This speech was prepared for the IQPC Base Metals Investment Summit 2008 in New York City on April 2, 2008. For a copy of the PowerPoint presentation, contact Cervino Capital Management LLC.
First, I would like to thank FinanceIQ for facilitating this worthwhile conference on base metals, and also thank the audience for sticking around for the final session. I'm sure that we're all worn out after listening to so many excellent presentations, and it is only natural to ask at this stage, "what else can be said?" But rather than this being a disadvantage, the last session provides us with the opportunity to discuss some unconventional ideas, perhaps even controversial viewpoints, to spark discourse as we take our leave.
Three weeks ago there was an article in the Financial Times titled: "Plummeting dollar a big headache for pegged currencies." Between hedge fund margin calls, the Fed's $236 billion plan to boost liquidity, Bear Stearns take-under by JP Morgan, and not least Elliot Spitzer's self-destruction, why focus on this particular back page headline? The reason this article caught our eye is that it focused attention on what we believe is the near-term "end game" within a longer-term era of commodity inflation -- in other words, a significant correction of some duration within the context of a long-term secular bull market in commodities.
Few will argue that we are in the early stages of a much needed infrastructure build-out that will drive demand for base metals and other raw materials. And infrastructure redevelopment is not only taking place in the so-called BRIC countries, Brazil, Russia, India and China, as well as emerging economic zones such as the Middle East, but we note there is also a dire need to replace the decaying infrastructure in the United States.
Notably, in 2001 we reached the end of a twenty year period of benign commodity prices. Benefiting from 20/20 hindsight, we can now see that this situation led to persistently low levels of reinvestment by those businesses that produce commodities, in order to just survive. The combination is economics 101: increased demand, reduced supply, equals higher prices. No argument there...
But where do we go from here? The current bullish argument takes the view that growth in the BRIC countries will decouple from the economic slowdown in the U.S., which in turn will lead to continued robust demand for raw materials. We think, however, it is more likely that a painful cyclical bear market in commodities will occur later this year or early next. Our thesis hinges on the three key ideas:
First, we are hard pressed to believe that the current deleveraging of the shadow banking system is not going to have a subsequent impact across the economies of the world. The outstanding question is the viability of the decoupling thesis. China is inextricably linked to the U.S. via its investment in our Treasuries, and is reliant on global consumption. As it stands now, China's investment in Blackstone is widely seen in China as a disaster, and the country's premier recently relayed Beijing's anxiety by stating, and I quote, that "global economic developments cannot but have an impact on China." Despite the Chinese government's emphasis on internal growth, it admits it cannot avoid the impact of a downturn elsewhere.
Second, the dollar peg has become a liability for countries such China and Saudi Arabia. In effect, the Fed's aggressive easing to stabilize the U.S. economy has caused inflationary pressures to grow in countries that have a fixed or quasi-fixed peg to the dollar. The peg imposes the U.S. easing policy at the exact time when these economies should be looking to control domestic inflation through tighter monetary policy. All one needs to do is read the newspapers to see that margins are being squeezed in emerging markets due to higher production costs. Eventually, countries such as China must abandon the dollar peg and allow their currencies to fully appreciate, if not float, in order to reduce their cost of raw materials.
Third, and most importantly, we believe that the securitization of commodities, vis-à-vis linked structured notes, ETFs and index funds, is the primary reason why commodity prices in mass have recently risen to the point that the wisdom of crowds is giving way to the madness of crowds. It should be noted that the demand-side fundamental case was well in place four-five years ago. Rather, what has changed in the last two years is the proliferation of securitized commodity vehicles. Such instruments have facilitated the ease through which traditional investors can now increase money flows to an area that was once deemed speculative and only available via futures trading.
Meanwhile, Fed Chief Bernanke is between a rock and a hard place, and he's picked his poison: cut interest rates and inject liquidity to the detriment of the dollar. But this action, rather than re-inflating the capital markets as it did in the 2001-2002 recession, has caused investors to turn to commodities in unprecedented numbers because they perceive that hard assets is the best possible "store of value" in this economic environment. And who can blame them -- it is wise to diversify across asset classes.
Nevertheless, just ten years ago, mainstream conventional thinking about commodities was largely negative. In a 1996 academic paper titled "Multi-Factor Models in Managed Futures, Hedge Fund, and Mutual Fund Return Estimation," Professors Schneeweis and Spurgin, two esteemed academics who have written multiple papers on the commodity and futures markets, stated at the time that the continuing low level of investment in managed futures was due to the fact that institutional investors require both a theoretical basis for their investment in nontraditional investments, as well as supporting empirical results.
The underlying issue is further revealed when you ask a futures trader where his or her source of return comes from. My experience is that most traders have given little thought about this concern, and find the question difficult to answer. Traders will associate their expected returns to an "edge" in their strategy or skill in their tactics. Or, they describe their returns as a loosely defined version of "alpha," in which the "beta" proxy is arbitrarily chosen, and does not accurately represent the same or all the factors which drive the trading.
The issue of constructing an appropriate benchmark for professional traders in futures, also known as managed futures, is an enormously complicated topic subject to prolific debate. For example, the S&P 500 is an inappropriate proxy in which to compare the relative returns of a base metals trader. Likewise, a gold ETF does not reflect the same return dynamics compared to a base metals portfolio consisting of aluminum, copper, platinum and zinc. But does that mean that the Powershares ETF for base metals (symbol: DBB) is the best beta proxy against which to measure an active manager's alpha? We think it is more complicated than that...
The answer, we propose, lies in developing customized multi-factor benchmarks which encompass the major return drivers that best characterizes a particular trader's strategy. While we are not familiar with research done on this area as it specifically relates to base metals trading, there is a working paper by Mssrs. Levich and Pojarliev, titled "Do Professional Currency Managers Beat the Benchmark?" Their paper relates currency fund returns to four factors: carry trading, trend-following, value trading and currency volatility. These ideas can be ported to base metals trading, but it should also be recognized that different managers may emphasize different factors in their trading styles.
That said, since the millennium, the "prevailing wisdom" amongst proponents for long exposure to commodities is that a structural risk premia is generated from something called a "roll return" or "roll yield." However, these product advocates conveniently forget the legacy of inconsistent research results from empirical tests which have sought to identify the source of positive expected returns from speculation in the futures market.
Ironically, the roll yield idea is derived from a water-down definition of backwardation and contango, which relates these concepts to the "term structure of the futures price curve." This "current convention" then became fodder for the fantasies of a much cited Yale University paper on commodity futures by Gorton and Rouwenhorst, proponents of the roll yield. Nevertheless, because the paper is briefly cited by Jim Rogers in his book "Hot Commodities," a perpetuated myth evolved around this deficient theory. Jim Rogers should have cited Erb and Harvey, who in their paper advocate a strategy return based on rebalancing.
Now, if one takes a close look at the statistics which underlies Gorton and Rouwenhorst's conclusion, it becomes obvious that their model supports a fictional trade that cannot be duplicated in real life. Rather than rolling the futures contract forward, they roll the futures contract backward to prove their thesis. This is done with the idea that the expected future spot price is a predetermined static constant, when in fact the expected future spot price, which is the lynchpin to Keynes' theory of normal backwardation, is an unknown to be discovered in the future at the time that the futures contract converges with the spot price.
Unfortunately, it now seems that this convergence, a requirement necessary to make futures contracts economically meaningful, has been disrupted by the proliferation of financial investors who are allocating only to the long-side of the commodity trade. What would support such outrageous claim?
To begin with, word on the street is that commercial hedgers are no longer finding it cost effective to use the futures markets to hedge. A comparison between the earnings of non-hedged miners versus hedged miners reveals this simple truth. Yet investors are ignoring the idea that convenience yield is founded on the very notion that risk-averse producers are willing to pay a risk premia. Instead, commodity markets have become either symmetric, in that financial investors are the predominate participants, buying and selling to each other -- a game involving the greater fool; or alternatively, panicking commercial buyers provide the basis for an asymmetric payout. This is a truer definition of a contango market, and if one accepts that there is a structural source of returns in commodity futures, contango conditions are detrimental to long positions.
But it gets worse... On February 5, 2008, the National Grain and Feed Association (NGFA) alerted the CFTC and the CME Group of "major underlying concerns over the lack of consistent convergence (narrowing) between cash and futures prices in delivery markets during the futures delivery period, and the dramatic adverse impact it is having on grain elevators, feed mills and grain processors that traditionally have used futures markets to offset price risk inherent in cash markets."
The NGFA goes on to say that, "in this environment, the marketplace is ill-equipped to efficiently absorb more investment capital and perform its core function of serving as an efficient tool for business hedging physical grain purchases, particularly when virtually all of that investment capital is long-only and a large share of open interest essentially is 'not for sale' for long periods of time."
While this statement is particular to the grain markets, it is apropos to all commodity futures markets, and should be heeded by those making investments in base metals. Base metals investors should also note that futures contracts are the core instrument underlying securitized commodity investment vehicles, even those linked to forwards and swaps. The paradox is that for every buyer of a futures contract there is a seller -- a zero sum game, and the same goes for over-the-counter derivatives.
Effectively, Wall Street has hijacked La Salle Street with financial innovation; albeit, again with arguably good intention. At the same time, La Salle Street is a willing patsy because it benefits enormously from the increased flow of transactions and "dumb money" into the game. But it is doing so at the risk of selling out its main benefactors -- the bona fide hedgers as well as the broader public at large. This new industry paradigm now risks sending the commodity futures markets into a dysfunctional spiral.
The ugly truth is that the securitization of commodities has eased the way for money flows to raise commodity prices beyond that which the current fundamentals of the global economy can be sustain over the long term. The last time securitizations got out of hand it turned into the credit crisis we now find ourselves in. The falling dollar is a continuum of that story, and currently investors view hard assets as a means to preserve wealth. The problem is that this thought process is reflexive, a self-fulfilling cycle -- the higher prices go, the more it causes inflationary pressures, which in turn support increased prices.
Ultimately, prices will zenith because high commodity prices grind economies to a halt. The argument that emerging economies are no longer linked to the United States, because of increased trade amongst each other, is flawed because of the dollar peg. The Fed's aggressive easing to stabilize the U.S. economy will eventually destabilize emerging-markets -- the same economies which are touted by commodity bulls as the fundamental demand driver for a continued bull market in commodities. And with consumer and business confidence falling along with the stock market and real estate prices, potentially turning into a severe recession in America, we believe it is only a matter of time before the economic malaise spreads.
We should therefore remind ourselves that properly functioning futures markets are suppose to serve a greater economic purpose -- a view assured through government policy. The secondary benefit provided by the futures market is that it functions as a mechanism for transparent price discovery and liquidity, which theoretically mitigates price volatility. The primary benefit provided by these markets, however, is that it allows commercial producers, distributors and consumers of an underlying cash commodity to hedge.
Hedging operations are designed to reduce the risk of adverse price fluctuations that may impact business operations, which subsequently results in increased capacity utilization. Hence, it follows that the reallocation of risk affords a reduction in the price of finished goods because businesses need not offset adverse price change risk with increased margins. However, as of late, this no longer seems to be the case.
Investors need to recognize that commodities are consumable, transformable and perishable goods that do not provide a yield but incur a cost of storage. Sure, one can obtain a collateral return for the privilege of exposure to spot returns, but this risk-free return does little to offset the risk that comes from leveraged exposure to commodity futures. There is no inherent beta in commodity futures. Trading of commodities must eventually be realized in their delivery and use. If there is a beta, it is derived at the time a company transforms "real assets" into earnings. Investors who invest in the underlying hard asset only for financial reasons and not for commercial reasons, are essentially speculators.
For this reason, we believe that dynamic active management by experienced speculators trumps passive long-only investment in commodities. Such active management can be access via managed futures.