Killing me “softly”…

The title of this post reflects what an investor in “Softs” (i.e. Sugar, Coffee, Cocoa, Cotton and Orange Juice. There’s also Lumber, but it has been on a tear and is very likely close to a major top connected with the housing cycle.) might be thinking of his holdings right now…A lot of nothing/nowhere action with a slight downward bias that wears out the vast majority of market players. This might ring a bell with gold bugs as well…
Of course, we as contrarians are delighted to see this kind of action, since more often than not it accompanies major bottoms (we are obviously also humans, so we’re also bored out of our skulls and frustrated by this indecisiveness like everybody else). This is particularly true when strongly favourable fundamental conditions are present as well, as is the case with Sugar.
The objective of this post is to detail the main reasons why we think the delicious and addictive white powder (the folks at the D.E.A. need not worry…) is ripe for a major multi-year bull run that has the potential to bring it back towards its old all-time highs in the 40 to 60c$/pound region. As a general rule, we do not like to make predictions or give price targets, as we think that this is often an exercise in futility, but in this case we want to point out our strong conviction that the coming bull market in Sugar is bound to take out the interim high established in 2011 around 36c$/pound.
And now, without further ado, let’s see what’s brewing in the market…

The Fundamental Backdrop

A) Economics 101

It’s often said that “The cure for low prices is low prices” and indeed this statement is correct. The main problem lies in determining whether a certain price is sufficiently “low” to put the supply/demand adjustment process in motion. With regard to sugar the reality is that very few people involved in the global supply chain (from growers to mills in different countries) can turn a profit with a price of 18c$/pound (of course we’re not oblivious to the fact that in most countries sugar is a very heavily subsidized commodity: it’s simply not relevant to our discussion). So yes, it’s low enough: let’s then see how this impacts the market on both sides.

1. Demand

It should be obvious that a low price generally entices demand, both new and old. Current users of the product/commodity can increase their usage of the product without suffering an increase in costs, whilst users of similar products/commodities (like HFCS in the case of sugar) may find it’s economically advantageous to engage at least in partial substitution. Finally, new sources of demand that didn’t exist before may be created altogether.

2. Supply

On the other hand, producers of the commodity have no incentive to increase production and in fact may even be forced to cut it. Moreover, they’ll strive to find new, alternative uses for their products which can either provide a greater margin or at least partially absorb their surplus (this is happening with bio fuel in Brazil).
Readers interested in exploring the subject, can take a look here, here and here.

B) The Bizarre Case of Chinese Buying

This point is partially related to the one above: whenever sugar prices reach the 18c$/pound area, Chinese buyers step in and take delivery of large quantities of sugar. The reason is quite simple: producing sugar there costs about 30s$/pound and out-of-quota imports are subject to a 50% tariff, so 18c$ + a 9c$ tariff + some spare change for shipping and handling < 30c$ = a nice, risk-free profit for the importer. There are talks of restricting the ability of importers to engage in this arbitrage play, but so far nothing meaningful has been done, thus the market enjoys a strong floor at this level.
See here and here.

C) The Brazilian Milling Industry and its woes

This point really is the most important one. Brazil is both the largest producer and the largest exporter of sugar. Troubles there mean troubles for the world sugar market.
And in the Brazilian milling industry big troubles are looming on the horizon. Actually, they’re already there and getting worse by the day. Let us explain: it all started many years ago, at the beginning of the last decade, when mills embarked on ambitious expansion projects in a race to gain market share, building new facilities and upgrading existing ones. How did they finance such heavy investments? By taking on huge debts, of course: after all, those were the credit bubble years…
In 2008, problems started to surface: the financial crisis hit and numerous mills all of a sudden found out that they were struggling with debt servicing. Some of them went bust or were forced to sell their operations to more financially sound multinationals. Many just kept on going in the hope that things would somehow get better. Fast forward to today and we have low sugar prices, rising costs, rampant overcapacity and plenty of nearly-insolvent mills: instead of getting better, things actually got a whole lot worse.
The main issue is that fixed costs (like e.g. the amortization of plants and equipment) account for the vast majority of mills’ costs and, in order to reduce their unitary cost of production, mills need to operate at or close to full capacity. Unfortunately, overcapacity is so huge that even bumper crops aren’t enough to satisfy the mills’ needs. The end result is that mills are forced to compete between them for cane to process, thus further driving up their input prices. To add insult to injury, a sugar price of 18c$ basically ensures that the vast majority of mills will be selling their product at a loss, further exacerbating their already precarious situation. Of course, even the most efficient ones, capable of turning a profit at the current low prices, won’t be drinking Pétrus to celebrate: their margins are razor-thin.
To us this means only one thing: either prices will have to go up a lot on their own for some exogenous reason, thus allowing mills to regain their financial footing (prices of 20/25c$ won’t make any substantial difference), or they will go up much more as a result of a wave of bankruptcies amongst mills which will bring about a marked reduction in the available supply of sugar. This is not something that is going to happen overnight: our best guess is that it will take approximately 2 to 3 years to bring this problem to the forefront. Obviously a new financial crisis/globalized recession could accelerate the process markedly. Regardless, we have no problem waiting, particularly given that we believe the downside to be severely limited.
Here, here, here and here readers can find additional information.

D) India: a complete mess

If trouble is brewing in Brazil, then what about India, which is the second largest producer and the biggest consumer of sugar?
The situation there is messy, and this is a euphemism. Why is it so? Thanks to heavy government meddling. We won’t delve into the details: we have already bored ourselves to death with them and we do not want to inflict the same punishment on our readers. We’ll keep it short and say that in India sugar production pretty much equals consumption. There has been a surplus in the last couple of years, but our impression is that this is more the temporary result of a series of favourable phenomena than the product of careful long-term planning that is here to stay. As such, we think it’s very likely that India will at some point in the next 2 to 3 years be forced to import rather large amounts of sugar. The last time this happened prices rallied handsomely. Masochistic readers can have fun here, here, here and especially here. There are many other sources of info on the web, but the main takeaway is always that self-defeating “Fair and Remunerative Price” policies, coupled with other idiotic rules and regulations, do not allow the sugar industry to develop and thus leave it vulnerable to a few-years-long boom-bust cycle and to the occasional drought/whether catastrophe.

Technicals, Sentiment and Positioning

The technical picture looks constructive and sentiment and positioning data lend credence to its validity.

Chart of Sugar via http://stockcharts.com/.

The market continues to be stuck in a “falling wedge” consolidation pattern, which is bullish. The recent breakdown below the lower trend line (and below the important level of support around 18c$) appears to us to have been a classic “bear trap”. Price has now rallied convincingly and is back into the pattern and above the 50-day simple moving average, which has acted as strong resistance in the recent past. Further levels of resistance can be identified around 19c$ and 20c$. Both MACD and RSI show positive divergences, with the latter having broke out of a triangular consolidation and above the level of 50.

Sentiment remains subdued and below neutrality, something which has pretty much been the rule since late 2011. CoT data are very bullish, with commercials continuing to hold a small net long position (like in 2007, just before a major bull was born).

CoT data via http://cotpricecharts.com/.

Conclusion

The sugar market continues to be very attractive. In fact, we think it currently offers one of the best risk-reward propositions available to long-term investors. We have bought it quite heavily in the recent months and we remain convinced that it has the potential to generate a very profitable multi-year bull market. Patience is of course always required, as it might continue to consolidate for a while more. What really matters is that we do not envision serious downside (i.e. we really doubt it would ever make it to 16 or even 15c$ as some analysts speculate). A powerful breakout above some key resistance levels might have us buying even more, but this time around with strict trader’s discipline (i.e. with a tight stop loss in case things do not go as planned).
A unrelated note: we’ve only made sparse updates to the blog recently and we haven’t produced any major articles (even this one is rather brief by our standards), because we’ve been quite busy following markets during the recent PMs turmoil and more importantly because we’re packing up for a very nice trip to the Seychelles, only slightly spoiled by the fact that we do not enjoy flying very much, to put it mildly. We’ll of course publish some photos of the trip, assuming we'll survive… The goal is obviously to cause some serious liver damage in over-worked readers currently stuck in their cubicles with no hope of breaking free before the summer (we are of course just joking).
As such, in the next two weeks readers can expect only occasional posts from us, which we’ll publish only in case there’s something going on in the markets which requires our attention.

Putting even more on…

Just a brief post to inform our readers that we’re adding to our silver holdings. We saw a decent washout on the 1st of March that might have marked the low. Even if it turns out that it hasn’t, sentiment and positioning (plus strong support in the 27.50$/oz. area) have us thinking that the downside is limited.
We also want to mention en passant that today’s action in miners looks promising: a nice reversal on large volume. Given how oversold they are, this strikes us as a good entry point. We do however remain convinced that outright ownership of precious metals is the way to go in this (and every other) bull market: mining companies may act as leveraged proxies from time to time (and this is likely one of those), but they can’t offer the safety and returns of the actual physical stuff.
As usual, do your own research.

Miscellanea

The objective of this post is to provide our readers with a quick update on the markets we have covered thus far, while waiting for our next major post, which will cover the precious metals market.

Stocks

The S&P 500 has advanced less than 4% since our post on the coming bear market, but judging from the bullish noises made by various pundits and commentators you’d tell it has doubled. CNBC has even put on their screens a “countdown window” measuring the distance between the current Dow level and the all time highs.

From a fundamental perspective, the recent data releases have confirmed what we’ve long been thinking: the global economy is at best growing at a very mild pace, but most likely it is in the first phases of a contraction. Europe is undoubtedly in a recession, no matter how desperately talking heads try to positively spin the data: the recent Markit PMIs were supposedly a success, since the pace of contraction eased a little…big deal! Not to mention the fact that France is falling fast into the grave Monsieur Hollande has been so busy digging since coming to power. European retail sales were also disastrous (no surprise here for those who understand the specular concepts of overconsumption during the boom periods and forced savings during the bust). China is showing a lacklustre “recovery” (we’d prefer to call it: “short-lived rebound artificially engineered by means of inflation”), as evidenced by the latest PMI readings. Japan continues to be stuck in a recession, with the only difference being that now companies face additional pressures on their margins, given that a weaker Yen has pushed up their input costs, while their output prices continue to fall amid strong competition and a lack of demand for their products: they can of course thank Shinzo Ape (no, it’s not a typo) for this one. The US economy is also sending more than a few warning signals (and we are not referring to the meaningless GDP) and is in desperate need of a recession to correct and liquidate all the malinvestments engendered by the Mad-Hatter-in-chief Bernanke. It seems likely to us that much of the positive surprises in data recently released are due to the already high and recently accelerating rate of inflation, which furthers the aforementioned malinvestments. Moreover, earnings and revenue growth have at least stalled, but our suspicion is that they’ve started reverting to the mean: after all, many companies have issued negative guidance, either for the year or the quarter.

Technically, the stock market remains very overbought and ripe for a correction. Bullish sentiment and complacency have reached new extremes and many sentiment and positioning measures are now well into their danger zones (e.g. NAAIM Survey, Investor Intelligence, AAII, Rydex Fund flows and positioning, Hulbert Survey etc.). In short: the retail investor is back, eagerly waiting to get fleeced again.

We’re willing to make a wager here: we think that the actual top is less than 5% away (i.e. we think the S&P won’t surpass 1575, much to the chagrin of CNBC). Timing-wise, the prediction is a more difficult one to make: we may be two weeks or two months away from a top. It will all depend on how the stock market behaves: given that it’s already very overbought, if it were to rise fast towards the all-time highs, it’d probably mean a top is in; however, if it were to correct a little and then resume it’s advance, then we’d be looking at a longer topping process that could drag out until March or April. In any case these are just exercises in futility: what really matters is that we are convinced a top is near and we’re committed to the short side, as this is were the best risk/return proposition lies. To all the bulls pressing us to buy we can only say: “After you, my dear Alphonse”.

Yen

This is were things really get interesting! The Yen is as oversold as it has ever been, with e.g. the EURJPY cross stretched more than 22% above it’s 200-day simple moving average, something almost unheard of for a major currency pair like the EURJPY, which only happened before during the 2008 panic, for strong fundamental reasons to boot. But we’ve discovered a little something that might turn the bears dreams into nightmares… We’ve already commented about the usual strategy employed by the BoJ (to say a lot and then do a little) and it appears that this time they’ve really surpassed themselves!

The details are as follows: the BoJ recently announced ¥13 trillion of monthly purchases of JGBs and T-Bills starting in 2014, but what has apparently gone unnoticed to the hordes of excited bears is that these purchases are gross (i.e. they include rollovers, that is purchases made to reinvest the proceeds of redeemed securities). Net purchases (which are made with newly printed money), on the other hand, won’t amount to more than ¥10 trillion per year, that is more than 10 times less than advertised (as a basis for comparison, consider that current monthly purchases amount to ¥3 trillion).

Now this is a remarkable sleight of hand! They’ve fooled pretty much everybody into thinking they’re going kamikaze, when in reality they’re going to print one tenth of what they claimed and one third of what they already print. We think that such an achievement might warrant an entry in the Urban Dictionary: “to pull off a Japanese”. Derren Brown stands in awe.

Of course market participants can continue to ignore reality for longer than it appears humanly possible, nonetheless with sentiment in the dumps, more and more stories pointing to the resurgence of the carry trade and extreme CoT readings we remain convinced that the Yen is going to revert to the mean and then some. It appears increasingly likely, though, that this will happen in concomitance with the decline of the stock market, exactly as in 2007: patience is advised.

Softs

Sugar is behaving in a rather bullish manner: after washing out some more weak hands with a new low on 23/01, it immediately reversed up on huge volume and then proceeded to play a new trick on bulls, staging a high-volume reversal to the downside on 29/01 and then going through a very volatile range on 30/01, before resuming its march higher over the next two days before closing the week on a mixed note. Price now sits right just below the 19c$ level and the 50-day simple moving average and both have acted as strong resistance in the past. We suspect however that an upside breakout is imminent, not least because the recent CoT reports showed commercials going net long for the first time since 2007. Sentiment remains subdued, increasing the likelihood of positive surprises.

Coffee on the other hand is showing weaker behaviour: after an initial follow-through from its break out level, it plunged right back to the 50-day moving average and then after a couple of days moved below it. It now stands again just below this key average, with favourable sentiment and CoT readings. We continue to remain bullish, but this latest development forces us to consider the possibility that the bottoming process is not yet finished and that as such further volatile spikes and corrections could occur.

A Technical Interlude

What’s better than starting the week sipping a nice cup of espresso, carefully sweetened by the addition of some sugar [Ed. Note: we actually like our coffee as it is and think that sugaring it should be made an offence punishable by death.]? Starting the week buying some coffee and sugar futures, that’s what!

With this post, we will provide a brief technical summary of these two markets, which in our opinion may be ripe for a buy. We won’t address their fundamental backdrop: suffice it to say that from a mid-to-long-term perspective we’re very bullish on sugar whilst we have mixed feelings on coffee. As a matter of fact, we’re convinced that sugar has not yet made its bull market high (i.e. we expect it to go higher than the 35c$/lb level reached at the beginning of 2011). Coffee on the other hand may have already had its blow-off top in May of 2011. Moreover the technical position of the former appears to us stronger than that of the latter. Finally, secular bear markets in equities tend to coincide with secular bull markets in the whole commodities complex (as opposed to specific, strictly supply/demand-driven cyclical bulls in single markets or sectors, which can happen at any time). You can peruse our post on stocks to better understand our perspective on this last topic.

Sugar

A daily chart of the sugar price, constructed using Stockcharts.

As we can see in the chart above, sugar has been constrained in a “falling wedge” pattern since its early 2011 top. This pattern tends to be resolved to the upside (i.e. it’s a bullish pattern). It’s important to consider that this current pattern represents a meaningful long-term development, given that sugar has been stuck in a rather brutal (-50% peak-to-current-trough) and persistent (two years and running) bear market. This fact also increases the likelihood that a significant bottom is either behind us (we are inclined to think that the 13/12/2012 wash-out low around 18.30c$ indeed marked such turning point) or just in front of us: as already stated, this is for us of utmost concern, as we always strive to enter positions at a time when we think that the actual risk is significantly smaller (and way less likely to manifest itself) than the potential return.
Zooming in on recent action, we can notice that significant momentum divergences started to emerge approximately six months ago and continued to increase during recent declines, reinforcing our view that there simply isn’t any meaningful selling pressure left in the market. Both the CFTC Commitments of Traders data and Sentimentrader’s sentiment survey seem to confirm this assumption. Except for a couple of short-lived spikes, the latter has been oscillating in the 25% to 50% zone for more than a year: this means that for a protracted period of time very few participants have been bullish on this market and the few that have have also been quick to become bearish at the first signs of trouble. Anecdotal evidence (i.e. news headlines) confirms an entrenched bearish mindset. The former (chart below) have registered a consistently low level of speculative longs (and a consequently low level of commercials’ shorts) since the end of this summer, recently reaching rather extreme readings (with small speculators’ shorts at record levels and large speculators’ and commercials’ positioning at opposite multi-year extremes). It’s worth noting that previous instances where market participants were similarly positioned gave rise at least to powerful rallies (see May 2012 as a case in point, although that period’s readings pale in comparison to the current ones). It is precisely this kind of prolonged despondency that generates new, powerful bull markets.

2012 Commitments of Traders data via http://www.cotpricecharts.com.

Finally, we can notice how price has been recently capped in its advances by the 50-day simple moving average, which also provided important support or resistance in the past. Although we’re already long sugar and are holding it as a long-term investment in our portfolio, the more technically inclined amongst our readers might want to wait for a convincing breakthrough above that level before committing to the long side. The previously mentioned low might act as a reasonable stop-loss level. A break-out above the important 20c$ level might also prove to be a good entry or adding point. However this is not really our cup of tea: we employ a different approach to risk management and to investing in general, but to each his own.

Coffee

As we already mentioned, we have a few reservations about coffee, but they’re mainly confined to the realm of the long-term. From a short-to-medium-term technical perspective this market seems to us to offer an excellent trading opportunity.

 A daily chart of coffee constructed using Stockcharts.

As can be clearly noticed, many of the considerations made for sugar apply to coffee as well: a long-term falling wedge pattern (not as nice as the previous one though) accompanied by meaningful divergences in momentum. Sentiment and positioning also paint a bullish picture: the survey on coffee has recently registered a depressed reading of 15% bulls (currently 26%), after having been stuck in the below-50% zone since late 2011 (with this summer’s rally constituting the only exception). Positioning is also at extremes, with commercials holding a record amount of longs and large speculators providing the mirror image with a record amount of shorts. Small speculators are in a no-man’s land, meaning they aren’t overly exposed to either side of the market. More details can be found in the chart below:

2012 CoT data for coffee via  http://www.cotpricecharts.com.

Again, it’s worth noting that a prolonged period of extreme readings usually produces a much more powerful and lasting trend than an episodic spike.

There is however something very important that differentiates coffee from sugar: the former has already broken above and rallied from its 50-day simple moving average and did so on a Friday (last one, to be precise) and with very convincing volume. Both of these are meaningful details: a powerful Friday break-out with a convincing close at the highs positively shapes the weekly chart and signals a strong commitment on the part of position traders (those willing to take their bets home with them for the weekend). It also signifies that all contracts that were sold during the week were actually sold at a lower price: this is bound to put significant pressure on many short-sellers and usually ensures at least a temporary follow through. And now enter volume: Friday’s volume on the March13 contract (the one currently traded) was the highest since rollover day (i.e. since the beginning of active trading). More importantly, it was higher than any previous down-day volume registered during the life of the contract (including both active and non-active periods). This not only shows the sheer buying pressure, but coupled with the surge from the 50-day SMA, over-qualifies Friday as a “pocket pivot buy point”. This is a concept developed by Chris Kacher and Gil Morales in their let’s-not-brag-about-our-successes book entitled “Trade like an O’Neil disciple (How we made 18,000% in the stock market)”: in the context of basing/bottoming patterns sudden, unexpected surges from or above important resistance levels or moving averages, accompanied by volume that is greater than the highest volume registered during the 10 previous down-days, often signal important changes in a market’s character and anticipate successful break-outs from the aforementioned patterns [Ed. Note: although we have more than a few reservations about the Authors and their work, editorial and not, and our investing style is as far removed from theirs as possible, we found this specific concept to offer value and we do have included it in our arsenal to our satisfaction.].

All of the above combines in making us think that coffee is a good buy at current levels, at least for the short-to-medium term. Technical traders might effectively manage their risk by placing their stop-losses either below Friday’s low/the 50-day SMA or somewhere around the recent 149/143c$ congestion area (the recent low at about 141.20c$ appears to distant to us).

Conclusion

We’re bullish on both sugar and coffee, although we do favor the former, at least from a long-term perspective. We’re walking the talk by actually being long both markets, but we want to stress that for us these represent rather small positions opened with the main purpose of diversifying our portfolio and keeping it well balanced. They offer good potential, but they also offer risks and more importantly plenty of volatility, hence they are not good candidates for a large exposure. Again, we recommend readers to embark on their own research and to always fully “own” their trading decisions: the best way to escape from losses is not to escape from responsibility.