Paul D.

Schwartzmeyer
Registered Representative
pschwart@walnutstreet.com

paulschwartzmeyer.com
585-757-2347
#2 Court Street Plaza, Batavia NY. 14020

Things you probably won't read anywhere else.

That giant sucking sound.... China.

The Nobel prize winning physicist Richard Fenyman once said, I think it's safe to say, nobody understands quantum mechanics. As a former geologist and engineer, turned stock broker, I think I can safely apply Mr. Fenyman's quote to markets. I think it's safe to say nobody understands markets, especially commodities. Yesterday, (which was a Friday) I saw three of my farmer buddies in a restaurant. When I broached the topic of corn prices, all three changed the subject to the same thing... diesel prices. And all three said the same thing. Diesel prices are rigged. So, are diesel prices rigged? Are markets rigged? The answer is complex and absolutely fascinating, but remember Mr. Fenyman. Don't expect your effort to lead to understanding. This may seem weird, but humans have a market instinct. (1) This is a trait we have that is a by product of the twin towers of biological evolution and social evolution. What it means is that humans, in a transaction that involves trade, will agree to be fair and equal, all the while they're trying to screw each other. This tells us a great deal about whether markets are rigged. Markets can only work if there's a general agreement on fairness, all the while people will try to rig them. Which is why the good lord created the Security and Exchange Commission. (2) But to try and understand the markets, one needs to recognize two things. First, they're human creations. They didn't just pop up on their own. And second, there is an almost infinite number of influences that factor into what the final price of anything is. Let me give you an example. In the last year, the price of cotton has doubled. In fact, since 2005 the price of cotton has gone up 400%, from 50 cents a pound to $2. Why? The answer is complex, and involves dozens of factors. I'll list a few not necessarily in order of importance. China is the worlds largest producer of cotton. It's also the worlds largest consumer, and it's textile industry is massive. In total, China produces about 40% of the worlds cotton and consumes 50%. Cotton is a robust crop. It's roots are deep and it can be grown in land that gets sporadic rain and is not as sensitive to the timing of fertilizer as some other crops. China's main competitor in the cotton business is India, who produces and consumes about 20% of the worlds cotton. India's roots in textiles are historic and deep set. In the 19 th century, using it's Navy and the Pound Sterling, Britain laid waste to much of India's textile industry by forcing trade deals and limiting their ability to export. When India gained independence, one of Mahatma Ghandi's first acts was to re-establish the industry, getting back the country they used to say, consisted of one thousand villages.(3) The reason I mention this, is one cannot overestimate the political pressure on India to maintain textiles. Both of these countries have experienced, between 2000 and today, a huge leap in their per capita gross domestic product. These leaps are important because both countries were poor and changes in GDP reflect changes in food consumption. Not in how much they eat, but in what. To use India as an example, prior to 2000, India's primary source of protein were from what they refer to as pulses. (Beans) (4) Studies showed that in India, when wages rose to above about 500 Rupee's per day, (about $10), the amount of milk products in rural Indians diets exploded at the expense of Pulses. But what's staggering is that this inflection point,

where beans are replaced by milk and cheese, was crossed, in the period between 2004 and 2010, by an estimated 220 million Indians!! But we were talking about cotton, weren't we? Here's where it gets complicated. In the time between 2008 and 2010, China reduced it's acreage committed to cotton by 1 million hectares. (2.5 million acres) Remember, China is the worlds largest producer of cotton. One million hectares represents 15% of their land area committed to cotton, but China's farms produce 2 times more cotton than India's per acre. (5) During that period, China's cotton production went down twice as fast as India's went up. China clearly is using their land for non-cotton purposes. But remember, China has almost half of the worlds textile production. So what has China done? To insure that it's factories run in the face of falling domestic supply, they've gone out and bought almost all the worlds available cotton inventory's. This has put enormous pressure on India. India limits the export of cotton, for political reasons mentioned above. In fact, India doesn't export any cotton. They export cloth. For India's farmers, the choice between growing cotton, whose export is restricted, to growing feed grains, where prices are escalating rapidly, because of milk production, is an easy one. Follow the money. The worlds largest exporter of cotton is, surprisingly, the United States. Since 2007, US inventory's of cotton have fallen 77%. In fact, US cotton inventories are the lowest since the civil war. (6) India and China currently hold almost half of the worlds supply of cotton but won't sell any. The rise in their standard of living which is putting pressure on their farmers ability to meet the changing market for protein, combined with their political pressure to control the worlds market for textiles, is causing huge distortions in the market's ability to adjust. As Subir Gokarn points out (7) agricultural commodities lack the elasticity of manufactured products. It's easy to ramp up the production of four wheelers, but crops have seasons. The world can't ramp up cotton inventory anywhere near as fast as fly swatters. China appears to be, for the first time in centuries, the bull in the China shop. They, along with India, have the power to move markets. Their actions need to be studied closely. From a market perspective, China is still, very much, a third world country. They have a billion people, most of which live just at the poverty level, their financial markets are still not sophisticated and their currency not traded widely. They are a huge country that is subject to sharp changes in policy and will have pronounced affects on the world markets for most commodities for a long time. But with that in mind, one must focus on the fact that Chinese and Indian gross domestic product per capita is rising and that will cause changes in mix of commodities the world produces for these people. But the real challenge for investors is in managing risk. The volatility in emerging market investments is, and has always been, quite large.

Paul Schwartzmeyer, March 2011

(1) (2) (3) (4) (5) (6) (7)
The Market Instinct: The demise of social preference for self interest. Andrew Reeson, John Tisdell, Springer Literary Journal. Nov, 2010 SEC. The primary federal regulatory agency for the securities industry, whose responsibility is to promote full disclosure and to protect against fraud and manipulative practices. Glimpses of World History, Nehru, Jawaharlal, The Price of Protein Gokarn, Subir, Presentation at Ghandi Institute of Research, Mumbai, October, 2010. Cotton: World Market and Trade Archives US Department of Agriculture. December 2010 release. Ibid (5) Ibid, Gokarn.

The statements and opinions in this article are those of Paul Schwartzmeyer and do not in any way reflect the views of Walnut Street Securities, Inc. (WSS) The material is for informational use only and should not be viewed as an offer to sell or a solicitation to buy any security from or through WSS or it's affiliates. WSS makes no representation or warranty relating to the facts presented or that all material facts necessary to make an investment decision are presented.