Dead cat bounce or time for bargain hunting?

At the start of last week, metal markets recovered from the sell-off in commodity markets. It is not an unusual behavior that markets rebound after a preceding plunge. This phenomenon is called a dead cat bounce. Those moves are only for extremely short-term long trades because markets are quickly returning back to the low, from which the bounce started. Often markets even fall further to fresh lows. Thus, a dead cat bounce is rather an opportunity to set-up short trades then a buying opportunity for traders holding a position for more than one trading session.

On the other hand, if panic caused the plunge and the market overshoot to the downside then it often presents an opportunity for bargain hunting. Once investors and traders analyze the market fundamentals soberly, they come to the conclusion that valuations of the market are extremely cheap and offer a buying opportunity.

Therefore, deciding whether it is time for bargain hunting or to use rebounds for going short requires an analysis of what caused the sell-off at the beginning of this month. Some commentators called the recent plunge of commodity markets a flash crash. Indeed, at a first glance, one might come to this conclusion. We fully agree that markets overreacted on the ECB press conference. As pointed out last week, it was not very rational to expect another ECB rate hike already in June. Also comments from ECB council members made it clear that the market misunderstood the message. Further rate hikes are likely to follow. And a one month delay really does not make a big difference.

However, we do not regard the current situation as a good buying opportunity for commodities. We disagree with Goldman Sachs commodity analysts this time, while we agreed when they recommended taking profits. Beside a panic reaction on the not as hawkish as expected ECB press conference, also the fundamentals – or at least how they are perceived - have changed.

After the report on Spiegel-online, the web-site of a German weekly magazine, about a secret meeting of some eurozone finance ministers and Greece leaving the euro, the nervousness of investors about a Greek default has risen again. Even after the finance ministers made it clear that Greece can not leave the eurozone and also Greece denied any intention to abandon the euro for a “new drachma”, some German professors regard this as unavoidable. They also demand Greece to declare default rather sooner than later. No wonder that S&P downgraded Greece by two notches to B- with outlook negative after this report at Spiegel-online. Also opposition within German government coalition parties against financial aid for Portugal, the creation of the EFS and further help for Greece is increasing. As it seems currently, the coalition is no majority in the lower house to push through legislation on eurozone bail-outs. Thus, the risk-aversion for the euro has risen last week and this is reflected by euro weakness against the US dollar, which is a negative fundamental factor for metal markets.

Chinese commodity consumers behave according to the Baumol model of inventory holding. As the Chinese central bank hiked interest rates and increased minimum reserve requirements several times, the higher funding costs for inventory holding have risen. Therefore, Chinese metal consumers reduce the inventories and also import less. The decline of imports is widely regards as a sign of slower economic activity in China. The summer season is also a period of normally lower import volumes. This could lead to further fears of a global economic slow-down.

The stock markets have recovered from the plunge following the unrest in the MENA region and the earthquake in Japan with all its negative consequences. However, the rise of US equity markets since late August last year was driven by the announcement of QE2. Next month, the Fed will terminate QE2 as scheduled. This does not necessarily lead to a correction in stock markets. However, even if the US (and also the European) equity markets consolidate at a high plateau, the year-over-year percentage change is probably going to decline. The performance of the US stock market is also highly correlated with the ISM index. Thus, lower yoy-performance of the S&P 500 is likely to be accompanied by a declining ISM Index. This would be a negative for metal markets over the summer months.

All in all, we conclude that there is currently a mix of overreaction triggered by the ECB press conference as well as a cloudier fundamental outlook. Thus, we would recommend bargain hunters to keep the powder try.