As Cotton Soars, How Should Investors Stitch It Into Their Portfolios?

Investors are scrambling to stuff cotton into their portfolios as the price of the versatile commodity continues to soar. Cotton is up more than 171% since this time last year, hitting a 150-year high of $1.90 a pound on Feb. 11 and breaking through the $2-a-pound mark for the first time ever on Thursday. The price of cotton hasn't been this high since the Civil War, when it sold for $1.89 per pound (not adjusted for inflation).

Analysts now fear that $2 cotton might look like a bargain soon, as demand shows no sign of easing, and last year's stockpiles have been quickly depleted since October.

India is expected to fall far below its projected output this year due to export restrictions, which continue to tighten supply. Major floods in Pakistan and Australia devastated cotton crops in those nations last year, and it will likely take several months before their output ramps up enough to begin stabilizing prices. In the meantime, apparel exports from China surged 34% in January, and global demand for clothing from emerging markets continues to grow rapidly. If these trends continue, cotton prices are sure to keep rising.

Converting More Land to Cotton

On Thursday, cotton for May delivery rose 3.6% to a record $2.0193 on the ICE Futures exchange in New York, and cotton for March delivery jumped to a record $2.0402. The prospect of paying higher prices for cotton and other raw materials has prompted retailers to announce clothing price hikes of 10% or more, and it could get worse. There's no guarantee that the current crop will be enough to meet projected demand, and growers have only just begun to expand the number of acres devoted to cotton.

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"Although the type of weather-related problems crops suffered last year are impossible to predict and are unlikely to reoccur in exactly the same manner, the depletion of available stocks has put a premium on the ability of new plantings to yield ever-increasing amounts," says Robert Hyman, portfolio manager at Jefferies Asset Management. "Higher prices will undoubtedly induce more land to be converted to producing cotton. Plantings are expected to be up 15% in the U.S. Demand remains heavy and growing."

Hyman says corn and other commodities will likely experience similar price hikes because of weather-related supply problems from last year. Inability to judge the quantity of cotton and other commodities coming into the market may lead to large price swings as the year progresses. If growers overplant and crops are plentiful, prices could drop dramatically. But if weather destroys a significant fraction of crops for a second year in a row, prices could spike for some time if demand remains high.

Commodity investors are now trying to decide how much rally is left in cotton after the past year's dramatic rise. All indications are that demand is still increasing, and some believe cotton prices might even double again before beginning to decline.

Cotton Combinations Are the Way to Go

However, Hyman cautions individual investors from taking concentrated positions in specific commodities because wild price swings may result despite the possibility that prices will keep appreciating generally. "Even if you have the correct directional view, a concentrated futures position may produce a loss because of an intermediate adverse turn of prices," he warns. "Markets don't just move in one direction."

Hyman recommends combining investments in commodity futures, commodity equities and even physical ETFs to provide broad exposure to commodity markets for the long term. The iPath Dow Jones-UBS Cotton Subindex Total Return ETN (BAL), which tracks cotton, was up some 18% in January. While no mutual funds target cotton specifically, some exchange-traded funds do provide exposure to a variety of commodities. Among those are the PowerShares DB Commodity Index ETF (DBC), the iPath DJ-UBS Commodity Index Total Return ETN (DJP) and the iShares S&P GSCI Commodity Indexed Trust (GSG).

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