Bullish Commodities Markets Produce Higher Metals Prices

I can point out a few compelling reasons to anticipate a continuation of the commodities rallies we've seen over the past couple of years: twin U.S. deficits, limited supply versus real demand, and antiquated production facilities and supply lines. But foremost in my mind is the behavior of individual markets, and a continuation of capital inflows into these markets.

Before we analyze individual market behavior, let's talk briefly about how incoming money fuels price movement. In the March 26th issue of Barron's, the Commodities Corner Column outlined how many pension funds are being advised to increase their exposure to commodity indexes from the current 1-1 ½ percent to as much as 5 percent. The article spells out how an estimated $50 billion came into commodities over the last two years, and how another $50 billion is likely to come into the markets this year. It concluded that with pension fund assets in this country currently at around $10 trillion, a 5 percent move to commodities would mean a $500 billion wave of money.

Silver Prices Are Rising

Silver is one of the markets I think will continue to see significant price appreciation because of these money inflows. Foremost, silver is a component of all the major commodity indexes: CRB, Goldman Sachs, Rodgers, and The Dow AIG commodity index. This is important because as the new money comes into these funds, they will have to continue to add to their already existing long positions in the commodities that make them up, just as stock mutual funds have to accumulate the stocks that comprise the S&P 500, or the Russell 2000. I believe this incoming money will insure an underlying bid for silver, and will in fact spur a rally as the combination of real and speculative demand combine to push prices higher and New York market makers and international silver producers are forced to withdraw their offers in anticipation of still higher prices.

A good example of how the infusion of pension fund money into indexes can affect a commodity market can be seen in the energy markets right now. Many market analysts are confounded by the rally in the energy markets because they see that there is a steady supply of crude oil to meet actual demand.  What they don't see, or understand, is the effect speculative demand is having on these markets. Crude is currently trading 68 percent higher than it was at the beginning of 2003.

Click chart to enlarge.

Following this impressive rally, silver went into choppy, reactive trade as it consolidated the previous gains. I believe that the price behavior following a significant, or impulsive, price move is key to determining the future direction of that market. In this case, despite some volatile price swings, silver held on to most of its gains, and one year later is currently trading around $7 an ounce, or 40 percent higher than where it traded at the beginning of 2003. Over this same time period, copper has risen 110 percent, while glamorous gold is up only a modest 22 percent. A natural explanation of this disparity is that copper and silver are much more actively consumed in industry then ornamental gold.

In technical terms, the price pattern painted over this one-year time period in silver is called an ascending triangle, or a bull flag. An old saying I learned on the trading floor years ago is that, "The flag flies at half mast," which means that the measurement of how far a market will move, once it breaks out of a flag formation, equals the length of the "flag pole," or the original impulse rally, which in this case was the $3 rally. This simple measurement, which is spelled out in nearly all books on technical analysis, gives us a rally of up to $10 per contract.

Another bullish non-linear indicator on this chart is the 75-bar moving average cross line. You can see how the market continues to trade above these long-term moving averages, which confirms that the market's path of least resistance is higher. Should silver trade below this line, which currently intersects at $6.67 basis May, I would change my bullish opinion. As an intermediate-term recommendation, I like buying the July 8.00 silver calls for 12 cents, or $600. For every 10 cents above $8 an ounce that silver moves, the call would increase $500. Should silver get to $9 by mid-June, the call would be worth $5,000. For the longer term, I like the September 8.00 silver call for 24 ce nts, or $1,200, which would be worth $10,000 if silver gets to $10 by mid-August.  

Click chart to enlarge.

Fractal geometry was invented by the scientist Benoit Mandelbrot, who describes it as "the study of roughness, of the irregular and jagged." In his book, The Misbehavior of Markets, he writes: "A fractal has a special kind of symmetry that relates a whole to its parts: the whole can be broken into smaller parts, each an echo of the whole."  I appreciate that description from a trading standpoint. The trader Bill Williams, author of Trading Chaos: Applying Expert Techniques to Maximize Your Profits, defines an "up fractal" in trading terms as a series of at least five consecutive price bars where the middle bar's high is higher than the two previous bars and the two following bars. A "down fractal" is the opposite, meaning a series of at least five price bars where the middle bar's low, is lower then both the previous, and following two bars.

A "bullish divergence bar" on the other hand, is a single price bar with a lower low than the preceding bar and a close in the top half of the range. Very often that key middle bar in a fractal is a divergence bar. In geometric terms a divergence bar, and a fractal, are significant because they often mark the point where the market changed course, or direction, thus altering the previous price pattern. Behavioral traders often refer to that significant low point as a "fractal," while academics would refer to the five-bar formation that included the low point as a "fractal."  I generally refer to the isolated high, or low, price point as a fractal.  

Now let's look at the daily chart. The two most recent bullish divergence bars, and the two most recent "up fractals" are marked. The bullish divergence bars are actually "old news" in that they previously provided buy signals once the market traded above their highs. Their significance here is that their lows represent "down fractals," or the price points which, if penetrated, would indicate a change of direction. One tick below these lows is where we would have our sell stop loss orders, or reversal orders, if we were inclined to short this market, which in this study we are not. If we did not have a long position in silver already, our first entry would be just above the March 31st up fractal at 722.50. We would place an order to buy 1 May Silver contract at 723.50 stop to initiate a long position, but only if this level is above the moving-average cross lines. We would be buying at this level because the market is making a new high, and it is at this point that the market would be confirming that its path of least resistance was higher.