The investment community was anxiously awaiting Friday’s employment report. Would it show a pickup in hiring in January, making December’s abysmal numbers seem like an aberration? Or would it confirm a pattern of weakness? Unfortunately for the U.S. economy, it was the latter.
Almost immediately, equity prices shot up on the assumption that the data would cause the Federal Reserve to re-assess the strategy of tapering its monthly bond-buying program. It’s the old belief that bad news for the economy is good news for stocks, which represents a fundamental disconnect between Main Street and Wall Street.
The disconnect has become commonplace, so it was no surprise to see stocks rally on Friday. But the reaction in commodities was surprising.
A Counterintuitive Rally
Normally, a lackluster jobs report, combined with general weakness in the global economy, would suggest reduced demand for commodities, and cause a drop in prices. But instead, crude oil skyrocketed to over $100 per barrel, and gasoline shot up by 7 cents in response.
|Watch the U.S. dollar for a sign on the direction of commodities.|
Not what a struggling economy needs.
That reaction may be partially due to hot, dry weather in Brazil, but it’s not nearly enough to explain the size of the move. The fact is, the rally was mainly caused by hedge funds, which are covering short sales across a large number of commodity markets and going long.
They seem to think that the economic weakness will make the Fed reluctant to continue tapering, thus putting downside pressure on the U.S. dollar, which in turn will prompt higher prices in contra-dollar assets such as commodities. But frankly, I just don’t understand this line of thinking.
We’ve been down this road before, and we’ve seen that even when quantitative-easing programs are proceeding full speed ahead, that liquidity does not necessarily make its way into the broader economy. But I guess old habits die hard.
Programming Trumps Strategy
Perhaps the reason I don’t understand the hedge funds’ strategy is because it’s not really a strategy at all — it’s simply a computer algorithm. Right now, hedge fund computers are buying across the sector, and they’ll keep buying until the market stops going higher. At that point, they’ll sell until the market stops going lower, then reverse again. And so on.
There’s no thinking involved — just computers reacting to movements in price. The machines are driving the markets. Sometimes there’s an underpinning of fundamental reality woven into the distortion field created by the computers. But many times, there is not.
That’s why trying to come up with an explanation for why prices are doing what they are doing is often an enormous waste of time and mental energy.
Dollar Gets Pulled In
Generally, strength in commodities and weakness in the U.S. dollar go hand-in-hand. [Chart 1: Please put a thin black border around this chart.]
The U.S. Dollar Index declined from mid-summer into October. Since then, it has trended gradually higher, recently hitting 81.40 before retreating again. The greenback has been dropping for most of this month, but it’s still effectively unchanged since the beginning of the year.
However, we have not yet seen a clear, sustained breach of the dollar’s downside support, so it would be premature so say this is the beginning of a new downtrend. Until now, nascent downtrends have been halted with large bouts of short-covering. But on the other hand, the fundamentals are not bullish enough to warrant strong uptrends. The result has been a volatile market.
In fact, this type of trading, in both currencies and commodities, looks to me like the kind of whipsaw pattern that is notorious for its merciless toll on investors. For trend followers like me, trending markets are our bread and butter, while sideways markets are extremely perilous.
So your best bet this month is to stay nimble and watch the U.S. dollar. If it goes down, commodities should go up, and vice versa.