With gold challenging $750
and oil quite comfortable north of $80, this young autumn trading season has
already proven exceedingly exciting and profitable for commodities
investors. But for students of
the markets, today’s price levels in the metals and energy complex are
certainly not surprising. Over six years ago the
fundamentals already pointed to an inevitable
worldwide commodities boom.
While virtually all
commodities have benefitted from this boom, as
their global demand growth exceeds their global supply growth, only a few are
widely followed today. Most
mainstream investors monitor the oil price and most contrarian investors know
the gold price as well. But far
fewer could tell you the price of silver, or natural gas, or uranium, or
copper on any given trading day.
Much to my shame, I am
certainly guilty of this commodities myopia too. As a stock investor and speculator, I
am primarily interested in commodities that are produced by publicly-traded
companies that I can buy and sell.
While the risks inherent in trading stocks are higher than those in
trading commodities futures directly, the potential returns are much greater
as well due to the inherent profits leverage of the commodities industry.
Due to this stock-centric
focus, wheat has never really captured my attention. Unlike the metals and energy, there
are few if any publicly-traded companies that produce wheat. And there are certainly zero junior
wheat explorers. Compared to the
hundreds of millions to billions of dollars it takes to open a new metals
mine, the barriers to entry in wheat are nonexistent. Any farmer can choose to plant wheat
any year, you don’t need to float a new
company to raise the capital to do it.
Although I don’t have
a professional interest in wheat, it still interests me academically. I grew up in wheat country and my best
friend from high school is still farming wheat today. So early every morning when I work out
while watching Bloomberg and CNBC, I steal a look at wheat as it crawls
across the tickers. Its price has
seemingly been trapped in the $3 to $4 per bushel range for decades, so I
have been increasingly amazed by its persistent strength of late.
In August wheat hit $7 and
then $8 soon followed in September.
By early October this tasty grass was trading above $9 per
bushel! About then I got a call
from my old farmer friend. His
bins were overflowing with a monstrously bountiful harvest, a huge blessing,
and prices were at all-time nominal highs to boot. He asked me what he should do. I laughed and advised him to sell and
then pay back all those government subsidies he accepted in the lean years!
By the time his hysterical
guffawing ended, I unfortunately had to tell him that I had no idea. I hadn’t studied wheat and
didn’t understand its fundamentals, technicals,
or sentiment so I couldn’t intelligently handicap its
probabilities. But the wheat seed
was planted in my mind and I knew I had to look into the stuff. Over the past month, my academic
curiosity has been galvanized by wheat prices driving the prices of breads
higher.
I mentioned casually
tracking wheat prices during my early morning workouts. Unlike most people though, I
don’t drag myself into the gym to be healthy, nor to look good, nor to
improve the blood flow to my brain.
I work out solely to “finance” my carbohydrate
addiction. I love eating, and
fresh breads and pastas are the pinnacle of culinary pleasure. A meal without something in it made
from wheat is uninspiring at best.
Naturally with wheat prices
on fire, the prices of most foods with a material wheat component are rising
as well. Even if the wheat in a
particular food is not a big fraction of its total cost, the finished-food
producers are using the soaring wheat prices to justify raising prices
anyway. And this is where wheat
gets really interesting. Since
this second most-produced crop on the planet is such a food staple, it is
really driving general food prices higher.
The full title of this
essay is “Wheat and Inflation Expectations”. As people around the world see the
prices of their basic foods rise, they are really going to start thinking
about inflation. Food and energy
prices, since these are things we all have to buy constantly in order to
survive, are the key drivers of how much the average person perceives inflation. And with the energy bull already
driving basic costs of living much higher, the finally-following food prices
are really going to clinch the deal on general inflation expectations.
Now a critical point must
be considered here. Inflation is
purely a monetary phenomenon. Per the dictionary, inflation is a
“persistent, substantial rise in the general level of prices related to an increase in the volume of
money and resulting in the loss of value of currency”. In the US,
the Federal Reserve is the sole source of all true inflation. As it continues to conjure up endless
amounts of new fiat-paper dollars out of thin air, relatively more money
chases relatively fewer goods and services which drives
up general price levels.
But any rising commodity,
whether it is wheat, gold, oil, or whatever, has two key components to its
price increase. True monetary
inflation is the first. More
dollars chasing any commodity lead to higher nominal prices. But the second supply-and-demand
component is not inflation. If global demand exceeds global
supply, and prices are bid higher as a result, this is a normal free-market
response that would happen even if the whole world was on an ironclad gold
standard with no monetary inflation.
But the key here is
perceptions and expectations. When
freshly-created Fed money floods into stocks or housing, everyone loves it
and no one considers it inflation.
But when the same new money pours into food or energy instead,
everyone hates it and really starts worrying about inflation. So today’s stunning wheat
prices, even though they are only partially driven by true monetary
inflation, will be universally perceived as purely inflationary by average
people.
Every time I hear this it
boggles my mind, but over the years I have read countless speeches by Fed
officials where they say “inflation expectations”
are the primary enemy of the Fed.
You get that? The Fed
doesn’t fear actual inflation, as it inflates our money supply all the
time with a vengeance. All the
Fed fears is that people will start to perceive this inflation, and hence expect more
inflation, and therefore change their spending and investing habits. The Fed’s peculiar goal is to
inflate constantly but not let the average person catch on!
Since everyone buys wheat
products everyday to feed their families, rising wheat prices will drive
general expectations of inflation like nothing else could. And following on the heels of the
rises in energy prices, people are already wary of inflation. Never mind that probably 80%+ of the
energy and food price increases are purely fundamental and driven by global
structural deficits with only a small fraction caused by money-supply
growth. People will still
perceive wheat-driven food-price increases as 100% inflationary and their expectations
for more “inflation” will soar.
So even if wheat
isn’t on your radar, its bull market will profoundly affect capital
flows into other investments. The
higher general inflation expectations grow, for example, the riskier general
stocks will become. As all who
lived through the 1970s remember, stock markets do not thrive in inflationary
times. And also like in that
decade, vast amounts of capital will shift into real assets like commodities
and the companies that produce them.
The higher inflation expectations go, the more capital will seek
refuge in hard assets.
As I’ve pondered this
over the past month, I’ve increasingly realized that maintaining some
awareness of the wheat bull is important for all investors. How does wheat look technically? Where is it likely heading next? How does it look historically once
adjusted for inflation? Is it
really at its highest levels ever or is there plenty of room to run higher
yet? This essay was written to
address these important questions for all investors.
We’ll start with the
usual Zeal-format technical chart of this wheat bull to date. Now for you farmers and wheat
enthusiasts, I do realize there are literally hundreds of different wheat
prices. It is not fungible like
gold. There are different
varieties like hard red and durum, there are different seasons like spring
and winter, there are different qualities and
protein levels, and different delivery regions. Wheat pricing is not simple or easy.
In these charts I used US
#2 grade hard-red winter traded in Kansas
City. Why? Because I have the most historical
data for this particular wheat benchmark. Amazingly this contract has
been trading since 1876!
Back in 2000, wheat was
trading under $3 per bushel and farmers were hurting. Like most other commodities,
investment in wheat production had been falling for decades along with
prices. And capital, which was
too busy chasing tech stocks, wanted nothing to do with something as boring
as growing grass. Yet out of
these seeds of despair, a great bull market was stealthily being born. No price stays low forever.
Late in 2000, wheat finally
surged above $3 and then started consolidating sideways. While $3.45 doesn’t seem all
that different from $2.75, it was still a 25% increase in price that made a
big difference at such low levels.
When wheat bounced along above $3 in mid-2001, it was defining a
support line that would largely hold until 2004.
During this initial
modestly-sloped and humble uptrend, wheat actually had a parabolic
surge. In mid-2002 it blasted 76%
higher between late April and early September alone. Bull to date by the top of its parabola
in September 2002, wheat had already climbed 107% higher. For comparison, gold’s young
bull market had only climbed 26% higher by that point in time. Although it wasn’t known in the
gold community back then, wheat’s bull was outperforming gold’s
bull by a whopping 4x! Who
would’ve thought?
Following its sharp
vertical surge in mid-2002, wheat was certainly due for a correction. So it contracted symmetrically in late
2002 before falling sharply to briefly hit $3 by mid-2003. But soon wheat recovered and largely
consolidated sideways for a couple more years ending in late 2005. Where wheat was barely trading at $3
much of the time before its 2002 parabola, afterwards $4+ prices were quite
normal. When parabolic ascents
don’t fully collapse, it is a major clue that real supply-and-demand
fundamentals are driving the price rise.
By the end of 2005, wheat
traders were very comfortable with $4 wheat and the long consolidation had
driven the mid-2002 euphoria out of the market. Wheat then launched a second major
uptrend, which was steeper and more aggressive than its initial one. Then this blessed source of all great
breads climbed higher in an orderly fashion within this new uptrend. Soon $5 wheat was considered normal
and sub-$3 was but a distant memory.
This second uptrend held
perfectly until June 2007, when wheat surged above $6 in a major
breakout. Now farmers, who tend
to be an older lot since not a lot of young people have enough capital or
interest to start in this tough business, were getting pretty excited. $6 wheat brought back fond memories of
the $6 wheat briefly seen only two other times in history, back in early 1974
and mid-1996. Granted, today $6
goes a heck of lot less farther than it did one or three decades ago, but $6
is still a lot better for producers than $3.
This breakout in wheat
started to get speculators and hedge funds interested in the grass game. The speculators were already plowing capital into hard commodities like the metals and
energy, so why not play the softs on the side? The new all-time nominal wheat highs
drove a lot of interest and wheat was bid vertically into its second major
parabolic surge of its bull to date.
Incredibly from April 3rd to October 1st of this year, wheat soared
89% higher! Such gains in just
six months are breathtaking and dwarf pretty much everything else but the
Chinese stock markets.
At its recent peak, wheat
was up 262% in its bull market since early 2000. On this very same day gold achieved a
new bull-to-date high too. But
the Ancient Metal of Kings was only up 191% in its own bull by that point,
with wheat’s awesome gains outpacing it by another third. So today’s wheat bull is not
only real and powerful, but it even stands out among the impressive gains of
its major-commodity peers.
So this leads us back to my
farmer friend’s question, where are wheat prices likely to head over
the short term? Should he sell
the wheat in his bins outright, put a floor under his wheat with puts, or
wait for the grain to head even higher?
This chart certainly offers some technical insights into this
important question.
Whenever a price goes
parabolic, rockets vertical to massive gains in a short period of time, it
creates a sense of euphoria amongst its traders. So with wheat up 89% in just six
months, odds are most of the capital that wants to buy wheat has already
bought in. So like pretty much
every other parabola before it in market history, wheat is unlikely to
sustain such lofty levels in the near
term. With all interested
buyers likely deployed, there just aren’t enough new buyers to offset
selling pressure from profit-taking.
So wheat is highly likely to correct here.
But the good news is a
correction is radically different from a crash. Just after wheat’s previous
parabola of mid-2002, the grain gradually retreated and ended up stabilizing
and consolidating at a level roughly halfway up its preceding parabolic
ascent. Wheat surged from $3 to
just over $5 then, and its consolidation in the years following centered just above $4. Our latest parabola of 2007 surged
from $5 to over $9, so if wheat follows its bull-to-date precedent it will
probably stabilize in the low $7s in the next year or so.
Indeed wheat has already
started what looks like an early correction. But if there is one thing that
mini-manias teach, it is that they are unpredictable. If we see some widely-reported supply
shock that drives a bunch of wheat futures buying from capital not currently
deployed in this market, wheat could still go higher yet before it corrects
and consolidates. As always, only
time will define an inherently unpredictable future.
So if I had wheat sitting
in bins, I would buy wheat puts to lock in a floor for the next six months
until spring planting. Although
puts are expensive, they offer the best of both worlds by protecting farmers
from downside until expiration while still allowing full upside exposure if
this wheat parabola hasn’t topped yet. Hedging via futures in a strong bull
is risky as upside surprises are far more likely than downside ones and
opportunity costs for being locked into a selling price quickly mount during
a surge. Unlike futures, put
options give farmers the option,
but not the obligation, to sell at a certain price.
And wheat’s bullish
underlying fundamentals also support generally higher prices, although
probably not parabolic gains. In
the US,
the world’s third largest wheat producer
after China
and India,
many farmers chose to plant corn this year instead of wheat. Thanks to the ethanol craze, corn has
been in high demand and last autumn it looked like it would be more
profitable to grow than wheat. So
where moisture allowed, many farmers in the US
were shifting traditional wheat acreage into corn to feed the ethanol beast.
On top of this, droughts
and bad weather hammered wheat crops around the world, reducing supply. In Australia,
the world’s seventh largest producer, a brutal drought continues to
restrict production. In this past
month alone, estimates for this year’s Australian wheat harvest have
fallen 20%. Canada,
the Ukraine,
and Europe,
also huge producers, have also had weather-related
problems to deal with this year.
This is coupled with
growing global wheat demand. Let’s
face it, breads taste darned good and they do wonders for the pleasure centers in our brains. As Asians start to sample the
wheat-rich diet we enjoy in the West, they are demanding more wheat and their
rising standard of living allows them to pay for it. Yes, carbs
are like a drug and a high-carb lifestyle without
moderation can cause all kinds of health problems. Regardless though, people all over the
world love to eat and they will eat what they like. Wheat is high on this list.
In light of all this, wheat
in the $7s seems totally reasonable to me technically and fundamentally. But is $7 wheat excessive in
historical context? In order to
answer this question, we need to consider the inflation-adjusted price of
wheat. This next chart inflates
the nominal wheat price using the US Consumer Price Index. The resulting blue line illuminates
the price of wheat over the last several decades in today’s 2007
dollars. It is really quite
striking.
As always, the standard caveat on CPI-adjusted
prices applies. I hate the CPI,
as it understates true monetary inflation for political reasons. Despite this, the CPI remains the most-widely-accepted inflation
gauge among mainstream investors.
Using it rather than true monetary inflation makes the following chart
more palatable for mainstreamers.
If I had used true monetary growth instead, these prices would be much
higher. Since it is designed to
hide inflation rather than track it, using the CPI yields conservative
numbers for constant-2007-dollar historical wheat prices.
So is $7 wheat reasonable
in light of history? Definitely. In today’s dollars, wheat traded
at $8 way back in the early 1970s before the last vestiges of the dollar gold
standard were sadly severed. $8
real was the normal wheat price back in that pre-devastating-inflation
era. And then in the 1970s and
early 1980s, wheat spent over a decade trading above $7 during the last
commodities boom. So history has
no problem at all accepting $7+ wheat in 2007 dollars.
And while wheat prices just
hit all-time nominal highs, in real inflation-adjusted terms today’s
wheat prices aren’t anywhere near all-time highs. Wheat actually briefly traded above $27 per bushel in early 1974 in constant 2007
dollars! Thankfully for bread
lovers everywhere, this staggering spike was not sustainable. Since then real wheat has gradually
declined on balance in a multi-decade secular bear. As the support lines above show, this
real bear trend did not finally abate until 2000 or so.
But although real wheat
prices are not at all out of line today for the midst of a secular
commodities bull, general perceptions of wheat prices are disproportionately
high. The red line above shows
the nominal, the usual non-inflation-adjusted, wheat price since 1970. As my pre-research perceptions had led
me to believe, wheat indeed spent most of its time between $3 or $4 per bushel.
And since average people don’t think in terms of real prices,
$7+ wheat today has to seem really expensive compared to their historical
experience.
Coming full circle, this is
where I suspect this wheat bull will prove the most relevant to investors and
speculators. Even though wheat
prices aren’t absolutely extreme, they are certainly going to feel extreme. Higher sustained wheat prices, which
are likely for fundamental and technical reasons, are going to drive up food
prices. Some of this will be
legitimate for foods with high wheat costs, but producers will probably raise
prices on foods with low wheat costs too since they can use wheat as a cover.
Higher food costs,
regardless of whether they are driven by real supply and demand or true
monetary inflation, are really going to stoke inflationary expectations. These expectations are the primary
enemy of the Fed, because people act very
differently with their money if they expect inflation than if they do
not. Rising inflation expectations,
partially driven by this wheat bull, are going to drive ever more capital
into the hard assets which tend to thrive during inflationary times.
At Zeal we are certainly
not new to this commodities game.
In this bull we started buying elite commodities stocks back in 2000
near multi-decade lows. During
the monstrous bull run since, we and our subscribers have earned fortunes as
more and more capital has flooded into the commodities realm. This wheat bull, by raising general
inflation expectations, will help spark a big new wave of mainstream capital
migrating into commodities and the stocks of companies that produce them.
The biggest gains of any
bull don’t happen until the mainstream investors, the general public,
get really excited and euphoric. More
than any other commodity-specific bull since oil, this wheat bull has the
potential to really wake up investors to the dangers of inflation and the
great opportunities available in commodities stocks. If you want to buy in ahead of the
mainstream and ride their huge capital surge higher, please subscribe to our
acclaimed monthly newsletter today. With many years left to run yet, you can
still multiply your own fortune.
The bottom line is this
wheat bull, despite not being widely followed, should have major broader
implications. People perceive
inflation most in things they have to buy often, and food tops this
list. With wheat-derived products
being major staples worldwide, wheat is going to drive up food prices. This will really ramp up general
inflation perceptions, despite government denials, and get people interested
in hard assets.
And while $9 wheat may seem
extreme today, it is nowhere close to being extreme yet in light of
history. With strong technical
and fundamental arguments suggesting $7ish wheat is sustainable in the coming
year, “high” wheat prices are not going away. The longer they persist, the more they
will be passed on to consumers. Thus
wheat is in a unique position to drive inflation expectations higher like no
other commodity ever could.
Adam Hamilton, CPA
Zealllc.com
October
12, 2007
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Thoughts,
comments, or flames? Fire away at
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messages though and really appreciate your feedback!
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