Deconstructing Fundamentals

The ever-growing world of social media brings new acquaintances almost every day, acquaintances who don't hesitate to ask me what I mean when I comment that "commercial buying is driving markets higher" or "a lack of commercial support has markets vulnerable to increased pressure." With that in mind, I want to go over a couple examples of how market structure gives us clear signals of what supply and demand may actually be, and how those markets can react.

If we take the study of fundamentals, supply and demand, down to its foundations we find clues as to what holds markets together. (By stevendamron (CC BY-SA 2.0)

To begin with, what is market structure? In my analysis, I look at markets as having two sides. The first is the noncommercial one, consisting of investment traders, speculators, funds, etc. This group's influence is caused by the flow of money into or out of a market, action that tends to set the price direction over time -- trend -- of the futures market that can be easily read on daily, weekly or monthly charts.

The other side of a market's structure is the commercial side. This group is made up of interests that are actually involved in the trade of the underlying cash commodity of a particular market (e.g. grain exporter, feedlot operator, petroleum refinery, etc.). Their view of supply and demand is indicated by the changing price differences between contracts of a particular commodity, otherwise known as futures spreads.

For instance, if commercial traders are comfortable with supplies available to meet demand, there is no need to push nearby prices higher, resulting in higher prices for deferred contracts. This price relationship, called carry or contango, reflects the idea that commercial traders don't need supplies now, so will pay more later for the owner to continue to hold the commodity. On the other hand, if nearby futures are priced above deferred contracts, commercial traders need supplies to meet demand, and therefore are willing to pay more now rather than later. As with noncommercial action, stringing days or weeks of these price changes between contracts results in a trend that indicates whether or not commercial traders are growing more or less bullish or bearish over time.

Markets continue to evolve, and a big bang moment in commodities occurred in 2006 when rules were changed that allowed noncommercial traders to basically double the size of their holdings. The resulting surge in trading interest led to a possible problem when discussing market structure: Would spreads be skewed by increased activity in certain contracts? The answer is yes, but there is a filter we can run the market's view of supply and demand through to either confirm or disprove what is being seen in spreads.

Basis is the price differential between the cash market and the futures market. It is useful as the base of understanding for a number of market nuances, including the existence of market bubbles and actual supply and demand. For this discussion, if basis is strong in conjunction with futures spreads that show a bullish commercial outlook, then the actual fundamentals are most likely bullish. However, if basis is weak while a futures market is rallying, bad things can happen to those who look for the bullish trend to continue.

Last Friday was the Grand Poobah of report days, with the release of a number of USDA reports ranging from "final" 2012-2013 production to quarterly stocks. As discussed in last week's column "If Not For," the corn market was indicating a bullish commercial outlook before the release of the reports through the uptrend in the futures spreads (the March contract was near par to the May contract) and a strong national average basis (DTN National Corn Index minus the nearby futures contract). Lo and behold, quarterly stocks of corn came in below expectations, as did both domestic and global ending stocks.

For months now, the nearby futures spread has indicated a bearish view of live cattle fundamentals. For much of the last year, the February contract has traded near the weakest levels seen over the last five years in relation to the April. Meanwhile, the futures market has traded near record highs, pulling away from the cash market, creating an increasingly weak basis. Given that both spreads and basis showed bearish fundamentals, the market just needed a reason to collapse. Hence, the hullabaloo when the Cargill story broke. (Cargill is closing its Plainview, Texas, beef processing plant.) As noncommercial traders raced to get out, there were no commercial traders willing to buy to slow the fall.This week, much attention has been paid to the meltdown in the live cattle market, culminating in contracts touching limit down Thursday after the release of a headline stating Cargill will idle one of its large beef processing plants in Texas. While jaws dropped as the market collapsed, those watching market indicators of supply and demand were less surprised.

The bottom line is this: We can see what the two sides are thinking about the market simply by watching the trend of the futures (noncommercial) and futures spreads (commercial). If we have a question about the latter, look at the differential between the futures market and cash market for clarification. And finally, if there is a difference in opinion between the two sides of the market, those betting with the commercial view tend to win.

Darin Newsom can be reached at darin.newsom@telventdtn.com

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