Defensive Notes On The Margin

IN THIS EDITION

DEFENSIVE NOTES ON THE MARGIN: Investors sharing our view that financial assets in general are fundamentally overvalued in real, purchasing-power terms naturally seek to preserve wealth in alternative assets, including commodities. However, while commodities may indeed be more fairly valued, that does not mean that they can decouple entirely from developments in financial markets. Should equity markets suffer a major correction, commodity prices are also likely to fall, in particular those for industrial commodities. But even non-industrial commodities can be subject to speculation from time to time and there is some evidence that this is the case at present. Defensive investors should take note.

DEFENSIVE NOTES ON THE MARGIN

In recent editions of the Amphora Report we have discussed why we have become defensive with respect to equity markets and also certain industrial commodities. In brief, the key reasons are the following:

• Rising commodity prices are not only creating rampant price inflation in many countries around the world; they are also severely compressing corporate profit margins;
• Many emerging markets are now raising interest rates to slow their economies and control inflation;
• The stock markets of the most dynamic economies, including those of China, India and Brazil, peaked several months ago and have performed poorly year to date;
• Governments in developed economies are seeking ways to reduce deficits. While entirely necessary, this is negative for corporate profits during the current cycle;
• As discussed above, bond yields have risen substantially in the developed economies, implying a tightening of credit conditions;
• Developed-world stock market valuations have reached levels normally associated with major asset bubbles.

The continuing rally in developed-world equities thus appears something of a puzzle. But rather than providing an indication of economic strength, perhaps rising valuations merely reflect fiat currencies that are weakening in real, purchasing-power terms. Indeed, in a world in which currencies are not reliable stores of value, it is distracting, perhaps even dangerously misleading, to think in absolute terms, as if any base currency is an objective frame of reference. Rather, we prefer to think in relative terms.

Yes, the US stock market might be “overvalued”, but what do we mean by this? Overvalued versus what exactly? Versus the dollar, which represents a claim on a shrinking portion of an expanding money supply, printed at will by a pathological central bank in pursuit of higher inflation? Versus Treasury bonds, which are growing exponentially in supply as the US government continues to run massive deficits in a counterproductive attempt to create jobs amidst huge structural economic headwinds?

The challenge in claiming that something is over- or undervalued is that it must be demonstrated to be over- or undervalued versus something else. Traditionally, this has been a base currency, such as the US dollar. But if the dollar is being devalued, we need to find an alternative. This is where commodities can play a role. They cannot be printed, devalued or defaulted on by governments. As such, in a world of fiat currency instability, we believe that commodities provide a superior benchmark for comparing relative asset values.

We can’t help but chuckle when some equity or bond analyst argues that commodities are “speculative” in that they don’t represent claims on future cash flows and, as such, cannot be properly valued. Perhaps that is true in nominal terms. But in real terms, commodities can be compared to currencies and financial assets, which naturally carry some combination of devaluation and default risk. As those risks necessarily grow as monetary and fiscal policies become more unsustainable, so does the relative attractiveness of commodities. (As an aside, we continue to take comfort in that so many otherwise smart people still don’t understand this point. How can commodities possibly be in a bubble if investors in aggregate prefer holding financial assets notwithstanding the sound of printing presses whirring in the background?)

That said, this does not imply that there is zero speculation taking place in commodities markets. But please, show us a market in which there is no speculation! For an investor concerned about chronic fiat currency debasement and rising government deficits, is it really a speculative act to reduce exposure to currency and bond market risk by holding some commodities instead? Hardly.

Regardless, investors should always be wary of markets in which speculation appears excessive. Within commodities markets, there are various ways to try and estimate the degree of speculation taking place. One popular way is to compare the positions of commercial vs non-commercial trading accounts on the major commodities exchanges. Commercial accounts are those that trade on behalf of an entity which has a natural exposure to the underlying, deliverable commodity by virtue of its business. Think of a farmer, for example, who might systematically sell various agricultural futures on an ongoing basis to lock in a sale price in advance, thereby holding profit margins more stable over time; or a mine owner selling various metals futures for the same reason. On the other side, think of the miller or the meatpacker seeking to lock-in purchase prices for their grain and livestock, respectively; or an automobile or appliances manufacturer requiring substantial metal inputs, etc. Futures contracts enable both producers and consumers of a given commodity to manage the price risk inherent in their businesses.

Speculators, however, are those who have no commercial need to either purchase or sell a given commodity. Rather, they are seeking to profit from price fluctuations, be they up or down. Speculators may have a bad name but, in fact, they perform an essential function, which is providing liquidity for the commercial buyers and sellers. In much the same way that a bank matches depositors (lenders) with borrowers, thereby providing a liquid market in money, so speculators can be understood to help match buyers and sellers of various commodities. Sometimes the speculators make money; sometimes they lose. But regardless, they create a larger, more liquid market for all.1

While this distinction between commercials and non-commercials is nice in theory, in practice it is actually quite difficult to make. One reason for this is that commercials can speculate. A farmer might believe, for whatever reason, that grain prices are likely to rise over the coming year and, as such, rather than lock in a sales price for his crop at today’s futures prices, he can leave his production unhedged, holding out for a higher sales price come harvest time. A similar decision could be made by the miller who, believing for whatever reason that grain prices are going to fall, leaves his grain input costs unhedged. Producers and consumers of all manner of commodities have tremendous flexibility, in practice, to determine just how much of their production or consumption costs to either hedge or leave unhedged. There is thus great potential for commercial speculation which cannot be measured by a facile distinction between commercial and noncommercial accounts.

There is another way, however, to try and estimate the degree to which certain commodity price increases are being driven by speculation rather than commercial supply and demand. This is to look at the “cost” of speculating, as measured by the amount of margin (collateral) that the speculator must put up on the exchange in order to open a position in a given commodity futures contract. The less it costs to speculate, so the thinking goes, the more potential for speculation.2 In the table below, we list the initial margin requirements for a selection of major commodities and also the current notional contract value for each. We then calculate the margin required, in percent, to hold a speculative position in each commodity.

Source: CME Group. Prices as of 16 Feb 2011

Taking a look at the far might column, it would appear that, at present, with the lowest percentage margin requirement, gold is perhaps the commodity most open to speculation and natural gas the least. But this approach is incomplete in that it does not take into account the volatilities (risk) of the respective commodities. Some commodities are much more volatile than others. In the table below, rather than simply divide spot contract values by initial margin requirements, we calculate the annualised volatility of the commodity as a measure of risk. We then divide this measure of risk by the margin requirement. This risk-adjusted margin (RAM) calculation gives a more complete picture of the “cost” of speculating in a given commodity. The higher the RAM, the higher the “cost”.3

Source: CME Group; Bloomberg. Prices and volatility calculations as of 16 Feb 2011

There are several observations we can make here. First, gold has by far the highest RAM at present, implying that speculators are unlikely to find gold particularly attractive. Second, among agricultural commodities, cotton, corn and wheat have quite low RAMs, potentially inviting speculative attention. Finally, of the metals, copper has the lowest RAM. It may be pure coincidence that these commodities with low RAMs are amongst the top performers over the past few months; but then again, it may reflect a potentially dangerous degree of speculation having entered into these markets.

Investors sharing our view that financial assets are fundamentally overvalued in real, purchasingpower terms should continue to hold a diversified exposure to commodities as an alternative to a more traditional portfolio of stocks and bonds. Defensive investors, however, concerned that equities and risky assets in general are at risk of a major correction, should now consider underweighting industrial commodities, which tend to be highly correlated to equity markets.

Non-industrial commodities, such as agricultural products, are normally uncorrelated to equity markets and are likely to remain so. However, defensive investors may now also want to consider underweighting even those non-industrial commodities which, according to the calculations above, are possibly attracting significant speculative interest. As copper is both an industrial commodity and one with a low RAM at present, it would appear to be particularly vulnerable. Gold, however, is not only essentially uncorrelated to equity markets but, importantly, appears unattractive to speculators from a RAM perspective at this time. Those claiming there is rampant speculation in gold at present should consider this important fact.

The Amphora Liquid Value Index (through 17 Feb 2011)

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1 This is an important topic in of itself and we cannot do full justice to it here. But briefly, there are those who believe that speculation is simply evil. At present, higher food prices around the world are placing the poor in a growing number of countries at risk of malnutrition or even starvation. It is all too easy to blame speculators seeking to profit while the less fortunate starve. But this view is false. Consider that food prices, or prices for any essential commodity for that matter, are a function of supply and demand, but not only for the numerator, that is, the commodity itself, but also the denominator, that is, the base currency. If the interest rate for the base currency is held artificially low and/or the money supply is rising, then it is the monetary authority, not the speculators, which is driving prices higher. In the same way that commercial banks transmit central bank money into the economy through lending, thereby creating credit and price inflation, so commodities traders transmit central bank money into commodity prices. To blame speculators for pushing up food prices is thus akin to blaming banks for lending. There are those, we suppose, who would prefer to live in a world without speculators, without banks and without free markets. We doubt that we will have much success convincing them that such a world would be a rather grim place.

2 In this discussion we assume that the speculation that is taking place is in the form of buying rather than selling, pushing prices higher rather than lower, as this has been the trend with essentially all major commodities over the past year.

3 Those familiar with the commodities futures markets are also aware of the roll yield (or carry cost) as a factor which can influence speculators. In this analysis, contract values could be adjusted higher (or lower) according to their positive (or negative) roll yields for a more precise analysis.We have not included roll yield calculations here because roll yields are currently much lower than volatilities and, as such, would not impact the results meaningfully.