CHEAP AS DIRT
2016-04-14 5pm EDT | #grains #corn #wheat #soybeans #China
I have a confession to make. Sometimes I get an idea, and so I put a position on the sheets. I intend to write about it, but it starts to take off. So I wait. And I wait…desperately trying to time a dip to get a post in. Sometimes it never comes. I am too much of a coward to write about something as it screams higher. I worry my post will be the top tick.
Today I will throw caution to the wind and talk about an asset that had its best week in a quite a while. With the knowledge I might indeed be putting in a top with my post, I will sketch out my long term bullish position in grains.
Have a look at the recent chart for Soybeans:
Soybeans have exploded to the upside and even traders who usually never even bother to glance at the ags are talking about the move. So far, the other two widely followed grains, corn and wheat, have not followed with an upside breakout.
But even though the soybean chart looks like it has already run a long way, stepping back and looking over the past five years yields a much different picture.
The recent soybean rally is barely a blip as all three grains have been mired in a frustrating multi year bear market.
Yet what does a really long term picture look like? Is this bear market a buying opportunity?
Most of us have heard the famous 1970’s bull market in grains. What trader doesn’t have a fleeting familiarity with the phrase “beans in the teens!” And you can see from this long term chart, there was definitely an exciting period where grain prices exploded upwards.
But after making millionaires out of many CBOT pit traders (back when being a millionaire meant something), grain prices treaded water for the next 30 years. It wasn’t until the mid 2000s that prices had any sort of decent rally. Yet that rally has been dashed with the great commodity bear market of the past few years.
Although soybeans are higher, corn and wheat are right back to nominal price levels that were reached back in the great bull market of the 1970s.
So let’s think this through. After a huge rise in the mid 1970s, grain prices have basically gone sideways for the past 40 years.
If you take into account the years of inflation, this means grains have actually been declining in real terms. Here is a chart of soybeans indexed to the CPI inflation gauge:
Soybeans are not at the lows in real terms, but they aren’t far off.
Wheat is another matter. It is sitting right at the lows:
And same deal for corn:
Obviously there has been a tremendous amount of technological advancement in the grain market that has allowed prices to decline in real terms over the past four decades. Improvements in fertilizer, farming technology and the huge leaps in genetically modified crops have created one of the most relentless deflationary pricing environments for any commodity.
Look back at these inflation adjusted charts with a specific attention to the 1970s bull market. The monster magnitude of that bull move is much more obvious. And then the relentless bear market that followed is even more pronounced.
The farming improvements that created this shocking decline is evident in this chart from Purdue University showing Corn Yield over the past 150 years:
Yields have been going one way - higher! And that has the expected effect on price - lower!
When you combine this secular trend with the near perfect growing weather of the past few summers, it is clear why grains have been sinking. The bumper crops have pushed grain stock piles up to record highs.
From a Bloomberg article last summer:
Global grain stockpiles are set to swell to the largest in almost three decades, further boosting supply that’s led to a slump in prices. World inventories of wheat, corn and other grains will reach 447 million metric tons by the end of the current marketing year, the highest since the 1986-87 season, according to the International Grains Council in London. The agency on Thursday raised its forecast by 2.8 percent from an estimate in July, when it had predicted inventories would fall from last year, citing better wheat crops in Europe and the former Soviet Union.
Not much to be bullish about, eh? Well although I understand the bear argument, the problem is that so does everyone else.
I recently watched a special presentation on HedgeEye that coherently outlined the bear case on grains. The fellow made a compelling case on why “grains were the last commodity market that had not cracked.” He went through the collapse in gold. The collapse in oil. The collapse in copper. He then argued grains were the next commodity market due to collapse.
His argument was centered on the secular trend towards improvements in farming technology, but the catalyst was focused on the large record grain stockpiles. These stockpiles were going to force the price of grains over the edge into a plummeting liquidation crash. He was really bearish.
Maybe he is right. Who knows? But since there are precious few bullish long term traders, let me give the other side of the argument a shot.
Let’s start with the secular trend. Yields have been on a relentless trend higher. Technology seems to continually magically come up with ever increasing better ways to farm. GPS precision has made planting, fertilizing and harvesting amazingly precise. Many of the new combines actually drive themselves! Google is probably a decade behind farmers with their self driving cars. GMO and the herbicides designed to not attack designer grain seeds has revolutionized pesticide use. And the advances in fertilizers have done wonders for maximizing the good weather when it comes. All in all, farming technology has been an amazing success story.
But can this rate of success continue? For a long time Moore’s Law seemed irrefutable, but recently technology companies have struggled to keep up with the predicated rate of improvement. Eventually technology matures and big advances become increasingly difficult. I am not forecasting it, but the rate of improvement in farming might suffer a similar setback. It’s not like there won’t be advances, it’s just that they won’t be as large. Yields might plateau, or at the very least, stop rising as quickly.
Yet even without a decline in the rate of improvement in yields, I believe too many traders are missing the other side of the equation. Sure supply is increasing, but what about demand?
Remember the record grain stockpiles? Sounds pretty bearish. But too many ignore that although supplies are at record highs, so too is demand. The world is consuming record amounts of grains. Have a look at this great chart from Bloomberg that shows the ratio between supply and demand:
Doesn’t look that scary after all. Supply is perfectly appropriate when measured against demand. It shows no record supply problem that will send prices crashing.
We all know the story about the growing Chinese middle class. The amount of people about to become wealthy enough to afford some Western style “luxuries” is scheduled to explode exponentially. Over the past few decades, meat consumption in China has dwarfed Western nations. But what will happen to grain use when China catches up?
I can’t remember the stat, but I think it takes something like 6 or 7 times more grains to produce the equivalent amount of meat protein. Demand for grains is about to skyrocket. It’s as simple as that. As China becomes more prosperous, the increased demand will dwarf any improvements in farming technology.
Maybe you don’t buy the “grains are going higher” argument, fine. But if you are worried about inflation making a comeback, you could probably at least accept that in this world where it is difficult to find an uncorrelated asset that tracks inflation, grains are a potential candidate. It is obviously not that easy as buying futures has roll problems and a myriad of other difficulties. Yet as an inflation hedge, it is intriguing. For me, this is is just an added kicker.
Finally regardless if you believe greenhouse emissions are causing global warming, it is difficult to dismiss the fact the trend towards a warmer climate. Although this has resulted in near perfect growing seasons for the past few years, I do not believe this streak will last forever. Eventually the hotter weather will create droughts that cause severe problems for the crops. The weather has been so perfect for farmers for so long, we have almost forgotten Mother Nature can be cruel.
The bears are counting on; 1. yields continuing to improve 2. supplies to weigh down the market 3. the growing season weather to once again be perfect 4. no nominal inflation.
Maybe this all plays out exactly as the bears hope. It has worked for the past five years, why not again? But instead of joining them in their pessimism, I am willing to fade them. Grains are dirt cheap. They have suffered through a four decade bear market in real terms. I can’t remember the last time anyone recommended a core long grain position. The relentless bear market has made this trade about as popular as Ebola. I might not know much, but I know the risk reward in this type of environment is skewed to the upside. Surprises always come in the direction no one is expecting.
I will leave you with one of Don Coxe’s famous lines:
“The most exciting returns are to be had from an asset class where those who know it best, love it least, because they have been hurt the most.”
Thanks for reading,