Diversify by investing in grains

On Monday, Hard Assets Investor published another article of mine, the premise of this one is that it turns out Grains (Corn, Oats, Rice, Soybeans, Wheat) have fundamentally NO correlation with the broader stock market. This makes them an excellent candidate for investors seeking true diversification.

When I say "true" diversification, what I mean is that most investors' idea of diversification is owning lots of different types of stock, and maybe a few bonds. The problem is that stocks (and even bonds, depending on which ones you own) tend to have high co-correlations. That is, if the share price of Coca-Cola suddenly bottoms out, you can bet that a lot of other companies will as well. If interest rates go up at some point ever in the future (I know, ridiculous right?), all other factors being equal, the entire stock market will go down. Lot of good your owning stocks in different industries does you then.

The traditional view has long been that you should own some combination of stocks, bonds, and cash or money-market funds, weighted depending upon your risk tolerance and age. The problem is that with those three categories its nearly impossible to diversify within your risk tolerance. That is, stocks are riskier than bonds are riskier than cash.

That said, commodities provide just as much risk (and upside) as stocks while, as my research demonstrates, offering little to no correlation with the broader market, depending upon which commodities you invest in (i.e. not oil or gold).

You all know my issues with Commodities ETFs, but if you're purely looking for diversification, an ETF that holds a big basket of different grains might be the way to go. Personally though, if you have an account with a futures brokerage I always prefer owning the contracts directly.

US Government to Grains Speculators: "You're all idiots"

Grains are notoriously one of the trickiest markets to play. First, the goods themselves are quite fungible. ("Corn too expensive? We'll feed the cows Oats for awhile.") Second, they're vastly interconnected to the prices of NUMEROUS other commodities. ("If Lean Hog prices plummet, we'll stop raising so many pigs, which means we'll need to stop buying feed. ") Third, most US grains are also produced in massive quantities somewhere else in the world, which makes the prices highly susceptible to currency effects. ("Well, it's a record Soybean crop in the midwest with the lowest export demand in history, but the Brazilian Real is the strongest it's ever been. Look for Soybeans to go up.") And fourth, (and this mainly applies to Corn but look for other grains to join the fun in the coming years), the government gives big subsidies to grain producers whose crops go to the creation of Biofuels such as Ethanol.

Obviously, with all of these factors you'd expect divergent opinions on what grain prices will do. The one thing you don't expect, however, is for everyone in the world to be wrong about basic grain facts. That is to say, it's one thing to incorrectly predict where and how prices will move, it's another entirely to incorrectly gauge the basic quantities of grain that exist. And yet that is precisely what happened. Allow me to quote from the "What's News" section of today's Wall Street Journal:

"The government stunned commodity markets by estimating record corn and soybean crops for 2009, sending prices tumbling."

The article goes on to report that the crop numbers were higher than ANY surveyed Dow Jones analyst predicted (geeze, I hope those guys still get their bonuses) . The markets responded by dropping their bottoms out. Take a look at this graph:

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View the full FUTURE:C00 chart at Wikinvest

I've zoomed in to about a three-week view to exaggerate the effect. Here you see front-month corn prices moving more or less sideways, and then shooting down the daily trading limit yesterday. As of this writing, prices are down a further 3% in today's market session.

Is there any reason for the prices to stop their descent? Honestly, I doubt it. Everyone and their mother was yelling about how 2010 was going to be a bull year for commodities, with China growing at a supposedly exponential rate and every other nation firing up its boilers to full post credit crisis. But already in 2010 the situation in China seems to be changing directions. Edward Harrison at CreditWritedowns.com recently had a great article about how the Chinese economy may be more of a bubble than anyone had anticipated, and with the Chinese government's insistence on keeping the value of the Yuan fixed, they're setting themselves up to have a currency as worthless as the one its pegged to (that would be the Dollar).

But the bottom line is that if your supply vastly outweighs your demand, no matter what that demand is, the price is going nowhere but down.

On the plus side, there'll be no shortage of corn tortillas.