Tis The Season

It's been a slow week posting-wise thanks to a busy week earnings season-wise. Earnings season is always a bit of a mind-numbing experience. Every day is met with a barrage of press releases, numerous analyst rating changes, and back-to-back conference calls with management explaining how their quarterly earnings would have been an all-time record if you just ignore the write-offs, higher commodity costs, lawsuits, accounting system transition issues, margin shortfall, higher tax rate, options expense, weather impact, goodwill amortization, order push-outs, and poor feng shui. It makes for some long days.

Of course, there are companies reporting good earnings -- mostly commodity-related companies, those benefiting from international growth and the weak dollar, and those that operate pawn shops. Those with the most excuses are the financials. The typical bank conference call this quarter can be summed up as follows:

We’re disappointed to report a record loss of 12 kajillion dollars, but our core business is performing strongly as you can see if you strip out the mark-to-market losses and the charge-offs.

Well, if I ignore my lack of buoyancy and my inability to breathe in the water, then I'm a world-class swimmer. They’re a bank! The purpose for their existence is to attract deposits/funds and invest the proceeds in securities and loans. It’s like Microsoft saying, “We had a great quarter aside from terrible software sales.”

Let’s be very clear. When a bank has to charge-off a good chunk of its loans, it's an admission that prior period earnings were overstated. Prior earnings benefited from these loans back when borrowers were actually making their payments and the bank wasn’t adding to reserves. These guys want the benefit of the overinflated prior period earnings but no penalty for the current period charge-offs. It would be genius if it weren't so ridiculous.

Despite some truly poor earnings in general from the financial sector this quarter, we did witness a very robust rally in the group. This wasn't terribly surprising. As I wrote on July 15^th in my Trader VIX post,

...the VIX has had an uncanny ability to predict short-term rallies (lasting between 2 weeks to 3 months) in the S&P 500 (top chart) each time it has exceeded 30 in the past year. As the VIX has approached this level, I've been less inclined to initiate new short positions and more inclined to cover existing shorts. Note that the intraday high for the VIX today was 30.81.

It seems I wasn’t the only one watching the VIX. Almost as soon as the VIX crossed 30, the market made its most recent low and began its latest bounce. With financials having been sold-off so brutally over the prior 2 ½ months, it was no surprise that they benefited the most from the rally.

Also from the Trader VIX post,

In general, I'm expecting plenty of earnings misses and fairly restrained (to put it mildly) earnings guidance over the next month. But, with cash on the sidelines and a pervasive sense of gloom in the market, an earnings season short of cataclysmic may be just enough to spur the next bear market rally.

This also turned out to be the case. Prior to Thursday, the S&P 500 rallied more than 6% over a mere 6 trading days. Generally speaking, the earnings results from the financials were awful, but since they turned out to be less terrible than feared, the group enjoyed a powerful rally.

The other strong move of note this month has been the sell-off in practically every commodity and commodity-related company. I’ve been cautioning that this would happen at some point and that this is normal bull market activity. I had pared back exposure to the group and have been keeping some dry powder ready for just such a pullback.

In recent days, I’ve been gradually putting some of that dry powder back to work, adding to some energy, metals, and agriculture names. I anticipate adding further should investors continue to bail out. As for the financials, I've had no interest in chasing the latest rally. For now, I'm on the sidelines, but should the group rally further, I'll be looking to rebuild a short position in the sector.

My writing is likely to continue to be a little thin over the next couple of weeks since we're in the meat of earnings season. I'm not as effective or coherent a writer when I'm in an earnings release-induced state of catatonia.

Disclosure: The Rubbernecker is long commodities and caffeine and very short sleep.

Agricultural Smackdown - South Asian Style

“Food is an important part of a balanced diet.” Fran Lebowitz

There was an interesting article in yesterday’s New York Times discussing the developing spat/misunderstanding between the U.S. and India about responsibility for the rise in food prices. The whole to-do started a couple of weeks ago with some comments by Condoleezza Rice and was exacerbated by President Bush a couple of days later (shocking).

I’ve looked over a number of articles discussing this issue and, as usual, most of them just pick and choose which quotes to offer or simply paraphrase what Rice and Bush (hereafter referred to as Brice) said. To paraphrase the paraphrasing, a good portion of the commentary has gone something like, “Brice blames rising food prices exclusively on the irresponsible growth in India and China and their lack of willingness to continue starving for the benefit of the West. To address this travesty, the U.S. is now developing a secret program to sterilize all of the women in both countries to ensure a continued orgy of steak, ale, Oreos, and Hummers for the best, brightest, sexiest, most shaved, and most smiled-upon people ever to grace the face of the planet – Americans.”

Let’s actually take a look at exactly what our beloved leaders said. First off, Rice was offered the following question at a recent Peace Corps Conference:

Many of us are in countries where the predominant source of food is grain, rice, et cetera. And I’m wondering about your thoughts about the US government’s thoughts about the skyrocketing prices of grain worldwide?

Her reply

We obviously have to look at places where production seems to be declining and declining to the point that people are actually putting export caps on the amount of food. Now, some of that is not so much declining production as apparently improvement in the diets of people, for instance, in China and India, and then pressures to keep food inside the country. So, that’s another element that we have to look at.

Now let’s look at exactly what Bush said a few days later.

Worldwide there is increasing demand. There turns out to be prosperity in developing world, which is good. It's going to be good for you because you'll be selling products in the countries, you know, big countries perhaps, and it's hard to sell products into countries that aren't prosperous. In other words, the more prosperous the world is, the more opportunity there is.

It also, however, increases demand. So, for example, just as an interesting thought for you, there are 350 million people in India who are classified as middle class. That's bigger than America. Their middle class is larger than our entire population. And when you start getting wealth, you start demanding better nutrition and better food, and so demand is high, and that causes the price to go up.

So…………they’re basically saying that declining production, trade restrictions, and the increasing demand for more and better food from a wealthier developing world are contributing to the rise in food prices. Sounds like a no-brainer to me. The problem with it, apparently, is simply that Brice didn’t explicitly state that these were SOME of the factors impacting food prices rather than ALL of the factors.
Because of this, we’ve seen an outpouring of hostility and disbelief from a portion of the developing world, most notably India, which is screaming that the U.S. is the real culprit behind rising food prices. Here’s an example from the NYT article,

…Pradeep S. Mehta, secretary general of the center for international trade, economics and the environment of CUTS International, an independent research institute based here, said that if Americans slimmed down to the weight of middle-class Indians, “many hungry people in sub-Saharan Africa would find food on their plates.”

He added, archly, that the money spent in the United States on liposuction to get rid of fat from excess consumption could be funneled to feed famine victims.

Explaining the food price increases, Indian politicians and academics cite consumption in the United States; the West’s diversion of arable land into the production of ethanol and other biofuels; agricultural subsidies and trade barriers from Washington and the European Union; and finally the decline in the exchange rate of the dollar.

Mr. Mehta just gave me my newest million dollar idea. Let’s re-package all of that cellulite into 8 ounce plastic containers and market it in the developing world as a high-calorie snack called YoGurth! Everybody wins!

Ok. Now let’s look at who has the upper hand in this argument. I’ve thought short and soft about this, and the winner is………..well, it’s a tie. We can debate the relative importance of each factor, but most of the points that both sides are making are valid.

• As wealth in India and China increases, demand for more and better food increases. This higher demand is one factor leading to rising food prices.

• The average American has enough fat to live off of for two entire years (note: this statistic has not been scientifically proven and was pulled from the author’s nether-region in the interest of editorial expeditiousness).

• Export barriers and tariffs may temporarily limit price increases internally, but they exacerbate global supply problems, lead to higher prices globally, and will likely result in lower domestic supply.

• Americans are the largest per-capita consumers of many things: oil, food, liposuction, therapy, fatuous TV programming, lust, gluttony, greed, sloth, wrath, etc.

• Some farm land has indeed been converted from food production to feed the ethically-bankrupt subsidized beast of ethanol.

What are the key points from all of this?
• The economies of China and India are growing quickly. It’s reasonable to expect them to want to improve their diets. Given that they’re moving from the starvation level to one of mere malnutrition, we Americans should take care not to speak too indelicately with our mouths so full.

• We’re never going to out-run the Indians and Chinese if they ever invade us. It’s in our own best interest to fatten them up.

• It’s hard to get the full story from the press. They write with the short attention span of the average American in mind and therefore feel the need…………….what were we talking about?

• YoGurth – Saturate Your Diet with the Taste of America!

• The fertilizer stocks are still looking good. Still a buyer of POT, AGU, and MOS.

Ricing Frustrations: Follow-Up

The pace of the increase in the price of rice has gone from a wok to a run since last fall. Brazil, Egypt, Vietnam, Cambodia, and Egypt have placed restrictions on rice exports. Other countries such as China are imposing punitive tariffs, and still others have begun stockpiling. Even Sam's Club and Costco have started limiting rice purchases. If the cost of water wasn't so expensive in my town, I'd be turning my yard into a paddy field.

It's difficult to really know the extent of the rice shortage because of the stockpiling and hoarding that is occurring at the country and individual level. These actions serve to drive up the near-term demand for rice which leads to higher prices which leads to more hoarding.....

As I wrote in the original "Ricing Frustrations" post:

Clearly, demand has been outstripping supply (as with many commodities). The key will be to look for the inflection point. There's a huge incentive these days (where prices are not constrained) to put even marginal land back into farm service. Pests, disease, and weather are always wild-cards, but the incentive to plant is there.

From an article in today's The Times of India:

Thailand's Prime Minister Samak Sundaravej promised Sunday that the kingdom would not cut rice exports, as soaring prices of Asia's staple grain continued to fuel concerns of a shortage.

Samak said in his weekly television address to the nation that there was plenty of rice in Thailand, the world's biggest exporter.

"Thailand will not announce a ban on rice exports. It would destroy our reputation," he said.

He explained that farmers were now planting five crops in two years -- up from the traditional two crops per year -- to ensure they met demand.

This is precisely the type of action we should expect to see with rice prices hitting record levels. More land will be put to agricultural use, and crops will be planted more frequently (which could have longer-term soil productivity implications).

Rice is a staple of nearly 3 billion people. Governments may tinker with education, health care, business incentives, and tax policy, but food is the most basic human need. If you can't feed your people you won't remain in power, so there's a strong incentive for governments to try and address this issue. We can expect to see more and continued export limits, price caps, farming incentives, rationing, tariffs, land conversion programs, etc. Some of these policies (such as price caps and higher export taxes) will impede the development of new supply but others (such as land conversion and farming incentives) will encourage development. Some countries will get it wrong, and others will get it right.

Ultimately, the natural forces of supply and demand will correct this rice crisis. We'll see new supply coming from countries which aren't limiting exports or prices. Hoarding will diminish. People will substitute Smores for Rice Krispy treats. We'll see more bubble blowing than rice throwing at weddings.

From an investment perspective, no one knows how high rice prices will ultimately go, but you can be sure that market forces are currently unfolding and sowing the seeds of a future sharp correction in the price of rice.

Agriculture Stocks - Pulling Back as Expected

It looks like we're getting the pullback I was expecting in the agriculture/fertilizer companies (see last week's post "This Sector is Full of Sh*t"). In the past couple of days, Potash (POT), Agrium (AGU), and Monsanto (MON) have pulled back about 10%, and Mosaic has pulled back about 15%. As suggested, I did modestly reduce exposure to these names and was lucky enough to do so pretty close to their recent highs.

Today, Potash reported outstanding results. The fundamentals of this industry remain terrific with companies enjoying strong pricing power and cash generation. Given the pullback in the sector, today I started adding back the position I just sold a few days ago with purchases of POT and MOS. Should the group continue to retrace (certainly possible), I'll likely continue to add to these names opportunistically.

This Sector is Full of Sh*t

Monsanto

Potash

Agrium

Mosaic

The fertilizer companies have been on a tear for a while now but have recently started going parabolic. This is largely due to the increasing amount of news and attention being paid to the global food crisis. Just today, Reuters reports:

China slapped massive tariffs on fertilizer exports on Thursday in a bid to control rapidly rising domestic agricultural costs and inflation, and above all to ensure it grows enough grain to feed its 1.3 billion people.

Beijing's 100 percent-plus tariffs on some fertilizer exports should temper domestic costs but may drive up prices in world markets that depend on China's supplies, the latest in a series of commodities-related protectionist moves around the world that risk fueling rather than cooling global food costs.

They're exactly right. A number of countries have started imposing export restrictions on certain types of food and now fertilizer. These types of restrictions are often accompanied by price caps, tariffs, and hoarding. Hoarding certainly will lead to short-term price rises. More importantly, to the extent that producers are restricted from selling their food and fertilizer at prevailing world prices they are also less incented and financially able to increase their production.

These agriculture/fertilizer stocks have been some of our best performers (AGU, POT, MOS). The longer-term thesis is still attractive, but the stocks are likely a bit ahead of themselves near-term. These are some of our larger positions given their appreciation. In this situation, we're likely to pare our position very modestly, taking some of the recent gains off the table. We plan to keep a sizable position in this space since the thesis is still attractive, and we would look to add should the stocks pull back.

Ricing Frustrations

To think, I was actually a little tweaked that the cost of my Bran Flakes was 30 cents higher on my last shopping trip.

This link offers a number of brief videos from the BBC on the global rice shortage. According to the United Nations Food and Agriculture Organisation (FAO), 37 countries are facing a food crisis, and food riots have broken out in several African countries, Indonesia, the Philippines and Haiti.

The beauty of investing in commodities is that there are relatively few variables that need to be monitored and no company-specific factors to worry about. Price boils down to supply and demand. Currently, with many agricultural commodities we are seeing demand increase due to increasing populations, a rising middle class in parts of the the developing world, and new demand for ethanol. Supply hasn't kept pace.

When we look at the US Department of Agriculture's figures for rice, we find that this supply-demand imbalance has led to a decline in global rice stocks from a peak of 130 million tonnes in 2000-2001 to 72 million tonnes in 2007-2008, the lowest level since 1983-84. According to the same report, nearly half of the world's 6.6 billion people are dependent on rice and are already eating more than is harvested yearly. The price of rice on the Chicago Board of Trade has doubled in the past year.

In response, governments are curbing rice exports in an attempt to keep prices down and bolster local supply. To the extent that they're instituting price controls they're taking away incentive for farmers to expand planting, and the limiting of exports is leading to crises in import-dependent countries like the Philippines. Consumers are hoarding rice as well, furthering the supply crisis.

Clearly, demand has been outstripping supply (as with many commodities). The key will be to look for the inflection point. There's a huge incentive these days (where prices are not constrained) to put even marginal land back into farm service. Pests, disease, and weather are always wild-cards, but the incentive to plant is there. The question is whether this will result in a narrowing of the supply-demand gap.

The fertilizer companies continue to be well-positioned and should be a key beneficiary again this year. I continue to like this space, but I'll be watching the supply figures carefully.

In the meantime, I'll be expanding my pantry and hoarding my Bran Flakes.