The Avocado Effect and the Hog Cycle

July 2005

The recent upsurge in demand for shipping of goods around the world has spurred a rise in ship leasing rates. Having a finite number of ships and an increasing demand for those ships to transport goods is a recipe for rising ship lease rates. Interestingly, the story that is playing out in lease rates is one that we have seen before.

Here is yet another fun pattern correlation, this one comparing the current action in the Baltic Dry (freight) Index to the Internet bubble top of 2000. As the text box states, it is important to note that there is a difference in the time scale of each chart, an adjustment that was needed to get the patterns to fit. I do not have a hypothesis to explain why the rate of change of time for each pattern should be different, although the time it takes to build a ship versus the time it takes to start a new Internet company might explain part of the time difference.

For the uninitiated, the Baltic Dry Index is a composite of 3 different shipping lease rate indices for different types of dry cargo ships (as opposed to tankers). It is maintained by the Baltic Exchange, a London-based shipping consortium. This index saw a big run up last year on huge demand for shipping, due in part to the booming economy in China and all of its exports to us (and other countries). Part of the rally in shipping prices was legitimate, as those with cargo to ship needed to bid up the amount they were willing to pay for the scarce supply of freighters, and part of it was speculation, as traders bid up the futures prices for such shipping in hopes of being able to sell those lease contracts later for a higher rate (to the proverbial “greater fool”).

A predictable result of this rally in ship lease rates was a huge boom in shipbuilding around the world, and those new freighters have been coming into service this year. Now we are seeing the results of what I call the “Avocado Effect”. What we call the Avocado Effect is a variant of what economists now well as the “Hog Cycle”.

In the Hog Cycle, pig farmers observe rising prices for pork products, and they decide to increase production of hogs in order to take advantage of those higher prices. The problem is that there is an inherent lag time between that decision and the effects of the increase in output. The lag time is related to the gestation period for piglets, and the time it takes for the piglets to mature into harvestable hogs. By the time all of the pig farmers start bringing pigs to market, there is a surplus which causes pork product prices to fall. That drop in prices causes other pig farmers to scale back production, since they know that they cannot make money raising more pigs at the depressed prices, and that creates a shortage of port products, thereby bringing an incentive for increased production…. And on it goes over and over again. Pigs have been raised as an agricultural product for centuries, and so anyone who is involved in that industry has no excuse for not being aware of its existence.

The phenomenon that we call the Avocado Effect is a slightly different version of the Hog Cycle, and the difference lies in the greater lag time, plus the lack of awareness by participants.

Back in the early 1970s, avocados became the hot produce item, with everyone clamoring for guacamole, and nutrition experts extoling the virtues of the fruit. Prices for avocados started going up really high, based on this surge in newfound demand. That surge caused a bunch of people to get the bright idea of buying up land in Southern California, mostly outside of San Diego, in order to plant avocado orchards and get rich selling into the hot avocado produce market. The only problem is that it takes about 7 years for a newly planted avocado tree to start producing. All of these nascent avocado barons were counting on produce prices remaining aloft, and few of them took into account the inpact on future avocado prices from the behavior of other orchard starters. They had no way of knowing that such a drop could occur, because unlike the Hog Cycle, this was the first time that there had ever been an avocado boom.

Once all the trees matured and began producing, an avocado glut hit the produce market coincident with a nutritionist backlash against eating fat of any kind. Avocados have a lot of fat, which was thought to be bad, bad, bad in the late 1970s and early 1980s, although it turns out now that nutritionists think avocados contain the “good” kind of fat. So avocado prices crashed, just as shipping lease rates are doing now that the new freighters are coming on line. The ultimate irony is that the few San Diego county avocado orchart owners who did hang on for a few years after the boom finally gave up in the early 1990s and sold out their properties for cheap prices, just in time to miss the great California boom in suburban residential real estate. It was a true “double-whammy”.

The incubation period for building a new freighter is not as long as it is for a new avocado tree, but the effect is similar in terms of the delayed response of the shipbuilding industry to changes in lease pricing. The rapid surge in global trade is a new enough phenomenon for people born in the 1990s that it is more appropriately likened to a surprise Avocado Effect as opposed to the normal Hog Cycle in shipping that the players should have been aware of. The Internet boom was similar in terms of the number of people explaining that “This time it’s different.”

This recent decline in shipping rates explains in part why the DJ Transportation Average has been doing poorly. It also likely is foreshadowing the economic slowdown which should become apparent in other measures about a year from now (2006), and which the stock market is likely to start to foreshadow as well later this year. That will all set us up for the 4-year cycle bottom due in 2006.