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Sweet and Sour Decoupling Clues


Chinese markets more significant everyday.

"Alright, let's go deeper. Uh, what kind of man are you? Well, you're weak, spineless, a man of temptations, but what tempts you? You're a portly fellow, a bit long in the waistband. So what's your pleasure? Is it the salty snacks you crave? No no no no no, yours is a sweet tooth. Oh you may stray, but you'll always return to your dark master, the cocoa bean."
--Kramer guessing Costanza's ATM password, "Bosco"

To celebrate Valentine's Day my firm took profits from our longstanding Cocoa position yesterday, along with other components of our Agflation trade. We will return on pullbacks. In lieu of higher priced chocolates I slipped a card with a chart of Cocoa under my wife's pillow. Not sure if her heart was fluttering but her eyes were rolling. Always the romantic, I took that to mean she'd rather I just roll to the out months.

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The reason my firm was long cocoa is that we saw a change in demand, and had less to do with this one very volatile crop and much more to do with solving the riddle of decoupling, for which our answer is in the sweet minority. In terms of consumption growth my firm believes decoupling is quite clear and historically profound. I find it comforting that almost universally it is considered nothing but a bullish mirage then to also believe stocks will separate in search of those same new consumers. Building positions based on capitalism flourishing in more parts of the world, genies not fitting back in bottles and deepening the pool for more to join middle classes than ever before in history – yes, I'll take that risk. The confusing part perhaps, is the view from where many of us are sitting. In the U.S., most of those tailwinds are now headwinds. If so, I believe many trading pairs can outperform bears.

The Next Soap Opera

My firm believes the overseas Industrial Revolution Part II capturing all the headlines with the most bullish outlooks on global growth squaring off against rabidly bearish convictions of slowdowns (we agree with some of both) may be distracting attention from a more subtle but far more planet shaking revolution: a new crop of consumers IN those buildings.

In my firm's offices we refer to this secular shift, one of six that we trade around, as the Next Soap Opera. The other five are not even close in terms of potential. Originally sponsored by Proctor & Gamble (PG) and others in efforts to sell soap and basic consumer staples, the original soap operas captured the daytime interest of a swelling group of American middle class consumers more than 50 years ago. Over the next half century with the most remarkable innovations the world has ever seen in the U.S., can you think of a single product that has changed less than these TV shows?

What a script to follow then, with 30 second reminders every 15 or so minutes about what would drive the economy. There were 150 million people living in the U.S. in 1950. Today, there are about twice that many in China's middle class alone.

Food manufacturers like Hershey (HSY) worked so well for so long to stretch the belts of growing U.S. consumption. But there is a game-changing wrinkle in the Next Soap Opera. When the number ascending to middle class status and reaching for their first candy bar swells to several times as many as during the original soap opera then multiple manufacturers are bidding - and it becomes the ingredients whose prices soar instead. Demand is startling. Just this month in China there were three people killed in a local market during a stampede for a special on vegetable oil.

I wrote several times in 2007 that because of rising input costs there were vulnerable members among the Consumer Staples, often regarded as the "safest" sector in the U.S. slowdown if you follow the rigorous "you don't stop eating" analysis I hear almost daily. Below is a one-year chart of Cocoa +39% on top of Hershey's (29%).

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An Inverse Understanding

After a several year absence, Hershey's rejoined Proctor & Gamble and all the famous soap sponsors to pitch their products for the Super Bowl two weeks ago. They were thrilled with a record audience of just under 100 million viewers here. The night before in frigid Milwaukee, several thousand folks gathered to watch a meaningless NBA game between two of the worst teams in the league. As a clue to what this Next Soap Opera is going to look like, consider that because there was a Yao and a Yi involved, a staggering 200 million consumers watched that hoops game in China.

These days original soap opera fans in the U.S. do not have as much time to watch, and judging by the recent economic numbers don't have as much extra soap money for those sponsors anyhow. For hundreds of millions of reasons it is time to watch the Next Soap Opera instead. When the batons are handed off this summer in Beijing the headlines and pictures of the buildup will be front page, and clear. I'd rather take a magnifying glass out and look at the logos on the shirts in the stands and the snack wrappers in their hands.

We have so much to learn about so many different cultures and I cannot imagine a more exciting time in history to be able to invest and trade in so many markets. There was a clue that few noticed about just how much we have to learn about the Chinese market, despite the fact everybody I know even off Wall Street already has a strong opinion.

The China Index (FXI) lost more than one-third of its entire value over the past few months, and just last week there was a timely launch of an inverse fund that would benefit from declines in its value. An existing ETF version of the same strategy traded 2.5 million shares a day last week and at one point produced a wild range in price of more than 20% in 3 days. Chinese ADRs traded even more, with bigger swings. The more interesting part of all of the trading and dramatic changes in valuing China's future is that the Chinese Stock market was closed all week, to celebrate its New Year.

Pairing Heavy with Heaven

If you believe that what is known is not worth knowing, and if you also believe this is not a time in any market to be digging in your heels from only one side, then you could look for trading pairs. Throughout my career I've never made much money by deciding when everything will be all good or all bad, rather I look for different instead.

I believe Materials (XLB) can outperform Industrials (XLI).

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The S&P 500 is down (6%) during the past few months shown above. Despite more pronounced pullbacks in Materials, as you can see the straight paired trade saw Materials rise +3% and Industrials fall (5%) for a dramatic out-performance over that time frame. Something to keep your eye on. Heavy machinery can always be over-produced. Heavenly bodies have to be called on to even have a chance for crops to be produced.

Take Sugar in your Coffee?

As a great trader and even better friend describes perfectly, "The people who lived in trees last year eating bark, moving into a city and eating a meal for the first time are not going back. The middle class is growing 20% a year around the world for a reason."

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Despite several completely different fundamental stories, fears, prospects and supplies you can see how similarly the simple idea that when a few hundred million people want a cup of coffee with a pack of sugar for the first time that consumption is changing these markets. Above is a one-year chart of Coffee and Sugar.

But even more responsible for these recent moves in many crops is that before we ushered the new middle class to their seats at the table, we were plowing under the supply of many raw materials for years. That's how cities are born. Recall that Silicon Valley was once an avocado farm. Consider that in this all-too mature economy that this is still happening. Even after our misplaced fascination with subsidizing the already profitable U.S. farmer to the tune of some $90 billion last year, a figure that has grown relentlessly, that the number of U.S. farms has still decreased in the last few years alone. I am guessing some of the homebuilders who converted farmlands are wishing vacant lots had a lemon law.

There will be severe pullbacks and doubts along the way for Agricultural prices and businesses serving them, but the math is quite simple. World population will grow from 6 billion to 9 billion over the next four decades while farming soil to feed them declines from two-thirds of an acre per capita to less than half an acre in order to make room for them.

A Bushel of Clues for the Blues

Hopefully it has helped Minyans over the past couple of years to share my firm's work concluding that feedstocks even more than blue chip stocks were the cleanest way to play decoupling economies. Stocks will take longer because they are commonly owned in too many places in too many funds, so that decoupling most certainly cannot take place just yet. When the margin clerks call, you sell what you can, not what you want to. But that may prove to be a blessing rather than a curse for those who believe it is times like this that stocks are returned to their rightful owners.

Not much has changed in core positions for my firm, the fundamentals of most of these Agricultural and Materials trades are on even more solid footing than when we began. But some of the prices are too good to pass up so we took some profits this week. I believe the moves in the brown stuff are clues to what happens with many blue chips selling to the same customers overseas. When the brown doesn't trade because they are lock limit up on the same days that blues can hardly find a buyer paralyzed by concerns about global growth – we are being told remarkably different stories. Or, was some of that selling not a choice at all?

It is my hunch that when this period gets written about it will be the poor decisions that the smart money made with leverage, not those of the belly-up homeowner with debt, that will be responsible for the sales that will be regretted the very most. The concerns about global consumption are growing and the bidding on its potential is slowing. The potential is becoming the un-crowded trade. Brown decoupled, I believe blue will too. Right now, that idea feels about as lonely as Corn did at $2 a bushel.
Positions in sugar, corn, coffee, XLB, XLI
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