Commodities: Are They About To Experience A Pause?

The long-term picture

• Is the stock market smarter than the commodity market?
• Commodity indexes short-term overbought

The long-term picture

Since mid-summer, commodity prices reflected in broadly based indexes such as the CRB ($CRB), Bloomberg Commodity ETN (DJP) or the DB Commodity ETF (DBC) have been on a tear. However, short-term momentum is now overbought, so it makes sense to ask the question of whether this strength part of a new bull market, or is it the end of a counter-cyclical rally?

Chart 1 gives us some long-term perspective for the CRB Composite. As you can see, the index broke below a major support trend line in 2015. It has been trading below it ever since. That line represented support prior to its penetration. Now it has become an equally formidable barrier of resistance. Remember, it goes all the way back to the mid-1970’s, which really enhances its significance. If prices can rally through and hold above it, this would represent a very bullish technical achievement. However, as long as the index is confined below it, that barrier still exists and is an impediment to any serious rally.

The solid red arrows approximate periods when the Coppock Indicator, in the lower window, reverses to the downside. These instances are typically followed by a bear market of some kind. The dashed arrows represent false signals in this regard. Since the Coppock recently reversed to the downside, it raises the possibility of a primary bear market.

Chart 1

Is the stock market smarter than the commodity market?

It’s often a good idea to hunt for a leading indicator of the price series you are trying to forecast.  In this respect, a fairly reliable leading indicator for commodities comes from an internal battle in the equity market. That battle is waged between sectors sensitive to inflation versus those that out-perform in periods of deflation. In this respect, the center panel of Chart 2 features the ratio between an index comprising inflation sensitive stocks, such as mines and oils, versus one that benefits when the market is in a defensive or deflationary mode. Comparing it to the CRB Composite itself, shows that they both experience similar price swings. The dashed red and green arrows point up that most of the time this stock market relationship leads turning points in the CRB.  One exception was the 2008 peak, when both reversed to the downside simultaneously.

Chart 2

Note that the ratio topped out in mid-2016 at point '1' and has been zig-zagging down ever since. The KST for the inflation/deflation relationship is basically flat, so it could move in either direction with relatively little effort. The same could be said for the ratio itself, since it would not take much in the form of upside action to violate its 12-month MA and surpass the 2015-17 down trend line.

However, Chart 3 suggests that such a move is unlikely. That’s because the ratio recently violated the neckline of an upward sloping head and shoulders formation.  Also, it peaked last September, so while commodities themselves were experiencing a rally, stock market traders in the form of the inflation/deflation relationship, were betting on a more deflationary outcome.

Chart 3

Another way of looking at this internal stock market battle is to compare the Goldman Sachs Natural Resource ETF (an inflation proxy) with the Spider Consumer Staples (a deflation proxy)  (IGE/XLP). As you can see from Chart 4, this relationship also moves in a similar way to the CRB Composite. The chart tells us that the IGE/XLP ratio experienced a false upside breakout earlier in the month. I always like to see such whipsaws confirmed by further price action because this enhances the odds that the false break is, in fact, false. Such proof was presented this week as it crashed through its August/November up trend line. Note that the KST has just gone bearish as well. The recent weak KST rally compared to the spirited one in the ratio itself, is also a cause for concern. That’s because it underscores the contrast between sharp upward price action and subdued momentum.

Chart 4

Commodity indexes short-term overbought

One of the problems for several commodity indexes is that they recently broke to the upside which, on the face of it, is good news. On the other hand, that breakout left them in a short-term overbought mode. For example, Chart 5 compares the DB Commodity ETF, the DBC, to its price volume oscillator (PVO), using the 12 and 26 parameters. The PVO recently experienced a buying climax. The red arrows tell us to expect lower prices following such an event. If that proves to be the case in the current situation, it will place high odds on the likelihood of a false upside breakout. That would be confirmed with a break below the red dashed up trend line at around $15.60.

Chart 5

Another way of monitoring the overbought/oversold status is to look at a basket of commodities registering net new highs over a 50-day period. We see in Chart 6, that this series has recently experienced a tentative reversal from its overstretched red horizontal line. Two such reversals in early 2016 and another in 2012, did not result in much of a decline. However, the majority did.

Chart 6

The same can be said for a similar series calculated with a 10-day look-back period, as featured in Chart 7.

Chart 7

Finally, Chart 8 features the Bloomberg Commodity ETN, the DJP. Here we can see a potential failed upside breakout from a reverse head and shoulders pattern. Partial confirmation is being offered by the violation of  the red dashed up trend line, but a stronger, more reliable indication of failure would come from a break in the longer red dashed line at  $23.60.

Chart 8

In conclusion, the CRB Composite stands ready to move above key long-term resistance. However, weakness in equity market inflation/deflation relationships, combined with an overbought short-term condition, conspire to prevent an immediate breakout. If one is to take place, these factors suggest that it will happen later rather than sooner.

Good luck and good charting,
Martin J. Pring

The views expressed in this article are those of the author and do not necessarily reflect the position or opinion of Pring Turner Capital Group of Walnut Creek or its affiliates.