Cotton's Come Up(pance)

06/02/06 08:45:08 AM

by David Penn

A cotton bounce in late 2004 looks to have come to an end in mid-2006.

Security: CT
Position: N/A

There is a strong technical argument that cotton was in a secular bull market from the mid-1960s to the mid-1990s—with the rude interruption of a vicious cyclical bear market from the early 1980s until the middle of the decade that wiped out nearly 80% of the gains of the previous, 15-odd year advance. See Figure 1.

FIGURE 1: COTTON, CONTINUOUS FUTURES, MONTHLY. A brief history of cotton points to a secular bull market from the mid-1960s to 1995. Has a secular bear market developed in its wake?

Graphic provided by: Prophet Financial, Inc.

From the mid-1990s, it could be argued that cotton has entered a secular bear market. Peaking at just over $1.10 a pound (basis continuous futures) early in 1995, cotton plunged over the second half of the decade, finally bottoming under the 30-cent a pound level in October 2001. This low was comparable to the cyclical bear market low in cotton in 1986, and it is no surprise that a powerful cyclical bull market emerged in its wake. Cotton futures soared back to the 85-cent per pound level within two years of those 2001 lows.

Any analysis of cotton's contemporary performance should probably begin with the top in October 2003. If we use as our thesis the idea of a secular bear market beginning in 1995, then the decline from the top in late 2003 should represent a resumption of a bearish trend of lower lows. And if there is to be a trend of lower lows, then the current low around the 42-cent level will have to be broken to the downside. Given the bounce that began in late 2004, what are the prospects for a reversal and a test of those lows near 42 cents?

FIGURE 2: COTTON, CONTINUOUS FUTURES, WEEKLY. Cotton futures find resistance at a Fibonacci 38.2% retracement level and appear to have given up the fight for higher ground as bears drive cotton below a key trendline in the spring of 2006.

Graphic provided by: Prophet Financial, Inc.

As Figure 2 shows, the bounce in cotton futures (basis continuous futures) has retraced approximately 38.2% of the decline. What is especially interesting about this Fibonacci benchmark is that cotton has been unable to penetrate it thus far. While it is true that the more time a resistance level is tested, the more likely it is that the resistance level will be broken, this idea persists as long as no other negative event intervenes—such as the drop below important support. Unfortunately for cotton's advance, "drop below important support" is just what cotton did in the spring of 2006, sliding below an uptrend line that has provided support for cotton's bounce since the autumn of 2004.

This trendline break already has taken out one of the lows (the November 2005 low) and will have another chance to test the next potential low (August 2005) if prices continue to slip toward the 48-cent level. How likely is such a test? The failure at the 38.2% retracement level potentially is a sign of major weakness in cotton, the kind of weakness that begs the question of whether the real lows near 42 cents—in other words, the origins of the rally—will in fact be the next target of the cotton bears.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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Cotton's Come Up(pance)

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