Wednesday, May 21, 2008

Beyond Greed

Beyond Greed. That was the story of the Hunt Brothers (temporarily) successful commodity pecadillo. And like many naive speculators of today, they were incited by an ideologically-gripping bomb-shelter anti-government gold-bug rhetoric about worthless fiat currency and impending financial armageddon. Now, before Moldy and all those psychologically, and financially over-invested in their long-of-commodity positions send me hate mail, let me say I am of the Masters view put forth before Congress yesterday (as reported by the Wall St. Examiner via Yves Smith). As such, I do unequivocally agree with them, The Blamers and the Anti-Inflation Brigade in believing that the ultimate problem lay in poor monetary, fiscal policy and non-existent energy policy and the ultimate excessive liquidity (and thus demand) that these have created. And as result I absolve The Specs, for they are not the ultimate villain, but The Messengers. Indeed slaying them, without confronting the ultimate issues would be but duct tape on the broken pipe.

That said, Masters has a good point. In fact, many good points about the impact of speculative hoarding on prices (not just by HFs but, by you&me through our Pension Funds GSCI Commodity Swaps and retail commodity-based ETFs). And the rub is: despite that they ARE all "right" and rational, because policy IS lame, and the long-term portfolio efficient frontier IS moved (at least on a modeled, and, a to-date implemented basis) to a more optimal level, (though tomorrow is always a new day) there is an most important point to be derived from Masters. That is, from a societal point of view, there is an enormous Composition Fallacy at work here. It simply cannot be better for everyone, (i.e. The Public Interest cannot be served) if everyone hoards their commodities two years forward, irrespective of how much sense it makes for anyone to do it individually (or within their hedge fund allocation) so long as others are increasing their hoarding. Skeptics would of course answer that if the price is so "wrong", then why don't the real sellers simply "sell"? This may, of course, be correct in the ultimate long-term, but coming from a commity trading background, this is nonsense in the short-term for there are too many imperfections and failures in current commodity markets for either instantaneous or near-perfect supply responses that would validate such a view, and numerous positive feedback loops that further prevent the same.

So what are we to make of such Congressional scrutiny? Part of me is naturally suspicious since these are the same irresponsible buffoons that got us here (or enabled our progression, or did nothing to stop our directional inertia) in the first place. That said, if one goes back to 1980, the slaying of the Silver Specs and some of the wildest and most unsettling of market edge was (according to Stephen Fay's account in "Beyond Greed") triggered by the Government's actions upon speculative activity, which was a precursor to the final inflationary Vampire Slaying undertaken by Volcker. Note, the proximity of the initial anti-speculative actions to the ultimate monetary policy change, and the proximity of the monetary policy change to advent of a new administration.

I cannot make a precise guesstimate of how "far along" we are. Or even whether the monetary holy cross will ever be used to move policy towards greater balance - both domestically and internationally. But, I can say that leveraged speculators and those riding the commodity-alpha wave should be concerned by the fact of the hearings, and Masters rather frank testimony to the potential lynch-mob . This is because the lesson from the Hunt Silver debacle was "Don't fuck with the people who make the rules, since the rules can be changed which will torpedo even the rightest and best-laid of market operations". You see, for elected lawmakers, speculators make the most excellent political sacrifices. This is because politicians can be seen to be doing something (anything!) to counter-act the real increasing cost of stuff, without actually doing anything that costs them aything (except a few campaign contributions), or more importantly asks their electorate to - heaven forbid - change their lifestyles. For this reason alone, leveraged specs should take specific note exactly where the fat-tail lay, for when pen hits paper in Executive Order or Rule-Change from above, there will be NO EXIT!


Mencius Moldbug said...

The trouble is that Masters' economics is just plain wrong. (Here's a direct link to his testimony.) Moreover, he is wrong in exactly the same way that silver bug Ted Butler - who is the intellectual heir of the Hunts, if anyone is - is wrong.

Both Masters and Butler are misreading open interest in the futures markets. This may be an interesting technical indicator, comparable to trading volume in a stock. But it is not an indication that the price is either too low or too high.

Here is another way to think of the problem.

Imagine a futures market that dealt only in physical contracts - that is, contracts that are actually delivered. It would be easy to construct such a market. Contract sellers sell their goods not to contract buyers, but directly to the exchange, which always takes delivery - and imposes substantial penalties for nondelivered goods. In turn, the exchange sells future contracts to real buyers of the physical goods, who are expected to remove them from the warehouse.

Speculators who are not real producers of the commodity would be ill-advised to sell contracts they cannot deliver on. Speculators who are not real users of the commodity would be ill-advised to buy contracts for goods they will have to dispose of. On the delivery date, both classes of speculators will be "squeezed."

But speculation could still exist in such a market. How? The price of the contracts would be public information, and a separate prediction market which was completely isolated from the exchange could be set up. Betting on this market would be no different from betting on, say, the number of sunspots next month. Obviously, no such bet can affect the atmosphere of the Sun.

Our present commodity exchanges are like both of these markets collapsed into one. Despite the CFTC's feeble efforts, it is not possible to distinguish between demand from real producers and shady speculators, or real consumers and shady speculators.

Again: excluding precious metals, if speculators move commodities prices to a point at which supply exceeds demand, stockpiles will build, prices will collapse, and the market will punish said speculators. And the Black Swan will make bacon. (PMs are different only because they can sustain stockpiles - although it is possible that low storage costs for some expensive "base" metals have pushed them almost into the PM category.)

What Masters does not mention is the speculators who are betting against the commodity index funds. The index buyers are not competing for a limited supply of physical deliveries. Anyone can short any commodity, if he or she has the margin and the gonads.

Given that index buyers are dumb money almost by definition, I would think the smart money should be watching these markets like a hawk, and looking for commodities in which index buying has pushed the price to a point which induces stockpile growth. At this point the Black Swan, whose beak is suspiciously hooked, pounces, and bacon is made. Nature red in tooth and claw.

I agree that commodities index fund buyers are dumb. They are trading a real trend - the hemorrhage of dollars and euros out of the spoiled West, and into the hands of those whose marginal propensity to consume basic commodities is much higher. This bleeding is not going to stop any time soon. But the trend is no longer a secret, either, and any trend can be overshot. It is impossible to make money on a fact everyone knows.

If Masters had evidence that stockpiles, public or hidden, were growing and the market was still buying, I would view this fact with intense interest - it would still be unsustainable, but it would indicate a dangerous monetary breakdown. Open interest? Go have a beer with Ted Butler.

Anonymous said...


Do you put oil in the same category as the PM's? It seems that the inventory storage is mostly taking the form of leaving the oil in the ground. I was reading that most oil producing countries are now pumping below potential. Could oil be the new mold?

"Cassandra" said...

I admit I don't know the right price. IF one begins from point of departure that fiat paper is worthless, no price for stuff is sufficient. I don't subscribe to that point of view so long as there is law, order, reasonably respected rules and a supply of paper not corrupted to the point of the Zim unit. Every other measure of value can be considered in relative terms. IF one is looking for rightness and wrongness in prices, large changes and departures from historical norms are a reasonable place to begin the search. One can then, on the basis of relatives, fundamentals, idiosyncratic things one might wish to take into account, make a more considered judgment of their appropriateness.
But that is only the point of departure.

I think you underestimate the (1) perfection of the market (2) the feedback mechanisms inherent in markets (3) changing market structure and (4) the impact of the marginal trade upon the price.

WTI is soaring, particularly in the long-dated futures, presumably as someone pukes. Yet, if you want to buy heavy Iranian crude, the physical market is soft and at a deep discount. Logistics, imperfect delivery mechanisms, lack of storage etc. are spanners in the works.

These feedback into the market, as does the marginal price move. Expectation builds upon expectation. Buyers emerge typically AFTER other buyers emerge. Continued hoarding jacks up the marginal price reinforcing expectations of the bias of the subsequent price. Moreover, it feeds back to the producer. Why sell today IF tomorrow will higher?

This intertwines with the changing market structure where speculative hedge fund investors are increasingly less-tolerant of loss and variability. This diminishes the willingness to supply counter-trend liquidity, even when one believes there is an over-shoot present. Wait for the break THEN pound it. Indeed trend-followers, CTAs, index funds ALL are non-price sensitive. I don't call them stupid, or even naive, for Maubisson (sic?) has a point in the frequent wisdom of crowds, but they are NOT making relative or absolute statements, only betting that the market has done this to create a trend and impulse that historically has had legs. BUT where the trend and prices are self reinforcing and divergent from relative value, they are making it worse.

I have a little exercise I perform each morning in Japan. I view the daily change in market cap through a lens of the liquidity it took to change the value. This is fascinating for it demonstrates how much value change was effected by associated actual trade. Of course there are many drivers, but to the cynic, the similarities say, between Lead and Tin, as well as cotton, orange juice and Molybdenum are striking.

Look, I am not against price and markets as a cornerstone signaling mechanism in the economy. But there is a major-league local optimization problem here and so I stand by my statement that hoarding and the push to the financialization of basic commodities as an "asset class" is creating unwelcome and probably misleading price signals, and thus is a fallacy of composition which should be of concern to all but the people who make their living upon it.

Mencius Moldbug said...


That's a fascinating question and I wish I knew the answer. At a certain price level oil, simply in BTU cost, gets outcompeted by other energy sources - the supply of oil is restricted in a vaguely gold-like way, the supply of coal is not, and CTL always works. So oil it cannot go to $500, at least not in today's dollars.

So, in the long run and the big picture, no. But in the short and medium run - maybe. I really don't know enough about the market to say.


Your point about the lack of willingness to supply counter-trend liquidity is quite interesting. There is money to be made here, for the bold. For the very bold. For the very, very, very bold...

The problem is, again, that the trend is very real and very durable. But it will overshoot. What is needed - as you point out - is not fewer speculators but more, and smarter ones.

What should not exist in the world is dumb speculation. Walls of money in commodity index funds is dumb speculation. The Swan is hungry.

Anonymous said...

Hi Moldy,

Good to see you continue your commodity discussions here.

Since you posted your Goldenstein articles on UR, GLD has fallen about 15% and is hovering between 85-90. Not quite the quickening moldbugs hoped for, but it’s not obvious that the dollar is any less debauched today than it was 3 months ago.

I guess I’m not sure why you disagree with Ted. If short positions in SLV are concentrated in just a few hands, and such concentration is illegal, then doesn’t that suggest that the market is being manipulated downwards? And unlike oil, SLV, like GLD, really has no “value” that you can get from a discounted cash flow analysis, it’s just money thanks to its limited quantities and winning game theoretic position.

As Interfluidity points out, money may be running away from dollars more than running into commodities, and is running away from dollars really a big wall of “stupid speculation”? Maybe holders of dollar bills just want some place to park their cash where the Fed won’t inflate it away to prop up homeprices etc.? And if you have no appetite for risk assets and just want to conserve wealth, where would you put your $ right now?

Cassie: I agree with what you say, and I also think that there are a great many other financial instruments out there that have had their information value debauched by turning them into an asset class. Maturity mismatch really has made the yield on a 30-year t-note meaningless. Do you want to unwind all the maturity mismatched garbage out there, or just reverse it’s most recent entre into the commodity space?

Also, on the subject of a big wall of dumb money, what do you think has driven the recent rush of cash into hedge funds if not for the fact that it’s now an “asset class” line item in reputable hedge funds like Calpers. Paying 2 and 20 to be long equities, now that’s dumb.


Mencius Moldbug said...


There's a reason I don't have Cassie's job! I wouldn't even dream of trying to trade PMs in the short term. The quickening has waited 75 years. It could easily wait another 75.

It's rational to exchange dollars for commodities if the exchange ratio of the latter to the former will increase in the future. But if you think this, it should be based on better-than-average knowledge about individual markets. The trade as a whole is hardly a secret. And you can't monetize a commodities basket.

What Cassie sees is people buying "stuff" the way they bought "tech" in 1999, and I have to agree.

Anonymous said...


your points are well taken. but are folks really buying stuff now like they bought tech in 1999, or are they buying stuff now like they bought mortgage backed CDOs etc. in 2002?

the distinction, I think, is important. 99 tech really was a magnet for money, the internet really was a new technology and a new way of doing business. And how many Googles and eBays did you need to make up for all your and kozmos? People ran *to* tech.

the demand for mortgage backed CDOs in 2002 were driven by the Federal Funds rate being at 1% for a year. If the Fed rate had been higher, money would not have left treasuries. People ran *away* from treasuries. Now that big dumb wall of money is rattling around all asset classes just trying to find someplace safe to live.

My call: long ING Orange savings account. It gives a reliable ~3%