Thursday, December 27, 2007

Turn, Turn, Turn

To every thing, turn, turn, turn
There is a season, turn, turn,turn
And a time to every purpose under heaven

A time to be born, a time to die
A time to plant, a time to reap

- Pete Seeger

History doesn't repeat itself, but it does rhyme.

- Mark Twain

The shapes of the annual price curves for wheat and corn follow reasonably predictable patterns based on their respective planting, growing, and harvesting seasons, as well as on seasonal fluctuations in demand for the products derived from those grains. Based on supply and demand factors in any given year, the degree to which grain prices rise or fall will change, but the basic seasonal pattern normally at least somewhat resembles those of past years. With the rising demand for grain products in China and India, price rises should continue to be in excess of the historical norm in 2008, just as they were in 2007.

As discussed in the previous post, both wheat and corn tend to rise in price between November and sometime in early-February, when prices tend to fall off sharply. Historically, the best contracts to play this seasonal rise have been the July contracts for both grains. Soybeans also tend to rise in early-January, but tend to fall again about two weeks later, and also tend to trade with more volatility than wheat and corn. Additionally, soybeans are much more affected by fluctuations in the price of oil than the other two major grains, so this discussion will focus on wheat and corn.

Both wheat and corn are already up from their November lows this year, and I am long July futures contracts of both. I started with a stop of $1,000 below my entry point on each and have now moved those stops up to lock in a $500 profit. I will continue to trail my stop up as these markets rise, and will move up those stops very tight in late-January in expectation of the "February break" frequently observed in these grains. Of note, in recent years corn has tended to "break" as early as mid-January, probably due to traders anticipating this traditional price move and getting out ahead of the pack.

Following the "February break," wheat and corn both tend to recover in price and go on to reach even higher prices, peaking sometime between May and July. If you are fairly confident this pattern will recur, another way to play this seasonal pattern that is developing right now is to buy options that are about 10-20% out of the money on the July futures contracts. Since you pay cash upfront for the options, you wouldn't have to worry about margin calls as the prices of the underlying futures contract moved against you during the "February break," as you would if you tried to hold a standard futures contract position all the way through to the summer decline in prices.

A more conservative way to play the likely agricultural commodity scenario for 2008 is to buy the corn/wheat "spread." This simply means buying the July 2008 corn contract, while simultaneously selling the July 2008 wheat contract. In 2006, corn prices went up more than wheat prices because of government subsidies for corn-based ethanol that distorted the free market (and led directly to tortilla riots in Mexico). So in 2007, lots and lots of farmers switched their wheat acreage over to corn to take advantage of the higher corn prices, which led directly to wheat prices rising more than corn prices in 2007 (to all-time highs). You can therefore expect to see farmers switch current corn acreage to wheat and soybeans in 2008, which should lead corn prices to outperform wheat prices due to the lower amount of corn harvested. By being long corn and simultaneously short wheat, you don't care anymore whether prices are going up or down - you win as long as corn becomes relatively more expensive than wheat over the holding period of the two contracts, even if both corn and wheat decline in price.

If you would like to play the agricultural commodity boom, but just can't bring yourself to trade futures contracts or options on futures contracts, probably the best way to do so is to buy some shares in an ETF with the symbol MOO that contains many agricultural-related stocks. If you want to increase your leverage on that bet, you can buy options on the ETF, the longer-dated the better. For those who prefer to play individual company stocks instead of ETFs, a personal favorite of mine that is in my wife's portfolio has the symbol POT. It's a Canadian potash mining company, and potash is a key ingredient in fertilizer. No matter how farmers decide how much of their acreage will be allocated to wheat, corn, and soybeans each season, they will still need ever more fertilizer! Again, you can increase the leverage by buying LEAPS on POT. A good friend of mine has had LEAPS on POT for more than six months and is currently up on that position in triple digit percentage terms even after the two market pullbacks that occurred this fall.

The main reason I prefer the futures to the ETF or to a single stock is that it is still not clear if we will suffer a major stock market correction in 2008 or not (regular readers know I consider this possibility to be highly likely). If we do, MOO and POT will most likely initially crash right along with the rest of the market, although I think that they will be among the first stocks to recover. I have MOO and GDX on my very short list of ETFs to buy once the crash is over.

Just a quick update on our old friends the yuan, the yen, and gold, all recommended here over the last few months.

I hope everyone had a very Merry Christmas! The upcoming year is filled with possibilities for profit, and we will be discussing them in this forum.


SilentBobSF said...

Hey...I have a question on your earlier post about Goldman Sachs. The news reports of the last couple of weeks state that they have made record profits and their CEO has gotten this huge bonus. So how are they virtually bankrupt?

Reptile said...

Great question, Silent Bob! The answer can be found at: Basically, under standard accounting rules, financial institutions must "mark to market" all of their financial instruments. For example, if they own shares of stock in Microsoft that they bought at $35, but Microsoft has dropped to $25 per share, the financial institution must lower the value of the Microsoft shares on their books to indicate that they are now worth less (This was how Japanese banks managed to stay afloat during the 1990's after their twin stock and real estate market crashes - under the Japanese laws in existence then, they were not required to mark their assets to market as long as they never sold them). But what do you do about assets that rarely trade, such as some of the complicated derivatives based on mortage bonds (now rapidly becoming worthless as homeowners are forced to turn in their keys and walk away from their loans)? The solution under accounting rules was to create three "levels" of assets: Level 1, Level 2, and Level 3. Level 1 assets are common assets such as stocks and bonds that can easily be marked to market; Level 2 assets are rarely traded assets that can be valued based on comparison to similar assets that are more actively traded; and Level 3 assets are allowed to be "marked to model" since there are no easy comparisons. The catch is that institutions are allowed to make up their own "models" to mark their Level 3 assets to! This has led cynical people to refer to these assets as "mark to myth" assets. The music can keep playing in this Russian roulette version of musical chairs only until somebody finally breaks ranks and sells some of their Level 3 assets. Once that happens, that price then becomes the benchmark, and everyone else must now mark to market since there is a market price to compare with. Since a lot of this toxic waste is for all intents and purposes now worthless, the major financial institutions will at some point be forced to dramatically mark assets down from 70 or 80 cents on the dollar to literally pennies on the dollar, and there are literally hundreds of trillions of dollars of this stuff clogging the financial system right now. This is why Warren Buffett (who if I recall correctly, you once shared an elevator ride with!) called these assets "financial weapons of mass destruction" several years ago, and publicly urged financial institutions to get them off their books as quickly as possible. Of course, they didn't listen, and now they are finding out the hard way what Warren meant when he said many years ago, "When the tide goes out, you find out who's not wearing any clothes."

silentbobsf said...

Fuuuuuuck... This is the same as the whole Enron scandal. I was not aware that mark to market was still legal. Hopefully the repercussions will not be as severe this time around, but I fear that is wishful thinking.