The most powerful signal of when to buy a commodity is when the commercial entities are near record long or have near record high positions in the futures market signaling that a major bottom is at hand. This information on commercial activity, as well as on speculative fund activity, is provided every Friday afternoon by the Commodity Futures Trading Commission (CFTC) in the regulator’s Commitment of Traders Report (COT).
Think of the commercial entities as the insiders in a publicly traded company. When the CEO, vice presidents and directors are buying large quantities of stock in the open market, they are signaling that the people who know more about the company than anyone else believe that the stock is a good value. While it is not exactly an apples to apples comparison, it is analogous to commercial entities in commodities.
Commercial entities in a commodity market represent the producers and the end users of the chosen commodity. Take coffee as an example. The producers in this case would be the Brazilian and Colombian farmers and the end users would be the coffee roasters like Starbucks or Procter & Gamble, the maker of Folgers and Nestle. The commercial entities know more about the economics of the coffee market than anyone else in the world. They are best equipped to make judgments as to when coffee is cheap and when it is expensive.
Fred and Ginger
Commercial entities make decisions based upon their own business economics while speculative funds make decisions based upon potential for investment profit. The waltz that these entities dance with each other is equal and opposite in that when coffee prices have been falling and prices are cheap, speculators are short while the commercials are long. Speculators typically care about following the price trend. Commercials simply are looking for good economic value.
For example, if coffee is trading well below the cost of production, farmers are more likely to store as much coffee as they possibly can instead of locking in losses. They will only sell what they must to pay bills. This has the effect of being long the futures market. Conversely, if coffee prices are trading so low that the profit margins for a coffee roaster like Starbucks are attractive, Starbucks will stockpile coffee in an attempt to lock in favorable long-term profit margins. This also has the effect of being long coffee futures. So, when farmers do not want to sell and the commercials want to buy as much as possible, you have a looming scarcity building in the market at prevailing prices.
The opposite is true when coffee prices are too high. When Starbucks is unable to make a profit when paying high prices for coffee, they will operate hand-to-mouth to try to buy time for when prices become attractive again. Typically, when coffee is bought at prices that are too high, a Starbucks will sell short so that it may recoup lost profit margins when prices do fall back down. This effectively creates a large short position.
When farmers see prices that are attractive and profitable to their operations, they will sell as much as possible to lock in these profits and store as little as possible. This effectively builds short positions on behalf of the farmer. So, with farmers being willing aggressive sellers of coffee and the commercials buying as little as possible and operating hand-to-mouth, a looming oversupply in the market builds.
In short, if you buy when the commercials are near a net record long/high position and you sell when commercials are near a record short position, you are more apt to be on the right side of the value commodity investor’s profit food chain.
To further illustrate this analysis, we will take a closer look at oats and milk. Oats is a market that has recently exploded higher and milk has yet to do so. In going over both markets, you can see how profits could have been achieved in the oats market and how an opportunity to profit in milk still exists using this commercial trigger mechanism.
However, there’s another powerful metric that, when synchronized with the above discussed near record net long/high commercial position framework, helps identify a deep value bottom. It also helps in the timing of when such undervaluation will be recalibrated to the upside. The metric is the relative value of a particular agricultural commodity with the continuous commodity index (CCI).
When a particular agricultural commodity is historically cheap in relation to the broad price level of the 17 most-traded commodities in the world, which is captured by the CCI through an equal-weighted format and concurrently is exhibiting near historical commercial net long/high positions, a rare investment opportunity has likely presented itself.
Here’s the buy alert criteria:
- Near record long/high commercial net positions have been established.
- Near historically cheap relative value against the CCI.
Since 1991, the oats market has seen four conditions where commercial net long positions were near historical highs and where the relative value of oats prices against the CCI were near historical lows. Those years were 1995, 2001, 2004 and just recently in 2010. The average percentage move in oats prices subsequent to this rare duel condition was 154%. In mid-July prices had already exploded higher by close to 40% since the recent bullish signal of the commercials near record long position and of the near record low relative value conditions kicked in.
Once again this duel indicator model for identifying major bottoms and rather timely price surges has demonstrated its predictive value in the oats market. If history is any guide, the oats market has far more upside before the current bull market subsides. The minimum move expected based upon historical price performance would be a 100% move from the recent lows near $2 per bu. This would project a minimum top close to $4 over the next 12 months.
Even though the oats market still has plenty of upside left, the object of using this duel commercial/relative value trigger is to be able to buy near the bottom and participate in the early part of the move, which tends to be the most explosive and where some of the greatest returns reside. The milk market looks like a textbook opportunity to take advantage of this effective commercial/relative value trigger before the explosive early part of the move takes place.
Since 1996, the milk market has seen four conditions where near record net long commercial positions have coexisted with near record low milk prices relative to the CCI. Those years were 2000, 2003, 2006 and now in 2010. The average percentage move higher in milk prices subsequent to these duel buy triggers occurring was 86%.
With current spot milk prices hovering near $13.50 per 100 lbs., a typical rally from such a bullish condition based upon history would take prices to $25 over the next 12 months. The predictive value of this duel commercial/relative value system has been remarkable in the milk market over the last 14 years. If history is any guide, prices can spike at any moment and will likely do so in violent fashion.
Timing and direction
Using commercial net position activity within the context of a relative value framework has proven to be an effective and predictive tool in not only identifying major bottoms but also in identifying the right timing for such a move to take place. The same predictive trends of this duel system can also be seen in every agricultural market that trades. This is not an isolated system for just a few markets but for the entire agricultural complex.
The other important aspect to understand is that such a bullish condition is typically only seen on average twice a decade. Thus this is a rare occurrence that when identified must be acted upon with a high degree of urgency. It is not that money cannot be made at other times, but it just means that the best ratio of risk to reward exists only a few times every decade.
This simple approach does not diminish the importance of understanding the supply/demand fundamentals of a particular market nor the technical picture of the recent price activity. To be a good commodity investor, you need to use all the tools available to make the best overall investment decision. But using the commercial/relative value trigger mechanism can help refine the price point of initial entry as well as the timing to maximize profits.
Commercial operators stay in business by knowing when to buy and when to sell to maintain profitability. History strongly suggests that investors would do well to heed their predictive warnings to maximize commodity investor profits.
Shawn Hackett, commodities broker and author of the Hackett Money Flow report newsletter (www.hackettadvisors.com), is a nationally recognized agricultural commodities expert with more than 18 years of money management experience.
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