Finding a Bottom in the Coffee Market

The coffee market is what you’d call a professional traders market. It is a large and volatile contract, which leads to equity swings that are too large, even with a single contract for small traders to withstand. Furthermore, commercial traders dominate the market through their access to global information and deep pockets. The coffee futures market has been in decline since May of last year, losing half its value from the $3.08 per pound high. Even with the decline in volatility as the market has collapsed the average daily range over the last month is still nearly $.04 per pound which equals an average cash account fluctuation of $1,500 per day, per contract. Those wishing to participate in the coffee market without the use of leverage may want to look at the coffee Exchange Traded Fund – JO.

The May highs are a good place to start looking at the commercial traders’ forecasting ability in this market. The International Commodity Exchange in New York, formerly the New York Board of Trade held 1.6 million bags of coffee in their warehouses when the market made its high last year. Commercial traders sold into this rally and accumulated a net short position of more than 38,000 contracts. As you might expect, this left small and large speculators with their largest position of the rally, right at the top.

The next piece to look at is the Commitment of Traders Index. This is the most common tool used to measure the participation of the primary market participants; commercial traders, large speculators and small speculators. The index normalizes the total position to a 0-100 scale. Zero is the most bearish and 100 is the most bullish while crosses above 70 and below 30 indicate overbought and oversold levels and sets traders up with a trigger mechanism. This tool would have been of little use as the market declined since the index has been stuck above 70 for commercial traders since late September of last year as the commercial traders began buying to cover their short positions initiated last May.

This is why we analyze the raw data and scale it down to daily levels with appropriate stop loss placements. As a trader myself, I have to look for opportunities to maximize my time in the market and the less time I spend in the market, the less overnight or, news event risk I have to take on. We’ve picked up eight trades since last September using the daily method we publish with 6 of them being winners, including buying the June lows and selling the July highs.

Coffee hasn’t been this cheap since June of 2010. Coffee warehouse stocks at this time were 2.2 million bags and the commercial trader position was net long 26,000 contracts. Currently, warehouse stocks are 2.5 million bags but, more importantly, the commercial long position is now more than 56,000 contracts. This also sets a record in managed money short positions. Referring back to the 2010 lows, we saw the same situation without quite the levels of determination by the market’s participants and that imbalance led to a 13% rally in eight trading sessions and was worth $8,250 per contract.

I’m not suggesting that the market is immediately set to turn around and put $8,000 in anyone’s pocket by Christmas. I am suggesting that the coffee market is extremely oversold. The typical resolution to this market’s imbalances lies in favor of the commercial traders. Furthermore, any managed money in the futures market that has called for redemptions due to the pending tax changes will see their profitable positions offset. This could fuel some buying and get the ball rolling.

Finally, it’s important to track the markets’ players and keep track of the winners and losers. This requires a greater attention to detail than just a quick glance at a normalized index. Tracking the raw data for each trader category allows us to compare historical levels of trader involvement as well as tracking their movement relative to warehouse stocks to ascertain the degree of scarcity in a market.

We will be actively looking for opportunities to buy the coffee market and fully expect at least a tradable bottom being formed somewhere in the $1.40 – $1.50 range.

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.

The Stock Market Bounce is for Real

We published a sell signal for the S&P 500 in our October 4th article, “Who is Pushing the Stock Market.” Several fundamental and technical reasons were laid out. The fact that the market topped out the very next day and sold off by 9% in the last month leads me to believe that this decline may have run its course. The easy money on the sell side has been made and perhaps, we should start looking at the buy side of the market.

Separating the, “what happened” from the “why did it happen” is always tough. Throwing political variables like the election and the Euro crisis into the mix along with individual accommodations for the fiscal cliff and estate planning leaves us with very real macro and micro implications currently in play. We’ll take a brief look at these and see why the odds may be stacking up in favor of the buy side of the market.

The markets clearly viewed the election results in a negative light by selling off 6.3% in eight trading sessions. I think the markets were fully prepared for an Obama victory prior to the debates however Romney’s debate performance was just enough to make it a bit of a race. Therefore, investors chose to hold on through the election just in case Mitt pulled it off. Had Mitt won, we wouldn’t have seen the selling pressure. Obama’s victory guarantees higher taxes going forward. Therefore, many people are rebalancing their portfolios to take advantage of the tax laws as they stand in 2012. That answers some of the, “why” for the decline.

Commercial traders greeted the sell off in the markets with open arms. Traders in the Nasdaq and Dow Jones were major buyers, doubling their net long position in the Nasdaq and increasing their position in the Dow Jones by more than 50%. The major surge in commercial buying has pushed momentum back in favor of the bulls. Furthermore, combining the recent sell off with commercial trader buying has provided us with a Commitment of Traders buy signal. This is the methodology I presented at the World Traders Expo in Chicago last month.

Further bullish indicators focus on the extremely bearish sentiment of the trading public. Without getting into too much detail, many of the indicators that measure investor sentiment are exceptionally bearish. These readings typically mean the opposite is about to happen because the investing public typically does the exact opposite of what they should do. This one of the primary reasons we follow the commercial traders, rather than the small speculators.

Technically speaking, there are two key points. First of all, the sell off pushed us to a new three month low. Secondly, the about face reversal the market pulled provided indication of a major rejection of that low. The rally on the 19th was so strong that 90% of roughly 2,800 stocks traded on the NYSE closed higher. That kind of rally provides a statistically valid bottoming signal. Merrill Lynch was the first to capitalize on the statistical relevance stating that since 2006 there have been 1,733 trading days and this type of day has been observed only 62 times. The relevant pattern is that we should pause for a couple of days before resuming our climb through the 10, 20, 30 and 65 day moving averages which come in at 1372, 1388, 1404 and 1417 respectively.

One last piece of evidence of the rejection of the new three-month low made on the 16th is that the market immediately opened .5% higher and continued to climb another 1.5% for the day. The strong rally off the multi month low has only occurred 9 times since the Daily Sentiment Report has been tracking this and their research shows 7 of the 9 led to multi week bull runs. The two that didn’t pan out were both in the months following the tragic events of September 11th.

The sell off that we anticipated came to fruition however, I believe it’s much harder to turn around and buy the market when the media is so full of naysayers. To them, I would concede that not coming to an agreement on the fiscal cliff would send the stock market much lower. However, I believe that they will reach some type of settlement. The market will gyrate according to the most recent piece of news but ultimately it will climb higher. Finally, we cannot let sentiment overrule quantitative analysis. To ignore the facts would be choosing to live in ignorance.

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.

Tax Hikes We’ll All Feel

The election is over, the dust is settling and the economic landscape is coming into focus. The fiscal cliff and the Federal debt ceiling dominate the immediate foreground. Both of these issues come down to the business practices of revenues and expenditures.  However, since this is the government and not a business it will be subjected to gamesmanship and hyperbole as both political parties spin their solutions in an attempt to come out, “a winner.” Unfortunately, the reality is that regardless of the spin, you and I will end up paying more for the year that’s already past as well as the coming years.

The post election stock market selloff is no aberration. Wealth, for many has come through the ownership of equities. When it comes to the vast ownership of equities we can quickly narrow the demographic to investors who’ve chosen wisely over the years and benefitted from their patience in the market. However, the economic crisis of 2008 saw the equity markets halved in the blink of an eye. When global market uncertainty is combined with rising estate and capital gains taxes, its no wonder that investors are pulling money out of a stock market that has very nearly recovered to 2007 levels, especially when the rally appears to have run its own natural course.

The estate taxes and capital gains tax increases may seem a bit out of touch with the everyday person but the alternative minimum tax (AMT) is something that will affect more than 70% of U.S. tax payers, according to the New York Times. Here’s the real world perspective you need prepare for. The Washington Post stated that the average income tax refund is $3,000. The expansion of the AMT will levy taxes on individuals earning less than $200,000 and married couples earning less than $250,000. The cost as applied to the middle 20% of all earners will be $888. The net effect will be nearly a $4,000 adjustment to your lifestyle. Furthermore, there will be no tax refund. In fact, odds are you’ll have to pay more taxes instead.

The combined effects of the tax increases for the middle 20% of earners ($40k-$65k) will be an increase of about $2,000. However, it is important to understand that this is an additional pay in, on top of the tax refund you probably won’t receive. Therefore, the net change in your spending habits will have to account for about $4,000 less in 2013. The same numbers for the top 20% (more than $108k) is about a $14,000 difference.

The second part of the fiscal cliff is the debt ceiling. Most of us are now familiar with this term thanks to the political standoff last summer that brought about the first credit downgrade of U.S. Treasuries in history. The debt ceiling is currently set at $16.4 trillion Dollars. The argument over the debt ceiling is the same as our family deciding which bills to pay except, rather than laying out a course of action, the politicians simply ask the Treasury to print more money. These arguments are about funding the same programs that they already passed (but shouldn’t have) in the budget. Technically, if Congress doesn’t raise the debt ceiling then the government has to decide who gets paid and who doesn’t, just like the rest of us.

The debt ceiling has, historically, been a non-event. It has been raised 76 times since it was first enacted in 1962. However, the economic welfare of this country and its citizens is being held hostage by both political parties as they attempt to find a deal that works best for themselves individually, rather than us collectively. Currently, there is talk of forcing the U.S. off the fiscal cliff in order to gain a political advantage as one side blames the other. The sad part is that it really would come down to whom has the best spin-doctor to sell the U.S. population on their version of what happened. After all, it’s not like someone is going to stand up and take responsibility. I believe the reality is that the truth is usually somewhere in the middle and most decisions aren’t as black or white as they first appear. Therefore, very little will be done, just enough to keep us rolling. Alarmingly, that may be the biggest problem of all as we are tossed back and forth between Scylla and Charybdis.

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.

Winter Wheat Drought

The summer is over but drought fears continue to haunt the grain markets. The rain we never received this summer has turned into snow that we hope is coming. The corn and beans have long since been harvested but the U.S. winter wheat crop is the next grain market to be left high and dry while European wheat is left to drown in its own wealth of precipitation.

The USDA Crop Progress Report showed 39% of the U.S. winter wheat crop in good or, excellent condition as of November 4th. Sounds pretty good, right? The reality is that this is the lowest, “good to excellent” rating for this time of year in the 27 years that this report has been issued. The U.S. Drought Monitor still shows drought across more than 62% of the nation. More importantly, the, “extreme drought” area still covers approximately 6% of the nation. This includes major growing areas like Nebraska and is expanding through the upper Midwest and Great Plains.

Meanwhile, across the pond, planting in France and England is well behind schedule with France’s plantings 24% behind last year’s pace. Further adding to the globally bullish tone is Russia’s recent reduction of this year’s harvest by half a million metric tons, which drops it to a 9 year low. These forces have reduced the global stocks to usage ratio, how much we have on hand relative to what we’ll need, to 25.4%, which is the lowest level seen since the 1970’s according to the USDA.

The tightness in the wheat market can be seen in its performance relative to corn and soybeans. Both corn and soybeans have pulled back considerably from the highs they made this summer. Corn is currently more than 12% off its August high and soybeans have pulled back by more than 14% from their September high. Wheat on the other hand is less than 6.5% off of the July high and has merely drifted lower following its peak.

The technical name for the chart pattern that wheat has created since its high is called a, “bull flag.” The reason for the name is when looking at the chart it resembles a flag fluttering in the breeze at the top of a flagpole. The wheat market began a vicious rally in late June, climbing more than 50% in five weeks. This rally can clearly be viewed as the flagpole. The market’s meandering since the highs have been confined to a range of 11.5%. This range marks the boundaries for the flag. Finally, as the volatility has died down, the trading ranges have become smaller and smaller. This consolidation is illustrative as the flag forms the tip of its pennant.

The market’s quiet period of consolidation also leads to the eventual eruption once the trading boundaries are violated. The expected breakout will give clear direction to the market’s participants that it is no longer in a trading range and higher prices lie waiting ahead. The target of the bull flag formation can only be determined once the breakout occurs. The simple measurement is the addition of the consolidation distance between the breakout point and the lower boundary of the flag to the breakout point itself. This is a 1:1 trade since the expected risk, without managing the position, is equal to the profit at the trade’s target price.

The primary trend in the near future will certainly be higher. However, I’d like to add a note of caution to trading the wheat markets. Dennis Gartman always uses the line, “Wheat is a weed and will grow as such.” There have been several instances where a poor wheat crop has made a substantial recovery. These recuperative powers are best viewed quantitatively through the actions of commercial traders. These are the people whose livelihood depends on proper analysis of their market. Mechanically speaking, one of the best trades is to wait for commercial traders to call a top in the wheat market. This can be seen in the Commodity Futures Trading Commission’s “Commitment of Traders” report. When the commercial traders start selling, we want to be with them. Trading a commercial sell signal has generated nearly $2.50 for every $1 risked while only being in the market for 5 days. Investors will profit from being long wheat. Traders will profit doubly as they ride the tight supplies higher and catch the fall from the peak, as well.

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.

Sandy’s Effect on the Cattle Market

Sometimes in this line of work the misery and poor circumstances of others creates profitable trading opportunities for our clients and us. Hurricane Sandy is making life miserable for millions of people. However, it is also providing us with an opportunistic trade in the cattle market. Millions of houses, stores and restaurants without power means that there will be lots of spoilage. Replacement of the red meat can only come from existing supply. Therefore, as we mentioned last week, tight current stocks will grow even tighter as the kill rate increases from animals already on the feedlots to meet the surge in demand.

My first experience with this trade was the ’03 Northeast blackout. The initial rush to liquidate positions in all markets and sell stock index futures to protect equity positions came in as a hedge against a repeat of the nightmare attacks of September 11th. Once it became clear that the blackout was caused by a power grid failure, the markets resumed their normal trading pattern and fear subsided. That was the largest blackout on record and affected approximately 55 million people. The crushing demand to refill the freezers created a 20% rally in the live cattle market that started on August 14th of ’03 and powered to a peak two months later.

Two thousand and five brought hurricane Katrina to the Gulf coast and displaced more than a million people. Obviously, there was far more to the reconstruction than just getting the power back on. For the sake of our purposes, the total loss of all red meat in houses, stores, restaurants and storage facilities caused the cattle market to rally 12.5% between September 1st of 2005 and October 12th.

The second largest power outage took place in Europe when the power grid failed and created massive blackouts in Germany, Spain, France, Italy and Belgium. This happened in November of 2006 and created an initial rally in the cattle market of 18.6% as cattle prices bottomed at $85.55 on November 4th. This also effectively put a bottom in the market for the next several months, finally peaking at 102.02 on March 12th of 2007.

Later in 2007, Barcelona went dark, affecting more than 1.5 million people. This was one of the longer outages as it took up to 78 hours to get the power back on throughout the city. The net effect was a rally in live cattle prices from July 23rd of 2007 through the end of the month of 8.7%.

The most recent example is Japan in March of last year. The tsunami and evacuations displaced around 500,000 people. Obviously this was a case of bringing only what they could carry and leaving everything else behind. Therefore, all perishables were a 100% loss. Fukushima’s impact on the cattle market was an 8.3% rally between March 18th and April 4th of 2011.

The current power outage estimates due to Sandy appear to be around 7.5 million people. It’s been reported that nearly a quarter of New York City is still without power as well as the same proportion throughout the state of New Jersey. This equals about 1.8 million people in NYC and another 2 million in New Jersey. The sum total of people without power into their second day is another 2.3 million in the surrounding areas with Pennsylvania in the worst position with more than 900,000 still without power.

The December live cattle futures are currently trading around $126 per hundredweight. The average statistics for the outages cited is a rally of 13.5% peaking 28 days after the event. This gives us a target price around $143 per hundredweight and a target date of November 27th. Given the current look of the live cattle chart, we will be buying the market as it picks up steam and risking the trade the recent low of $124.60. Therefore, our risk profile for this trade is to risk $800 per contract while hoping for a profit of as much as $6,640. We will start to lock in profits however at the much less greedy level of $136.70, which represents the minimum average upside movement we’ve seen during events like this while still maintaining a solid profit/loss ratio of $4,000/$800.

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.