Sunday, December 14, 2008 0 comments ++[ CLICK TO COMMENT ]++

Agriculturals and a flaw in thinking

I have no strong bullish view when it comes to commodities but I do feel that soft commodities (agriculturals) may do better than the industrials or energy in the future. I want to refer you to an article in last month's Globe Investor magazine presenting a bullish argument for agricultural commodities, and highlight a flaw in the thinking. The article is Canadian so it refers to Canadian securities but agricultrual bulls and bears may still want to read it (although nothing earthshattering was discussed.)

The biggest flaw commodity bulls can make--and I see them doing this all the time--is the following:

No matter how deep or protracted the economic downturn becomes, the world’s population will still need food on the dinner table each night. So, for some, it’s been a bit of a curiosity that grain prices have been halved in recent months as equities tanked and economies contracted.

Tight bank credit and a splurge of investor redemptions forced many hedge funds and other speculators to quickly liquidate their futures positions in the sector. But the supply and demand fundamentals that drive these markets remain largely intact.

Unlike other commodities, such as copper and oil, the agriculture sector feels little impact from gross domestic product fluctuations, because consumption depends more on factors such as population growth and biofuel development.

Some analysts suggest grains and oilseed prices may have fallen victim to a herd mentality of selling commodities across the board. And many believe the commodities are poised for a rebound.

Before I say anything, I think it's ok to follow that thinking for momentum and growth investors. But if you are a value investor or a contrarian, it is fraught with peril. It is also risky if you are a macro investor.

I see many commodity bulls following the thinking I highlighted in the quote above. That is, people always argue that 'everyone needs to eat food' and that the current sell-off is due to herd selling.

Regarding the first point, you could have said that about almost any commodity over the last 100 years. People have always needed to eat food, and food consumption has actually grown with the population explosion, yet agricultural commodities have been a horrible investment in the long-run. The same thing applies to oil, with oil consumption increasing all throughout the 80's and 90's while oil prices kept falling--this is with a powerful cartel purposely cutting production too (if this was more of a free market and OPEC did not exist, oil prices would have fallen much lower.) I will note that, in the long run, oil has retained a real price of around $22 (source: WTRG) whereas agricultural commodities have completely collapsed over the century.

What matters to any investment, assuming you are not a momentum-type investor, is price! It doesn't matter if people still buy more of the product if the price was too high in the first place. The argument that the fall in agricultural commodity prices is due to herd selling is meaningless in the grand scheme of things. One can just as easily argue that if the selling is due to the herd, then the price ascent was due to the herd as well. That is, the price wouldn't have gone up in the first place if the herd didn't push it up.

I don't have a strong bearish view--I used to a few years ago but not now--but, just because grains are down 50% doesn't necessarily mean that it is an irrational price. I lean towards the bearish side because I am concerned about a potential implosion in China (some analysts are expecting 3% GDP growth for early next year--an unthinkable scenario.) However, that is a low probability macro call on my part. If you are bullish on these commodities, you need to check with fundamentals and see what can be attributed to irrational selling and what is sustainable in the market place.

Agriculture ETFs Differ Significantly

If you are investing in agriculture, it is important to realize that a big chunk of it is localized (similar to natural gas.) That is, the food consumed in one part of the world may be different from what is produced in another part of the world, and this may not change for many decades. For instance, let's say you are bullish on Chinese food consumption. Well, depending on various factors, such as taste and cost, it is quite possible for rice and pork consumption, two of the popular items there from what I understand, to rise significantly while, say, corn and wheat may not see similar increases. The following chart illustrates the differences between the various agricultural commodity indexes:

As you can see, the differences are quite significant. Typically, competing indexes for stocks or bonds are quite similar. The difference between the worst and the best index, although not insignificant, is not something to kill yourself over. For example, whether you invest in Russell 2000 or S&P 600 or Dow Jones Wilshire small cap ETF--all these are small cap ETFs--they end up producing similiar, although not identical results. In contrast, commodity ETFs can yield wildly differing returns. Although correlations between all commodities, not to mention between commodities and stocks, has been high in the last 5 years, individual commodities, especially soft commodities, have historically performed independently of others. Each commodity has its own cycle, with some peaking long before others. For instance, just because sugar went up does not necessarily mean that wheat will go up as well--even though they are both agriculturals.

I would argue that anyone betting on agricultural commodities should spend a lot of time thinking about which specific commodities are likely to do well. Picking the right index will likely produce a radically different outcome. This is especially true over the super-long-run, which is what many commodity bulls are looking at. Of course, if you are not confident with your commodity calls, you can bet on commodity stocks either directly (eg. agriculural companies) or indirectly (eg. farm equipment manufacturers, fertilizer companies). Stocks are much more correlated and you can make a blind "bulish agriculture" bet and not worry about whether corn is going to do poorly compared to sugar, or whatever.

I am still neutral to bearish on commodities and would wait and see if China can survive through this recession without a political crisis.


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