Posted 5-10-02

Our Current Recommendations Are:

Buy Cotton

Buy Bonds

Nuts and Bolts

If you have traded commodities for any length of time, you may have heard the expression, "It is always bearish at the bottom". This newsletter addresses that idea, which is true, and why....and how it relates to the Cotton market today.

Unless a commodity is being replaced by something better, over time (years and decades), total consumption, or demand, for that commodity should be on a fairly constant upward slope. This constantly rising demand takes place simply as a function of world economic and/or population growth.

This means production must continue to grow as well.....If production did not grow to keep up with demand, the price of the commodity would have no place to go but up, continually, and probably through the roof....and in reality, total production of most commodities, over time, does grow to keep up with demand.

With this in mind, it can be said that, from time to time, as regards just about any necessary commodity, you need to hear that expression, "record production", or, "record crop".....If you don't, at some point, you are probably going to hear that other expression, "record prices".

There can be exceptions to anything, but I would say, demand growth, over time, is much more of a constant than production. The population of the planet grows every day, meaning increased demand for just about any commodity, in general, regardless of what is happening to inflation, GDP, the business cycle etc....Production, however, does go through more fluctuations due to low or high prices, economic conditions, political policy, weather, war....whatever....which results in the chart below, describing the long term relationship between commodity supply and demand, looking as I have drawn it.....

Sometimes supply is greater than demand and sometimes it is the opposite.....but they are never equal. Maybe there is some hypothetical point in time where you could say they are exactly the same, but generally, both sides of the equation are moving all the time, and  prices, therefore, keep moving as well....up or down. This is pretty basic stuff, but, on the chart, when you have supply greater than demand (when the supply line is above the demand line), you will probably have a period of falling commodity prices, and when supply falls below demand, you will probably have a period of increasing commodity prices..... 

The Psychology of Prices and Commodity Supplies

Every commodity has to have more of it stockpiled than we need. If, for example, you were to reach a point where there was no lumber, or gasoline, or wheat available for the next fifty days, you would have a pretty nasty situation on your hands. Aside from the severe social disruptions, I would guess you might see skyrocketing prices for those commodities to levels nobody has ever even dreamed of......Therefore, we can never, ever allow those stockpiles to get to zero....Running out of flour in your house is not the same as the world "running out" until the next crop gets harvested---We always have to have extra supplies of everything we use.

Those extra supplies in agricultural commodities are referred to as the "ending stocks" or "carryover" (what is left over each year from the previous year's harvest), the size of which varies from year to year depending on how much was produced, and how much was used. In the years where the carryover is very tight, you tend to get higher prices.... and when you have a "mountain" left over, you tend to get lower prices, which is very much what we have in the marketplace today. 

Along with those low prices goes a certain  negative psychology in the market which is something like, "We have so much of it, we will never use it all!", or, "We've got a two year supply and a RECORD CROP (remember my comment above?) is on its way!", the implication of either statement being, if you think prices have any reason whatsoever to go up, well, "You are just plain stupid. Can't you see it's just all over the place?". This sort of psychology, which has been present at every market bottom I can ever remember, makes it just about impossible for the average speculator to step up and seriously put money on the table as a buyer. Most people want the comfort, somewhere, of something in print making a logical case for risking money as a buyer. When everything they read (which is where everybody gets their information) only focuses on how much there is of it.....When all the "fundamentals" just argue totally against it....It's just feels plain dumb to say, "I'll buy it.".

So why should you be a buyer when this is the case?

The first thing I'd say is, rather simplistically, "It just will". That sounds like a pretty stupid bit of analysis, but in 22 years, I cannot count the number of times I have seen it happen....... 

Today's low price has come about as the result of that "mountain" having grown to what it is today.....But, in reality,  today's mountain has nothing to do with prices over the next year. Where Cotton prices will be six months, or a year, or two years from now will be determined by totally new fundamentals coming in to play in the market, and, I'll say it again, prices in the future have nothing to do with what has happened to bring prices down to these historically low levels. 

What matters is what happens in the future....What sort of supply will we be working with in future?---How much will be produced in the future?---What will demand be in the future?.....Nobody knows the answer to any of these questions, but with prices the same as they were in the 1950's and 1960's, there are some suppositions I think you can make (and they are the sort of thing that has happened over and over throughout economic history) as to what may happen.

Low, low prices do not stimulate increased production. When a crop price is so low it is unprofitable to produce, producers tend to say, "I'll won't plant it", and, even with government programs in various countries which do support production, we will probably see less cotton planted in the coming year, or years, for that matter. Thirty cent cotton just does not encourage more acres in cotton.

Low, low prices do stimulate demand. When the price of a commodity becomes ultra-cheap, it does change the way users view that commodity. If you are a manufacturer and your cost of materials falls through the floor, aside from improving your profit margin, it also induces you to produce more.....I mean, in that old capitalist equation---25% labor, 25% overhead, 25 % materials, and 25% profit---if your cost of materials has gone relatively to nothing (50 year lows), it does give some manufacturers an incentive to put more people to work, to produce more finished goods.....to use more Cotton.

As we are dealing with prices at historically low levels, I would guess there is no real yardstick for any analyst to use to determine what supply and demand will amount to over the next 12 months. My assumption is, again having seen this same situation over and over, production will end up being less than anticipated, and demand, which is more difficult to predict, will be far greater than anticipated.....and prices will spend the next year moving substantially higher.

It should also not be forgotten, you do always have weather to deal with....especially today when the planet is going through some very real changes in climatic conditions.  There is no guarantee we will have ideal growing weather this year (no drought, no Gulf Coast hurricanes), yet here we are at 50 year lows, and the coming year's Cotton crop is still only half-way planted. In other words, current prices are priced to have absolutely ideal growing conditions.....There is no weather premium whatsoever in the market.

This next chart is my concept of some of what I have been describing....

What you will hear.....

Cotton finished today up about 1  3/4 cents for the week (after this morning's monthly report indicating "stronger demand than analysts had been anticipating")....Let's say the move continues on the upside over the next few weeks, and does so enough to attract some attention and commodity media coverage. I can almost promise you, you will be able to read something like the following: "Cotton has moved up 8 cents over the past three weeks but analysts say further gains should be limited due to RECORD PRODUCTION AND BURDENSOME STOCKS OVERHANGING THE MARKET.".......I cannot count the number of times I have read something to that effect as I watched markets go from "1 to 10", and, if I am right in Cotton, I don't think it will be any different this time.....In my experience, a market will be miles off its lows before you start to hear even the mildest bullish fervor at all.....As the train leaves the station, at every stop along the way you will probably hear those same phrases, "burdensome stocks" and "record production", and, "Don't buy it.".

I am not positioning for a three or four year bull market in Cotton but the chart above does outline the way I believe most commodities tend to move.....They may go up for three or four years and then go down for three or four years, with "ending stocks" either growing or contracting as the market goes through its bear and bull phases....

And just to look at the chart above from a different angle, Cotton, back in 1995, was trading at over $1.00 per pound. There was bullish news everywhere and it looked like it would never see 70 cents a pound again, much less 50, or 30.....But it did. And here is a chart to describe what has taken place between then, $1.10 Cotton in 1995, and now....

And here is the chart that just says it all to me......

Cotton Futures (monthly since 1971)

Buy Low????

I think the U.S. and world economies are absolutely resuming the same sort of growth we have been experiencing for the past twenty years. I think the world today is about "doing business", whether it is here, in Russia, China, Japan, Europe or wherever......The last two or three years have wrung out some needed excesses, money is cheap, and everybody is ready to go again....If you want to worry about the one out of ten economic indicators that says we haven't started forward yet (and decisively so), go ahead....In my opinion, and I may be dead, dead wrong, the engines are truly humming everywhere, and six to twelve months from now, Cotton, an "industrial" commodity, will be far, far above the 35 cent level you see it at today.

And DO look at this chart and the numbers following.....

Forget anything about why.....Would it look like 
any big deal for this to be trading at 50 cents?

The December 40 call closed today at 2.57, or $1285 plus commission. If Cotton rallies to 48 cents, that option is worth $4000. I think it WILL, at a very minimum, and I like my odds. Obviously, if I am wrong, that option can end up being worth anything from far less than what you pay for it, right down to nothing.

Thanks for the read....and do something about this. This stuff is about educated guesses and calculated risks and, right or wrong, I don't think they really get any better than this.....Call me....and if you get a chance, please send somebody else to take a look at this on the site.

Bill Rhyne
Hiram, Ga.
770-439-1001
800-578-1001