- “There is no tool to change human nature ... people are prone to recurring bouts of optimism and pessimism that manifest themselves from time to time in the buildup or cessation of speculative excesses.”
- —Alan Greenspan
Witnessing the grain complex shatter all-time-high price records and continue to climb during the now-infamous 2007–2008 commodity rally was nothing less than breathtaking. However, by late 2008, the party had ended. Many retail traders and fund managers watched in horror as the grains made their way relentlessly lower. The selling pressure and losses in the commodity markets were so profound that hedge fund managers experienced unprecedented numbers of redemption requests, adding fuel to the already raging fire.
Ironically, the same asset class that investors swarmed to for “diversification” from stocks played a role in the demise of equities during the 2008–2009 bear market. We now know that this boom-and-bust cycle was destined to be repeated, although in slightly less dramatic fashion. Perhaps feast-or-famine trade is the new reality: high margins, high risk, high reward, and even higher adrenaline rushes.
What Has Changed?
Several theories attempt to explain the historical volatility in the commodity markets near the turn of the decade. Valid contributors are likely ethanol demand and the government programs promoting it, the European debt crisis, sheer market exuberance in the absence of an attractive equity market, sidelined cash looking for a home, government stimulus, and, most of all, ease of market access for the average retail trader. One thing is certain: The commodity euphoria causes the agricultural, energy, and metals markets to overshoot equilibrium prices in both directions on a seemingly regular basis.
In the midst of the excitement, the lure of a swift commodity rally clouds the judgment of many. Looking back at boom-and-bust cycles, which are now relatively common, it is rather obvious that expecting market fundamentals to maintain such lofty prices is simply unrealistic. However, in the heat of the moment, nobody knows how high is “too high,” and speculation runs rampant. Investors who enter the market “early” with bearish strategies likely pay dearly for their aggression. Yet when the tides finally turn, they do so in a vicious fashion, enabling well-timed bears to reap substantial rewards. After all, the stunning fall from grace is typically even steeper than the preceding rally.
In a speech delivered at the American Enterprise Institute in the late 1990s, then–Federal Reserve Board Chairman Alan Greenspan warned that the equity market might be overvalued through the use of “irrational exuberance.” In my opinion, this is a good explanation of the illogical rallies and bear market sell-offs in the commodity markets. In an environment in which anyone with a computer (and a mouse) can buy or sell commodities with a single click, logic sometimes has little control over the outcome. Nevertheless, such cycles of excess and price contraction open the door for speculators to achieve abnormal profits, assuming that they are willing to manage and accept the corresponding risks.
Naturally, speculators aren’t buying or selling commodities on a whim. They are holding on to some fundamental story that justifies the initial price move, but the bandwagon mentality often takes reality into fantasy. Here are a few of the primary factors driving the wave of commodity market volatility that began in 2007 and has continued to thrive.
Easy Market Access
Investors trading commodities in the 1990s knew that the only way to place a trade in the commodity markets was to pick up a phone and call a broker. Because brokerage firms relied on paper tickets and statements, they weren’t necessarily able to keep close tabs on client trading accounts throughout the trading day. This posed large risks to traders and the firm. Accordingly, commodity trading was typically reserved for well-capitalized and sophisticated investors. That simply isn’t true anymore. Anybody with at least a thousand dollars and an operable computer can buy or sell commodities online without ever picking up the phone.
Individually, such traders have little influence on the market, but collectively, this new breed of futures speculators can have a significant impact on price movements. If you don’t believe me, look at the roller-coaster ride gold futures took following the S&P’s credit downgrade of U.S. debt in Figure I.1. I speculate that much of the late-comer buying was done by inexperienced, yet convinced, retail traders who were unaware of the risks of having convenient online access to buy or sell commodities without being properly educated.
Figure I.1. It has been argued that the one-month gold rally that spanned $1,500 per ounce to $1,910 was largely fueled by small retail traders and a herd mentality. Once the last buyer was in, the market quickly retreated, to eliminate most of the gains, which equated to about $40,000 per contract.
(Chart courtesy of QST.)
European Debt Crisis
The U.S. credit crunch eventually sent Europe into a tailspin. For years, the domestic financial and commodity markets have been hijacked by the possibility of a credit market collapse overseas, despite improvements in the homeland. Obviously, a healthy economy leads to healthy demand for commodities, but certainly other fundamental factors are at play. Nevertheless, there are times in which traders focus on European headlines and put individual commodity market fundamentals on the back burner.
Before the 2008 U.S. debt crisis and similar chaos to follow in Europe, financial market speculation only moderately influenced commodity prices. Yet in a post-credit crunch world, when the financial markets become enthralled with European headline risk, the commodity markets follow. As a result, commodities, currencies, and the U.S. stock market often become highly correlated. When all three asset classes begin moving in the same direction, it can be nearly impossible to stop the bleeding. This is because excessive moves in all three trigger margin calls galore in all three arenas, and the liquidation becomes a seemingly never-ending endeavor.
In late 2008, the Federal Reserve announced that it would be undertaking a little-known practice known as quantitative easing. In summer 2012, the Fed declared it would continue to implement the quantitative easing program indefinitely.
Quantitative easing is now a household phrase, but it is most commonly referred to as QE. QE is a rather complex scheme in which the U.S. government essentially buys the Treasury bonds it issues. In layman’s terms, the federal government is selling bonds to itself. The net result is a cash injection into the economy, or simply money printing.
The increase in money supply stemming from the Fed’s QE campaign tends to put upward pressure on asset prices of all types, including commodities. This is because, all else being equal, more money is chasing the same number of goods; therefore, prices are driven higher. Another way to look at it is, the larger the money supply, the weaker the U.S. dollar. A discounted dollar tends to put upward pressure on asset prices because it results in more purchasing power for foreign buyers and, thus, higher demand.
Accordingly, much of the boom-and-bust pattern we’ve seen in commodities likely is exaggerated by artificial price inflation via QE and the subsequent correction from unrealistic levels.
Fear of a U.S. Financial System Collapse
Fearful savers have been known to store wealth in nonfiat currencies, namely gold and silver. The theory is that if the financial system as we know it fails, the “gold bugs” will manage to maintain their prosperity by exchanging precious metals holdings for goods and services. For example, in summer 2012, an older man in Nevada died in a humble Carson City home with about $200 in his bank account. As the home was being cleaned and prepared for resale, approximately $7 million in gold bullion was found hidden within secret compartments in the walls and in boxes in the garage. The metals hoard was said to be in response to the man’s lack of faith in the current fiat money financial system. In my opinion, this type of thinking has had a profound impact on overzealous rallies in precious metals and might continue for quite some time. Figure I.2 depicts just how far fear of a failing domestic currency can drive precious metals prices beyond reason.
Figure I.2. Fear of a U.S. financial system collapse triggered an historic rally in silver prices that simply couldn’t be sustained by fundamentals.
(Chart courtesy of QST.)
The New Investment Fad
Swirling newscasts, financial newspaper editorials, never-ending infomercials, and social media buzz regarding the emerging opportunities in the commodity markets have successfully lured an enormous number of investors looking for opportunities other than traditional stocks and bonds.
For all intents and purposes, the U.S. equity markets made little or no progress throughout much of the 2000s, causing many investors to lose faith in the system. Frustrated by stocks, and with Treasury bond yields at record lows, savers found themselves intrigued by the commodity story. Accordingly, the general investment public is allotting substantial amounts of capital to self-directed or full-service commodity accounts, commodity hedge funds, commodity equity products such as electronic traded funds (ETFs), and Commodity Trading Advisors (CTAs). The newly discovered simplicity of participating in this alternative asset class has greatly benefited the industry but likely plays a part in the relentless boom-and-bust cycles. Unfortunately, in many cases, money is flowing into commodities from investors who have little experience in the futures markets and limited knowledge of the high levels of risk involved in participating.
Not only do I believe that too many speculative investors are relatively undereducated about the futures markets, but I also argue that numerous money managers might be as well. For instance, many of them fail to recognize a few things, such as the fact that the commodity markets aren’t as deep as equity markets and are thus highly influenced by bandwagon trading. Naturally, this occurs in the equity markets as well—just look at social media shares such as LinkedIn, Facebook, and Zynga—but in the futures market, it takes arguably fewer dollars chasing assets to see a price reaction. In some of the smaller commodity markets, such as rough rice or even cotton futures, it is possible for prices to make substantial moves on the buying or selling of a moderate number of contracts. In other words, it isn’t difficult for deep-pocketed speculators to temporarily alter the price of some commodities. With droves of cash making its way to the long side of commodities, it doesn’t take long for things to get out of hand. This is why it is important to limit your trading activity to futures contracts with ample liquidity. Leave the exotic commodity markets to the “other guy.”
Additionally, commodity prices normally trade in envelopes instead of ongoing inclines, as stocks tend to do. Yet commodity market newcomers sometimes behave as if this isn’t the case, causing prices to increase sharply beyond what are feasibly sustainable levels. These simple concepts seem obvious, but fear of missing out on a rally, and the greed that prevents profit taking, sometimes overshadows the red flags and concerns of commodity veterans who “know” that the hysteria can’t last.
Of course, this is my personal perception, and it is in stark contrast to the opinions of some other analysts. In fact, well-respected and well-known market commentators believe that the original 2007 commodity boom was purely the result of tight supply and high demand. Although I agree 100% that this was the initial cause of the skyrocketing prices, I am not convinced that fundamentals alone blazed the trail for such unprecedented high pricing and volatility.
Unfortunately, markets and their participants are complex, and this often makes pinpointing the driving force behind any price move impossible.
- “If the models are telling you to sell, sell, sell, but only buyers are out there, don’t be a jerk. Buy!”
- —William Silber (NYU)