How to Profit from Irrational Exuberance in Agriculture

Grain markets are on fire as traders worry that an unusually hot and dry summer will harm the crop. Wheat and soybean prices have posted large gains as the weather baked farmland across the Midwest, but corn was the biggest winner with a 32% gain in June. Now, traders are looking at those moves and plotting their strategies.

History shows there is a way to profit from moves like this in grains, but it’s probably not what you think...

Grain prices are driven by weather and a number of other factors. Analyzing these markets requires a great deal of specialized knowledge. Experts estimate the number of acres planted, the expected yield per acre, the chances that weather will damage part of the crop and the demand in each grain market among other things. Grains may be one of the most complex markets for analysts to understand.

Farmers are also very tuned into markets, and they decide what to plant in part based on their own market forecasts. They are also limited by the needs of their soil with crop rotation requirements playing a role in the decision. Users of grains then add to the market uncertainty. As prices change, demand varies. As one example, the jump in corn prices has led some ethanol distillers to scale back their production. Ethanol, a common gasoline additive, is made from corn and with prices up some refiners decided to idle their plants and wait for the market to adjust. They can quickly bring the plants back online if the price of ethanol rises or if corn prices drop. History shows that the latter is the more likely outcome.

News reports are comparing the current corn market to the one seen in 1988. That June, corn gained more than 16% but lost half of that gain in the next month. A year later, the entire rally had been wiped out.



This is a typical pattern for corn prices. July has been a down month 61% of the time over the last 44 years. The average decline in the month has been more than 20%.

After the recent run-up, corn is now extremely overbought. The short-term RSI, for example, has been above 90 more than five days in a row. Corn has fallen in the week after this type of extreme action more than 60% of the time. Prices have fallen after a one-month, 30% gain 100% of the time.

Traders could take advantage of these patterns by shorting corn. This can be done directly in a futures account. There is also an ETN that tracks corn, the Teucrium Corn Fund (CORN), and it is possible to short that ETN. An ETN is an exchange traded note. It is similar to an ETF except that is backed by derivatives instead of owning the underlying stocks as an ETF like SPY does. ETNs can provide access to markets that are more difficult for individual investors to trade... there are unique risks, however.

One risk is that there are times when large tracking errors develop in commodity ETNs, and directly shorting these funds carries a great deal of risk if that tracking error works against the investor. Tracking error is present in all index funds. It is a measurement of how the return of the fund differs from the underlying index. While corn futures gained more than 30% last month, the CORN ETN gained only 16%, about half as much. There are other risks with shorting, and they outweigh the potential gains in this trade. A better way to profit from an expected drop in corn is with an inverse ETN.

PowerShares DB Agriculture Double Short ETN (AGA) is a long position in a commodity index that delivers gains when grain prices fall. AGA is oversold on a short-term basis and 75% of the time a rebound has followed after becoming this oversold.



Traders get carried away in all markets and it looks like corn is a classic example of irrational exuberance. Buying AGA will allow traders to profit from this situation.