Sugar has rallied more than 50% since the February lows, primarily based on supply concerns. There are current weather issues in South America and Southeast Asia as well as structural issues that will see the sugar market shift from surplus to deficit this calendar year. The common news reports regarding global El Nino issues combined with speculators increasing need to own something in a 0% yield investment landscape has led to a new large speculator record long position in the #11 sugar futures contract, according to the weekly Commitments of Traders report. We believe the record position is unsustainable.
We’ve suggested that the recent rally of more than 50% since August 24th in #11 sugar futures is unsustainable, even to the point that we sold the market early in October in anticipation of its failure. As usual, the market told us exactly what we could do with our, “suggestions.” Fortunately, the consolidation between November and December has provided us with another chance to short the market. This time, perhaps even more decisively thanks to increased commercial trader selling as reported by the CFTC in its weekly Commitment of Traders report.
Sugar futures have rallied more than 40% since the August 24th low. Let that sink in for one second. That’s 40% in 37 business days, a solid rally to say the least. This rally has brought the market back to exactly, unchanged on the year yet, well below the $.30 and $.36 per/lb highs of 2011’s rallies. Interestingly, this rally appears to have been fueled by supply fears shifting to short covering. The main growing regions are preparing for the impacts of this year’s El Nino event even though our own El Nino research has shown that historically, El Nino fears spur rallies to be sold in the sugar market. Furthermore, the recent rally has finally forced many long-term short positions to cover in the face of heavy commercial selling as this rally has progressed.
A brief review of our primary El Nino forecast shows considerable agreement that this year’s El Nino effect will be similar if not, stronger than the El Nino event of 1997. You can read the summary of the meteorological information in our first piece on this topic, “2015 El Nino and the U.S. Grain Markets.” This week, we’ll look at the anticlimactic chart evidence that suggest the media may create a bigger threat than reality suggests is warranted. Headlines draw readers. Readers support advertising. Headline writers get paid. As a trader, definitely not a writer, my goal is to profit from projected price action. It may not be glamorous. It may not draw readers. But, this is the primer you need for the next 18 months of global grain trading.
The sugar market, like many commodity markets has been grinding lower, now down 40% for 2015. Additional problems have been forced on the sugar market by currency weakness among key producers Brazil and India. This has made it cheaper for them to produce sugar domestically and sell it globally thus, increasing the current supply glut on top of 5 years of production surpluses. In spite of its recent dismal performance, we see commercial trader action indicating that the sugar market internals are gearing up for a rally attempt.
We began this week by revisiting the sugar futures market. We started talking about it a couple of weeks ago for Equities.com in, “Time to Sweeten on Sugar.” We updated this outlook Monday for TraderPlanet.com. This trade finally triggered on Thursday and currently sits above the $.1310 level that we believe will induce some speculative short covering. See, “Sugar Prices on the Decline.”
This morning’s unrevised Q4 GDP number at 2.2% on declining corporate profits provides just the right ambiance for a what has been a gloomy week. While we had a completely separate trade looking at multi-year lows in , “Time to Sweeten on Sugar,” most of our focus was on the financial markets.
The sugar futures market has been in a slow motion slide for nearly two years. This follows the market axiom that nothing beats low price like low prices and the expected surplus this year further adds to those concerns. That being said, the sugar market is trading at prices not seen since July of 2010. Furthermore, the sugar market’s seasonality should coincide with commercial long hedgers taking advantage of these multi-year low prices. Finally, the sugar market’s inherent volatility tends to reward forward thinking traders as this market can quickly leave its participants playing catch up.
Louise Yamada, a very well respected technical analyst was recently on CNBC discussing the case for a, “death cross,” in the commodity sector. While I agree with the general assessment that commodity prices as a whole could soften over the next six months, I take issue with the market instrument she chose to illustrate her point, the CCI as well as the general uselessness of this instrument as an investment vehicle. Therefore, we’ll briefly examine why we agree with the softness of the commodity markets and what I believe will follow shortly thereafter as well as a useful tool for individuals looking for commodity market exposure.
The CCI is the Continuous Commodity Index. This index originated in 1957 as the CRB Index as named by the Commodity Research Bureau. It’s been revised and updated many times over the years to generally represent an equal weighting of 17 different commodity futures contract and is continuously rebalanced to maintain an equal 5.88% weighting per market. This really was the pioneering commodity index contract and was traded at the Chicago Mercantile Exchange actively until the early 19990’s. The proliferation of commodity funds and niche indexes since then has rendered the CCI useless and untradeable. In fact, the Intercontinental Exchange that held the licensing for this product delisted it this past April.
Louise Yamada’s point that the commodity markets may be softening is worth noting. She attacked it from a purely technical standpoint. She used the bearish chart pattern that was setting up on her hypothetical contract to illustrate the waning nature of the commodity markets’ failed rally attempts over the last year to suggest that there is more sell side pressure on the rallies than there is a willingness to buy on the declines. She further illustrated her point using the “death cross” of declining moving averages to suggest further bearishness was in store for the commodity markets cleverly noting the frown pattern made by the highs over the last two years.
I’m a big proponent of technical analysis as well as chart pattern recognition (Our Research) however, my reasons for generally bearish commodity behavior over the coming months has far more to do with the sluggish nature of the global economies. China is still the primary source of global economic expansion. Their economy is both large enough and strong enough to buy the world time to work through the overexpansion and corresponding crash of the housing/economic bubble that hasn’t been completely digested, yet. Furthermore, the unabated quantitative easing has lost its ability to boost the economy as a whole and is simply fueling an equity market bubble as the world’s largest players seek parking spaces for the ultra-cheap money that only they have access to. Therefore, until Europe turns the corner and we begin to reconcile the difference between the doldrums of our economy and the exuberance of our stock market, the end line demand for commodities will remain soft.
The flip side to the waning demand story is that once the tide turns, all of the liquidity that’s been pumped into the global economic system will finally trigger the next massive commodity rally. The first leg was fueled the Federal Reserve and Mother Nature. Massive quantitative easing in the wake of the housing collapse fueled massive speculation in gold, silver and crude oil markets. This was followed by one of the worst droughts in U.S. history sent the grain markets to all time highs. Clearly, we’ve gotten a taste of what happens in the commodity markets when there’s a rally to be had. Money attracts money and that’s why we saw the evolution of the Continuous Commodity Index from a single to contract to every conceivable niche market in futures, ETF’s and index funds.
Some of these niche markets have developed a strong enough following to make them tradable. The most liquid commodity futures index contract is the Goldman Sachs Commodity Index Excess Return contract. This is based on the Goldman Sachs Commodity Index (GSCI) affectionately termed the, “Girl Scout Cookie Index” by floor traders when it came on the scene in the mid 1990’s.
This market currently has an open interest of more than 25,000 contracts. The bid/ask is relatively wide at approximately $100 per contract difference but the liquidity is solid with a total of more than 100 bids and offers showing on the quote board. This index, like the old CCI is still heavily weighted in the energy sector with Brent crude and West Texas Intermediate crude accounting for nearly half of the weighted index. The bright side is that this index only has a margin requirement of $2,200. Ironically, a half size mini crude contract requires $2,255 in margin. You can find all futures market hours and point values here. The balance of the index is weighted 15% towards growing commodities like wheat, corn, coffee and sugar. Livestock comprises another 4.5% and metals makes up about 10.5%.
This fall and winter should provide time for the markets to finish digesting some of the previous boom cycle’s excesses. We’ll also have lots of global data coming from Japan, China, India and Germany as well as a new Federal Reserve Board Chairperson of our own. The trillions of Dollars that have been poured into the economy will eventually end up chasing returns. That will be the point when inflation begins to creep in. Weaning the economy off the monthly doses of funding is becoming harder and harder with each dose administered and the major players won’t be happy about it. Therefore, it’s sure to continue for too long and will only be reigned in once it’s too late.
The sugar market, currently trading around $.17 per pound has been drifting slowly lower since making its all time high of $.2957 per pound in August of 2011. Last week, the market fell through a key support level at $.1662 and traded down to $.1617 before reversing to close on its highs for the week. This could very well be the catalyst to rising sugar prices over the next few weeks.
The sugar market can be exceptionally volatile. Sugar’s average annual movement over the last five years is about 225% from high to low. This year, we’ve only seen a 20% range between the high and low. We expect volatility to increase with range expansion for the year’s range to show up in new highs. We also expect a near term increase in volatility as the market rejects the recent low and reverses course.
The sugar market’s decline has been quite orderly. This means there’s been low volatility. Low volatility compresses risk levels, which leads to tight stop prices. Tight stop prices allow more people to access the market. Tight stop prices also lead to added leverage. Smart traders view risk as a percentage of equity. Tight stop placement allows traders to add multiple contracts while maintaining their own risk tolerances. This ease of access and tight stop placement leads to ballooning open interest. Open interest recently peaked at just over 450,000 contracts. This is the largest open interest since January of 2008.
Staying with the technical characteristics we can compare the change in open interest to their price levels. Tying these observations to the Commitment of Traders reports then allows us to assign the change in open interest to individual trader categories like small speculators, index funds and commercial traders. This type of analysis shows that there were 95,000 new contracts added between March 1st and today. These contracts were all initiated between $.1684 and $.1778 per pound. Furthermore, the build in the commercial trader positions since mid-March is almost exactly 90,000 contracts.
The final technical piece lies in reading the chart itself. The weekly sugar chart shows last week as a key reversal bar. The textbook definition is a chart bar that makes a new high or low for the extended move indicating continuation of the trend before pulling an abrupt about face and closing beyond the previous bar’s high or low. The rejection of this new price level and quick return to previously traded prices indicates a market that has moved too far, too fast. The details of the setup show the weekly range for the week ending June 7th as $.1666 high to $.1632 low. Last week’s reversal bar traded down to $.1617, below the previous week’s low before closing at $.1678, above the previous week’s high.
Finally, we are just beginning the strongest seasonal tendency for October sugar. The seasonal strength lies between the middle of June and the end of July. We feel that the build in commercial long positions, coupled with the large increase in the speculative short position near their current breakeven levels will ultimately resolve its imbalance to the high side.
Last week’s key reversal bar leaves 90,000 contracts in jeopardy of being stuck holding the hot potato. Given the low volatility the market has been experiencing I believe that many of those new positions have pretty tight protective stop loss orders tied to them. Therefore, as this market turns higher it should begin to trigger these stops. The buying pressure triggered by the stop loss orders could very well kick off the seasonal strength. The first trend line resistance is just shy of $.18 per pound with further technical resistance around $.20 per pound. Meanwhile, since we are in fact bottom picking, a protective stop loss order should be placed no lower than $.1683. The primary key to profiting from this trade will be the ability to gauge the buying pressure that comes from small speculators being forced out of their short positions.
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.