Why a COW Should Be in Investors' Portfolios

I suspect that Keith is a Canadian cowboy at heart. I arrived at this suspicion based on several clues: 1) last Halloween he came in to the office dressed in full cowboy regalia, 2) when he and I first met it turned out that one of the few friends that we had in common was the former two-time national Bull riding champion of Canada (it takes one to know one principle, myself notwithstanding), and 3) his tendency to shout "Hoowah!" when trades work out better than anticipated.

Thus when he first asked me what I thought about the ETN COW last year, I realized that I had to take it seriously, because it might well end up in the portfolio. Since then it has remained on the back burner of my market universe. Our decision to go long this week was based on a convergence of factors: Keith was attracted by the technical set up that it was presenting, several underlying fundamentals looked compelling, and it ties in with our overlapping macro view on reflation and the US consumer.

COW tracks an AIG commodity sub-index that consists of Live Cattle and Lean Hog front month futures contracts. The mix is currently 62.27% front month Live Cattle, 37.73% front month Lean Hogs.

SEASONAL INFLECTIONS:

Although earlier today I wrote that I have a bias against historical comparables, for agricultural commodities, the seasonality is undeniable.

Traditionally, US beef consumption is greatest during cold weather months, and supply levels are driven by the spring calf breeding cycle/late summer slaughter cycle. The start of slaughter cycle coincides with lower consumption patterns to drive prices down in late summer, while prices tend to rise in March and April when demand typically is still high but supply is at its lowest after the slaughter cycle has ended and the breeding cycle just begun.

In the chart below I illustrated the 20,15,10 and 5 year average indexed price returns for the front month LC contract under the current year. Although earlier today I wrote that I have a bias against historical comparables, in this instance the seasonal inflection is undeniable. Clearly the futures are currently underperforming historical seasonal averages as macro factors weigh on anticipated demand.

Pork demand also follows a seasonal pattern, but the price pressure inflections for that market are different because the breeding and slaughter cycle tends to be based on the corn harvest since farmers breed heavily in advance of the cheapest feed prices. As such, supply is at its lowest in midsummer during comparatively low demand. Like cattle, Lean Hog futures are currently outside typical seasonal inflections.

Now keep in mind that these are just general rules based on long term historical observations (which I have stated on multiple occasions that I tend to discount), but in agricultural markets it is dangerous to ignore seasonality.

CURRENT ENVIRONMENT:

• Current USDA forecasts anticipate that both Beef and Pork production will be reduced for 2009 based on statistical data showing declining slaughter and carcass weight measures.
• Canadian Pork exports are forecast to decline more sharply than US production as overlapping local factors have driven feed prices higher simultaneous to a strengthening Currency versus the US Dollar. Next Friday's quarterly USDA Hog report should provide a better picture of the developing import situation.
• Argentina's Ministry of Agriculture officially estimates that cattle production will decrease by 13% this year due to decreased demand from customers like Russia. Unofficially the disastrous policies pursued by the Kirchner regime have driven Argentine farmers to despair and it has been reported by some media sources that the country may become a net importer for the first time since 1871. Getting hard data on the impact will be difficult as the Ministry stopped generating monthly data in November of last year.
• Although the work Howard Penney is doing in the restaurant sector shows that the dining industry continues to face a challenging environment, the data continues to suggest that the situation has not deteriorated to levels initially anticipated for mass market food retailers as cheap gasoline; cheap food prices and cheap money have left broad domestic consumption patterns relatively unscathed.

OWNING THE COW:

So now we have COW in our portfolio with supporting seasonal inflections, a solid technical setup and a some positive fundamental data points. That doesn't mean there aren't risks involved, primarily tactical in nature. For starters there is always a liquidity risk trading livestock futures, and during summer months the volume can get especially thin. Also, since the ETN tracks the Index, during each delivery month the product must "roll" into the next series: this roll impact will result in a divergence between the continuous front month levels and the ETN performance.

For now we remain long US livestock and will continue to own the COW for as long as the data supports our thesis.

Yipppie Kay Yay.

Disclosure: Long COW

Comments

[Donald Ingram:]

Cattle on U.S. feed lots this past Spring had fallen to 1962 levels, with slaughter of lamb and mutton at an all time low record.
Continuing drought conditions world wide further deteriorates food supply.
The future is agriculture and agribusiness. Anyone who invests long here will make money.

Jun 19 01:28 PM

[robert99:]

A frickin cattle and pork futures ETF. I thought I had seen them all... Thanks for pointing this out. Time for some research...

Jun 19 03:20 PM

[Paul Price:]

COW has been in a steady downturn ever since its IPO.

I doubt that livestock prices have done nothing but go down for that whole period. Is there some fundamental flaw in the ETF's make-up that makes this a poor choice for playing this sector?

Jun 20 08:10 AM

[Daigo:]

Hi Research Edge and all,

Thanks for the great post! So encouraging.

I have been long COW. I am not expecting it to go up until we see the real economic recovery since live cattle and lean hog price saw almost no bubble even in 2007, when everything from corn to platinum sky-rocketed.

I am still long COW because the beef and pork price at future trading is multi-year low, and farmers are not profitable for over a year and half at least in case of pork. They cannot sell meat with th e price to cover their expense. The corn price started to go up again to their disappointment. More and more farmers are quitting, and the recent swine flu only fueled this tragedy. Meanwhile, not majority of us became vegetarians, and thus the simple logic of supply-demand imbalance. That is why I am bullish in 3 to 4 years span.

I also want to add a note that from late 80's to early 90's, the beef price first plunged because of mad cow disease, but rebounded and price went even higher after things get normal. This is telling me something.

One precaution about COW is that the investors should pay attention to the risk around this financial instrument. I am bullish to beef and pork price, but I am also aware the scenario of the discontinuation of this ETN. Who knows. So, "don't put all eggs in one basket", for sure.

Investors should also pay attention to how the value of this ETN is decided. We should know how future market works, and how the price movement of live cattle and lean hog, not the spot price alone, affect the value of this ETN. Or at least read the prospectus of the ETN until we fully understand.

I left lot of URLs I found during my small research in Gonzalo's post
seekingalpha.com/artic...

I carefully examined those numbers in the stats before deciding to buy COW, but I am just an armature investor, so if any body has better insights, please let me know. Thanks!

Jun 20 01:16 PM

[Jake Silberman:]

I see performance of individual trades on your website, but do you report a composite performance and compare it to a benchmark?

Jun 20 03:19 PM

[tunaman4u2:]

I would LOVE to invest in the COW but ETN risks thrown me off

Motley fool had this:
But while they may look similar on the outside, ETNs and ETFs are very different on the inside. ETFs, like most mutual funds, directly hold assets related to their investment objective. For instance, a sector ETF will typically own shares of the companies in a particular industry. Even an ETF that invests outside the stock market holds an actual asset, such as a futures contract, that is tied to its value and intended performance characteristics.

ETNs, on the other hand, are technically debts of the company that issues them. That structure gives them some potential tax advantages that ETFs lack. Yet although their performance is contractually tied to whatever index they're intended to track, ETNs don't have any assets, other than a claim against their issuer for payment according to the terms of the contract.


Hence bankruptcy of the parent company wipes you out... not likely but BSC & LEH were cool at one point too

Jun 21 09:52 PM

[BioBoy:]

Let's see... those seasonal variations in commodity futures contracts will wreak havoc on a fund like COW, as the cost of rolling the contracts into heavy contango will destroy returns.

Jun 25 05:02 AM

[Mayer Amsch...:]

I would stay away from COW. Low volume, horrible performance. Even if you think that ag demand will pick up, beef has traditionally occupied a much smaller share of our diets because of its expense of production, and I think it will return to these lower normal levels.

Jun 25 08:58 AM