There are a lot of really interesting things occuring in the commodity markets over the past few weeks. With extreme bearish sentiment leading to a nice mean reversion move in the grains, I think there is a possibility that we see something similar occur in Cotton over the intermediate term.
The place we want to start our analysis is the weekly chart, going back roughly 5 years. What’s important to us here is that Cotton, which had been rangebound since early 2012, broke below that range in July and has since started to form a base. After correcting ~36% off the early ’14 highs, we’re left with the question as to whether or not this base is a reversal or a pause in an otherwise clear downtrend. What I find interesting is that this consolidation is occuring at the 161.8% fibonacci extension of the November ’13 lows to the March ’14 highs. Additionally, we have a positive momentum divergence present and the time we’ve spent basing is long than I’d expect if this was a continuation of the prevailing downtrend. Lastly, from a mean reversion perspective, prices are currently ~45% below a declining 200 week simple moving average. To me, that is something that isn’t sustainable over the long term and the only way for that to correct is by prices moving higher, or through time. If we can get a weekly close above 68.50 to confirm this positive momentum divergence and false breakdown in price, I think we can head a lot higher.
The next aspect we want to look at is sentiment. The index below is based on a number of sources including futures and options data, surveys and a few others. As you can from the data, there is extreme pessimism towards Cotton as we test levels rarely seen, in this case not since early 2012.
Another gague of sentiment worth looking at is the positioning of commercial hedgers, or the “smart money” of the commodity markets. They aren’t hedging at all, which signals to me that they are expecting cotton prices to move higher. Again, we have not seen this little hedging by commercials since late 2006, early 2007.
So what does this sentiment data tell us? Well first, it says we can’t be short here because being short with this level of pessimism in any market is just asking to be squeezed. Also, if we think these conditions are ripe for a squeeze and that sentiment unwinding is going to be a tailwind for prices then we want to be leaning neutral to bullish on Cotton.
Another important factor we want to be paying attention to is seasonality. From the chart below, we can see that December through May has proven to be the strongest period for Cotton performance over the past 30 some-odd years. If prices can get through November without breaking down much,they’ll have seasonaility as a tailwind heading into the start of the year.
Now that we see that there are opportunities in Cotton from a structural perspective, let’s look at a contract adjusted daily chart to see how we can approach this commodity from a tactical, or shorter term perspective. As we can see from the chart below, prices have been trying to put in a base above 62, after a false breakdown confirmed a positive momentum divergence in early October. Current resistance sits at ~64.50, which represents the November ’13 lows and resistance from earlier in the month that we’ve yet to overtake on a closing basis. If we get a close above that level lies at 68 and then above that we’re looking at 73, which is 12% above current prices. The 73 level is where the declining 200 day SMA and a 14 month resistance level comes into play. With sentiment, seasonality, and improving price action converging here, I think we could see a test of that 73 area over the next few months.
After looking at cotton from a number of angles, I think that the risk/reward favors the long side here. There are a variety of ways you can play this from a structural or tactical perspective depending on your timeframe, but the levels outlined above are just some that I feel are important.
Perosnally, I’d wait for a weekly close above 68.50 to confirm this false breakdown and positive momentum divergence. For me, that is the best way for me to define my risk as if we closed back below that level, I’d know I’m wrong. If we do get a close above 68.50 I think Cotton can really get going to the upside with the first weekly resistance level being at November ’13 lows of ~75.40.
As always, trade your own plan. These are just my thoughts – let me know what yours are on twitter or stocktwits!