Bearish Cotton Forecast: Expect Further Falls

This article was written by Cole Winston, a Financial Analyst at I Know First.

Bearish Cotton Forecast

Summary

  • Cotton Fundamentals
  • iPath Bloomberg Cotton Subindex Total Return ETN (NYSE:BAL)
  • Price Action
  • Bearish Forecast

Cotton is a natural textile fiber that is used in the production of a wide-ranging variety of products, including towels and robes, pants, socks, underwear, t-shirts, bed sheets, and yarn, just to name a few. It goes without saying that Cotton as a commodity is central to modern day life, as it is one of the most used natural fibers in existence today.

Cotton Fundamentals

Commodity prices of the primary sector tend to be much more volatile than prices in other sectors and industries. This is basic econ 101; supply and demand. Cotton – also a commodity – is no different. Therefore, to understand the price outlook for cotton over the short-, medium-, and long-term time horizons, a solid understanding of the past and current supply and demand fundamentals of cotton is necessary.

The overarching narrative has been that rising demand for cotton globally should be increasing upward pressure on cotton prices, but that a fast-expanding production base has, and will continue to, counteract this upward price pressure to actually maintain cotton’s negative price movement.

The three largest producers of cotton are China, India, and the United States. Now, while the stock of cotton inventory in China is expected to fall noticeably over the next little while, it is essential to note that the majority of Chinese cotton production is sourced for domestic consumption, and is therefore unavailable on world markets and plays a diminished role in influencing cotton prices sold internationally. Paired with this development is the fact that, while Chinese production is falling, cotton production coming out of India and (more importantly) the United States are expected to rise by volumes that will more than counteract the hypothetical price contraction that would be caused by Chinese cotton exports. The ultimate result is that cotton prices will continue to fall as they have been, regardless of upward pricing pressure caused by falling Chinese supply and increasing global demand.

With this bearish outlook, the next question that must be answered is how to best play this bearish cotton sentiment, or how to best expose one’s self to developments in the cotton markets. Common means of commodity exposure include commodity company equities and/or debt, commodity futures, or commodity ETFs. It is this last choice that the I Know First algorithm has selected as its focus.

iPath Bloomberg Cotton Subindex Total Return ETN (NYSE:BAL)

The iPath Cotton Subindex Total Return exchange-traded note (ETN) (NYSE:BAL), issued in the U.S., tracks a single cotton futures contract with one month to five months to maturity, depending on the time of year. BAL provides investors with a cash payment at the scheduled maturity or early redemption based on the performance of the underlying index, the Bloomberg Cotton Total Return Sub-Index. The Bloomberg Cotton Subindex Total Return is a single commodity subindex of the Bloomberg CI composed of futures contracts on Cotton. It reflects the return of underlying commodity futures price movements only and is quoted in USD.

BAL tracks this index that holds cotton futures contracts ranging from one to five months out. This strategy takes into consideration the lifecycle of the cotton plant—holding longer contracts during incubation and shorter contracts during harvest. It also allows the index to select the most liquid contracts available given the lifecycle constraints.

With $9.88 million assets under management, BAL has an expense ratio of 0.75%, the fund trades at a premium/discount of 0.10% and is cheaper and more liquid than its closest competitor fund; the iPath Pure Beta Cotton ETN (CTNN). The main value-add offered by exchange-traded products stems from their significantly-lowered fees and the direct exposure that they provide to the underlying index or product group. It is therefore clear that BAL should be an attractive place to get exposure to the downside of cotton prices, as long as the price action supports the above analysis.

Price Action

As demonstrated below*, the price history of the BAL fund (and cotton in general) reflects the above fundamental analysis. After declining significantly from mid- to late-2014 (on the monthly timeframe), cotton prices became stuck in a sideways market that they have only recently started to escape from. This same price action is also evident on the weekly and daily timeframes. Most importantly, however, is the recent downtrend that BAL has exhibited on the daily timeframe, beginning on May 15th, 2017 and continuing to this day. Looking at historical prices is a key component to any technical analysis – by definition – but the downturn in price as previously detailed is the major signal that tells market participants that the bearish outlook on cotton is alive and well, as is being predicted by the I Know First machine learning algorithm. Additionally, due to the extending nature of this daily downtrend, this price movement is beginning to appear on both of the higher (i.e. weekly and monthly) timeframes, reflecting the strength of this bearish sentiment.

*Chart Guide: white candles represent the close being higher than the open (an up candle), black candles represent the open being higher than the close (a down candle), the top chart represents monthly candles, the middle chart represents weekly candles, the bottom chart represents daily candles, and the price data is sourced from BATS (an electronic exchange platform).

Bearish Forecast


Given the above agreement between technicals and fundamentals in the current global cotton market environment, it is a vote of confidence that the I Know First algorithm has predicted, over a 1-month, 3-month, and 1-year period, continued negative price action. The I Know First algorithm is bearish on BAL over a 1-month, 3-month, and 1-year time horizon. Market participants would be wise to further examine BAL over these timeframes.

I Know First Algorithm Heatmap Explanation

The sign of the signal tells in which direction the asset price is expected to go (positive = to go up = Long, negative = to drop = Short position), the signal strength is related to the magnitude of the expected return and is used for ranking purposes of the investment opportunities.

Predictability is the actual fitness function being optimized every day, and can be simplified explained as the correlation based quality measure of the signal. This is a unique indicator of the I Know First algorithm, allowing the user to separate and focus on the most predictable assets according to the algorithm. Ranging between -1 and 1, one should focus on predictability levels significantly above in order to fill confident about/trust the signal.

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