Speculation and Commodity Prices

Ah, good - I've been meaning to do something like this myself, but never got around to it. Jeff Frankel sorts speculation into three types and notes that only one of the three types, "bandwagon behavior," is worrisome. However, there's little evidence that this type of speculation is present in commodities markets:

Commodity Prices, Again: Are Speculators to Blame, by Jeff Frankel: ...Many currently are trying to blame speculators for the high prices of oil and other mineral and agricultural products. Is it their fault?

Sure, speculators are important in the commodities markets, more so than they used to be. The spot prices of oil and other mineral and agricultural products — especially on a day-to-day basis — are determined in markets where participants typically base their supply and demand in part on their expectations of future increases or decreases in the price. That is speculation. But it need not imply bubbles or destabilizing behavior.

The evidence does not support the claim that speculation has been the source of, or has exacerbated, the price increases. Indeed, expectations of future prices on the part of typical speculators, if anything, lagged behind contemporaneous spot prices in this episode. Speculators have often been “net short” (sellers) on commodities rather than “long” (buyers). In other words they may have delayed or moderated the price increases, rather than initiating or adding to them. One revealing piece of evidence is that commodities that feature no futures markets have experienced as much volatility as those that have them. Clearly speculators are the conspicuous scapegoat every time commodity prices go high. But, historically, efforts to ban speculative futures markets have failed to reduce volatility.

One can distinguish three kinds of speculation in the face of rising prices. First, there is the “bearer of bad tidings”... The news that, in the future, increased demand will drive prices up is delivered by the speculator. Not only would it be a miscarriage of justice to shoot the messenger, but the speculator is actually performing a social service, by delivering the right price signal that is needed to get real resources better in line with the future balance between supply and demand. Without him, the subsequent price rise would be even greater, because supply would be less. But it does not appear that speculators played this role in the commodity boom that started earlier this decade: as already mentioned they, if anything, lagged behind the spot price.

Second, when the price is topping out, stabilizing speculators can sell short in anticipation of a future decline to a lower equilibrium price. This type of speculator again adds to the efficiency of the market, and dampens natural volatility, rather than adding to it.

Third, in some case, when an upward trend has been going on for a few years, speculators sometimes jump on the bandwagon. Market participants begin simply to extrapolate past trends and self-confirming expectations create a speculative bubble, which carries the price well above its equilibrium. Examples of previous bubble peaks include the dollar in 1985, the Japanese stock and real estate markets in 1990, the yen in 1995, the NASDAQ in 2000, and the housing market in 2005.

It is the third kind of speculation, the destabilizing kind (also called bandwagon behavior or speculative bubbles) about which politicians, pundits, and the public tends to worry. There is little evidence that this has played a role in the run-up of commodity prices. So far, that is. Just because the boom originated in fundamentals does not rule out that we could still go into a speculative bubble phase. The aforementioned bubbles each followed on trends that had originated in fundamentals (respectively: rising US real interest rates, 1980-84; easy money and rapid growth in Japan, 1987-89; US recession, 1990-91, and Japanese trade surpluses; the ICT boom in the late 1990s; and easy US monetary policy after 2001). It could happen yet in commodity markets.

Comments

[im1dc]

There is a fourth area of Commodity Speculation not mentioned in the article that was reported on CNBC by Steve Liesman at 2:40 pm EST, the US taxpayer is now on the hook for $1.43 TRILLION in home mortgages due to its bailouts of Fannie, Freddie, IndyMac and the others.

Here's why its a commodity Futures Speculation and not an investment:

The $1.43 TRILLION is not a LOSS, not yet anyway, just loan assumptions or guarantees.

The number is climbing rapidly as more firms need more money to stay afloat as home values continue to fall (as they should).

The Commodity: Residential Real Estate

The Speculation: The Fed Chairman has made a bet that US home prices will not decline further and may rise over the term of the US Treasury guarantee.

Indeed, Chairman Bernanke told a Congressional Committee that the FedRes has a good track record on such investments -- rescues -- that is they have not lost money.

Wake up my fellow Americans, this Administration and Congress are clearly out of control and both need to be stopped ASAP.

[Alex Tolley]

"Speculators have often been “net short” (sellers) on commodities rather than “long” (buyers). In other words they may have delayed or moderated the price increases, rather than initiating or adding to them. "

No chance this is the physical owners hedging then?

The idea that that there is "good" and "bad" speculation depending on how prices move is silly and, I suspect, unfounded. Far better to recognize that speculative instruments like futures can represent volume many times the underlying physical or money instrument and thus can take on a life of its own, un-anchored. Currency markets have been chronically like this for over 30 years at least, creating wild gyrations in forex rates. Low transaction costs lubricate these markets.

I don't know if one can mitigate this trading without either incurring regulations that limit the # of transactions or increasing transaction costs. Alternatively we could go back to the bad old days of fixing prices by fiat. None of these choices seem desirable to me.

[Demand Side]

There is a financial bubble in commodities. The proof is in the charts. Were home buyers speculating? Were dot.com stock buyers speculating? You can define it away, I suppose, but this bubble is bursting and people are clinging to a supply/demand explanation. Perhaps they are too invested in their theories. It will probably to be followed by "Nobody knew," "How could anybody know?" and the outing of fraud as if it were the sole explanation.

[odograph]

We get to wait and see ... when oil prices peak and decline we should see a run from oil ETFs, and then see if the investment run feeds back to lower prices.

More tea reading, before the data, seems pointless.

[ddt]

JF: "There is little evidence that this has played a role in the run-up of commodity prices."

MT: " Jeff Frankel sorts speculation into three types and notes that only one of the three types, "bandwagon behavior," is worrisome. However, there's little evidence that this type of speculation is present in commodities markets"

Mark, this last sentence isn't supported by anything in the article and I don't understand where you are getting it from. Frankel said that there was little evidence of an effect from bandwagon speculation, not that there is none. there's a huge difference there. You must not have seen more than 5 minutes of CNBC in the last year (probably a good thing), if you think that there is no bandwagonism. The bandwagon jumping is absolutely rampant - this is not even debatable.

I think that it has an effect on futures prices, Frankel says that there is not sufficient evidence to prove this, and I concede that point, but I don't think anyone can say that there hasn't been a huge bandwagon movement in commodities.

[ndd]

From Yves Smith at Naked Capitalism:

James Bianco, a respected fixed income analyst at Arbor Research, was so kind as to pass along his observations about the retreat in oil prices from his morning research note. "Is This Why Crude Oil Is Getting Slammed?":

The Financial Times - Oil trading company files for bankruptcy Access
SemGroup, the US physical oil trader, on Tuesday filed for bankruptcy as it acknowledged trading losses of more than $3.2bn in different energy markets after betting this year that crude oil prices would fall.... Oil traders said SemGroup could have exacerbated the spike in oil prices this month, when the market experienced unprecedented swings of more than $10 a barrel, as the company was buying back some previous bets on lower prices. The bankruptcy of SemGroup, which describes itself as the fourteenth largest US private held company, affects approximately $3.1bn of debt, according to court filings. Oil company BP is the largest creditor, with almost $160m.
....

Comment - This story reminds us of the May 2006 parabolic rally and collapse in copper. Back then it was the short position held by China and Dwight Anderson's Ospraie Management that was forced to cover and when they did, copper prices collapsed.
....

This time around, it is crude oil that rallied enough to force SemGroup to take a $3.2 billion loss..., [T]he current correction is approaching the biggest correction in crude oil since February.
....

It ... is often the case that stories like this that lead to market reversals often do not involve that much money relative to the size of the underlying market.
....
Whether SemGroup's forced cover is the catalyst for one of the biggest recent corrections in crude oil can be debated. But the fact that this correction started literally hours after SemGroup were forced to cover (July 16/17) seems to be more than mere coincidence.

Once again, those active in the actual markets seem to have a different view than economic theory.

Does someone want to show that a 17% drop in the price of oil in a little over a week is actually supply and demand?

[Mark Thoma]

I don't see anything inconsistent between what I said and what Frankel said. I meant there was little evidence that the run-up was due to bubble-type speculation, that's what he said too. When I said it wasn't present in commodities market, it was in this context. Sorry if it was misinterpreted.

As to the other comment, the article you are quoting was posted here first - see the daily links - so yes, quite aware of it. Doesn't change my view.

If you want a simplified explanation involving S and D, see here for one part of it (other effects are at work as well, e.g. more pessimism about the future,the announcement last week of more reserves in the US than thought, etc., etc., also, the model I built awhile back showed how overshooting can occur even when only fundamentals are at work):

http://krugman.blogs.nytimes.com/2008/07/19/oil-outlook/

"Oil outlook

As I think I’ve written on several occasions, there’s a reasonable case for believing that oil prices will fall for a while — not because high prices were the result of runaway speculation, but because of the delayed effects of high prices on demand. And I thought it might be worth offering a moderately wonkish diagram. ..."

[Barkley Rosser]

My view on this is that there has been bandwagon speculation in commodities and that it did drive prices of some of them up. My guess is that the sharp drop in oil prices we have seen recently has been the ending of that bubble in oil, which was triggered by some small changes in fundamentals. Those are

1) declining gasoline consumption in the US over the last several months

2) increased production in both Saudi Arabia and Iraq that has finally come on line (and inventories are now rising, finally), with this amounting to nearly 1 mbpd.

3) Bush sending Undersecretary Burns to speak directly with the Iranians over nuclear weapons, with in recent months war noises over Iran having kicked the oil price up noticeably every time they have increased.

Republicans would like to say also Bush's talk about offshore oil drilling, but as even Bush himself acknowledges, any such event, if it were to occur, would be quite a few years from now. The first two items above are actual current flow changes, and the market has already shown great sensitivity to the third item. This final one might be playing in the market as well, but in my view if is, it is far less significant than the other three, not more than a dollar or two out of the recent price drop, if that much.

[anne]

http://krugman.blogs.nytimes.com/2008/07/19/oil-outlook/

July 19, 2008

Oil outlook

As I think I’ve written on several occasions, there’s a reasonable case for believing that oil prices will fall for a while — not because high prices were the result of runaway speculation, but because of the delayed effects of high prices on demand....

http://www.fao.org/docrep/010/ai470e/ai470e04.htm

July, 2008

UTILIZATION

World cereal utilization will grow at a slower pace in 2008/09 on reduced feed use

World cereal utilization in 2008/09 is forecast to rise to 2 167 million tonnes. Growth in food consumption and industrial usage are among the main factors for the rise in total cereal utilization but high prices are expected to cut into feed use and slow down the overall expansion in total cereal utilization to 1.9 percent, well below the 3 percent growth observed in 2007/08....

[anne]

http://www.fao.org/docrep/010/ai470e/ai470e04.htm

July, 2008

Cereal markets remain tight in 2008/09

Higher cereal production in 2008 is expected to contribute to some improvement in the global supply and demand balance for cereals in the 2008/09 season. However, with total cereal supply (carry-in stocks plus production) just barely exceeding anticipated utilization, the recovery in world cereal reserves will be limited. As a confirmation of a continuing tight supply situation in the new season, the ratio of world cereal stocks to utilization is forecast at 19.7 percent, up just marginally from the low of 19.4 percent in 2007/08. Against this background, international cereal markets are likely to stay volatile and export prices for most cereals could remain historically high although below the peaks of 2007/08....

[anne]

http://www.fao.org/docrep/010/ai470e/ai470e07.htm#22

July, 2008

In China, harvesting of the 2008 winter crop, which accounts for about 95 percent of China’s total wheat production, has virtually been completed in the major producing provinces. The country’s 2008 aggregate output, which includes some 5.1 million tonnes of spring wheat, is now tentatively estimated at a record 112.5 million tonnes, 2.4 percent above the previous high set last year. This increase is a result of government support to wheat production (direct subsides and increased procurement price) and favourable weather in the major producing regions. A record maize production is also expected, at 154 million tonnes, some 2 million tonnes above the previous high of last year....

[Subsides, subsides, subsides....]

[odograph]

How do those of you confident in your analysis feel about the whole "Fooled by Randomness" thing?

That book reinforced for me the idea that even when you correctly predict a price move you can never be sure that your mechanism was true.

I mean, when you are right you don't know if you were right for the right reason. And yet it seems many want to be "right" about speculation before the data even rolls in.

I suspect speculation had a role. I know that can never be proven, but possibly some outcomes could weigh against it (for instance if speculative investment inflows rise as prices fall? or if there are investment outflows as prices rise again?)

[odograph]

(I don't think Taleb's "Vinny" would buy complex arguments against speculation driving prices.)

[anne]

http://www.fao.org/docrep/010/ai470e/ai470e05.htm

July, 2008

FAO global cereal supply and demand indicators

As a strong evidence of the continuation of a tight market situation in the new season (2008/09) the ratio of world cereal ending stocks in 2008/09 to the trend world cereal utilization in the following season is expected to reach only 19.7 percent, up marginally from the estimated 30-year low of 19.4 percent in 2007/08. Among the major cereals, market conditions for coarse grains (maize in particular) are expected to be the tightest. With the anticipated total utilization exceeding world production, the stock- to-use ratio for coarse grains is forecast to plunge to 13.9 percent, the lowest in 30 years. For rice, the ratio is expected to reach 23.9 percent, still relatively low and nearly unchanged from 2007/08. However, the wheat ratio is anticipated to rebound, by almost 3 percent, to 26.6 percent. The expected increase in world wheat production in 2008 is forecast to result in some replenishment of stocks and improvements in supply....

In spite of the expectation for a strong recovery in grain production in 2008 in those major exporting countries which suffered production cutbacks in 2007, the ratio of their aggregate grain supplies compared to normal market requirements in 2008/09 is estimated to remain unchanged at a relatively low level of 118 percent. This represents a surplus of just 18 percent....

[Mark Thoma]

I'm absolutely certain I could be wrong. But I'm calling it like I see it.

[SGC]

So in Frankel's definition are commodity fund investors speculators or not?

If not, why not.

If so, aren't they the bad kind of speculators?

[anne]

Mark Thoma:

"Jeff Frankel sorts speculation into three types and notes that only one of the three types, "bandwagon behavior,' is worrisome. However, there's little evidence that this type of speculation is present in commodities markets."

I agree....

says...

Odograph,

Nobody on this blog has seriously read Taleb.

[Barkley Rosser]

Taleb is someone to read for his wisecracks, but not for serious economics.

says...

Taleb is not an economist. He would take that as an insult. There is no such thing as serious economics, except for in the economist's mind.

[Gegner]

Sometimes the best way to get at the root of the matter is to ask a different question...like where do you put your cash when the currency you hold the most of is sinking like a rock?

Wouldn't logic dictate that you invest in an item(s) that would 'appreciate' in value relative to your currency?

Sure, it's not 'foolproof'...but all investment involves some risk.

[BJ Feng]

Taleb is an interesting read, his point is that we humans misjudge the frequency and consequences of both likely and unlikely events. We also look for patterns because it's our nature to do so, yet the patterns might be meaningless and random. The stock market's daily gains and losses do NOT fit a bell shaped normal curve. The distribution is not normal, but we underestimate the likelihood of huge movements. The same applies to the commodities market, this is the second large move of its kind in the past 30 years, huge moves happen a lot more often than we think. When they do happen, we all dismiss it as an once in a lifetime event when it is actually a three in a lifetime event. I didn't read very closely, and it was years ago, but I think that is the jest of what he has to say.

[BJ Feng]

Good point Gegner, if I am investing in commodities as a hedge against inflation and to diversify against other asset classes, am I speculating? In fact, the latest studies show that everyone should hold 10% of their investment assets in a commodities futures index type fund that rolls over futures.

http://www.edhec-risk.com/edito/RISKArticleEdito.2008-06-19.5935

"Our research has made it clear that commodity futures can be used to successfully generate abnormal returns. For example, trading on momentum is a reliable source of alpha in commodity futures markets (Miffre and Rallis, 2007). Similarly, combining the information present in the term structure of commodity prices with that provided by a trend following strategy provides a highly profitable signal on which to allocate wealth (Fuertes, Miffre and Rallis, 2008). Interestingly, because of their low return correlations with traditional asset classes, the active portfolios can additionally be utilized as tools for risk diversification. Besides, the active strategies we develop are implemented on a relatively small cross section of assets, which are cheap to trade, liquid and easy to sell short. Thus, they offer the additional advantage of being both feasible and cheap to implement. For all these reasons, it is our contention that long-short active strategies may well become viable alternatives to long-only investing in commodity futures markets."

[a]

May I politely ask why he thinks there are only three? There is at least also the front-runner speculator - someone who knows that good X will be purchased soon in the future, so buys it now so that he can sell it (hopefully for more). Probably the most typical instance of this is when someone gets wind of news that the government will be building a highway or what not, and so buys up the land beforehand. IMHO, this kind of speculation doesn't fit into any of the three categories presented here. It's certainly not "bandwagon", anyway, and it would seem to be a negative type of speculation.

Is this type present in commodity markets? Sure, that's what investors have been doing when they have been buying commodities as an asset class.

[a]

And just to add, there are probably other types of speculation as well. I see no evidence presented why there should be only three.

[Lafayette]

Who's watching the watchdog?

Article: Clearly speculators are the conspicuous scapegoat every time commodity prices go high.

Interesting article, but beside the point in several ways.

The author has not justified rationally the existence of speculators, naked-shorting on the futures market (not having the means to cover future resale of shorted stocks). What is their economic purpose? By osmosis, bid up the FOB price of commodities?

Some people say no, but wherefore the run-up in petroleum prices – according to production reports that show supply just about meeting demand in the present summer period of the northern hemisphere – the largest user? Is this a reason for the 15/20/25% rise in prices that we notice at the pump (in Europe)?

Article: Not only would it be a miscarriage of justice to shoot the messenger, but the speculator is actually performing a social service

Please, as harbinger of “bad news” from far and wide, I prefer Bloomberg. For the moment, it is free, gratis and for nothing and very much the same “service to society” in general.

Article: Second, when the price is topping out, stabilizing speculators can sell short in anticipation of a future decline to a lower equilibrium price.

Oh right. Having done the damage (and made a profit), they now help fix the damage (and make another profit).

Profits are an integral part of the capitalist system, when done justifiably within a functioning market system. I cannot understand the justification of short-selling speculation on a word-of-mouth whimsy. Speculators make and break a market on frenzied rumor, then walk away to the bank with a smile.

That's insane.

From the Economist (24 July): This month America’s Securities and Exchange Commission (SEC) banned “naked” shorting—the sale of stock that investors do not yet have in their possession—of the American-listed shares of 17 investment banks as well as of the country’s mortgage giants, Fannie Mae and Freddie Mac. Last month Britain’s Financial Services Authority (FSA) introduced a new disclosure regime for short positions in companies that are selling new shares. Both announcements bore a whiff of panic: they were made during steep falls in bank shares …. Both were accompanied by the rattling of regulatory sabres.

The Economist goes on to decry the constraint, it too deploring any effort to restrain “the Invisible Hand”, one might imagine. Fairly, however, the Economist article does mention this: Naked shorting too can be a cause for concern. It can result in failed trades if investors sell shares without properly checking that they will be able to obtain them before their trade settles. This can sometimes lead to disorderly markets. But the SEC already has rules against this as well—although some argue they could be enforced better.

Sometimes? May I suggest that all times, worth mentioning, are disorderly markets?

OK, right, one more new rule won’t solve any problem when existing rules are not enforced. So, maybe we should be looking at yet another regulatory arm that has been asleep on its watch?

Who's watching the watchdog?

[Lafayette]

Subtle BIG difference

a: Sure, that's what investors have been doing when they have been buying commodities as an asset class.

The subtle difference being that when one "buys" an asset (stock, land, product) in the hopes of appreciation, they put down their money. They actually own the asset.

Naked shorting in a futures commodity deal done by speculators who put nothing down until they must purchase for delivery an asset (a commodity, if you like) at a future price.

Obviously, in a speculative market this is done for a profit. But, what happens when the future price -- on the day of delivery (resale) when the speculator must purchase the asset in order to deliver it at the price agreed -- is more than the past price agreed upon? Either of two things: (1) the speculator makes one helluva loss or (2) the speculator defaults on the deal.

The difference in future markets is that the speculator does not own the asset being speculated upon . This is not at all the same thing as buying land that one hopes will go up in price, but if it doesn't then it more than likely will not go down either.

And, if a speculator defaults on a “deal”, they become quickly ostracized. Either they play the game by the stated rules or they don’t play the game at all.

I suggest that the circumstances of the risk taker are very different on futures markets from other speculative markets.

[hari]

From a commodity market perspective, Mark has missed the significance of speculation in Futures Market. As I argued here before, on same subject, there is a reason why futures market was created - ie. to allocate Spot Price!

First, it seems to me that this sampede to commodities took place in the aftermath of last Aug rate decision(s) by Fed. Liquidity in the market is best illustrated on FX daily turnover ($Trillions!). From what we know, now, a lot of liquidity did in fact stampede into commodities - crude oil in particular.

Second, CFTC is now taking a Dutch invesment company to court for its actions on the oil futures market. Don't ask me for details - they're expected when filing of the case in court. Dutch firm made a good profit of US$1Million, so CFTC claims (confirmed by Dutch firm also now). I suspect it was a *naked* option.

Third, recall during recent Congressional Hearings on the matter, trading experts estimated crude price at $70-$75/Barrel. It was their trading knowledge which indicated that there was a *speculative bubble* taking place on oil futures - something Krugman refused to admit.

Fourth, oil prices are retreating and will get closer to above estimate - after summer holidays over.

[odograph]

I read Taleb after talking to the Peak Oilers for a year or two. His book was good at wrapping up things I'd been noticing (and of course the well-known emptiness of TV financial punditry). People can become very attached to their models (for markets, oil production, and sometimes even "catabolic societal collapse").

Many of those folks have short-term predictions that fail. They respond, as Taleb observes, by making new predictions.

I guess Gilbert in Stumbling on Happiness makes the argument that our brains are structured to think about the future. We are often pretty good at that, but often we stretch beyond the data.

This makes me think it is important to look for limits to our understanding and prediction. We should say "OK, I think I get this, but I can't say for sure" ... "I certainly can't call next year's oil price on this basis."

[im1dc]

Finally someone is talking about VALUE, in this case ala Ben Graham, though in regard to the purchase of financial stocks.

However, the same analytic holds for the recent FedRes/US Treasury decision to invest in Residential mortgages via the bailout of Wall Street and the Mortgage bankers (the supposedly 'too big to allow to go under'), i.e., ""You must never delude yourself into thinking that you're investing when you're speculating"."

IMHO, too few here seem to grasp what is happening and what it means and I hope this entry spurs further deep reflection of the propriety of the FedRes/US Treasury actions on behalf of the US taxpayers.

Or, said in a different way, if Chairman Bernanke and SoT Paulsen were advising you on how to invest would/could/ought you trust and take their advice with YOUR OWN MONEY?

HINT: They are so you should be paying rapt attention to their actions on YOUR behalf.

"Posted by Barry Ritholtz on Saturday, July 26, 2008 | 11:30 AM":
Jason Zweig has an interesting column today in the WSJ:

Would Benjamin Graham Buy Financials? (No!)

Inquiring minds want to know: What would Graham do?

This column, named after Benjamin Graham's classic book on value investing, launched only two weeks ago -- and several readers have already asked whether Graham would be loading up on financial stocks now. Unfortunately, I can't ask the great investor directly. Graham died in 1976. But a close look at his writings suggests that the answer is unambiguous: No.

That may seem surprising. After all, by mid-July, the Dow Jones Wilshire Financials index was down 46% from one year earlier. It's such big red numbers that get value investors licking their chops.

Even after rising over 30% in the past week, the 1,001 financial stocks tracked by Dow Jones Indexes are trading at an average of just 1.1 times their book value (assets minus liabilities). Before bank stocks climbed part way out of the crypt, you could buy Wachovia Corp. for 51% of reported book value. If that isn't Ben Graham territory, what is?

To see why I think Graham would sit on his hands, you need to understand his crucial distinction between investment and speculation. "An investment operation," he wrote in his first book, Security Analysis, "is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."

Trained as a mathematician and Greek and Latin scholar, Graham crafted his definition with the stark rigor of a Euclidean theorem. He wanted no weaseling about what he meant. All three, not just one or two, conditions have to be met: Your analysis must be thorough, your principal stay safe and your expectations be reasonable. "Thorough analysis" demands "the study of the facts in the light of established standards of safety and value," while "safety of principal" means "protection against loss under all normal or reasonably likely conditions or variations."

You cannot even pretend to be protected against loss while real estate prices -- the wobbly foundation for most financial stocks -- are still crumbling.

Nor can you study the facts when it's unclear what the facts are. Each quarter, the banks set money aside in reserve against losses on their loan portfolios and say they believe those reserves should be adequate. The next quarter, they find out they were wrong. Loan-loss provisions at Washington Mutual, for example, have mushroomed from $967 million to $1.5 billion to $3.5 billion to $5.9 billion over the past four quarters.

The timely Graham admonition that "You must never delude yourself into thinking that you're investing when you're speculating" is a reminder that no one really knows when the real estate crisis ends, or what the true situation of the financials firms balance sheets really are like.

As Zweig states, "For many banks, the nightmare has only begun."

http://bigpicture.typepad.com/

[anne]

Mark Thoma:

"I'm absolutely certain I could be wrong. But I'm calling it like I see it."

Simply look carefully to food production-consumption-prices data from 2000, and it becomes clear price increases were not driven by speculation more than routine day to day futures trading as conditions in markets are assumed to change. There has been no holding stocks from market by speculative funds, and price problems have steadily developed with futures traders likely being continually too optimistic for too long.

Food price increases would have occurred in the absence of pronounced energy price increases, and we should notice that as is usually the case food flows away from poorer areas as prices increase unless there is intervention.

[anne]

Also, as I have often written, we should be paying attention to how Chinese planners were early on concerned about food price increases and repeatedly used subsidies to counter the problem with remarkable success. The Chinese pattern of subsidy use in agriculture, which extends to assuring low cost fuel for farmers, should be a model for developing countries but is normally turned away from by analysts.

The United Nations Food and Agriculture Organization, however, has noticed just how effective Chinese subsidies have been. Chinese leaders have learned well to be especially sensitive to farmer's needs, and if China is determined not to harmed by limits in fuel and mineral commodities there is as much determination to be independent in agricultural production.

[hari]

Yesterday I read in People's Daily that CCP has now directed the government to accomodate (!) inflation while maintaining macroeconomic policy to promote GDP growth - estimated now at +10%. It seems the management of the currency is still a serious constaint to policy makers - Yuan is appreciating although at a relatively slow pace.

I suppose the disparity between urban/rural livelihood is being further exacerbated with current slowdown in the economy.

[anne]

Hari:

"I suppose the disparity between urban/rural livelihood is being further exacerbated with current slowdown in the economy."

I do not understand the rural-urban living standard dynamic but expect migration from rural to urban at least somewhat lessens the disparity, and both President Hu and Premier Wen have personally emphasized need to protect farmer's well being by making resources available at reduced prices, a personal intervention at such a level that is as rare as powerful.

[hari]

WTO/Doha Round in Geneva is extended until next Wed with anticipation of closing a deal - says Mandelson/EU Trade Commissioner - France and Italy have gone against the offer (made by EU Mins during Bxl meeting yesterday). Time is running out of Doha Round - EU is blaming Indian Min of Commerce (Kamal Nath) for blocking final deal.

Very difficult to find out what's making them extend the deadline from this weekend to next Wed.

[kthomas]

Thanks for the update, hari.

[Barkley Rosser]

Taleb is a very interesting guy to read, knows a lot of history and philosophy and odd bits of this and that. However, when it comes to markets and economics he comes on a bit too strongly. He plays an "I play the markets for real" game to economists and philosophers and "I am great at economics and philosophy" to the market practitioners.

As far as pointing out that financial asset returns have kurtosis and are not normal, this has been known for some time by anybody dealing seriously with the markets, even if one has to look awfully hard to find this stylized fact in most financial economics textbooks, even advanced ones. Of course Taleb calls the usual fat tail stuff merely "grey swans," the truly black swans being the much harder to model or forecast surprise events akin to Knightian-Keynesian uncertainty, that is not describable by any probability distribution.

So, this is where things get funny. Taleb actually does propose a strategy for dealing with this, the "barbell" strategy of basically combining buying a lot of very safe securities long with also some very long puts on major financial catastrophes (although he privately declares that he is not himself so stupid as to buy "naked puts"). There is only one problem with this strategy as it appears to be presented in his book. It has given lousy returns in recent years, despite all the financial catastrophes that have been happening. Too many people have been trying to do it, perhaps inspired by Taleb's earlier writings, and perhaps buying such puts from Taleb's firm, although I do not know that. But if so, then his book amounts to a "pump and dump" game for suckers.

I will also note that in the past Taleb has threatened to sue people who say too much in the wrong way about this sort of thing in the blogosphere. He is someone who flies off the handle and cannot take the heat of criticism worth a bean. So, while he has many interesting things to say, he ultimately comes across as an arrogant hypocrite.

So, Mark, if he comes at you privately and demands that this be taken down or you face being sued, I shall understand. He has done it to other bloggers before. And, any readers out there, if this comment suddenly disappears, you will know why.

[ddt]

I've read a bit of Taleb and generally I like what I have read:

- anti-platonism is always good in my books
- his defense of Voltaire and bashing of Descartes is spot on
- I like the critique of Gaussian mathematics (most quants are useless autistics that should not be let anywhere near financial markets - thanks for the MBS guys! loved your projected default rates! how many sigma 12 events have we had this year?)
- his mockery of academia is pretty funny

When I trade it is predominantly through options (I'm a pure speculator, not an investor), and these days puts, so I was very interested to hear a semi-celebrity talking up put options in the New Yorker. I find his advice to routinely buy long-dated OTM puts on random companies regardless of whether or not you know of any problem with the company a little curious. How long-dated is he talking about? Long-dated puts are expensive as hell, and lose value exponentially as they approach expiration. If you were to buy them based on the general idea that something bad will happen someday, you would have to have a pretty massive cushion of capital to absorb all the losses you would take on the way.

I guess in the long run it is a good strategy, but what institution or investor has the structure in place to deal with a potential decade of massive losses before getting the mammoth meat? It's way too risky for pensions, too long term for hedge funds, requires too much capital for an individual investor. Sitting in treasuries while buying naked puts seems like a good idea to me, but completely impractical for the vast majority of traders.

[odograph]

My three comments would be: First that I was first exposed to Taleb by way of his PopTech presentation, in which I thought he showed good humor (and diffused his criticisms in ways that would not be obvious in text). Second that I don't think anyone is foolish enough to think that Taleb's, or any man's, thoughts are wholly unique. Third, when TV, radio, newspapers, and financial blogs are full of unfounded prediction, his message still has merit.

I mean, turn on CNBC Monday morning, and tell me again if Taleb's popular message is superfluous.

Finally (I guess this is four), how many economists pride themselves on their analysis of the oil situation without offering anything testable in the Popper/Mandelbrot/Taleb sense?

[Barkley Rosser]

odograph,

What has Taleb offered that is "testable" might I ask? The barbell strategy? It has been tested and loses money.

[BJ Feng]

Taleb has lost money in the barbell strategy, he bought out-of-the-money puts and calls for years, but there were no large movements. If he had done that at the beginning of this financial crisis, he would have made a lot of money. I think his strategy is unsound, who has enough capital to wait around for years hoping for a black swan event?

And it's uncertain if over the long term, his strategy works. All the studies I've read indicate that buying OTM calls and puts is unprofitable. That's because there is an insurance component that you have to pay the seller, if that premium is large enough, then the strategy is unprofitable. Plus out-of-the-money options already imply an increase in volatility. They assume that strange things are going to happen. Option sellers learned from 1987 and restructured their models accordingly. The standard formula for options pricing is still taught in schools, but never used in reality. All the new models are proprietary secrets as far as I know.

[a]

"I think his strategy is unsound." If his idea is to buy puts and then to earn money the day of financial apocalypse, he better make sure of his counterparty. Many counterparts may have difficulty paying when financial apocalypse arrives.

"It has been tested and loses money." Well, we really haven't had financial apocalypse. The Fed and other central banks have softened volatility at key moments over the past forty years. IMHO that will be coming to an end, as people are losing confidence in the Fed.

[odograph]

I think when someone points out that predictions are weak, we have a very natural (but dangerous!) impulse to ask who can do better. Or if someone faults prediction, can they do better.

I consider it a weakness actually, when our society latches on one bad prediction after the other, rather than accepting the uncertainties.

Are there real limits? I think there are. It's probably more important to say we don't know oil production or oil prices 5 years from now than to predict them.

(I consider Taleb's barbell to be a strange niche case, certainly far outside my life and far from my problems.)

[im1dc]

The numbers are getting bigger, a lot bigger.

No longer $1.43 TRILLION, its now $5 TRILLION, making the US taxpayer on the hook for a total of $10 TRILLION, not the $5 Trillion US Debt before the current bailouts.

Mr. Poole says I wrong to object to the bailouts b/c in actuality the damage is going to be limited to, best guess today, "$25 Billion." And of course, Fannie and Freddie are 'too big to fail'.

Since Mr. Poole was head of the St. Louis Fed from '98 to '08 I say he's part of the problem not a part of the solution and with his Libertarian leanings his credibility is nonexistent, i.e., the Libertarians words are insightful but their prescriptions are worse than the disease.

Lifted from The NYTimes today:

Too Big to Fail, or to Survive

By WILLIAM POOLE
Published: July 27, 2008

"CRITICS of the Congressional housing package complain that we are now committing taxpayers to huge new outlays to rescue Fannie Mae and Freddie Mac. That view is wrong: Congressional inaction over the past 15 years had already committed taxpayers to the bailout."

"...the national debt, usually viewed as the $5 trillion held by the public, is really $10 trillion once we add the Fannie and Freddie obligations and the mortgage-backed securities they guarantee."

"For now, the Congressional Budget Office has entered a “place holder” of $25 billion to cover the bailout costs over the next two years but recognizes that this is a guess..."

"...The wisest move, in the end, is to carefully let them wither away."

http://www.nytimes.com/2008/07/27/opinion/27poole.html

William Poole is a fellow at the Cato Institute, was the chief executive of the Federal Reserve Bank of St. Louis from 1998 to 2008.

[Lafayette]

Such knowledgeable folk

Poole is right and wrong.

He's right to say that "Congressional inaction over the past 15 years had already committed taxpayers to the bailout."

He's wrong to say that FM2 are "Too Big to Fail, or to Survive". They must survive, perhaps with different management, but we can't fold these institutions just because there's a need to show idiot management that idiots get canned.

There is a Social Morality to this sad tale. It is dead simple: The same people who are "taxpayers" are the ones who will have their mortgages foreclosed if FM2 are laid to rest.

So, these fellow citizens have a right to expect that a government-backed institution, which made a big mistake, should be backed by Federal finances which exists because of ... you guessed it - Taxpayers. If a sense of solidarity was ever needed in this overly individualist country, it is now.

If that requires hiking taxes, then so be it. And, I'll bet you know which class of citizen I have in mind ...

I know you know. You know that I know that you know. (We are such knowledgeable folk on this forum. ;^)