Hershey's: Is A Chocolate Correction Coming?

Summary

• Commercial hedgers (smart money) are the most net long cocoa futures.
• Non commercial money (dumb money) is the most net short ever.
• Hershey's and cocoa futures usually have an inverse relationship.

Cocoa prices fell sharply over the past year, and Hershey’s (NYSE:HSY) stock has done well during that time. That trend should reverse as cocoa prices are most likely going to bottom out.

Commercial hedgers (smart money) are net long 31,486 cocoa futures contracts as of 06.27.2017. Compared against the last two decades, this is the largest net long position ever for these investors. The last time they were this net long was in April 2003 with over 29,453 contracts net long. On the other hand, non-commercials (dumb money) are net short 38,256 contracts. Compared against the last two decades, this is the largest net short position for these trend traders. Before this year, the last time they were this short was in 2003.

The dumb money consists mainly of hedge funds, trend followers, and CTAs. While some of these individuals make money, most of these individuals are wrong at position extremes. The same pattern occurred in 2012 when they shorted at the bottom and were extremely long at the top last summer. If the same pattern holds true this time, the non-commercials are going to lose big on their short position.

Although smart money is extremely bullish, there are some negative fundamentals regarding the cocoa market. Recently, the International Cocoa Organization increased its surplus forecast by 382,000 tons. In addition, the ICCO raised its forecast for global production in 2016-2017 to 4.69 million tons, which is 18.1% higher than last year. Most of the surplus came from the Ivory coast.

When prices contract, farmers don’t stop planting cocoa trees, unlike for other crops like grains. The farmers keep their trees when prices plummet, but limit usage of fertilizers and pesticides. Rather than let supply and demand come into equilibrium, this process slows it down, and keeps prices lower.

If cocoa prices rally, this may negatively impact the stock of chocolate stocks like Hershey's. Jeffrey Hirsch states there is an inverse relationship between Hersheys and the price of cocoa. This relationship makes sense as 80% of their revenues is linked to chocolates. What may also hurt Hersheys shares is that one of chocolate’s main ingredients is sugar. As I mentioned in a previous article, sugar prices are most likely going to increase, especially when the commercial hedgers are now the most net long sugar futures.

Hershey’s Q2 earning should do well as sugar and cocoa prices plummeted. Q1’s EPS was 1.31, which is an improvement of 19% from the previous year. The stock on July 5th is currently oversold with a RSI below 30, and this stock should bounce in the third quarter. If cocoa and sugar prices do increase, then Hershey’s margins and stock price should take a hit later this year. Another company that should take a hit to its bottom line is Mondelez (MDLZ). Chocolate consists of 27% of its revenue. The benefit for Mondelez is that it’s not solely dependent on chocolate for its revenues since it sells a diversified set of snacks.

Hershey’s stock should rally in the coming months. However, this may be short-lived as some of their core ingredients of cocoa and sugar may see an increase in price.

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Analyst’s Disclosure: I am/we are long NIB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

I am shorting a put contract of sugar and two put contracts of cocoa in the futures (this is a bullish bet). I am also long one contract of cocoa futures.