Friday, October 26, 2012

Sugar Bottom Is Approaching

Market Notes
Source: Short Side Of Long
  • The Global economy continues to slow month after month and the corporate manufacturing powerhouses out of Germany are definitely feeling it with the deteriorating world trade market. Recent sentiment readings out of Germany, tracked by the Ifo Business Climate Index, show industry and trade fell for the sixth month in a row. The survey was quoted saying that "clouds over the German economy are darkening" as the majority of CEOs now think we are on the edge of a recession, according to the business cycle update. Interestingly, the business expectations sub index, which is a leading indicator of the survey, is now in contraction for the first time since September 2009. At the same time German manufacturing is already in a recession, while the services sector still holds the economy together (charts here). But for how long?
 Source: Short Side Of Long
  • Financial stress, according to the St Louis Fed's Financial Stress Index, has now returned to calm neutral conditions (read more on the index here). While bulls are holding hands and singing "Kumbaya... Europe is saved," I personally disagree (it seems that I always disagree). During periods of turmoil and secular de-leverging, whenever financial stress conditions have returned back to neutral levels, this has almost always been a contrarian sell signal. To understand this indicator better, one has to grasp the underlying fundamental economic conditions, which were positive from 1995 to 1998 and from 2004 to 2007; the same conditions were negative between 1999-2002 and from 2008 to the present. In my opinion, can kicking has bought politicians enough time to get re-elected, but you cannot solve a debt crisis with more bailouts funded by debt. The climax of the EU crisis is still ahead...
Source: Short Side Of Long
  • Recent data from the New York Stock Exchange showed that margin debt increased to $315.11 billion in the month of September, from the previous readings of $286.62 billion in August. In other words leveraged hedge fund exposure to the US stock market rose over 10% month on month and well over 20% year on year. This fact completely dismisses constant buzz-phrases like "head funds are extremely underinvested", "plenty of cash on the sidelines" and "the market is up this year, but no one is invested" used by perma-bulls everywhere, including CNBC's Bob Pisani, who has used those phrases well over a hundred times by my calculations between late August and early September. The reading above shows that hedge fund leveraged exposure and speculation within the stock market remains extremely high, only second to readings seen in 2007.

      Featured Article
      Source: FinViz

      The Sugar price still remains in its cyclical bear market, which started in February 2011 with a peak at 36 cents. Basically, the current downtrend has persisted for almost 20 months now and Sugar prices have corrected by more than 45%. There aren't too many other financial assets with an improving long term fundamental picture, within a secular bull market and trading at a 50% discount from recent value. The only other asset that comes to mind with all of the criteria above would be Silver. However, hardly anyone seems to agree with me. 

      The demand and supply situation shows that Sugar dynamics are currently in an overwhelming glut condition. A recent Bloomberg feature article titled "Sugar Glut Extending to Longest in More Than Decade" made the following points worth mentioning:
      • global sugar glut is extending into a third year
      • current oversupply is the longest in a decade
      • production will exceed demand by 6 million tons
      • oversupply is equivalent to 6 months of US demand
      • ISO estimates that inventories will rise to record
      • Brazil might produce 11% more than a year earlier
      • Australia will finally return to strong production
      • CSA says Chinese import demand will remain slow
      Furthermore, I was reading the latest forecast from US Department of Agriculture (USDA) on the Chinese Sugar market, the world's largest consumer. The note stated the following (in a summary):
      The US Department of Agriculture's Beijing bureau estimated China's sugar imports in the 2012-13 marketing year, starting this month, at 1.0m tonnes, a slump of more than 75% year on year on its numbers. 
      China sugar forecasts 2012-13, source: USDA attache report:
      - Beet sugar output: +15.1%
      - Cane sugar output: +18.6%
      - Imports: -66%
       
      Higher domestic sugar supplies may cause prices to ease and increase overall demand for Chinese domestically produced sugar. Industry sources also believe the Chinese government may try to restrict or discourage imports in order to support domestic sugar mills. China's appetite for sugar imports is seen as a major determinant of world sugar prices ahead, in its ability to mop up growing world production.
      All in all, apart from Indian under-supply news, everything else is as bearish as it can get. As a matter of fact, at this point of the article, a rational investor would be scratching his/her head and wondering why the hell do I want to invest in Sugar? In other words, what is wrong with me? Have I lost the plot?

      Well the short answer is maybe. But the long answer is maybe not, and here is why. Everyone, everywhere that has anything to do with Sugar is negative, bearish and pessimistic. Therefore, everything I have listed above is already known and most likely discounted to a degree in the price as of now. This is what a bear market does and the way it operates. 

      The price has lost almost half of its value, the downtrend has lasted for almost 2 years and there isn't any optimism on the price going forward. Major players such as world institutions like International Sugar Organisation or US Department of Agriculture, to various investment bank analysts or Sugar merchants like Czarnikow are all now negative.
      Source: Elliot Wave / TradeFutures.com / Short Side Of Long

      Therefore, one should not be surprised that market participants are quite bearish. According to tradefutures.com, the Daily Sentiment Index on Sugar sits at 14% bulls. Furthermore, apart from a short term spike in June and July of this year, sentiment has been constantly depressed for a prolonged period of time. This is what sentiment during a bear market looks like, but the longer the negative sentiment persists the stronger the up-and-coming cyclical bull market will be if and when we finally do bottom.

      Furthermore, the current report from the CFTC Commitment of Traders report showed that hedge funds reduced their net long bullish bets towards 71,500 contracts as of last Friday, from 160,000 or so during the February 2011 peak at 36 cents. What is even more important is the fact that, small speculators also known as Dumb Money, are now net short Sugar futures for only the seventh time in the last decade. These guys usually have an awful track record when it comes to timing, so as they engage into shorting activity in coming weeks, it might be prudent to do the opposite.

      So when one reads that there is a glut in the Sugar market, one can understand why the price has declined by 45% over 20 months already and therefore one can also make a connection between the low levels of optimism and short positions by Dumb Money. Therefore, what is happening right now is not as important as the question of what will happen in the future?

      Well, while none of us can predict the future, traditionally agriculture works in a very basic cycle. On the upside, higher prices create more optimism and engage more farmers into high production rates as their profits will rise. Eventually higher production overwhelms demand and prices decline. The longer the prices rise for, the more enticed the producers become to increase supply levels. The cycle works in the opposite manner too, where prolonged lower prices decrease profits and force farmers to cut production. Eventually demand overwhelms supplies and prices rise.
      Source: Short Side Of Long

      Source: Short Side Of Long

      Furthermore, from the long term technical perspective,above one can see two favourite charts of mine right now. I have been studying these for awhile, as I expect the Sugar trend to soon reverse into a bull market and the poor performance to turn around. I believe the price has almost completely discounted the majority of supply issues. Why do I say that? Well basically, the media has bombarded the Sugar market with continuous bad news and yet the price refuses to break below the psychological level of 20 cents. Maybe it still might do so, but as I always say it was Marc Faber who first taught me that when the price of an asset fails to make a new low on unfavourable news, it could be starting to price in more favourable conditions. The inverse is true for an asset that fails to make a new high, under very favourable conditions.

      While the Sugar bear market might not be over yet, we are definitely coming closer to the end of it. On a historical performance basis, Sugar offers amazing value. Consider that at today's price, Sugar is 45% below its February 2011 bull market highs, more than 55% below its November 1980 high and finally more than 65% below its November 1974 all time peak.

      On inflation adjusted basis, Sugar is even cheaper.  The last two price peaks during the last great commodity secular bull market were 57 and 43 cents in November 74 and November 80 respectivly. If we adjust those peaks via BLS CPI inflation rate (and we all know those inflation figures are understated and bogus quite honestly) we get a price between $1.10 towards $2.40. Using Shadowstats CPI data, the price becomes insanely expensive. Now consider that Sugar today trades at only 19 to 20 cents. What more can I say?

      Trading Diary (Last update 25th of October 12)
      • Long Positioning: Long focus is towards the secular commodity bull market, with positions in Precious Metals (weighted heavily towards Silver) and Agriculture. A small individual position in Sugar was recently added. Underlying position as well as call options are held on Japanese Yen (long dated OTM).
      • Short Positioning: Short focus is towards the secular equity bear market, with positions in Dow Transports, Technology, Discretionary, Industrials and Junk Bonds. Put options are held on Apple, Amazon and recently Salesforce (long dated OTM). Put options are held on Pound and Loonie (long dated OTM). 
      • Watch-list: A major short in due time will be US Treasury long bonds, as they are extremely overbought and in the midst of a huge bubble. While Grains have exploded, Softs present amazing value for investors. Japanese equities are down about 80% from their all time high over two decades ago and offer great value.
      What I Am Watching