A Literal Bull Market
Featuring Shawn Hackett
Published on: April 18th, 2019 • Duration: 18 minutes • Asset Class: Commodities, Equities, Options • Topic: Food agriculture, Macro, Valuation, TradingShawn Hackett, president of Hackett Financial Advisors, predicted the outbreak of African swine fever and its potential ramifications on meat protein prices in an episode of Real Vision’s “Trade Ideas” six months ago. He now returns to review the enormous impact it's had on meat prices, highlights why this protein bull market is far from over, and discusses new trades to play the situation, in this interview with Jake Merl. Filmed on April 16, 2019.
JAKE MERL: Welcome to Trade Ideas. I'm Jake Merl, sitting down with Sean Hackett, president of Hackett Financial Advisors. Sean, it's great to have you back on the show.
SEAN HACKETT: Thanks, Jake. Really, really good to be here. Lots to talk about today.
JAKE MERL: So you last year about six months ago, you and I sat down to talk about African swine fever. And you made a bold call. You said that this disease would actually ignite a bull market in meat protein prices.
And that's exactly what we've seen over the past six months. You were exactly right. So can you please talk a little bit about African swine fever, what it is, and how it's led to a meat protein bull market over the past six months?
SEAN HACKETT: African swine fever is a disease that impacts pigs by killing them within 30 days. And it spreads very rapidly through multiple ways of contact. And so what has to happen in order to eradicate or to get control over the disease is you have to slaughter pigs rapidly in advance in order to get your hands around it. And the more it spreads, the more you have to slaughter animals. It's a self-fulfilling prophecy.
And so what started to happen with China the last time we were here, we were starting to see this disease spread. And we were thinking maybe 5% or 10% herd liquidation was going to be necessary to get it under control. We now know that it got so far out of control it's now required-- at least the Chinese are admitting it's required-- for the herd to be reduced by 20%. And some other evidence suggests it could be is down as much as 30%.
So the problem has really gotten much, much worse than we originally thought. And so the bullish thesis that we had, which we were right about, is actually still maybe only in the third inning with quite a few more innings to go. And so we do not believe that the opportunity has fully been missed in just the last six months. We think there's still plenty of room ahead. And that's what we're here to talk about today.
JAKE MERL: Is it only pork? Or are there other meat proteins that are affected by this?
SEAN HACKETT: Well, let's just put this into context. 20% down, which is what the Chinese have said, is roughly 24.5 billion pounds of pork that's down year over year. The entire pork export market globally is 19.4 billion pounds, which means the Chinese could buy the entire export market that's available and not fill this gap.
So there's no way to solve the problem by just buying pork. They're going to have to buy beef. They're going to have to buy chicken. They're going to have to buy fish. And so this is a protein meat bull market, not just pork. It started with pork. But in order to get their hands around the problem, you're going to have to be looking and substituting demand for these other meat proteins.
We've started to see imports of meat proteins from China really grow. So for example, we've seen in the month of March, just as an example, beef imports from Australia up 80% year over year. It's just astonishing. Just in the last week's US export report, they brought more pork in one week than our all-time record weekly export record for pork.
So we're starting to see big-time responses from the Chinese realizing that they have a big, big meat protein problem in pork. And we're starting to see that play out in some very strong demand, starting to drive prices higher. Because we can't solve the problem just buying pork and because there's a lot of consumers in China that don't want to eat pork anymore because they don't want to eat tainted pork and they've been looking for other avenues, chicken and beef are certainly alternatives.
And one of the things we look for is what's going on with pricing within China within their borders. And you can look at a line exactly when the African swine flu was first detected in August. And you look at what happened with the chicken price. It immediately started to turn up.
And it really has never stopped going up, steadily going up, showing that we have clear substitution demand going on between the pork and the chicken trade. And as that continues, it's going to draw prices internationally higher and draw imports in. So that to me is a very telling idea about how the substitution thesis is playing out in China.
JAKE MERL: So where are we right now? Do you think this disease will continue spreading?
SEAN HACKETT: Well, in China, we think it spread just about as bad as it could get. It's the worst-case scenario. We did, however, see that Vietnam has now caught and detected African swine fever. It's something we talked about last time-- that there is a risk that we could see this disease jump into Vietnam. Vietnam, by the way, for those who don't know, is the sixth largest consumer of pork in the world. So this is not trivial.
And this is only like a month into it. So we're just getting our hands around what that could be. But it's going to be an add-on effect. But right now we think the Chinese situation is as bad as can get. And now we just have to play out how do they solve the problem?
JAKE MERL: So given the run up in meat protein prices we've seen over the past six months, you think that's going to continue like that?
SEAN HACKETT: Well, we think it's going to switch a little bit. It started off with the pork prices really, really taking off and really being the first mover as China panic bought the market. We've been seeing cattle smartly moving up nice and stable. But we really haven't seen too much volatility yet.
We think cattle is probably the next meat protein to go. We also think chicken is going to start getting its act together as well. So we think we're going to shift our price trajectory a little bit away from the pork spike price to more chicken and beef.
JAKE MERL: And so last time you were here, you not only talked about this idea, but you gave three actionable recommendations. You recommended going long the company JBS around $5.50. You suggested taking half profits around $8 and the rest around $11 or $12. In addition, you also suggested the livestock ETN COW around $48 and $49. And it's currently trading around $54.
And finally, you highlighted a potential lottery ticket-- an options trade on the August $130 strike live cattle futures for $0.60. I'm a little confused about this last one, Sean. Can you please review why the August $130 strike live cattle futures contract actually went down more than 60% at the same time the price of live cattle futures were actually skyrocketing higher? And actually, also, can you highlight what happened recently? It looks like that contract just spiked higher a few weeks ago.
SEAN HACKETT: Sure, Jake. That's a really good question. When you buy out-of-the-money call options, until you get closer to the strike price, what primarily drives the price of those options is perceived risk in the market. That's called volatility premium.
And so what happens is the cattle market was moving up but steadily moving. There was no real fast moving, anything to get everyone concerned or worried that there's extra risk in the marketplace. And so what was going on is as the market was moving up gradually, the volatility premiums were continuing to decline and time value degradation as time goes on.
And then what happened was we had this very short burst where cattle prices really took off in a very short period of time and blew out the volatility premiums. And we saw those options-- I think they were $0.20 or $0.30-- go almost to $1.80 just like that. That's what happens with out-of-the-money call options. And as that volatility continues to go and you get closer to the strike price, then you have your lottery ticket in vogue.
So you have to understand why it's a lottery ticket because it's not a one-to-one correlation to what's going on with cattle prices. You are betting on a big volatile move over the time frame that you own it. And we still feel that that trade is worthwhile.
But we would be rolling out from the August month over to the October month. And we think we would roll out to the same strike price but give ourselves a few more months to October so we can fully appreciate what we think is going to be not only continuing moving up market, but when it's going have more volatility to it.
JAKE MERL: In addition to that options trade, do you have any new recommendations for today?
SEAN HACKETT: Well, we want to recommend a new option trade. It's in the feeder cattle market. And for those who don't know, when a cattle farmer has a cow and he's feeding them, he'll wheel them off at about 800 pounds. And he'll them to a feedlot to fatten them up the rest of the way. It lowers his risk. It lowers his costs. And it's a way for him to continue to own more livestock but not have the total risk on the line.
And so the feeder cattle market a lot of times can outperform live cattle prices in the beginning of a volatility move. In this particular year, there's a few reasons why we think that's going to happen. One really primary reason is that we had this very, very difficult winter-- extreme cold, blizzards, bomb cyclones, massive flooding. And it caused a very severe situation where the weights of the feeder cattle are way, way down year over year.
And so what's going on is that the cattle producer is retaining his live cattle on the farm to fatten up so he can sell it at a higher price. And he's letting the feeder cattle go. What this is doing, though, is it's causing a contraction of feeder cattle populations or animal feeding units that's going to have to be rebuilt in the upcoming months.
And so we feel that as that process and that dynamic takes place and the cattle bull market really takes hold, we could see the feeder cattle market really outperform for at least a little while before the live cattle catch up. This is something we saw in the bull market of 1978 and the bull market of 2014, where this took place. So there is a basis for why this could be a supercharger in the beginning. And then the live cattle options can be a kicker at the end.
JAKE MERL: So what are your key levels for that?
SEAN HACKETT: Well, we have a target. Right now those options are trading around $0.60, $0.65. We think they actually can trade around $12. We did a correlation coefficient analysis of 1978 bull market and the 2014 bull market to see if the current pricing was similar because we think this is a big bull market. And if it's going to be similar, we think there's a possibility it could trade similar to those years.
We are trading 84% correlation coefficient. That means that 84% of the current price is acting as it did in 1978 and as it did in 2014. So that gives us a pretty high degree of confidence that if we're right about what's to take place, we are going to continue to mimic those markets. And that means that in those two years from where we are today to where we were in late summer, early fall, the market rallied 22% exactly in both those years. That would mean that October feeder cattle prices would go to $195
So $195, if you're buying a $180 strike price call, means that the intrinsic value at expiration would be $15. So we try to be a little conservative and say it could be $12. So there really is an actual basis for why we put $12 as a realistic target if we're right about this being a big bull market for feeder cattle and cattle prices overall.
JAKE MERL: Do you have any other trades for today as well?
SEAN HACKETT: We have two other trades. We really want to play some of these other meat proteins. Of course, JBS is one that we recommended. And we still like that as an overall play on everything because they're involve in pork and chicken and everything. But Pilgrim's Pride, which JBS owns 75% of, is a pure play on their chicken business only.
So we feel that the chicken business-- remember, you can produce chickens very, very fast. And the cycle is very short. And you give them the right price signal, within six months you're producing more chicken. So it's a short cycle. But we're at a situation where we think that demand's going to overrun the supply of chicken, at least for the next six months, and provide a big significant increase in price.
And of course, Pilgrim's Pride is duly suited to gain dramatically profit-wise and investor attention during this period of time. And so we think that that is a great way to play what we think could be a really exciting price increase in chicken.
The other kicker here is that Pilgrim's Pride-- because it's owned 75% by JBS, there's always a chance it could be taken over completely. We know JBS is looking to float a US offering here maybe next year. And it wouldn't be a surprise that they may want to just consolidate and take total ownership of Pilgrim's Pride. And so we never can count on that. We're not betting on that. But it is something that could happen. That wouldn't hurt the price of the stock.
JAKE MERL: And do you have a target price?
SEAN HACKETT: Well, we have a clear double top there at $40. We think with this kind of setup and this kind of a move in the price of chicken and demand that we see coming, there's no reason that we think that we couldn't go back and at least retest that double top at $40 from where we are today at $23 and change.
JAKE MERL: And what about risk? Do you have a stop loss for that trade?
SEAN HACKETT: We think on that trade, if we were to trade below $20, something would be going wrong with our thesis. We really don't see at this point with what we have-- many birds in the hand and still a lot in the bush-- to go below $20, it would have to be something else going on macro-wise or something that changed our thesis. So we would try to get out of the trade if it goes under $20.
JAKE MERL: And so what's your third idea for today?
SEAN HACKETT: Third idea is a pure play on Australian beef. Australia's had a heck of a deal. They've had one of the worst droughts in 150 years this past year. And it's decimated cattle producers. They've been forced liquidation. The price has caved in.
Then they had floods. It just is horrible, horrible conditions. So everything that could go wrong went wrong. That's usually a good time to buy a stock-- usually. And Australian Agricultural Company is the largest cattle producer in Australia. It has been around since the 1800s.
And so we like about this particular stock is they're a dominant exporter of beef to the Chinese. As we said earlier, Australian exports of beef to the Chinese are up 80% in the month of March. They were up 75% in the month of February.
And we're starting now to see prices starting to move up as they've gotten some rains. It looks like the drought might be easing. Herd liquidation is coming to an end. And if those prices start to move, Australian Agriculture Corporation is going to start making some money again and really start to do well. And so we think that that is a really interesting play on Australian beef and getting the price off the tarmac.
The other thing is that Joe Lewis, who is a billionaire UK investor, owns 42 and 1/2% of the stock. And just like JBS, they just added to their position a few months back. We never know if something like that is going to happen. But if Joe Lewis happens to see that maybe things are on the mend and there's a big, big upside coming in the stock, he may want to either buy more shares or decide to take the company private, which of course would likely benefit the stock price from where it is today.
On the chart, we have a clear, clear resistance level at about $1.50. So we're not suggesting that the stock do anything that it hasn't done quite a few times before. But we think from where it is today at $0.80 with a tangible book value of $1.50, going back to that level between now and the fourth quarter is very reasonable, especially if we're right about what's going on with Australian beef supplies.
JAKE MERL: And so how long do you see this meat protein bull market actually lasting?
SEAN HACKETT: We really, really feel that it's between now and the fourth quarter. And the reason that we say that is because we know that chickens can get their act going within six months. We know that pork can get their act together within six to nine months. And we know demand destruction usually starts to really become severe within six to nine months.
So when we look at everything from a demand destruction perspective on when prices go up a lot and when production could really start to respond, we keep thinking that the first quarter of 2020 will be where this protein shortage gap begins to narrow. And usually the market will price itself in advance of the peak of shortage.
And so we really feel this is a play from right now into the fourth quarter. So if we were to weigh a baseball game from first inning to ninth inning, the first three innings are behind us. But the middle three innings are still in front of us. And those usually actually is the best three innings to participate in.
JAKE MERL: And so what could go wrong here? What's the biggest risk to the trade?
SEAN HACKETT: The biggest, biggest risk that we see to this trade is that we have some very, very severe economic problems, especially in China, some macro problems. The dollar really, really spikes-- something really severe like we had in 2008, where all bets are off. And it changes the profile of supply and demand and makes everyone run for cover. And I guess that would be a risk that you would have in any position that you'd be taking right now.
I don't really see a specific risk with the particular protein trade that we're talking about because we already know so much about what has taken place. It's really a macro factor at this point. That's the greatest risk. And if we were to see that happen, then we would certainly want to get away from the trade and take a look at it another day.
JAKE MERL: Sean, that was great. Thanks so much for joining us.
SEAN HACKETT: Pleasure to be here. Hopefully we can come back again in six months and talk about how this trade played out again.
JAKE MERL: So Sean is still bullish on meat protein. Specifically, he suggests going long Pilgrim's Pride, ticker symbol PPC, at $23 with a stop loss at $20 and a target price of $40. In addition, Sean likes buying the Australian Agricultural Company, ticker symbol ASAGF, at current levels with a target price of $1.50
And finally, Sean recommends buying the October 180 strike call option on feeder cattle for approximately $0.60. He sees upside potential as high as $12. That was Sean Hackett, president of Hackett Financial Advisors. And for Real Vision, I'm Jack Merl.