Thursday, January 28, 2016


The cocoa market has a soft spot in my heart. It was the first commodity I ever concentrated on, and I have continued to follow it all these years. My first real job in commodities was as cocoa analyst for MARS Inc., the privately help candy company. BTW, MARS was a truly excellent company and probably still is. The big reason for this was (is?) guidance from a really smart family that takes a multi-generational outlook. I doubt if they will ever IPO, but if they do, I'm in.

Anyway, there are a few structural issues in cocoa that make it somewhat unique:

- Cocoa is a tree and it takes 6 -8 years from the time prices provide incentive for an increase in plantings until you start getting substantial production from the new trees. Say one to two years for the plantings to occur and another five or so for the trees to mature. Once the tree has matured cash costs for harvesting are very low. So cocoa can and does have multi-year cycles, like oil.

- Cocoa fundamentals are exquisitely researched by the major participants in the industry. The large candy companies have staffs continuously examining the trees in the major growing regions. They see even minor effects of weather or disease quickly. Some of the large trade houses also do this research, but on a smaller scale.

- Cocoa speculators are generally technical. This makes sense; it's more difficult and costly to get fundamental info than in say, corn or soybeans. So technicals are all they have. This mostly means they follow trends.

Let's start with the long run position of cocoa using the ten-years graphs. Click here for an explanation.

Interestingly, cocoa has the highest r-squared on this graph of all the commodities in my universe, over 90%! I've backtested it, and you can actually do pretty well in cocoa using this alone. The ten year outlook is still bearish. Let's go a little deeper.

I'm not going to spend any time on current year's supply/demand because as I said, the major players know far more about that than I ever could. So I'll concentrate on the longer term and then discuss tactics. This "time arbitrage" is where Commodity Strategists have their edge.

The bullish case in cocoa can be summed up like this: Demand in emerging markets will increase as their populations adopt a middle-class western diet. Meanwhile cocoa production in the traditional area of west Africa will stagnate as old farmers retire, and their sons move to the cities.

I don't find this argument persuasive. First, as I said in my post of 10/21/15, I don't believe that most EM residents will ever move to a western diet. This is even more true for cocoa since chocolate is a cold weather food. Even in the US or EU consumption strongly dips in the summer. Second, the current productivity of cocoa trees is extremely low. Most African cocoa is grown by "smallholders" who cannot or will not adapt current farming techniques. Yields per acre on commercial plantations are much higher. Also, the African farms mostly use older cocoa varieties that yield much less than newer ones (although they do have better taste). As an example of what can be done with yields on a modern plantation, see United Cocoa.

My view is that cocoa is still historically overpriced, and that there is no "this time is different" case to be made. So I want to be short. Now let's look at tactics.

As noted in the beginning, cocoa speculators are largely trend followers. I once backtested a simple strategy using the CFTC's Commitments of Traders report. The strategy simply waited until the managed money went long (short) by a certain amount. The system did the opposite. It was a net positive strategy, although the drawdowns were too large to actually trade. Here's a graph of the COT over time from

My backtest found that the key statistic is the position of Large Speculators (CTAs). That is the green line in the middle panel. You can see that these specs got maximum long slightly after the peak in prices in early December. You can also see that they are now largely washed out, down to about the lowest long level they have been on the chart. On this basis, now would not be a good time to initiate a short position in cocoa. In fact, now is probably a good time to cover shorts.

So is this a good time to actually go long? I wouldn't. As a Commodity Strategist, I am only playing this from the short side. Nonetheless, the combination of the spec washout and the appearance of heavy manufacture buying at this price back in early 2015, is tantalizing. If you want to do it, you could probably buy here with a 2,700 stop.

Sunday, January 17, 2016

The 10-Year Forward Graphs have been updated. You can view them at the Ten Year Forward Graphs link on the right side of this page.

There aren't too many surprises. Most commodities have fallen into a general value level, and are not clear buys or shorts. A few of the industrial commodities (some metals, iron ore, uranium) still have further to fall. And there are a limited number that do seem to warrant long positions. I'll talk about a few of the last category in this post.

Crude Oil has finally become officially cheap. It has happened quite quickly, in about a month. Using the current spot prices for Brent and WTI, I expect them to double in the next ten years. But of course you cannot buy the current spot and hold it. Well actually you can, but storage and other costs will more than eat up your gains. If you want to do this trade, it's best to buy the forward futures position. Guess what? The last currently traded future, Dec 2022, is going for $48.79. So if I am right, and the price goes up to $60, you make 23%, or about 2% per year. Not good enough. So no trade there.

Shrimp is expected to go up by about 80%. You can invest in this via non-US aquacultural companies. However I would caution against it. This is one of those commodities where there really has been an "this time is different" event. Over most of the history of my price series, shrimp was a wild-caught product. I remember as a boy what an expensive delicacy a shrimp cocktail was! Now most shrimp is farm-raised, and costs are much lower. Different world. Of course you might get an outbreak of some shrimp disease that comes from the unnaturally close confinement of shrimp in the farms, but I wouldn't want to bet on it.

Wheat and Barley are somewhat undervalued, but they have the same contango structure that oil has. So same non-trade.

Aluminum and Nickel are expected to gain by 60% and 80% respectively. I think nickel is a buy. The best bet is to buy cash metal and pay the storage. If you don't want to open a commodity account there is a somewhat thinly traded ETN, symbol JJN, that will do it.

Both hardwood and softwood are cheap. These can be bought via timber companies or REITs. I would worry that electronic communication has given us a "this time is different" situation in softwood. Paper production has already fallen by a lot, and may have a lot more to go. Also, given the world's demographics, I don't see homebuilding going back to pre-recession levels. Hardwood may be a buy, since many old growth forests in S. America and tropical Asia are being cleared. I cannot think of a clean way to play this. If any of you can, let me know.

Cotton is both cheap and has a flat futures curve going out three years. The problem here is that if the supply/demand balance tightens, the years after 2018 may go into the same kind of contango that Wheat or crude has. That would eat up profits. Nonetheless, this is an interesting situation, and I will look into it further.

Sunday, January 10, 2016

Equities and the Emerging Market Curse

OK, I'm not an equity analyst, but as a non-professional (unprofessional?) investment blogger, I am entitled to my opinion. So here it is:

The most important factor in equity prices is the future growth of corporate earnings. Graph the long term S&P against corporate earnings and you get parallel lines (on a log scale). So, where is future earnings growth going to come from? Not from the developed world. The demographics of these areas, combined with their debt levels, make for a long period of slow growth in the US and very slow or zero growth in EC and Japan.

That leaves the emerging markets, BRICs and such. For most of the century, it looked like the ball had been passed to them. But it hasn't been organic total factor productivity growth for many years. Rather their growth was the result of capital inflows and movement of non-market peasants into the market economy. I remember talking with a portfolio manager of a major asset management company about four years ago. His working maxim, "you've got to put your money where the growth is. That's China." BTW, I also seem to remember a series of pieces from Goldman a few years ago that divided the world into stable and growth markets. The "growth" was EM.

What did the BRICs do with the inflows? Well a lot of it was stolen. Brazil is the poster child of this only because Brazil has a somewhat honest judiciary. Many of the countries that don't make the corruption news were as bad or worse. Much of the rest went to uneconomic or vanity projects (the skyscraper curse). And a lot went into an overcapacity of heavy industry. That's why we are where we are in the commodity space and the traditional manufacturing space.

But that's over now. The inflows have almost dried up; I'll bet that net of corruption they are about zero. Meanwhile:
- The demographics of EM are moving towards EC levels.
- There's no more developed market export market growth for the stuff they are able to produce (commodities and manufacturing).

So where's their growth going to come from? Ideally they should transition from a commodity/manufacturing model to a consumer goods/services model. The problem is that this is hard to do. With manufacturing, you only have to import the technology from in the West and add a few million impoverished peasants. Services are more culture-dependent. You have to develop the human capital within the context of your society. This is not a quick job. It will happen, but only slowly, and it may not need much help from the S&P 500.

What I'm trying to say is that multinational corporate profits are likely to grow only slowly over the long term, maybe low single digits. With the P/E of the market at about average, this means overvaluation. And this is why any news from China has such a disproportionate effect on the market. It's the only source of growth left!

I've been almost out of the stock market for about a year now. Still hold a few special situations, but not overall beta. Recently I have started nibbling on high yield and senior loans via discounted closed end funds. I suspect that will continue for most of 2016.

Monday, January 4, 2016

Post Number 13 - Industrials Metals in the New Year.

Happy new year to everyone! 2015 was a great year for value traders in commodities. Most of the overvalued assets fell closer to their long term value. Here's hoping that 2016 sees more of the same.

The next few posts are going to go through the value situation for most of the commodities I cover. The format will be pretty much the same for all of them. I'll give a forecast by drawing a regression line on the ten-year long-term graphs (the Pure Value forecast). Then I'll give my personal forecast with some adjustments (Burt’s Forecast). Finally I'll talk about how I intend to trade them, or just stay out.

This post is on the metals. Here's the table of forecasts of real (inflation and US$-adjusted) prices:

Pure Value Forecast
Burt’s Forecast
+60 %
+80 %
+20 %
+20 %
- 4 %
+5 %
-30 %
-21 %
-42 %
-26 %
-30 %
-20 %

Why are my forecasts different from the ten-year graph forecast? I also have a proprietary model that adds to the Pure Value model a term that accounts for the “financial” flows. In other words it considers the non-producer and non-consumer money that comes in and out of commodities over time. These flows have been especially important for metals, but less so for harder-to-store commodities. The last few years have seen strong outflows of this money, depressing prices. So my forecasts are nudged upwards, on the assumptions that this source of selling will eventually end.

One more thing about biasing the forecasts. A thoughtful reader emailed me that I may be using the wrong index for the US dollar (Remember, all prices are adjusted for the international US dollar value). I am using the Federal Reserve’s trade weighted index. He noted that the currencies of many commodity producing emerging market nations have fallen precipitously. Many of these countries are either not in the Federal Reserve's index or only have a small weight. However, their weight in commodity production may be quite high. For example, Russia and Indonesia are the world’s largest nickel producers, and their currencies have fallen by almost half. This will reduce nickel’s cost of production, and thus price.

This is a good point. However, prices are made at the margin. For example, there is plenty of nickel production in Canada and Australia. What will probably happen is that these places will see a reduction in their high cost output. So as the price goes up towards equilibrium, the miners in Russia and Indonesia will see a return to profitability. Nonetheless, this is something to keep in mind, especially when we get into the agricultural forecasts.

Well Holy Toledo, we actually have a metal with a substantial undervaluation, Nickel. This is the first time in years! I'll trade this from the long side.  Aluminum is also undervalued, but the amount is not enough for a good risk/reward.

The other metals are still mostly overvalued. The problem is that the overvaluation has been reduced, and the fast money is heavily short. So these are somewhat dangerous. My strategy is to wait for short covering rallies before going short. Copper is my favorite because of its liquidity, and I now have a small short position. Even copper has been squeezed in the past, but I would be more nervous about the smaller markets.

Also, I plan to keep shorting the actual commodities, not the stocks of commodity producers. Some of the junior miners have been reduced to little more than options. And of course, you pick up carry being short a metal, you pay carry short equities.

Another thing to keep in mind is that we may well see a credit event of a large metal producer or trader. Not mentioning any names, but readers probably know the usual suspects. Were this to occur, the first reaction (probably starting before the actual event) would be liquidation of inventories. This would lead to spikes down. Longer term, these are probably healthy. Production is simply higher than expected future consumption in most metal markets. So taking capacity out is needed. This could be by a shutdown of the bankrupt company or, more likely, its merging and rationalization.