Plexus: A Sleeping Market Finally Wakes Up
October 23, 2012 Plexus
After having been asleep for nearly three weeks, the market finally woke up on Monday, blindsiding the bears with a ferocious rally that saw December gain over 800 points in a matter of just four sessions, as the spot month rose from a low of 71.09 cents on Monday to a high of 79.19 cents today.
Yesterday’s close of 77.86 cents in December was the highest in over five months and we were quite impressed by the enormous volume that was traded over the last three sessions, averaging over 60,000 contracts a day! We typically see this kind of turnover only during the index fund roll period, which is still ahead of us. Also, overall open interest increased by about 4,000 contracts over the last three sessions, measuring 200,917 contracts as of this morning. Increasing volume and open interest are seen as a sign of strong momentum!
Many shorts were caught off guard by this advance, after another bearish USDA report had reassured them just last Thursday that they were on the right track. But as we have explained last week, the market was setting up for a potential rally. First we had the trade aggressively reduce its net short position in futures and options by buying around 26,000 contracts in a matter of just two weeks, with December trading at around 71/72 cents at the time. This buying was probably linked to reports that the US crop may not yield as many tenderable grades as usual, mainly due to a high micronaire problem stretching all the way from South Texas to the Carolinas. Since speculators had been adding a large amount of new shorts during the decline that started in late September, they provided the ideal fuel for a potential rally with their buy stops, which were triggered when December traded above 72.50/73.00 cents earlier this week.
However, the fact that overall open interest went up this week, even in December, leads us to believe that there may have been more to the story than just short covering. It is quite likely that Hedge Funds and HFTs (High Frequency Traders) recognized the set up and jumped on the long side for a raid on the shorts, which would explain the unusually high trading volume. The way commodity markets are structured these days lends itself to these ‘flash rallies’, because there is a large contingent of passive longs that belongs to index funds, which leads to an imbalance between actively traded longs and shorts. Whenever a situation arises in which trade shorts (quality concerns) and spec shorts (reversing trend) are no longer comfortable with their positions, it doesn’t take much to trigger a rally.
Looking at the daily classing data this week, there is good news and bad news to report. The good news is that we are seeing a significant quality improvement in Lubbock, with the average now coming in at a 21-3 grade, 34.8 staple and 4.2 mic. In other words, short staple seems to be no longer a concern and this holds the promise that the bulk of the West Texas crop, which has yet to be harvested and classed, will be of decent quality. Now to the bad news, which is that the quality in the Delta and Southeast has not improved by much. Memphis is still reporting the average quality as being a 41-4 grade, 35.9 staple, with a relatively high 4.95 mic average. Other classing offices report similar recaps, with only minimal improvements in regards to the high micronaire situation. This means that the bulk of tenderable grades will come from West Texas this season. As more cotton from this region gets classed, the overall percentage of tenderable qualities should go up and we could still end up with around 9.0 to 9.5 million bales good enough for certified stock.
So where do we go from here? We doubt that we are currently witnessing the beginning of a new bull market and believe that this is simply a flash rally that will soon run out of steam. The fuel for this rally has been provided by a) quality concerns, b) spec short covering and c) new spec buying goosing up the market. The quality concerns should ease with the news that West Texas is likely going to have a big block of tenderable grades. Spec short covering can only last for so long, with most of it probably done already, and it may now be the turn of the spec longs to cash out of positions. Mills have been mostly unimpressed by this price move and unless we see a change in their behavior, the market won’t be able to run too far. We therefore maintain our 65 to 77 cents price range for now, albeit recognizing that December may temporarily overshoot this target.
In the longer run, say 6-12 months out, we remain cautiously optimistic based on the acreage story as well as increased inflation expectations due to all the money printing by central banks.
The above is an opinion and should be taken as such. Plexus cannot accept any responsibility for its accuracy or otherwise.
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