Monday, August 11, 2008

Expectational jumps and commodities

Crude oil prices have fallen off a cliff. Metals prices are down hard and grain markets are more than one third off of their highs. What causes all of these markets to turn at the same time? A look at correlations across the commodities markets shows that there has not been a strong correlation between many of these markets so the swift change in prices has to do with a common factor across all of these markets.

The common factor for a decline in all of these markets is not hard to find, a global recession. The issue is why there was such a large change in a matter of weeks? Even if you believe that the common growth factor was the cause for the price decline, it is then less clear why there was such a run-up in prices since the beginning the year. Either the current decline does not make sense or the run-up does not make sense. The common factor view cannot explain both without some mental gymnastics.

The mental exercise requires that all of the investors who owned commodities changed their view of global growth in mid-July.The rational story is that investors believed that world growth would continue in spite of the credit crisis in the US or that the credit crisis was not viewed as a significant problem. The current decline is a common view that all investors now believe there will be a global slowdown. Another explanation could be price pressure from everyone moving from equities into commodities and now out again. Call it a herd behavior or a cascade of changes. We live in a non-linear world.

These explanations are flawed based on the simple forecasting criteria that a good explanation or model will have some predictive power. The change in expectations story is descriptive but not predictive because we cannot say what are the conditions that will lead to the next run-up or decline. The stories seems to be unique descriptions of the current state of the market and not something that can tell what will happen next time.

An explanation for the abrupt change could be created from complexity theory but again we are only left with the conclusions that these types of rapid changes can occur not when or how they will occur. The only hope for investors is to create an exit strategy for every trade that is undertaken. Riding a momentum wave is filled with peril regardless of your power or intellect.

I am reminded of the comment of former Citigroup CEO Charlie Prince who said during the height of the credit bubble, "as along as the music is playing, you've got to get up and dance. We are still dancing". We now know the risks of dancing to the wrong tune if the record skips a beat.

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