Coffee Perks Up Agricultural Index

Howard Simons
  MAR 19, 2014 11:16 AM

The commodity is hot, but traders may not want to rely too much on its current dominance.

 


Long before natural gas futures entered the scene in the early 1990s, coffee ("C"), or Arabica, futures -- traded then on the New York Board of Trade, now part of the InterContinental Exchange (NYSE:ICE) -- were the most volatile physical commodity. There are several good reasons for this. First, the supply of coffee is very inelastic: Small changes in supply can have a very large effect on price. Second, demand is elastic, as firms such as Starbucks (NASDAQ:SBUX) have shown. If you need your fix of morning joe, you're probably willing to pay up to obtain it, and a lower price probably wouldn't induce you to guzzle more. Third, while certain goods don't grow on trees, coffee actually does; a crop shortfall leading to higher prices today will induce large new production in subsequent years.
 
The Agricultural Index

While grains such as wheat and corn probably shouldn't be lumped together with soft commodities such as sugar, coffee, or cocoa, they do have the common thread of crop cycles -- sometimes in one hemisphere, sometimes in two hemispheres. The good index-meisters at Dow Jones-UBS have separate indices for grains and softs, and a combined one for agricultural commodities. The year-to-date total return on this index is 15.46%. This is what happens when you have droughts in Brazil and unnaturally cold weather in the winter wheat belt of the US.
 
If we peek behind the curtain at this gaudy return, we find it is skewed massively by coffee's 83.1% gain. Corn is a distant second at 13.2%.  This is the sort of thing that gets stock market technicians yelping about narrow market advances and the like.



We also need to step back, presuming we're not standing near a cliff's edge, and look at the history of the agricultural index's total returns, relative to those for US stocks, as measured by the Russell 3000 Index (INDEXRUSSELL:RUA), seven- to 10-year Treasuries, investment-grade bonds, and high-yield bonds. Instruments such as the PowerShares DB Agricultural Fund (NYSEARCA:DBA) did not exist in January 1991, but the comparative underperformance of the agricultural index should give you food for thought.



Let's just say this index does not scream "buy and hold" as much as it does "chuck and duck." The long-term history is one where upturns arrive swiftly and disappear swiftly, and where the roll yield between futures contracts eats you alive. The old floor traders understood coffee to be a great day-trading instrument and behaved accordingly. Why anyone would want to expose themselves long term to an index dominated by a single commodity is beyond me.
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