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November 19, 2010
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December 5, 2010

High Cotton…

A funny thing happened while I was in Asia—cotton made new all time highs. I’m a big believer in watching what assets are at new highs as new highs always tell you an interesting story. What sectors are booming? What’s popular as an investment? What associated industries should be doing well, or hurting? You always have to ask yourself those questions.  All time highs mean something. It might take a few years before the next high, but the first time something goes to new all time highs, you need to start following it. There will be higher highs in the future.

Normally, when looking at new all time highs, the previous high was the last economic cycle a decade or two ago. Not for cotton. The all time highs in cotton were in 1863 and 1864. It took almost 140 years for those highs to be exceeded. That fact makes October’s highs even more significant.

2 year chart. From futures.tradingcharts.com

It makes sense to put this all into context. In 1860, the American South produced 3 million bales or 77% of British consumption. Three years later, much of the South was overrun by union troops and transportation infrastructure was being destroyed by the war. Cotton that made it to Southern ports was rotting in warehouses unable to clear the Union blockade. No wonder cotton in London was at such extreme prices.

Leave it to an investment banker to try and make money out of this mess. The South was desperate for money to buy munitions with, so Emile Erlanger and Company of Paris underwrote Confederate cotton bonds. The idea was simple, the bonds paid interest at 7%. Both principal and interest were payable in cotton. Here was the catch; the cotton was only available in Confederate ports. The worse the war went for the South, the lower the bonds traded in Europe and the higher the price of cotton rose. This created the incentive for investors to purchase bonds on the cheap, hire a vessel and hope to run the blockade. If successful, you would get paid back (in cotton) at par plus interest. Erlanger cotton bonds make imploding CDOs look passe by comparison. Alas, the war ended, and the bonds became yet another failed investment “innovation.”

I digress; it took a rebellion and the near destruction of all worldwide cotton infrastructure for prices to levitate from a dime to a dollar and change a pound. It makes you wonder what current calamity has befallen the world cotton crop. As far as I can tell, nothing is seriously wrong. There’s flooding in Pakistan and a light harvest in India. Clearly nothing drastic enough to account for cotton tripling in price this year. That’s the problem. For lack of a better term, the world is running out of stuff.

I like to talk about mining services and the need to increase depleted mineral reserves, but all commodities are experiencing similar problems. Increasing food demand has converted prime cotton land to edible crops. For three years now, the world has consumed more cotton than it has produced. This has led to cotton stocks being run down. Suddenly, textile mills realized there was a problem and they frantically bid up the price for remaining supplies.

Next year, you can be sure that farmers will plant more cotton. This means less land other crops. Will soybeans soar in price? Will fertilizer demand increase? The price of everything will go up. There will be spikes and gluts, but the trend is unmistakably higher for all agricultural commodities. The truth is that the world population is growing, demand for agricultural products is increasing and the quantity of land is staying relatively constant.

You can expect to see higher prices of everything in the next few years. There is no avoiding it. 5 billion people in the third world are discovering that they want a first world standard of living and that will put tremendous upward pressure on commodity prices. Add in a Federal Reserve intent on creating run-away inflation and you have a truly volatile mix. If you don’t have exposure to commodities, it is not too late. It will be the asset class of the coming decade—just like it was the asset class of the last decade. Eventually excess profits will allow people to repay debt and add capacity in the commodity industries. High prices are the best solution to shortages. In the short run however, expect to see the price of everything go up.

Cotton has already dropped a third from the highs last month. I have no idea what it does in the next few months, but I can pretty much guarantee you that it will be higher at some point in the next few years. New 140 year highs always lead to further highs. Watch new highs. They’re important. Multi-generational highs tell you something. You cannot ignore them.

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