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Collapsing Spreads Signal Major Commodities Correction

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"Ag bulls are still reading January's news," says one money manager.

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"Spreads generally portend structural shifts in the ag markets that can give you a good heads-up about future commodity behavior. And we're seeing spreads collapsing right now."

So says Shawn Hackett, founder and president of Hackett Financial Advisors, a money management firm with a specific focus on agricultural commodities that services end-users, hedgers, and investors.

In a new letter to clients, Hackett writes:

Bear futures spreads in cotton, sugar, oats, wheat and soybeans have all collapsed over the last 45 days signifying that demand destruction has begun to take center stage in the overall prices discovery mechanism for most agricultural markets. Spreads are very sensitive to true supply/demand and are not very affected by testosterone induced speculative activity. Collapsing futures spreads between old crop supplies and new crop supplies almost always precede and are very good warning signs for an imminent collapse in the actual underlying price of the commodity.


"Sometimes markets are driven by a supply shock, like what happened last year with Russian wheat," Hackett tells Minyanville. "Then there are times where you have a demand-side shock, like what we saw when the ethanol craze first took hold in 2006. Other times it's an inflation trade, where a weak dollar is the driving force in the price discovery mechanism. This time, it's demand destruction."

When there's a perceived shortage, says Hackett, "end-users – Kraft (KFT), ConAgra (CAG), General Mills (GIS), Campbell's (CPB), and so forth -- buy as much as they can, far more than they need. However, the market sees this demand and they go out and buy as much as possible, as they overestimate this as demand that will continue. That produces a huge overhang and a demand-side vacuum. Now you have a glut and the spreads begin to break down."

Hackett points to sugar as an example.


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"This bear spread has collapsed as the typical effects of a monster Brazilian sugar crop put an end to any notion of any supply scarcity which never existed to begin with," he writes. "There was actually a small surplus in the last crop cycle not a deficit so this whole market was driven by fear of scarcity and not an actual one. Also huge sugar current supplies coming out of Thailand and other Asian countries will swell surpluses in the next crop cycle. India's sugar crop from last year was much better than anticipated and all indications are that this year will likely set a new all-time record for production as the monsoon should be normal. All in all, the sugar market is likely entering a multiyear surplus cycle that will maintain pressure on this market and only allow for very intermittent rally attempts."

"Even against a crashing dollar, wild money printing by the global central banks and wild speculative fund buying in overall commodities, the sugar market has lost 30% of its value and is not done yet," Hackett continues. "This is a bearish warning shot for other commodity markets when the two darling bull markets in cotton and sugar that have led the way have broken to the downside. Usually when the leaders fall, it then spreads a bearish psychological contagion to all other markets."

Hackett says that "everyone tells you about the bull market in ag because they're still reading January's news."

"There's a collapsing spread structure in almost every area of the entire ag sector," according to Hackett. "Look at cotton – the July/December spread gave up 70 cents just in the last couple of months. Now it's starting to free fall."



"Even a drought in the state of Texas of the highest order that grows over 50% of US cotton can no longer support cotton prices," Hackett says. "Nothing has changed with the cotton market. Global planted acreage will be huge in 2011 against a destroyed demand base and record supplies coming out of South America especially Brazil as we speak. The surpluses that will be seen over the next crop cycle globally will be simply massive. The hangover from this bull market will be felt for many years before a healthy resuscitation of demand will likely be seen. If it ever rains in Texas by the end of June 2011 then the death spiral to lower prices that has already begun will reach its crescendo."

Hackett notes that the "only spread left standing, currently, that has yet to completely break down is in the corn market."


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"It is just a matter of time before this historically high spread crashes back to earth," he maintains. "All one has to do is look at the billions of dollars of losses that have been incurred by the publicly traded companies in the meat processing industries and one can plainly see that corn demand is on borrowed time at best."

Why?

"Current prices are being supported by the current late planting season that a very wet spring has created," Hackett says. "May I remind everyone that last year's crop was planted record early and we had the worst crop this decade while the crop in 2009 was planted very late and produced a record yield. When one looks at the facts of the case, late-planted corn rarely produces a below trend line yield. The odds favor that the current corn rally is being over-embellished and should be sold by farmers."

In short, Hackett recommends getting short.

"This is a shot across the bow."

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No positions in stocks mentioned.
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