Circular Reasoning about Commodities

Can you beat the market?

If you think so, you must not believe in the efficient market hypothesis.  Join Warren Buffett, who has famously stated that he would be standing on a corner selling pencils from a tin cup if markets were efficient.

Most people who actively manage accounts — their own or others — believe they can add some edge.  This might be either through returns or risk control, but it must include more than just blindly following the market.

Let us now turn to those who seek the “message of the market.”  They hope to beat the market by watching it, seeing something that everyone else is missing.

If you claim to be able to beat the market, you had better have something more than a chart of some standard market indicator.

The Case of Commodities

Let us apply this test to the current decline in commodity prices, highlighted by many as a sign of worldwide economic weakness.  Why this conclusion?  Some past recessions were accompanied by falling commodities.  Researchers who have simple regression models and do not understand multicollinearity place too much emphasis on the concurrent decline in many prices.  This can be a fatal weakness when the model does not also include fundamental economic data.

The ECRI Error

I believe, but because of their secrecy cannot prove, that this combination was behind the 2011 ECRI failed recession call.  They relied upon market indicators since these were timely and not revised.  The government indicators are revised, of course, but the later versions reflect better data.  The market data are only based upon perceptions (guesses?) about the future.

In 2011 there was a view of commodity prices that we now know to be mistaken.  People thought that the Fed’s QE program was going to spark massive inflation.  Many blamed Bernanke for the “tortilla riots.”  The real cause of the commodity spike was not QE, but the mistaken market prediction of inflation.  When this eventually proved wrong, commodity prices collapsed.  This decline triggered the false signal for the ECRI, which insisted that things would get “much worse” and there was “no escape.”

The lesson from this experience is twofold:

  1. When the commodity price rise is suspect, so is the decline.
  2. Market price series should be supported by actual economic data, even if we need to wait for the revisions.

Current Relevance

In today’s market we are seeing a rerun of 2011.  Commodity prices had a run that was partly related to worldwide tensions and also some speculation about Fed tapering.

Commodity prices are now declining as these fears recede and also as the dollar strengthens.  “King dollar” reflects a preference for US investments as opposed to Europe or Japan, so an inference of relative economic strength is reasonable.

The falling prices are a result of these factors.  To evaluate the effectiveness in forecasting the economy you really need to hold constant the dollar variation.  Unfortunately, there are really not enough cases to do that properly, but that is typical for economic analysis.

Investment Conclusion

Current commodity price declines reflect relative interest rates, dollar strength, the Ukraine crisis, and other factors.  There is also a popular perception of future economic weakness.

Is this an effect of past events or a predictor of the future?  Are the markets efficient, or can you find an edge?  You cannot have it both ways!

Count me in the latter camp.  I see the economic skepticism and the sale of energy and materials stocks as overdone.  Like other value managers I own some of these names and I am buying more.  I especially like some of the oil drillers that have good future revenues streams (like ESV) and materials stocks (like FCX).  In some cases you can do well by selling short-term calls against these positions, since the implied volatility is very high.

A Final Kicker

Any settlement about Ukraine would change economic prospects dramatically.  The reciprocal sanctions are having a cumulative effect.  I do not yet see imminent signs of a settlement, but it is worth watching.

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