CME: Pork Cutout (PRK), CBOT: Corn (ZC)
Diversification is a fundamental concept in investing. In order to minimize the chances that market volatility wipes out your entire net worth, it is important to put your money in several investments with different levels of risk and potential return.
This is summarized nicely in a single phrase – “Don’t put all your eggs in one basket”.
In 2022, however, if you have followed this time-honored advice and allocated your money carefully across major assets, you would have lost money! Why did diversification fail this time? Let’s look at the annual return by major investment category:
- Stock Market: S&P 500, -13.9%, Nasdaq 100, -25.5%
- Bond Market: 2-Year T-Notes, +6.7%, 10-Year T Notes: -10.6%
- Precious Metals: Gold, -6.9%, Silver, +8.8%
- Currencies: US dollar index, +6.7%, Euro, -4.1%, British Pound: -9.9%
- Energy: WTI crude oil, +1.2%, Henry Hub natural gas, -12.7%
- Agricultural Commodities: Wheat, -1.9%, Corn, +11.3%
- Cryptocurrencies: Bitcoin, -53.3%, ETH, -55.4%
A diversified portfolio is not necessarily low risk. In time of distress, assets thought to have low correlation could all move in the same direction – going down. Last year, geopolitical crisis, high inflation and central bank tightening took turns driving financial markets lower.
When a major crisis breaks out, all correlation goes to 1. This happened in 1998, when the Russian debt default took down Long Term Capital Management (LTCM), the largest hedge fund in the world.
It repeated in 2007 and 2008, when the subprime crisis bankrupted Bear Stern and Lehman Brothers, the mighty Wall Street investment banks. It also wiped out the entire asset class in credit default swaps and exotic mortgage-backed securities.
In this past year, troubles in one crypto Exchange, FTX, drove all cryptocurrencies down. Bitcoin, Ethereum and stablecoins all lost value by half, even though the decentralized nature of the crypto market design is supposed to prevent this from happening.
The Soaring Egg Price
Ironically, if you put all your eggs in one basket, figurately, your investment would have doubled! According to price data reported by the Bureau of Labor Statistics, Large Shell Eggs, Grade A, have average retail price at $4.25 per dozen across US cities at the end of December, up 112% for the year.
A portfolio of shell eggs beats the return of all 15 assets listed above, by a wide margin! A new term, Eggflation, has been invented to capture this phenomenon.
Americans in recent years have increased egg consumption while reducing intake of red meat in their diet, according to data from the U.S. Department of Agriculture.
Interesting statistics: the total flock of egg-laying hens in the U.S. is around 320 million, almost matching the population of people. Each grown hen could lay as many as 320 eggs a year. And each of us eats about as many eggs as one hen can lay in a year.
Egg consumption has grown in part because more families are eating them as their main protein diet. As demand for eggs has risen, chicken production in the U.S. has slumped as we are currently experiencing the most severe avian (bird) flu epidemic in the US history. Nearly 58 million chickens have been infected with bird flu as of January 6th, according to the USDA. Infected birds must be slaughtered, causing egg supplies to fall and egg prices to surge.
So far, the total flock of egg-laying hens is down about 5% from its normal size, as farmers work hard to replace their flocks as soon as they can after an outbreak. On average, new-birth chicks take four months to grow into egg-laying hens. Egg prices are not likely to fall in coming months until decease-free hens are fully grown.
While US CPI has cooled to 6.5% in December, inflation for food items is much higher at 10.4%. Eggs are just one of many food staples that skyrocketed in price in 2022. Margarine costs in December surged 44% from a year ago, while butter rose 31%, according to the CPI data.
Egg Futures Contracts in the US and in China
CME Group, the world’s largest Derivatives Exchange, traced its root to the Chicago Butter and Egg Board founded in 1898. Standardized egg futures contract started trading in 1919, as the Exchange reorganized as Chicago Mercantile Exchange.
CME egg futures were actively traded for sixty years. As the egg industry consolidated and egg prices stabilized over the years, the contract was delisted in 1982.
In November 2013, China’s Dalian Commodity Exchange launched its own Egg Futures. The contract is based on 5 metric tons of shell eggs. As a consultant, I assisted DCE in contract launch as well as ongoing support. On January 13th, daily trading volume of DCE egg futures was 98,893 lots, with open interest standing at 204,202 contracts.
A Case for Intermarket Spread
The huge surge in egg prices amplifies the market risks for egg industry. Without the price discovery function at the futures market, farmers would have a hard time projecting future price trend. They rely on cash market prices to make production decisions.
It takes four months to grow chicks into egg-laying age. Each commercially-raised hen will lay eggs for 1-1/2 years before being slaughtered. For each flock, farmers face price risks for up to two years. The main feed ingredients, corn and soybean meal, could be hedged with CBOT futures contracts. But egg and chicken prices are exposed naked.
Farmers are rapidly expanding their flocks as egg price skyrocketed. At some point, there will be too many chickens in the henhouse, causing egg price to crash.
Maybe an egg futures contract could make a big difference. I think it is time to bring back the CME egg futures.
Until then, you could consider intermarket spread want to participate in the market:
Buy Pork Cutout (PRK) and Sell Corn (ZC) and Soybean Meal (ZM) futures. August PRK rose 14% from October and currently prices at 30% above the front February contract.
- Like Hog Margins, this intermarket spread attempts to capture the profit margins in egg production. This is based on projected up trend in pork and egg prices.
A second intermarket spread is to Buy DCE Egg Futures (JD) and Sell Corn (ZC) and Soybean Meal (ZM) futures, if you could trade the Chinese futures market.
Finally, you could buy shell eggs in cash market and store them in a cold storage. You would make money if future egg price surge could cover the storage cost.
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
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