buyers pushed the spot-month futures contract to a high of $147.27 in July, all while the strengthening carry in the forward curve (series of futures spreads) in the market indicated an increasingly bearish fundamental situation was brewing. While talk of $200-per-barrel crude grew louder, those that saw what was coming hinted that $50 was more likely. We all remember what happened when the market moved back in line with its supply and demand, falling all the way back to near $32.50.
2012 just has the roles reversed in the markets. Instead of buying against a bearish fundamental backdrop, fund traders are selling at a time of bullish supply and demand in some markets. Unless that commercial outlook changes, and current national average basis markets for both corn and soybeans indicate it isn't anytime soon, this group will likely find prices attractive enough to start rebuilding their long-futures position.
The long-term key will be, as it has always been, fundamentals. Keep an eye on the forward curve for the various markets for signs of possible change, as well as basis. The bottom line remains that there is growing global demand for many commodities despite another economic downturn, and investment traders will likely want to take advantage of the opportunity at some point.
