- 1999: Volume 8, No. 4 An End to Deflation and a Low in the CRB?

Back in August 1992 few traders were bullish toward commodity prices as the market basically tracked sideways for seven months before starting an uptrend in February 1993. Sentiment since the 1996 top in the CRB was equally negative but didn't really reach a crescendo until this past February and in some cases not until the end of May. Using non-financial Commitment of Traders small spec and large spec position readings, it is clearly evident that sentiment was overly bearish. A comprehensive look at the cumulative non-financial fund position (by the CFTC COT report) around the February 1999 low showed a massive net short of 260,000 contracts (see Figure 1). It is also interesting to note that only recently did the small spec traders become aggressively bearish. This indicates that the deflationary condition has become overstated and with the improvement in global economic conditions, there is reason to suspect solid bottoming action. With some signs of improved international economic activity, it could well be that most commodity markets made significant long-term bottoms either in February or late May! In fact, the collection of economic conditions present in the world today suggests that the CRB Index itself made a key historical long-term low around the late February time frame. While the markets might not offer massive instant upside, the trade focus in many markets might already be in the process of change. The ill conditions that fostered commodity price deflation are many, but the most prevalent might be the pervasive bearish sentiment of the funds, hedgers and speculators. In fact, it is possible that most of the upside action in commodities since the February low has been short covering of those heretofore aggressive short positions by the funds and small specs. In contrast, commercial buyers have been rewarded by being stubborn, and until the perception of risk rises, they may not be easily swayed.

In our opinion, major commodity price turns can be grouped into two primary categories with a plethora of variations. In general, a major turn in commodity price trends seems to follow either a demand or supply change or, more accurately, a change in the perception of demand or supply. It is our opinion that demand lows by nature are typified by consolidations and slow recoveries, whereas supply lows could have a tendency to be of the more violent recoil-type because of the surprise factor. Thus far, the 1999 low appears as if it will be driven by demand instead of surprising supply problems and therefore, the bottoming process might be an extended, gradual affair.

As mentioned, back in 1992 it eventually took the CRB seven full months to bottom. Similarities between 1992 and 1999 are important, as many conditions have been duplicated in the current environment. These similarities include a significant downtrend in prices before the low, a recession in Europe, international central bank conflict between keeping interest rates low without prompting currency weakness, and an apparent end to a cycle of falling interest rates. In contrast, it could be argued that several more commodities are burdened with excess supply in 1999 than in 1992. Yet, an additional and even more critical correlation might be that the late summer of 1999, like that of 1992, has the potential to be a time when raw demand truly recovers, thereby replacing deflationary sentiment with more normal supply-versus-demand trading. For the past three years, commodity markets have been inundated by a "supply" infatuation. Back in 1992 some of the first markets to bottom were the livestock sector, the industrial sector and the oilseeds. Certainly trend changes can be combinations of the aforementioned conditions and can vary their focus between the two without much notice. Prior to November 1997, we realize that commodities were weakening but that the key issues behind the slide were the Asian uncertainty and the injury to world wide commodity demand.

Figure 1

While all markets can't be expected to return to the November 1997 price levels, the chance that many will at least run in that direction is growing. Low inflation and soaring equity markets should allow things to return to normal, and markets like copper and silver could be in line to catch some of that benefit.

Figure 2

Many times, improved demand can make minor supply problems significant. For instance, the energy market saw significant downside action from October 1997 before bouncing in late 1998 on news that OPEC planned to reduce production. We think the energy price gains after the April break came off news of improved demand and minor refinery problems. Prior to the hope for improved demand, minor refinery problems were routinely ignored, as in the summer of 1998. It has been said that demand markets can bore traders, but prior to the Asian crisis there were not too many supply problems and the CRB Index was doing just fine off growing "global demand!" In fact, in 1997 there was talk about commodity prices moving to a new, higher level despite the outstanding production success of most commodity producers. Therefore, the only way out of the current dismally low price environment lies solely at the feet of demand. Looking at the monthly CRB Index chart with the notation of when the Asia/currency crisis began to chain react and crash into economic sentiment, it's clear a "good thing" was ruined for commodity prices. In the December 1998/January 1999 time frame, a false start to the recovery unfolded, only to be stopped by a delay in Japan's economic recovery. Hence the sharp top in the CRB in January. Toward the end of May, economic improvement was once again anticipated in Japan, as well as other regions. This time the numbers are spreading. With confirmation of ongoing low inflation and significantly higher world equity markets the current recovery does not appear to be another false start.

Figure 3

Back to the Basics: Supply and Demand
Markets Oversold on Poor Demand	Markets Needing Supply Problems
Copper Sugar Cocoa Silver Gold	Soybeans Coffee Platinum Cattle Corn Wheat

Long Picks for the Summer

SUGAR—Sugar is a prime example of a market finding a bottom despite soaring supply forecasts. In the last several months, the surplus forecasts for sugar have risen from 3.5 million to as high as 5.3 million tons, but the market has nonetheless managed an impressive bounce off the April low (see Figure 4). Even in the face of excessive Brazilian supply flow, the market managed to bounce 181 points in less than two months! Sugar is considered by many to be the classic "global market" that can be affected by wide-sweeping economic conditions. Since late 1997, sugar fell from 12.22 cents per pound to the low of 4.96 cents. We would think some, but not all of the 7.26-cent drop, was a result of the expected surplus. Therefore, sugar is high on the list to see moderate or significant short-covering if supply problems surface. It is our opinion that imputed into the April 28 low at 4.46 was a surplus over five million tons with almost no demand improvement. Looking at the long-term charts, we think sugar could easily return to a 7.50 to 10.00 weekly nearby range if current fundamental improvements continue.

Figure 4

COTTON—The cotton market might take the prize for developing the most bearish posture toward demand (see Figure 5). Since the Asian crisis was the primary motivating factor behind the recent commodity price slide and the trade has generally assumed a pronounced hit on world cotton demand (without letup), we think cotton prices are extremely close to forming a long-term low. Possible rain and hail damage in the U.S. begins to create some doubt on the significant year-over-year production increase in the U.S. Going into the Asian crisis, nearby monthly cotton was trading between 68.20 and 73.00. More recent pricing was around 53.00 to 56.00. Recent USDA estimates suggest that world cotton use projects 1999 to rise above 1998 levels, but still come in below the levels seen in 1997. Therefore, we feel it's safe to predict cotton to rise back to the 1998 levels but be restricted by the 1997 lows!

Figure 5

COPPER-The April rally in copper tips the hand of the market for the remainder of the year (see Figure 6). Copper prices could certainly be considered to be near fully deflated levels, with the 1999 lows being the lowest since early 1987. Again the driving force behind the severe copper price decline since late 1997 seemed to be the expectation of falling demand in Asia. Structural changes in the Chinese copper industry and excess South American production might serve to limit the copper market in the initial stages of the global recovery, but it would seem that the low 60 cent price area will provide support as prices below that area could cause some U.S. producers to cut production. Slowly improving global demand and the threat of lower U.S. production could make the May low in copper solid, thereby setting up an eventual recovery to levels above 80.00 basis the nearby weekly chart. An ongoing strong U.S. dollar and stagnant Asian economics could make early gains choppy, so traders need to monitor Shanghai prices and stocks closely.

Figure 6

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