Juggling Dynamite

As I am in Vancouver today speaking at the largest commodity investment conference in North America, a new UN report highlighting the unhealthy rise in commodity prices caused by “investors” and unregulated speculation is very much on topic for my presentations. The UK Guardian reports:

“Government intervention may be needed to burst the huge bubble that has developed in the price of commodities such as food staples and oil, a UN report says .

Prices have rocketed in response to dysfunctional commodities markets, according to the report, which also disputes the view of many senior economists and central bankers that commodity prices have jumped as a result of a surge in demand.

“The changing role of commodity markets, which are turning into financial markets, has enormous repercussions for the economy,” said one of the report’s authors – Heiner Flassbeck, a director at the UN conference on trade and development (Unctad).

“The possibility of allowing governments’ direct intervention in the physical and financial markets needs to be considered,” the study concluded.

Investors are encouraged to behave like a herd, says the report, with few incentives to arbitrage or bet against the tide of rising prices. Without checks and balances in the system, investors create price bubbles that put many basic foodstuffs out of the reach of millions in the developing world.

Oil may be as much as 20% over valued while maize, the staple food of many developing world economies, is subject to wild swings in price…

“If the efficient market hypothesis were to apply, commodity price developments would reflect nothing but information on fundamentals. However, this study shows that the hypothesis does not apply to the present commodity futures markets,” the report says.

“Another major factor is the financialisation of commodity markets, which has played a significant role in price developments in recent years,” the report says. Its importance increased steadily after 2004, as reflected in rising volumes in commodity derivatives markets – both at exchanges and over the counter (OTC). “This phenomenon is a serious concern, because the activities of financial participants tend to drive commodity prices away from the levels justified by market fundamentals, with negative effects on producers and consumers.”

The whole article is worth a careful read here and underlines the large downside risk now present for commodity-centric countries like Canada where the inevitable correction in prices needed to reconnect with demand reality will hit our stock market, currency and economy with particular force. This downside risk is not likely to be reflected in our government’s new budget being presented today.

The reining in of commodity speculation will also hit investment banks who have been milking the commodities frenzy hard the past few quarters with a 55% jump in revenue coming from their commodity based products. No wonder the US government has been reluctant to enforce proper controls against their banker buds. See WSJ: Big banks cash in on commodities.

Steve Kroft gets a rare look inside the secretive world “high-frequency trading,” a controversial technique the SEC is scrutinizing in which computers can make thousands of stock trades in less than a second.

As I often tell my kids, there is no accounting sometimes for how crazy people can be. “Crazier than a shit outhouse rat,” as my Grandpa used to say, shaking his head.

We know now that QE2 was a bust, it made over-valued stocks and commodities even more over-valued and the hike in input costs naturally caused friction and drag on consumption, corporate profits and economic growth. As recent data is confirming the medicine provided no lasting benefit and has actually helped to re-sicken the patient. Some are shrugging this off with “oh well the Fed will serve us another round”. And given the track record of the Greenspan and Bernanke-led Fed nothing much would surprise me.

That said, the question for thinking people today is not “how crazy will others be?” The question is “how much of my life savings do I want to wager on the perpetual success of a Ponzi scheme where I must hope for a never ending supply of greater-fool-buyers to keep the lie going?” We all must answer this question for ourselves, and be prepared to live with the consequences.

Some seem to be answering with a hearty “count me in.” Many of these are actually bravely betting with other people’s money “OPiuM”. Others have little to lose in the first place, so they’re desperate and reckless. They feel they have to go for broke because, well, they are broke, literally. Nothing much to lose, and no real management method makes them in for a penny in for a pound, no matter how catastrophic the odds. Another group are just blindly hoping; they don’t realize how badly the odds are stacked against their capital at current market prices. And they don’t seem to realize that the choice of whether or not to ‘play’ these odds is ultimately their’s to make.

As Madoff investors learned the hard way, when you buy into a Ponzi scheme you sign up for an inevitable financial loss. One way or another, fake gains are taken back and then some. We all must decide our rule set in advance in order to stand for something or we will fall for anything. At the end of the day, each one of us gets to choose how much we will run with the madness of crowds.

In this video, PIMCO CEO, Mohamed El-Erian explains why he does not believe the Fed will implement a third round of quantitative easing because it would be more damaging than helpful. It’s a good discussion and I agree on the damaging part; not so sure that will stop the Fed from doing it, but I hope that it might. Either way, I know our own rule set. Do you know yours?