Royally Skewed

By: Michael Ashton | Mon, May 9, 2011
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Although commodities do occasionally crash, in general commodity prices are positively kurtotic (fat-tailed) and positively skewed. This is in contradistinction to equity prices, which are positively kurtotic but negatively skewed. In English, that means that both stock prices and commodity prices crash more than we would expect them to if price changes were random, but while stocks tend to crash down, commodities tend to crash up.

The reason for this is simple: commodity supply curves become very inelastic (steeper) when the level of actual, current inventory is fully allocated. There are only so many soybeans available right now. But at low levels of demand and lower prices, the supply curve gets more and more elastic (flatter), which means large declines in demand don't drop prices as sharply as large increases in demand can increase them at the other end of the curve.

The practical import of this observation is this: one must be more careful shorting commodities than shorting stocks, because while a bull market in stocks can grind you to death, a bull move in commodities can rip you to suddenly to shreds (the fact that in a limit up market there is literally no price at which you are allowed to cover, while this situation rarely exists in equities, means that market infrastructure contributes to the danger).

Today, this lesson was made painfully when energy markets jumped about 6%. This was no 'dead-cat bounce,' which often follows a sharp move down. Last Thursday and Friday, NYMEX Unleaded dropped about 23 cents. Today, it rallied back 20 cents. The reason? Well, there was a rumor that NATO was bombing Libya, but that can hardly be surprising can it?

The bounce in Silver was more like 7%, but in the context of the 1/3 decline over the last week or so that really may be a 'dead cat' bounce. Silver really had gone too far too fast, and while I think at the current levels it is probably a reasonable wager I wouldn't expect (or want) it to rally sharply back to the highs. As I said last week, commodities are generally in bull trends over the last year because of the oversupply of dollars in the market relative to "stuff." But that is both a reason to rally and a speed limit. If the amount of money in circulation goes up 10%, commodity prices shouldn't be doubling. I continue to be a commodity bull (although I invest through indices where there is some expectation of positive returns from rebalancing effects, rather than directly into specific commodities), but a patient one.

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Skewness and kurtosis, in addition to being great cocktail-party words, are also important concepts for investors to understand. More specifically, it is important for investors to think carefully about the difference of the "higher moments" (as skewness and kurtosis are sometimes collectively called) between asset classes and particular investments. Given a choice between two investments with the same expected return and variance, a long-only investor should always choose the one with 'fat tails' on the upside rather than the one with 'fat tails' on the downside. This is true for two reasons. First, the marginal pleasure of a gain, for most investors, is lower than the marginal pain of a loss, and this is increasingly true for large gains and losses. Second, a large gain increases the bankroll, but a large loss can be a portfolio-ending experience. All of the rules about long-term investing are based on the assumption that the long term can be reached - or, as Warren Buffett has said, one "-100%" really messes up any series of portfolio returns.

Recently, in a great customer letter called "Five fallacies about inflation (and why global policy rates are too low)," Markus Heider, Jerome Saragoussi, and Francis Yared of Deutsche Bank made some very adroit observations about the risks of inflation going forward. The quick summary is that they see inflation as the greater risk than deflation because 1. The output gap is smaller than suggested by the high unemployment rate; 2. A negative output gap does not imply declining inflation [frequent readers know I harp on this a lot]; 3. EM countries are exporting inflation rather than disinflation; 4. Commodity price inflation is becoming structural and is exacerbated by low global real policy rates; and 5. Central banks' credibility is at risk of being eroded.

But the single best part of the report, in my opinion, is the chart they created to summarize the effect of their views on the distribution of possible inflation outcomes going forward. That chart is below (reprinted with permission):

Deutsche Bank's chart
Deutsche Bank's chart showing their assessment of how the distribution of inflation outcomes has probably changed. Used with permission.

In short, the higher expected value, flatter distribution, and fat upper tail combine to make long-inflation bets worthwhile even if they are somewhat expensive right now. This is one reason that TIPS are seemingly egregiously priced. It's all about the skew. If we don't get inflation, we probably bounce around between 1% and 3% inflation for a while. If we do get inflation, it could get ugly. Therefore, it makes sense to give up some current return to 'buy the tail option.' I agree, and think their picture is truly worth a thousand words. (I still think that TIPS are too expensive for my taste even with this fact, but it is the reason I was willing to be long them when 10-year real yields were as low as 1%. It's just a harder call at 0.65%!).

I highly recommend you contact your Deutsche Bank contact to get a copy of this report (from April 1). Honestly, while the overall state of inflation research is clearly better now than it was, just a few years ago, these guys at DB seem to me to have some of the most consistently high-quality research in the space.

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The rally in equities (0.5%) and commodities comes with the caveat of occurring on low volume. I am clearly less sanguine about the former rally continuing than I am about the latter rally. Bonds also rallied slightly again today, with the 10-year yield falling to 3.14%. That is the rally that is a serious head-scratcher to me right now. I guess it is part and parcel with the current optimism that the Fed has engineered a recovery - at least, a modest one - without serious signs of widespread inflation in the sticky prices. But if I think about ways that optimistic assessment is likely to prove to be inaccurate, it seems to me that it is far more likely that the outcome is going to be much worse (in terms of the growth and inflation mix) than investors/economists currently expect, rather than much better.

In other words...I think we're skewed.

 


 

Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
E-Piphany

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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