"We read the world wrong and say that it deceives us." - Rabindranath Tagore, poet.
Have you ever had one of those nagging feelings that something isn't right, but couldn't quite put your finger on it? When it comes to talking markets, I've had that sense for a long time.
At times, it felt like I was speaking a different language than everyone else and I couldn't figure out why that was. As I tell friends, I may not be smart, but I am slow and, thanks to a recent email from a customer, the lightbulb finally came on. As it turns out, I have been speaking a different language and that deserves some explaining.
Every now and then, I will hear someone express frustration that grain prices aren't responding to some bullish news. "Don't they realize how wet our area is?" Or this summer it was, "don't they realize how dry it is around the country?" "Why aren't corn prices trading higher?"
I was responding to that kind of email last month when it dawned on me that at the heart of these questions were two underlying problems: 1) A common misunderstanding of supply and demand; and 2) An implied belief that markets should be fair.
For anyone interested in exploring the flaws of economic theory, I recommend the 2011 book, "Thinking, Fast and Slow" by Daniel Kahneman, a professor of psychology at Princeton University and co-winner of the 2002 Nobel Prize in Economic Sciences. For our simple purposes, let me point out some things you probably did not learn in economics class.
From looking at a typical supply curve that slopes upward to the right and a demand curve that slopes downward to the right, it is easy to get the impression that a bullish change such as dry weather in the summer should result in higher prices. After all, the textbook will show examples of events that shift the supply curve to the left and you can see price go up and quantity transacted go down. Nifty eh?
It would be, but we have to remember those two lines are theoretical drawings that might or might not match reality. Prices don't just go up and down on their own. In the real world, markets are people and prices don't move until people do. Let's close the textbook and look again at this summer's corn market through the eyes of the market participants.
A month ago, when many were wondering why corn prices weren't going higher, noncommercial traders were already net long 137,764 contracts and commercials were net short. According to USDA, there was going to be 2.37 billion bushels of old-crop corn left at the end of 2016-17 and futures spreads were showing no sign of commercials bidding front-month prices higher.
With noncommercial traders already net long and commercials not showing any concern about securing supplies, who was left to bid corn prices higher? Even more dramatic evidence of what I am saying is seen on a scatter chart that compares corn prices on the Y axis to USDA's monthly estimates of U.S. corn ending stocks-to-use ratios on the X axis.
For this comparison, I used monthly closes of DTN's national index of cash corn prices and, because the study covered 20 years of data, I back-adjusted corn prices to account for inflation. The resulting correlation coefficient of -0.70 produced an R-squared value of 49% which meant that less than half of corn's price fluctuations were inversely related to monthly changes in USDA's estimates of ending stocks-to-use ratios.
More importantly, the price data arranged itself into three distinct groups. Stocks-to-use ratios of less than 7% put corn prices in current terms above $5.00 a bushel and ratios of 17% or higher held most of the prices below $3.00.
The most interesting group of prices was associated with ratios between 7% and 16%. This group randomly traded between $2.00 and $5.00 a bushel without regard to what the corresponding ending stocks-to-use ratio was. In other words, as long as corn supplies stayed within this comfortable range, changes in supply showed no predictable price impact.
I understand if that does not sound fair, especially for those who thought the world was governed by supply and demand curves, but the unfairness of markets doesn't stop there.
Because markets are people and prices are the result of people negotiating, there is an obvious advantage for the relatively few numbers of buyers in comparison to grains' numerous sellers. Everyone knows producers face a negotiating disadvantage, but the topic rarely gets included in discussions of price outlooks for crops.
Unless something is happening to actively motivate potential buyers, grain prices tend to fall under their own weight. Seasonal tendencies show that the gravitational pull on corn and soybean prices tends to be especially strong in late summer, a time when commercials are often sitting back, waiting for new harvest supplies to come in.
If you're feeling like the market's deck is stacked against the American farmer, you're right and I see no reason to sugarcoat the tough challenges producers face. To survive this uphill battle, producers need to toss out the myths that aren't serving them -- no matter how popular they might be.
Understand the limitations of USDA's ending stocks estimates as a source of price influence and have respect for grains' seasonal tendencies. The six months following corn harvest and seven months following soybean harvest have consistently shown themselves to have the better chances for higher prices.
Finally, look at the markets through the eyes of people, especially commercials. I am glad to say DTN Senior Market Analyst Darin Newsom began tracking market participants more than two decades ago and continues to do so in DTN's Six Factors Market Strategies -- an effective practice that still reaps valuable benefits. For more information on DTN's market strategies, see http://bit.ly/….
Todd Hultman can be reached at Todd.Hultman@dtn.com
Follow him on Twitter @ToddHultman1
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