JPMorgan Chase & Co. strategists believe that the selling in resource sectors is only just getting started and considerable downside remains – in the near term – as bullish speculative positions are unwound.
Nikolaos Panigirtzoglou is the Britain-based managing director of global market strategy for JPMorgan. Mr. Panigirtzoglou has been warning clients about excessively bullish positioning in commodity-related futures markets because the reversal of this optimism will put significant downward pressure on commodity prices.
In a Friday report called "Commodity Downside" he wrote: "We believe that the normalization of commodity futures positions is far from completed as the level of spec positions remains rather elevated even after [last] week's big move."
The strategist pointed to energy and precious-metals futures to support this claim. The top chart (above) shows speculative positioning in West Texas intermediate crude, which is extremely stretched despite a small decrease in optimism last week.
Since Feb. 19, 2016, the non-commercial net futures positioning – the number of bullish futures bets on oil, minus bearish investments by hedge funds and other managed assets – has increased by 220 per cent while the commodity price climbed a much smaller 64 per cent. Net futures positioning is now more bullish than the 2014 peak when crude traded well above $100 (U.S.) a barrel.
The theme of aggressive bullishness extends to silver markets, which JPMorgan describes as "very overbought." As indicated on the second chart, hedge-fund managers have pushed the net bullish futures position on silver higher by 12 times since July, 2015, while the commodity price has remained range-bound between $15 and $20 an ounce.
Mr. Panigirtzoglou's report noted the important role played by a type of managed futures fund called commodity trading advisers (CTAs). These are predominantly automated products – trading decisions are made by software – that make up roughly 11 per cent of the $3-trillion hedge-fund industry in the United States.
CTA trading strategies are largely based on price momentum, meaning they buy when commodity markets are rising and sell when resource prices turn lower.
The strategist wrote, "mean reversion [in speculation levels] is primarily driven by active investors such as hedge funds and in particular CTAs … momentum trading models suggest that CTAs are turning incrementally more negative."
Bullish futures trades can only be removed from the market by a new offsetting bearish position.
For this reason, some resource prices are likely to see considerable weakness in the near future as optimism returns to more normal levels.
The silver lining for investors here is that these price adjustments are technical in nature – based more on large, fast-money portfolios getting caught offside and scrambling to cover their bets – than a reflection of fundamental supply and demand factors.
Once these portfolios have reallocated, fundamental factors should again become the primary mover of commodity prices.