Follow the Market Makers - Not the Chasers

This year’s corn market provides a textbook example of the accumulation and distribution of positions throughout a market’s trend as well as identifying the strengths and weaknesses of the market’s primary participants. We’ll use empirical data to reveal why the Commodity Index Funds have little impact on the markets major moves as well as which trading group does move the market and finally, who comes up with the short straw when the market turns.

The corn futures market began the year with talk of steady to lower prices throughout the year. We commented ourselves in early April that this was going to be a, “Buy beans, sell corn” kind of year. Our expectations weren’t based on rocket science. The early planting intentions called for record acreage and the beautiful spring weather accommodated the seeding process. These factors kept the price of corn in check between $5.50 and $6.50 per bushel. This also matched the USDA’s crop insurance price threshold of $5.68 per bushel for the 2012 marketing year.

The corn market has two strong seasonal periods.  The first is planting time. There is always fear that the crop won’t get in the ground and therefore, limit the year’s crop. Small speculators and end line users of corn tend to bid up early prices. Speculators hope that this the drought year and they finally hit a home run while end line users hope to lock in the year’s input prices in the production of cereals and chips. The early seasonal attempts to rally were cut short by commercial traders hedging their crop above $6.25 while hoping to lock in trend line yields around 160 bushels per acre. This would’ve generated about $1,000 per acre. 

The mild spring finally flushed out the small speculators as prices made new lows for the year by the end of May, around $5.50 per bushel. The commercial hedgers then began to cover the hedge positions they had placed above $6.35 per bushel. This represented a cash gain of more than 12% to the supply side commercial traders. The decline brought prices down to the low end of the year’s forecast. At this point aggregate global demand for 2012 put a fundamental floor under prices. 

Corn buying from commercial producers and Commodity Index Funds took place in waves. This also represents the low point for small speculator positions as they had been forced out of the market on the April-May decline.

The June 12th USDA Supply and Demand Report was the first evidence that spring’s early plantings were wilting in the heat of May and June. The market pushed to new highs by June 26th. The rally provided a definite shift in mentality. Traders were now in the classic, “accumulation phase” of the market. This is characterized by rising open interest and new highs in price. This shows that the market is welcoming new participants who are happy to enter – even at all time high prices.

Commodity Index Fund position changes are tied very closely to the accumulation and distribution processes of the market. Commodity Index Funds are forced to maintain a percentage allocation stated in their prospectus. Therefore, as the market climbs, they are forced to buy more while they are forced to sell as the market declines. The net result is that Commodity Index Funds will raise the floor price of a commodity as they venture into a new market and establish their position. However, once their position is established, their position management only affects the speed with which the market moves, not the final prices. Thus, Commodity Index Funds may only be guilty of increasing the volatility of a market as they add or, shed positions accordingly. Throughout this summer, the number of contracts they’ve held has remained within 4% of their starting point. Their value, on the other hand has fluctuated by more than 20% as the market has rallied.

Finally, the market has stabilized between $7.75 and $8.40 per bushel. The decline in volatility over the last six weeks has brought the retail traders back to the game. Just like clockwork, we can see that the small traders are purchasing their contracts from the commercial traders. Commercial traders have shed about 27% of their total position over the last month while small speculators have increased their positions by 25.5%. This is the classic distribution pattern as those who’ve ridden the trend take profits by selling their positions out to the small speculators. The small speculators will be left holding the hot potato and will be burnt at the top of this market just like they were at the bottom in April and May.

The likely outcome is that the corn market will fall through the support it has built up around $7.75. This will likely trigger the exit for most small speculators. The fall may be swift as Commodity Index Funds shed contracts to maintain their portfolio balance. Finally, the commercial traders will be waiting as ready buyers who will now cover the short positions they’ve initiated over the last month between $7.75 and $8.40 per bushel.


This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.


 
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