The power of Linkages: Cotton prices, Nike and V.F. Corp

“What we learn from history is that people don’t learn from history” – Warren Buffett

Last October 21^st we took a look at the linkage between Crude Oil prices, which had dropped 10% over the previous 6 weeks, and the trading in Airline stocks.  We wondered what happened to Airline stocks when Oil prices were trending in a similar fashion over the previous 20 years.  We highlighted US Airways as the stock that typically had the best run up in the 1 month after, with an average return of 7.94.  One month after our projection, US Airways was up 15.42%.

Is it groundbreaking to suggest that Airline stocks will perform well when Crude Oil prices are dropping?  No, but as usual the devil is in the details, and in this case that’s the EidoSearch analytics and range of historical outcomes.  Otherwise, we would have known that the drop in Crude Oil was positive for Airline stocks generally, but the questions being asked would have been, “when have we seen Crude Drop like this from a recent high?”, and, “how quickly do airline stocks typically react to the drop in Crude”, and “what airline stocks have been most sensitive to Crude price moves historically?”.  Again, all these questions answered accurately in seconds.

Currently, there are some strong macro trends at play in commodities.  Many key indicators are in a downward trend, including Copper, Grains and Natural Gas, but Cotton is bucking the trend and is up 23% in the last 4 months.  Let’s take a closer look.

Let’s first answer the obvious question, “when has Cotton looked like this historically and what typically happens next?”  Per the chart below, we’ve seen this 4 month upward trend in Cotton (CT) 19 times historically with high similarity.  To no big surprise, the two biggest gainers were in 2010 (when Cotton hit all-time highs) and the two biggest drops were in 2011 (when Cotton was falling back to Earth).  Including those 4 tail examples, on average cotton prices are historically flat in the next 3 months.  Excluding those 4 historical instances (two green to the right and two red to the left), the average outcome is still flat and you can see that the range of outcomes is pretty tight to the mean.

Historically, we haven’t seen a strong reversal in Cotton prices over the next few months, so what does this mean for larger apparel manufacturers most sensitive to the cost of this primary raw material?  We focused in on two of the largest consumers of cotton, V.F. Corp and Nike, to investigate.

It seems widely accepted that rising cotton prices are usually not good for margins and in turn share prices, and we see just the opposite effect when cotton prices are falling.  Take Last February, V.F. Corp announced record gross profit margins in large part thanks to lower cotton prices (less than half the cost in 2010), and the stock went up 50% over the next 6 months.  Beginning last Thanksgiving, cotton has run up 23% through last week.  What has been the effect on VFC and NKE, who not surprisingly have similar price trends?  They are both basically flat year to date per the chart below.

So, all this points to a rocky few months ahead for Nike and V.F. Corp right?  Actually, no.

EidoSearch looked at the price trend in Cotton (CT) beginning in November, and captured the 19 most similar historical instances of this trend as detailed above.  We then looked at how NKE and VFC have reacted in these 19 similar environments and to see how they performed in the next 3 months historically.  Very well per the charts below:

This analysis identifies the historical instances of the current price trend in cotton, but the 3 month forward return statistics show Nike’s performance historically.  Each bar represents the return for NKE in each historical instance.  On average, the stock is up 7.8% with limited downside risk (8 historical instances of this pattern are up 10% or more in the next 3 months and there are no instances historically that fall below 10%).

VF Corp, in these similar historical instances for the current price trend in Cotton, is up 9.9% on average and 73% of the time, again with low downside volatility compared to upside potential.

We see this as a great example of how pattern search technology can provide quick and objective answers to the Linkages between assets, securities and investors occurring daily.  Coupled with investors’ knowledge and experience of these historic periods, these predictive analytics create tremendous new capabilities to anticipate opportunities and measure risk.

Have a great week.