Cotton Remains Good Long-Term

Apr. 8.11 | About: iPath Dow (BAL)

By Jack Barnes

You could have just banked 123% gains on cotton.

That's what Money Morning readers are sitting on right now.

A few months ago, I told our readers to buy cotton. And if they bought when I advised, they already more than doubled their original investment.

When I recommended cotton, it was trading at roughly a dollar a pound - after a run-up from 45 cents, where cotton traded for the last decade.

I told readers that cotton prices could hit $1.25 a pound in the six months.

As it turns out, cotton prices were in an unprecedented bull market. And my estimates were conservative, very conservative.

Just one year ago, cotton was trading at 70 cents a pound. As I write this, it's trading at roughly $2 a pound.

Readers who bought in when I originally recommended cotton have more than doubled their money. In fact, the exchange-traded note I recommended has soared more than 120% since I recommended it.

The real question, of course, is: What happens next?

Here's the answer.

The Case for Cotton

Let's cut to the chase.

Cotton remains a long-term "Buy." But there is a near-term shakeout due - something that at this point is pretty much true of everything in this crazy commodity bull run. After that dip, however, there are three very good reasons to expect a long-lasting upward trend in cotton prices.

Cotton will continue to gain in the long-term because:

  • Of the primary traded commodities, cotton has the longest lead-time - the time it takes for crops to be planted, grow, be harvested and brought to market.
  • Basic cotton products are currently seeing a 30%-plus "cost push." .
  • China, as the world's largest grower, and consumer, of cotton, can set global prices. And the country has announced that it will drastically increase the price of cotton products.

Let's look at this in deeper detail.

The very nature of cotton as a crop makes it an extremely long lead-time commodity. In fact, it is said that cotton has the longest cost - in total time - of all commodities. It takes 18 to 21 months for cottonseeds to grow, be harvested, cleaned and prepped for actual usage.

In China - the world's biggest cotton consumer, as well as its biggest producer - demand for the fiber is soaring.

China imported 390,720 metric tons of cotton last month, the country's customs agency reported. That's 31% more than a year earlier. And it follows an 86% increase for all of last year, which saw China import 2.84 million tons, the customs agency said.

Global investors are worried that worldwide cotton supplies are not keeping pace with China's growing - and seemingly insatiable - appetite for the fiber.

China's National Bureau of Statistics reported that cotton output in the country declined 6.3% to 5.97 million tons last year. The loss of domestic cotton means China will be looking to import even more this year.

This - and several other factors, including damage wrought by storms and flooding in Australia - has fueled the huge run-up that we've seen in cotton. In fact, the rally in cotton prices so far this year is the biggest of the 19 commodities tracked by the Thomson Reuters/ Jefferies CRB Index.

After hitting a record of $2.0893, cotton prices have declined about 6%. Most of that loss came in one week, when prices for the fiber dropped 5.5% - the biggest decline since last year and the first weekly loss in seven weeks.

Investors don't expect this retrenchment to continue. In fact, funds are already beginning to return to the market. And on a very basic level, supplies are still low compared to demand in the cotton market.

A Pullback ... Followed By Another Breakout

If you missed the last move in cotton, I would suggest being patient. You see, I'd be remiss in not pointing out that cotton has experienced a "blue-sky breakout" - meaning there is a high probability of a real - but near-term - correction as profit-takers provide liquidity to the market.

But it's not time to turn away from cotton altogether. At this point, cotton prices are still in a long-term bull market.

That bull market kicked off when China - desperate to keep its factories humming along - had to buy up the U.S. crop.

Global weather patterns have damaged Australia's cotton harvest.

And in China, the weather patterns for this spring continue to be unfavorable for the cotton crop. All signs point to an ongoing boom in the price of physical cotton.

In the short-term, I would expect some choppiness before the next major run up in prices. We need to see the volatility get squeezed out of the options on the futures before it's truly safe to enter again.

With any investment prediction or "call," there's always a qualifier - an "if." And my near-term prediction for a market pullback is no exception.

I see a pullback in cotton prices unless China shows up in the pits and starts buying in size again. If that happens, cotton could hit $3 a pound before it sees $1 a pound again.

It really comes down to how China spends its money.

If you followed my advice and invested in cotton when I first recommended it ... well, congratulations on a great run - you're sitting on a gain of 120% or more.

Given that it has been such a great run, it's probably time to take some risk off the table. My suggestion is that you consider selling half your position, and holding the rest. This locks in a solid 100% gain on your risk capital.

If you missed the gains as cotton prices doubled - and the exchange-traded-note I advised Money Morning readers to buy returned gains of more than 120% - there is currently no fundamental reason to believe that cotton will pull back to the "breakout" price.

You should use the current weakness to establish a position that's half the size of the total investment that you'd like to have in cotton.

To do this, buy the iPath Dow Jones-AIG Cotton Total Return Sub-Index ETN (NYSEARCA:BAL).

This ETN is based on the total-return sub-index for cotton - the return of a single futures contract in cotton. BAL is extremely small, but gives investors direct exposure to the expected changes in price.

This ETN is already up 46% year-to-date. I expect it to move even higher by the end of the year.

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Disclosure: None