Understanding Fundamentals – the 2nd Most Important Skill a Trader Needs
Understanding the #fundamentals, the environment of #coffee #supply and #demand is the second most important skill that a #coffeetrader or #analyst needs to develop. As #traders and analysts, it is our business to understand not only the price activity of #coffee, but also the industry of coffee—buying and selling. That’s all "the fundamentals" really is, understanding who is buying and selling coffee.
In this article I will share the key to understanding coffee fundamentals, outline the #supplyanddemand dynamic, and how to translate #coffeefundamentals into price expectations.
Before I get into it, I mentioned that Fundamentals is the 2nd most important skill a trader needs. So what is the first?
Mindset
The first most important skill that a trader needs is mindset. I know, I know. That sounds terribly hokey, but it relates to the fundamentals very closely and I will tell you why with a short true experience.
After spending a couple of years as a trainee, I remember vividly when I proudly announced to an older trader well known for being a fundamentalist that I wanted to learn “the fundamentals” and asked if he would teach me. He was kind to me, but in his response he said, “the Fundamentals are a journey, not a destination.” Some others rolled their eyes at this remark, but over the years I have come to understand this remark better.
He was saying, the fundamentals are not a box that you check, but it’s a commitment to understanding the truth. He was saying forget trends, forget opinions, forget bullish and bearish. Focus on the numbers. Focus on understanding reality.
This takes a certain bravery and integrity for a fundamentalist. It is why the term “fundamental trader” is often used synonymously with “contrarian trader.”
This all comes down to mindset, a skill that is applicable to multiple aspects of trading, and it is why it is always the subject of the first lecture on Day 1 of my Coffee Trader’s Course.
Key to Understanding Fundamentals
In my experience, a true understanding of the coffee fundamentals begins with an understanding of the #biology of the plant. The coffee year, #harvest cycles, vulnerability to #weather, storage, #origins, cultivation and best practices, even the reasons that we drink coffee, these all stem from the plant’s biology.
When considering supply and demand of coffee, #production is the key volatile factor, and production is driven by biological concerns of the plant.
Some key points in the biology of the plant that make Coffee a unique agricultural commodity are as follows:
Location – Coffee is a #tropical plant that grows beans optimally for coffee in high altitudes. This means that pretty much everywhere between the tropic of cancer and Capricorn that has mountains is a potential origin, and most of those locations grow coffee.
Coffee is a tree crop – Tree crops are not as vulnerable to rainfall deficits as row crops like wheat and cotton as they have deeper root systems and can hold water longer. However, it also takes several years for a coffee tree to reach a maturity where it is producing optimal levels of coffee. This means that coffee production is slow to react to price. Coffee coming to harvest was planted several (or many) years ago and high prices will primarily influence production several years in the future.
Crop Cycle is related to the local climate – In general, the origin’s position to the equator will drive when coffee comes to harvest. Those in the Northern hemisphere harvest in October, those in the Southern hemisphere harvest in May, and those countries that straddle the equator have two harvests…a main crop and a midcrop.
Flowering – Coffee trees flower on branches grown the previous year (new growth). These flowers are typically triggered by rains after the harvest, and following a normal seasonal rainfall pattern is important not only for triggering the flower, but ensuring that the flowers are supported through the pollination period and the setting of the new beans. Weather will also impact the length and quality of new growth, the development of the cherries, and the overall health of the plant.
The Supply and Demand Dynamic
The end result of supply and demand is the balance sheet. The balance sheet outlines the net production and consumption in the world or a specific region. Supply minus demand is the “balance”, either a surplus or deficit that summarizes the net impact on stock levels.
Much of the coffee world focuses on this balance number for the coffee year, but there is a secret sauce number that is more important than the balance. That number is the stocks to use ratio.
The S/U ratio puts into a normalized format the essence of the fundamentals. Many roasters put this into more practical terms with a phrase like “weeks of consumption.” In other words, roasters often think about the global supply of coffee in terms of how many weeks will stocks last without replenishment.
This number is the key to estimating a fair value for the coffee market as it encapsulates the intersection of buyers and sellers in a single value.
To get to this number, that means calculating total supply and total demand.
Supply is calculated in various ways from trend analysis to crop counting. However, the real “proof” of what is produced, the hard number, is the exports. We can look at exports from a country to determine how much was produced there.
Exports are not a one size solution though unfortunately, as estimating the crop size from exports is complicated by domestic consumption and stock levels.
Consumption can similarly be estimated through “disappearance,” which is a function of imports and stock change in destination markets.
Translating Fundamentals into Price Expectations
One popular way traders talk about the fundamentals that I want to challenge, is using supply and demand to say that they are bullish or bearish without context. In other words, saying, “there is a deficit so I’m bullish.” Or “there is a surplus so I’m bearish.”
Bullish compared to what? Bearish compared to what? If there is a 10 million bag deficit, is that bullish? What if prices are at $3.50? Is it still bullish?
The Stocks to Use ratio really shines in its ability to answer these questions. The stocks to use ratio allows us to state what we think fair value for coffee is compared to an objective measure of the fundamentals. When we get a fair value of say $2.00 from a stocks to use ratio, this allows us to make a judgement on current prices. From this perspective $3.50 would be overvalued, but $1.50 would be undervalued.
Conclusions
The truth is, even if everyone agreed on the same principles of fundamentals for the coffee market there would still be a lot of divergence of opinions on the value of coffee.
This is because of two key reasons:
1) imperfect information
2) varying time frames
It should be relatively easy to understand number 1. As we saw in the section on biology, coffee is very dependent on the weather, and humans still are not able to predict weather with certainty very far into the future.
The weather is not the only area where we have imperfect information. Stock levels, consumption levels and even import and export figures can vary widely depending on how they are counted and which sources are used. This can lead to substantial disagreement on fundamentals.
Additional to imperfect information, varying time frames also play a big role here. We trade coffee on a futures market. Our imperfect information is constantly pushing our forecasts and view as far into the future as we can, right on the edge of uncertainty.
In many respects, this is the dynamic that is playing out right now in the market. We are in a situation with tight fundamentals showing a high fair value in the present, but the future is ambiguous with a large surplus in one potential reality and a continuing deficit in the other.
This where we come back to mindset, as we continue our search for the truth, we will have to steel ourselves for the uncertainty and chaos of forward predictions. We will need the bravery to stick to our views and when the data supports it, and the humility to change our view when the situation changes. To learn more about Fundamentals and Trader Mindset, join us for our next Coffee Trader's Course.