Editor’s Note: This article was previously published in The Amphora Report, Vol 5, 09 May 2014.
“Capitalism is not chiefly an incentive system but an information system.” -George Gilder
“Don’t shoot the messenger” is an old aphorism taken primarily to mean that it is unjust to take out the frustrations of bad news on he who provides it. But there is another reason not to shoot the messenger: News, good or bad, is information, and in a complex economy information, in particular prices, has tremendous value. To suppress or distort the information industry by impeding the ability of messengers to do their jobs would severely damage the economy. As it happens, messengers in the price signals industry are normally referred to as ‘speculators’ and the importance of their economic role increases exponentially with complexity. So don’t shoot the speculator. Embrace them. And if you feel up to it, consider becoming one yourself. How? Read on.
IN ADMIRATION OF SPECULATION
Back in high school my sister had a boyfriend who was quite practical by nature and, by working odd jobs, saved up enough money for the down payment on a 4WD pickup truck before his 18th birthday. It was a powerful truck and as a result he was able to generate additional business doing landscaping and other work requiring off-road equipment transport.
His truck also had a winch, which was of particular use one night in 1982. A severe storm hit, flooding the primary commuting routes north of San Francisco. Hundreds of motorists got stranded in water on roads stretching all the way to the Sonoma County borders. The emergency services did their best but the gridlock severely curtailed their ability to reach many commuters, who ended up spending the night in the cars. Fortunately, it was not particularly cold, and the conditions, while unpleasant, were hardly life-threatening.
As word got round just how bad the situation was, among others, my sister’s boyfriend headed out in his truck and sought out stranded commuters to winch out of the water. Sure, he wanted to help. But he also had payments to make on his truck. And he needed money generally, not being from a wealthy family. So naturally he expected to get paid for his services. What he didn’t expect, at least not at first, was just how much he could get paid.
As he told the story the next day, at first he was charging $10 to winch a car to safety. But as it dawned on him just how much demand there was and how few motorists he could assist-attaching a winch to a car and pulling it to safety could take as long as 20mins-he began to raise his prices in response. $10 became $20. $20 became $50. By midnight, stranded drivers were willing to pay as much as $100 for his assistance (Marin County is a wealthy county so some drivers were not just willing but also able to pay this amount.)
I forget exactly, but I believe he earned nearly $3,000 that night, enough money to pay off the lease on the truck! He was thrilled, my sister was thrilled and my parents were duly impressed. Yet the next day the local papers contained stories disparaging of ‘price-gouging’ by those helping to rescue the stranded commuters, who also noted and complained about the lack of official emergency services.
This struck me as a bit odd. The way my sister’s boyfriend told the story, he thought he was providing a valuable service. At first he was charging very little but as people were obviously willing to pay more, he raised his prices in return. The price discovery went on into the wee hours and reached $100 in the end. Did he plan things that way? Of course he had no idea he would be in the right place, at the right time, to make nearly $3,000 and pay off the lease in one go. But to hear some of the stranded commuters talk as if he was a borderline criminal just didn’t fit.
I didn’t think of it at the time, but as I began the study of economics some years later and learned of the role that speculators play in a market-based economy, I recalled this episode as one that fit the definition rather well. Speculators provide essential price information. Yet their most important role, where they really provide economic value, is not when market conditions are simply ‘normal’-when supply and demand are in line with history-but rather when they help to determine prices for contingent or extreme events, such as capacity constraints. Without sufficient capacity for a rainy day-or a VERY rainy day such as that in 1982-consumers will find at critical times that they can’t get access to essential services at ANY price.
In that rare moment, when prices soar, it might be tempting to shoot the messenger-blame the speculator-but this is unfair. Sometimes they take big risks. Sometimes they take huge losses or reap huge rewards. But regardless, they provide essential price discovery signals that allow capacity to be built that otherwise might not exist.
Consider those who speculate in electricity prices as another example. Electricity demand naturally fluctuates. But electricity providers are normally contractually required to meet even unusually large surges in peak demand. Occasionally, due to weather or other factors, there are extreme spikes in demand and capacity approaches its limit. If there is a tradable market, the price then soars. At the limit of capacity, the last kw/hr goes to the highest bidder, much as at the end of an auction for a unique painting. Such is the process of price discovery.
Absent the unattractive option of inefficient and possibly corrupt central planning, how best to determine how much capacity should be made available? Who is going to finance the infrastructure? Who will assume the risks? Well, as long as there is a speculative market in the future price of electricity, the implied forward price curve provides a reference for determining whether or not it is economically attractive to add to available capacity or not, with capacity being an option, rather than the obligation, to produce power at a given price and point in time.
My sister’s boyfriend’s truck thus represented an undervalued ‘option’ with which to winch cars to safety. Under normal conditions this option had little perceived value. But on the occasion of the flood, it had tremendous value and the option was ‘exercised’ at great profit. Valuing the truck without speculating on the possibility of such a windfall would thus be incorrect. And failing to appreciate the essential role that speculators play in building and maintaining economic capacity generally, for all goods and services, can result in a temptation to shoot the messenger, rather than to get the message.(1)
HOW DO SPECULATORS SURVIVE?
If speculators are the ‘messengers’ of market economies, how are they compensated? Obviously, those who are consistently right generate trading profits. But what of those on the other side who are consistently wrong? How can speculators as a group, right and wrong, make money? And if they can’t, how can they exist at all? (Of course, if they are too big to fail, they can count on getting bailed out. But I’ve already flogged that dead horse in many a report.)
This was once one of the great mysteries of economics, but David Ricardo, Ludwig von Mises and others eventually figured it out. Speculators do more than just speculate, although from their perspective that is what they see. Speculators also provide liquidity for hedgers, that is, those who wish NOT to speculate. And they charge a small implied fee for doing so, in the form of a ‘risk premium’. This risk premium is what keeps them going through the inevitable ups and downs of markets. They assume risks others don’t want to take and are compensated for doing so. In practice, it is impossible to determine precisely what this implied fee is, although economists do have ways to approximate the ‘liquidity risk premium’ that exists in a market.
Hedgers can be those who have a natural exposure to the underlying economic good. Take wheat for example. A highly competent farmer running an efficient farm might want to concentrate full-time on his operations and leave the price risk of wheat to someone else. He can do so by selling his estimated production forward in the futures markets. On the other side, a baked goods business might prefer to focus on their operations too. In principle, the farmer and the baker could deal directly with one another, but this arrangement would give them little flexibility to dynamically adjust hedging positions as estimated wheat production or the demand for bread shifted, for example. With speculators sitting in the middle, the farmer and the baker needn’t waste valuable time seeking out the best counterparty and can easily hedge their risk dynamically. Yes, they will pay a small liquidity risk premium to the speculators by doing so, but advanced economies require a high degree of specialisation and thus the professional speculator is an essential component.
While it is nice to receive a small risk premium in exchange for providing essential price information and liquidity, what speculators most want is to be right. Sadly, pure speculation (ie between speculators themselves, not vis-à-vis hedgers) is a zero sum game. For every ‘right’ speculator there is a ‘wrong’ speculator. While there is an extensive literature regarding why some traders are more successful than others, I will offer a few thoughts.
THE UNWRITTEN ‘RULES’ OF SUCCESSFUL SPECULATION
There are several unwritten rules in speculation, and I would confirm these through my own experience. The first is that it is the rare trader who is right more than 60% of the time, so most successful traders are right within the narrow range of 51-60%. Then there is the second rule, that 20% of traders capture 80% of the available profits. Combining these two rules, what you have is that 20% of traders are correct 51-60% of the time: So 0.2 * 0.5 or 0.6 = 0.10 to 0.12 or 10-12% of all trades initiated are winning trades for winning traders. The remaining 88% are either losing trades or they are winning trades spread thinly amongst the less successful traders.
These numbers should make it clear that successful traders are largely just risk managers: Yes, they succeed in identifying the 10-12% of trades that really matter for profits but they are also wrong 40%+ of the time so they must know how to manage their losses as well as when to prudently take profits on the 10-12% of winning trades.
Internalising this negative skew in trading returns is an essential first step toward becoming a good trader. Just accept that something on the order of 50% of trades are going to go against you, possibly even more. Accept also that only 10-12% of your trades are going to drive your profits. Focus on finding these but keep equal focus on minimising exposure to the other 88-90% of trades that either don’t matter, or that could overwhelm the 10-12%.
At Amphora, we have an investment process that we believe is particularly good at identifying and isolating the most attractive trades in the commodities markets. Sure, we make mistakes, but our investment and risk management processes are designed to keep these mistakes to a minimum. Indeed, we miss out on many potentially winning trades because we are highly selective. So while speculation may have a cavalier reputation of bravado trading, day in and day out, the Amphora process is more patient; an opportunistic tortoise rather than a greedy, rushed hare.
CURRENT OPPORTUNITIES IN THE EQUITIES AND COMMODITIES MARKETS
In my last Report discussing the financial and commodities markets outlook, 2014: A YEAR OF INVESTING DANGEROUSLY, I took the view that the equity market correction (or crash) that I anticipated from spring 2013 was highly likely to occur in 2014, for a variety of reasons (2). While I did not anticipate that the Ukraine crisis would escalate as much as it did, as quickly as it did, thereby causing some concern, I did expect that corporate revenues and profits would increasingly disappoint, as they most certainly have done year to date. This is due in part to weaker-than-expected economic growth, with the drag from excessive inventory growth plainly visible in the Q1 US GDP data. But the news is in fact much worse than that, because labour productivity growth has gone sharply negative due to soaring costs. These costs may or may not be specifically associated with the ‘(Un?)Affordable Care Act’ depending on who you ask, but the fact that productivity has plunged is terrible news for business fixed investment, which is the single most important driver of economic growth over the long-term. While a recession may or may not be getting underway, the outlook is for poor growth regardless, far below what would be required to justify current corporate earnings expectations, as implied by P/Es, CAPEs and other standard valuation measures. For those who must hold an exposure to equities, my key recommendation from that previous Report holds:
[I]t is time to rotate into defensive, deep-value, income-generating shares. These could include, for example, infrastructure, consumer non-discretionary and well-capitalised mining shares, including gold miners. That may seem an odd combination, but it so happens that even well-capitalised miners are trading at distressed levels at present, offering unusually good value.
Turning to the commodities markets, I expressed a preference for ‘defensive’ commodities in the Report (Although I did recommend taking initial profits in coffee). Indeed, basic foodstuffs, in particular grains, have outperformed strongly of late, continuing their rise from the depressed levels reached last year. However, the large degree of such outperformance now warrants some rotation out of grains and into industrial metals, including copper, aluminium, iron and nickel. Yes, these are exposed to the business cycle, which does appear to be rolling over in the US, China, Japan, Australia and most of Asia, but the extreme speculative short positioning and relative cheapness of industrial metals at present makes them an attractive contrarian play.
Precious metals have not underperformed to the same degree and they are normally less volatile in any case, but given the nearly three-year bear market, attractive relative valuations and the potential for a surge in risk-aversion, I would add to precious metals. Silver in particular looks cheap, although gold is highly likely to be the better performer in a risk-off environment. My recommendation would be to favour gold until the equity markets suffer at least a 15-20% correction. At that point, incremental rotation into silver would be sensible, with a more aggressive response should equity markets suffer a substantial 30%+ decline.
Turning to the platinum group metals, palladium is unusually expensive due to Russian supply concerns. While this is entirely reasonable due to the Ukraine crisis, the fact is that near-substitute platinum is much cheaper. And the on-again, off-again strikes at the large platinum mines in South Africa could escalate in a heartbeat, providing ample justification for platinum prices to catch up to palladium. Alternatively, should the Ukraine crisis de-escalate meaningfully, palladium is highly exposed to a sharp downward correction, and I would recommend a strong underweight/short position at present.
(1) Perhaps one reason why many fail to appreciate the essential role that speculators play in a market economy is that mainstream, neo-Keynesian economics treats speculation as mere ‘animal spirits’, to borrow their classic depiction by Keynes himself.
(2) This report can be accessed here.