After the December contract had reached a high of 93.72 cents last Friday, followed by another attempt to a high of 93.54 cents on Monday, the ferocious rally that took the spot month nearly 900 points higher over the course of just nine sessions was finally losing steam.

With momentum oscillators flashing warning signs and with December opening below its steep uptrend line on Monday night, the stage was set for speculators to head for the exit.

What followed was a brutal smash that knocked the December contract down 874 points in just two sessions. Many commentators seemed perplexed by the severity of this decline and were looking for explanations, such as reports of a bigger crop in India or rumors about a resumption of Chinese Reserve auction sales in conjunction with smaller import quotas. However, since this was mostly old news to traders, we have to look elsewhere for the culprit.

We believe that this sell-off was primarily caused by a lack of liquidity! Speculators had sponsored the market’s advance after it broke above a triangle formation on August 7, with open interest jumping by around 39’000 contracts over the following nine sessions.

Specs couldn’t possibly keep on buying at this pace and were therefore relying on trade short covering to take over at some point during the rally. However, unlike in early 2008, trade shorts stood their ground this time and weren’t in any hurry to buy their shorts back, even after the market started to move lower.

Since most speculators obey technical signals in their decision-making, a massive amount of sell orders hit the market when the tide turned on Tuesday, with very little trade buying absorbing it on the other side. This caused the market to fall into a void of buying on Tuesday, locking limit down for a good part of the session and thereby limiting the amount of longs that were able to get out.

Only 19’410 December futures traded on Tuesday, with open interest dropping by just 5’206 contracts! This set the market up for yet another big decline on Wednesday, which proved to be more accommodating in terms of liquidity, as volume increased to 40’828 lots in December, while open interest decreased by a further 13’256 contracts.

The market finally regained its footing on Thursday, as trade buying supported the spot month at around 84 cents. Needless to say that this sell-off left its marks on the chart, as it took just two days to erase the constructive efforts of the last five weeks.

Furthermore, December broke through an uptrend line that dates back to June 3rd and we also completed a triple-top formation on the weekly chart. In other words, spec longs and technical traders are pretty beaten up and have probably not much love left for the cotton market at this point.

With speculators incapacitated, the trade is once again in the drivers seat! Activity in the cash market has definitely picked up over the past couple of days, as mills are busy securing additional supplies and fixing open contracts. If last week’s surprisingly good US export sales of 91’800 running bales net are any guidance, then sales should be a multiple of that after the big price break.

Despite the high price level last week, there were still 15 different markets pursuing US cotton, which tells us that available supplies must be quite scarce around the globe. The fierce pace of shipments seems to confirm this notion, as no less than 573’200 running bales were exported during the first 15 days of August.

So where do we go from here? Although specs have liquidated a decent amount of longs over the past few sessions, open interest nevertheless remains fairly high. We estimate that specs (large and small) still carry a net long of around 6.5-7.0 million bales, whereas the trade probably has a 13.5-14.0 million bales net short, with Index Funds accounting for the difference.

As mills buy and fix additional supplies, more of these trade shorts get lifted, which spec longs will welcome as an opportunity to lighten up on their longs. For now we expect this process to be fairly orderly, with the market probably not straying too far from current levels.

In the longer run a lot will depend on how the US crop turns out, both quantity and quality wise. Then there is the uncertainty regarding China’s price support and import policy, which could yield some surprises.

However, before getting too negative on China, we need to remember that the seasonal production surplus in the ROW (rest of the world) is only expected to amount to 9.53 million bales, according to the latest USDA report, so that’s all China needs to absorb in order to prevent ROW stocks from rising.