Global Macro Notes: Commodity Carnage and Speculative Froth

May 6, 2011
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It had recently been argued there is a $20 per barrel “speculative premium” built into the price of oil. (Via Niels Jensen, citing Frank Veneroso of Veneroso Associates.)

If so, nearly half that premium was evaporated in a single trading session, via Thursday’s commodity complex carnage. (Will cinco de mayo be remembered as a day of massacre for real asset bulls?)

Just about everything commodity related got smoked, with oil — arguably the most important commodity in the world — leading the record rout with a 1,000 basis point drop.

And as Bespoke has noted, silver’s 4-day decline of 25%+ (still ongoing?) counts as the third worst sell-off of all time for the poor man’s gold.

As my colleague Mike McD instant messaged near Thursday’s close: “So what was that between 2:30 and 3:30 — mass margin related liquidation? It looks an awful lot like someone getting blown out.”

It is likely an elephant was brought to its knees by this move — and quite possibly a whole herd of them.

Given this turn of events, a few quotes seem appropriate:

“As long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

- Chuck Prince, ex-Citigroup CEO (no longer dancing)

“Risk is a no-fooling around game; it does not allow for mistakes. If you do not manage the risk, eventually they will carry you out.”

- Larry Hite

“…every time I’ve seen volatility like that, I don’t care what the market was, whether it was soybeans in ’76 or ’83 or whether it was silver at the top in 1980 or whether it was some of the biotech stocks at the top earlier in the ’90’s, when you get that kind of volatility you know that generally that’s associated with a top.”

- Paul Tudor Jones

Maniacs at the Table

For some time now, prevailing market conditions have called to mind the “maniacs at the table” metaphor. In short, there are certain times when the action in a poker game is dominated by a handful of aggressively bad players — with lady luck favoring their every move.

But Fortuna is fickle, of course. The market giveth, and the market taketh away — which is why bad traders and investors, like bad poker players, don’t actually make profits. As the old saying goes, they merely take short-term loans from the market. The reckoning takes back all they have won, and usually much more.

Playing fast and loose with risk can look like genius near the tail end of a cycle. Irrational valuations are not accidental, but a deliberate byproduct of pushing a profitable market narrative to the point of terminal exhaustion. Self-reinforcing feedback loops of optimism and greed tend to peak just as the most serious warning signs appear.

Then, when overreach hits a certain critical threshold — or when the pile of Jenga Blocks grows shaky enough for a random low-level catalyst to bring it down — you get what we are seeing in the commodity complex now: Vicious, violent reversal.

Almost invariably, these swift and brutal “reversals of fortune” wind up favoring the savvy, patient players: Those who choose to hang back, stay cautious, and focus patiently on risk management as the maniacs go wild, knowing the worm will once again turn (offering great opportunity when it does).

Secondary Drivers and Speculative Froth

Why did the commodity complex implosion take place? Why now? There are many secondary drivers that can be fingered as reversal contributors:

Really, though, it all comes down to “speculative froth” gotten far, far out of hand. The main driver of trends extended to silly extremes has been overwrought faith in an accommodating Fed, and the normal deafness, dumbness and blindness that occurs near a euphoria cycle’s end.

To quote Lord Keynes (who knew a thing or two about trading):

“Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”

- John Maynard Keynes

Commodity Catch 22

In Pension Funds and the Zero Bubble we discussed the deep bid of large pension fund managers, who surely added a dollop of “speculative froth” to the commodity complex in their desperate bid to find some source, ANY source, of persistent real returns in a zero rate environment.

If you’ll forgive the indulgence, the last two paras are again worth citing in reference to commodities, the institutional darlings of “no brainer” asset class exposure:

But if this pension fund force is genuinely powerful, then it is also deeply distorting. Managers who buy because they have to — who edge out onto the risk curve because they have no choice — are not likely to be considering market valuations, profit margin regressions, or top down inflation threats in their investment decisions.

Instead, they are blindly and forcibly contributing to yet another Fed-engineered bubble that will be enticing as long as it lasts… yet unleashing new castrophe when it bursts.

The question of what happens next in respect to real assets (commodities et al) is intriguing, and a little frightening. The stupidly manipulative policies of the Federal Reserve may have driven markets — and the global economy — into a sort of box canyon where both outcomes are bad:

  • If commodity prices continue to collapse, this could be disastrous for large-scale pension managers (like CalPERS) who loaded up on real asset exposure as a “can’t lose” bet. Such a collapse, coinciding with a post-QE2 comedown, economic indicator downturn, and housing double dip, could lead to broader asset sell-off and deflationary spiral, thus forcing the Fed to go “nuclear” at a time when debt concerns are escalating.
  • If commodity prices surge back, however — juiced by new shots of emergency adrenaline from the Fed, Beijing etc — then we are right back up against the record high food and gas prices / cost-push inflation wall, with oil price elevation and $USD decline hitting unsustainable extremes (as laid out in “‘Not Today’ (Dancing With the Year 2000“).

Copper as China Proxy

The message of copper also deserves special mention. (We have been short copper from April 29th, along with various silver and energy related names, and took partial profits in Thursday’s carnage as time-stamped in the Live Feed.)

Copper, at this point, has become (1) a speculative football and (2) a fairly clean proxy for the nuttiness going on in China.

Copper bulls invariably cite Chinese infrastructure demand as the core driver for higher price expectations in the red metal. At the same time, the Financial Times and others have done an excellent job tracking the “base metals gone wild” narrative, as Chinese speculators play warehouse games in their succcessul effort to use copper (and now zinc) as a sort of property development funding currency. In other words,

  • There is real risk that China is a white hot bubble waiting for a pin.
  • There is further risk of the Chinese “miracle” being grossly manipulated and inflated.
  • Copper prices are thus representative of real China slowdown fear and speculative froth alike.

And of course, if China goes — if we get the “Dubai times 1,000″ outcome that Jim Chanos has argued for — then the commodity carnage has only just begun.

JS


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