Speculation – Page 18 – The Aleph Blog

On Penny Stocks

Posted on 2 October 2011 by David Merkel

I am often a fan of neglected small cap stocks.? When I find a good one, I add it to my portfolio.? But I am generally not a fan of stocks that trade below $1.00.? Why?? Because there are many promoters of the stocks who deceive those who are illiterate regarding the markets, promising big gains, but end up delivering significant losses.

I see lots of penny stock ads.? Big deal. But one ad got under my skin.? This article was motivated by an ad that said, “Penny stocks made me rich.”? Now, there may be a handful of people for which that is true, but in general, those that invest in penny stocks lose money.

There is a constant in investing, that amateurs who invest in volatile asset classes tend to lose money, and more money as the asset classes get more volatile.? Penny stocks are volatile in the extreme.? Even leaving aside the promoters who pump-and-dump, it is a rare person who can approach these in a businesslike manner.

But now, if I can, I’d like to describe the penny stock universe to you.? Here is how penny stocks differ versus the market as a whole:

Because biotech companies tend to be small, and have a high failure rate, the healthcare sector is much larger for penny stocks.? With basic materials, the adage that a gold mine is a hole with a liar at its mouth holds true.? Thus there are more companies in those two sectors.

Services, Energy, Consumer Noncyclicals, and Utilities are all industries where there are increasing returns to scale, and where minimizing costs likely dominate over trying to offer specialized products that add value.

Now let’s look at penny stocks segmented by sector and size.? Same sectors, but the $21 billion of market capitalization that the 2,800+ penny stocks live in are divided into five roughly equal quintiles by market capitalization.

Here’s the breakdown:

The financials have Fannie, Freddie, and some other large failed banks in the first quintile.

Health Care has a lot of companies, regardless of size.? Services, Basic Materials, Energy and Technology are similarly consistent.? Many small companies pursuing advantage versus much larger competitors.

The smaller sectors are random as should be expected. There is no surprise there.? After all, they don’t have advantages from economies of scale.

Here is my final table:

In general, the smaller the market capitalization gets, the less liquid the stocks are.? This is not perfectly linear, because there are promoters pumping and dumping the stocks in the lowest quintile. (and in higher quintiles as well.)? The larger the market capitalization, the harder it is to pump-and-dump.

So be wary when buying stocks with small market capitalizations.? All the more, pay attention to balance sheets, revenue recognition policies, and other accounting quality measures.? Act like an intelligent value investor, if you dare, because you are playing on dangerous ground.? There are safer places to play, go elsewhere.? Don’t let the seeming cheapness delude you.? This is an area where accounting frauds are rife, and where ordinary investors lose a lot.

DON’T BUY PENNY STOCKS.

Please Sell Your Treasury Bonds, China

Posted on 21 September 2011 by David Merkel

This will be a short post.? I am not worried about China selling its US Treasury bonds for several reasons:

As they sell, the Yuan will rise versus the Dollar, which the Chinese Government does not want. Eventually their exports will fall, as US exports rise.
After that, the Chinese Government faces a reinvestment problem.? What do they reinvest in??? The Euro is under threat, the Yen doesn’t want more investors, and the rest of the developed world’s currencies are in the stratosphere.

I think the threat of the Chinese Government to sell US Treasuries is empty.? They can’t do it without hurting themselves significantly.

Options:

Buy storable commodities, gold? Done that.? Hoard more?? At these prices?
Switch to other types of debt than government debt? After the brouhaha with Agency debt, I suspect they would be less than willing to wander off the beaten path.? Besides, they are pretty big, and they are dealing with thinner asset classes.? If they have driven up the prices of Treasuries, imagine what they could do to corporates?
Start buying companies around the globe?? If governments would let them, maybe, but there would be a political stink.
For a weird idea, China could buy surplus US housing and restore liquidity and collateral levels to a market in oversupply.? After a decade they get out at a profit, probably.

Also, the lower level of liquidity could be an issue if actions need to be taken to recapitalize their banks when the next crop of bad loans has to be reconciled in the next few years.

China’s options for holding the proceeds from its trade surplus are limited.? For all of their deficiencies, US Treasuries are a liquid and deep market.? Chinese exporters benefit from keeping the Yuan weak versus the US Dollar.? I don’t see things changing soon, absent a bolt from the blue.

Book Review: Debts Hopeful and Desperate

Posted on 30 August 2011 by David Merkel

This book review is different.? It was written back in 1963, and has not been reprinted.? If you want to buy it, you will have to buy it used.? My copy used to be a part of the Newport, Rhode Island Public Library.? It is a short recounting of the economic history of the Pilgrims.? The total pages allocated to the main text are less than 60 pages.

But a good 60 pages they are.? Michael Milken once self-servingly said, ?America was built on Junk Bonds.?? If we were talking about the Pilgrims some might say their effort was financed by loan sharks, but really, it would be fairer to say that they were financed by venture capitalists, which occasionally worked on an equity basis, and also on a debt basis.

The author does not dwell on the religious views of the Pilgrims, aside from the effects it had on the financing of the colony.? Given that this was written in 1963 that is not a weakness, because writers in that era had better historical knowledge than most in the present era, in my opinion.

Though the book has only two chapters, it breaks down into 5 phases:

The decision to emigrate from Leyden (in Holland) to the New World, obtaining an initial patent, gaining financial backers who were less than reliable, to the formation of a Joint Stock company.
Leaving England and arriving at Plymouth, Massachusetts which was not their intended destination.?? Disaster happens with their Winter arrival, with many dying.? The initial ability to service the debt is poor, which leads to squabbles among the financiers.? The joint-stock company breaks up, and the Pilgrims agree to buy out the financiers at a price that gives the financiers a profit, but leaves the leaders of the colony in debt to a new set of financiers.
Socialistic policies lead to disaster, until residents get their own land to till, leading to relative local prosperity.? In order to pay down debts the Pilgrims enter the fur trade, though with difficulties.
They get a new patent, and find that their agent, Isaac Allerton, was not fully trustworthy.? Disputes over accounting embroil the Pilgrims and their financiers, probably to the detriment of the Pilgrims.
Their financiers quarrel among themselves, after which an agreement is struck, where the amounts of goods that the Pilgrims delivered are adequate to pay off the debt.

The book doesn?t deal with the aftermath.? Anyone that has read Bradford?s writings on Plymouth Plantation would recognize that at the end, Bradford was dispirited, because almost all of those who came and survived, had moved further west to get more and better lands.? The religious motives of the colony were sufficient for its founding, but proved inadequate for its continuation.? After 25 years, the debts were paid, but for the most part, the colony had evaporated.

The collective financiers earned a handsome return, between 20-40%/year, maybe.? We don?t have enough details to be certain.? All I know is that the heavenly reward of the Pilgrims was far greater than their earthly toils to pay back their financiers.

Quibbles

The book could have dealt a little more closely with the motivations of the pilgrims, and their willingness to take deals that were against their interests.? Yes, the pilgrims were not as financially savvy as those that financed them, but they weren’t stupid either.? They were desperate to get out of the Netherlands and Britain.? That desperation drove some of the bad deals they took, and made them look like a bad risk, which narrowed down who would deal with them.? Leaving that aside, financing for most colonial ventures was stiff.

Who would benefit from this book: If you want to understand the economic struggles that the Pilgrims undertook, you will like this book.? If you want to, you can try to buy it here: Debts Hopeful and Desperate: Financing the Plymouth Colony.

Full disclosure: I bought the book with my own money.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

The Rules, Part XXIII

Posted on 2 August 20112 August 2011 by David Merkel

A Ponzi scheme needs an ever-increasing flow of money to survive.? Same for a market bubble.? When the flow?s growth begins to slow, the bubble will wobble.? When it stops, it will pop.? When it goes negative, it is too late.

Here’s how a Ponzi scheme works for the promoter:

Prior Net Assets + Receipts + True Investment Earnings (if any)? – Withdrawals – Expenses = Net Assets

But this is what it looks like to the investor:

Investor Prior Net Assets + Receipts + Reported Earnings – Withdrawals = Investor Net Assets

The investor’s view of the assets is higher than the actual assets by the cumulative difference between reported and true investment earnings, and cumulative expenses. The promoter wants to keep the good times rolling, and keep the ratio of actual to investor net assets as high as possible.? But to do that requires additional receipts, and a lack of withdrawals, which in turn requires an attractive reported rate of earnings, higher than what could be ordinarily achieved. But the higher the reported rate of earnings goes, the further behind the promoter gets.? Also, at very high levels, the authorities take interest.? At very low levels, the Ponzi dies.? Part of the evil genius of Madoff was striking the balance.? He also did four other things:

Soft-peddled the marketing so that it was like joining an exclusive club.
Discouraged withdrawals by saying you would not get back in (for some).
Deluding regulators into thinking that it was a front-running scam.
He did not rake off much.

Most Ponzi schemes die rapidly because of the greed and impatience of the promoters.? All Ponzi schemes eventually fail. So how does this relate to market bubbles?? With a market bubble, the increase in market values significantly exceeds the increase in intrinsic values.? This could be due to a number of factors:

Players see that borrowing to chase a rising asset is a winner.
Promoters make it easy to do for inexperienced investors.
An easy monetary policy lowers financing costs, aiding bubble financing.
Players seek stock gains, and disdain debt claims.
At the end, investors have to feed the asset to keep it afloat, giving up current income to support the “asset.”

Positive cash flow into the bubble asset class supports valuations for a time, the cash flows driven by momentum, but eventually positive cash flows are overwhelmed by negative cash flow from an overvalued asset class. My advice: avoid speculating on momentum, particularly after it has gone on for a few years.? Put a margin of safety first in your investing, such that you will always be around to invest in the future, no matter how bad the? investment environment is.

The Costs of Illiquidity — II

Posted on 28 July 2011 by David Merkel

I thought it was bad enough to try to dissuade people from buying life contingent cash flows.? Now I get to talk about Non-Traded REITs.

This is the first time I heard about them.? Doing a little digging, there is controversy around them.? But let’s talk about the benefits first:

You receive a high and steady income.
The stated value of your holdings remains stable, thus insulating investors from the chaos of the market.
Professional management of commercial real estate is now available to small investors, with high returns.

But then there are the limits:

Liquidation through the sponsor is limited.? (Dated, but gives you some idea…)
You likely can’t cash out in full except through illiquid secondary markets where you take quite a haircut.
If the underlying real estate does not do well, your income will shrink or disappear.
You have little data on how the underlying real estate is doing.? Is the dividend they are paying coming from income or return of capital?

Long-dated, illiquid assets exist for two reasons:

To illustrate high yields to non-knowledgeable investors.
To pay large commissions to those that sell them.

It’s hard to tell which of those are more important, but this is another reason why I continue to talk about illiquid investments, and why most people should avoid them.? It is much easier to cheat people when there is no liquid market available to validate what is happening with the investment.? It is not that Non-Traded REITs protect investors from volatility, as much as they hide volatility from investors.

Large commissions on investments are only possible when there is a lock-in where surrender charges pay off the commission.? Where there are large commissions, misguided investing is more likely.

Look, I could set up 10-year stock trusts.? I will tell you what I will invest in, but since you have no withdrawal rights, you’ll have to wait 10 years for liquidity.? That does not sound like a better investment than going to Vanguard.? But many don’t go to Vanguard because they will not do their homework.? Should we begrudge those who sell to the fools that will not do their own homework?

I wish that we could.? Hey, the SEC is going after them.? Why not?? It is a reply of the limited partnership era of the ’80s.? Illustrate high returns — deliver capital losses.? I could not get why my first boss bought his limited partnerships, because of the losses taken in the era.

It follows the paradigm for illiquid investments — Offer high yields, suck in money, pay high yields, and if things go bad, deliver large capital losses.

With publicly traded REITs low yields have returned better then high yields.? The attempt to generate high yields requires a strategy where everything must go right.? That doesn’t work.? The low yield strategy does work, because there is more flexibility to manage, and raise payouts only after strategies have succeeded.

It is the same for Non-Traded REITs.? They offer high yields after paying high commissions.? Those high yields rely on capital gains on the properties.?? Relying on capital gains is poison.

I will say it plainly: unless you are an expert who knows more than the seller, avoid buying illiquid investments.

Closing notes

There are many well-dressed people in this business.? But none discuss the scandal surrounding it.

This an example of those that prey upon small investors to get them to invest in non-traded REITs.

This is a growing area of investment, as people seek yield.

Pricing of Non-Traded REITs is controversial.

Here’s an example of a Non-Traded REIT that failed.

Look, my view is that that value of liquidity is usually underrated.? Liquid investments allow you to shift when opportunity favors such a move.? Whether you are ready for such a move is another matter, but whether you are ready to give up liquidity should require a similar degree of thinking.

I would not invest in Non-Traded REITs, the protections are lower than comparable investments.? Avoid illiquidity.

Book Review: Lords of Finance

Posted on 23 July 2011 by David Merkel

I really enjoyed this book.? It taught me a lot regarding the four main central bankers and the problems that they faced between WWI and WWII.? Add in Lord Keynes and you have real party.

WWI Reparations were too large for the Germans to afford.? But worse, France and England relied on those repayments so that they could repay America on their loans.? That made the squabble over reparations far worse.

What is more fascinating is how WWI with reparations helped lead to WWII.? The resentment of the Germans to occupation, reparations, etc., led to a fighting spirit, combined with antisemitism because of hatred of bankers, and you have a lot of what drove the war.

You will learn a lot if you read this book.? It is long, but valuable.? I recommend the book highly, subject to my disagreements.

Quibbles

Crises do not come as a result of a gold standard but from overly levered banking where liabilities are short and assets are long.? The book showed minimal understanding of basic principles of banking.

As a result, don’t listen to Keynes as much as Fisher.? Fisher understood the real cause of the Depression: too much debt.? Once debt came back to normal levels in 1941, the economy normalized.? WWII did not get us out of the depression, rather, it prolonged the suffering for those at home.

Who would benefit from this book:

Those wanting a good historical understanding of the financial facts between the First and Second World Wars will get it here.? You will understand the players and their motivations.

If you want to, you can buy it here: Lords of Finance: The Bankers Who Broke the World.

Full disclosure: I asked the publisher for the book and he sent me a copy.

The Costs of Illiquidity

Posted on 13 July 2011 by David Merkel

Liquidity is underrated.? What’s that, you say?? You are earning nothing on your slack cash balances?

Well, welcome to the club.? I am earning nothing there as well.? To earn money on short duration assets in this environment means taking risks, like Pimco does with its ETF with the ticker MINT.

Now, many will offer yield in an environment like this, but at a cost — a long surrender charge.? The long surrender charge hides the transfer of future yield to the present.

I am talking? about more than annuities here.? There are other illiquid investments being proffered today that offer a high “yield,” notably fixed payment streams from insurance companies that are life-contingent.

This is the deal:? There are some annuitants who would rather have a lump sum than a payment stream.? Some firms will buy the payment stream at a price attractive to them.? Then they try to sell the payment stream to an investor at a higher price, thus eliminating their risks on the annuitant prematurely dying.? But how good as an investor would you be at evaluating the risks?

You do realize that you aren’t buying a bond here — at the end you are not getting your principal back.? So what’s the yield? — it isn’t the annual payment divided by the purchase price because part of each payment is an uncertain partial return of principal.? Do you have your own actuarial consultant to calculate the yield, or are you blindly trusting the seller?
So you bought out the annuity of another person.? How certain are you that he will live a long time?? Why are you smarter than the seller regarding? his own life?
Unlike an annuity on your own life, the payment stream may end before or after you die — a classic asset/liability mismatch.
Is there any possibility that you will not get paid?? Is your contract illegal?? Have you retained your own counsel in the matter, or are you trusting the seller?
Do the IRS immediate annuity tax rules apply in this situation?
If you need cash, you will have a hard time selling this — one of the few potential buyers is the friendly guy that sold it to you.? The price spread between selling and buying is huge, and not in your favor.
You do realize that unlike an annuity on your own life, this is not judgment-proof.

There are all manner of illiquid investments offering yield, but almost all of them lock the investor up for a time.? Think of them as quirky Certificates of Deposit, minus the FDIC.? Particularly egregious are EIAs with long and high surrender charges.? (The agents are paid a lot to sell those.? Never trust an insurance agent who is receiving a large commission to sell you an annuity.? Note: if they won’t disclose the commission, know that it is roughly the size of the initial surrender charge.)

The Cost

Illiquidity means a loss of flexibility.? If your money is tied up during a fall in the market, you will not be able to take advantage of what could be a 30-50% return over one or two years when the market bounces back.? That is a lot to give up for a little bit of yield.? Personally, I prefer flexibility.

The costs of illiquidity are quiet.? The extra yield seems free until there is a need for ready cash, whether to spend or to take advantage of investment bargains.? Personally, I’ll take the loss of income, and keep the flexibility.

Also, avoid unusual investments that are hard to evaluate unless you have expertise greater than that of the seller.? Don’t buy what someone wants to sell you; buy what you have researched and want to buy.

PS — this is another reason why I encourage people avoid “sales loads” in investing.? Mentally, it ties your hands, because you want to recoup the load, or not incur the surrender fee.

Full disclosure: I have one client that owns MINT in his portfolio with me as a cash substitute.

Enduring Ponzi

Posted on 2 July 20113 July 2011 by David Merkel

Why did Madoff’s Ponzi scheme last so long?

He didn’t take that much from it.? If the gross exposure was $60 billion, he took only 1/2% of it — $300 million.
The growth rate was high enough to attract investors but slow enough to not exhaust cash rapidly.
The SEC was clueless, with little expertise in quantitative investing, and little basic auditing knowledge where one traces every transaction back to the source, which would have revealed Madoff in an instant.? There were no assets in the accounts.
He had a reputable business that produced significant profits, and was viewed by many as an industry leader.? Many Europeans, among others, thought he was front-running, and Madoff implicitly encouraged that idea while explicitly denying it.? The idea of “front-running” was a honey pot to distract regulators from the idea that a Ponzi scheme was going on.
The marketing club.? You are the lucky one who is invited to partake of the gravy train.? Don’t question, just enjoy, and refer friends, maybe we will consider them.
Feeder funds that were looking for looking for a high-ish return and a low standard deviation found Madoff irresistible.
“Pus luck.”? There were many times where the scheme almost died, but new cash flows bailed them out.? The term, “pus luck” was unique to my block where I grew up in Brookfield, Wisconsin, and described a situation of undeserved luck.? A brother of my friend, and a friend of my brother always seemed to get the lucky break at unusual moments.? We called it “pus luck,” perhaps in an effort to denigrate his skill in unlikely situations.
Madoff did not encourage a marketing frenzy.? He tried to keep it low-key.? That kept it below the radar, and allowed it to be marketed to a wide number of people who would not fall for a hard sale.

And so it was for Madoff, skating through unlikely situations where others would have easily died, until it got too big, as all Ponzis do.

We know when it ended, but have no idea on when it started, ’60s, ’70s, ’80s, ’90s…? We really don’t know.?? Madoff has revealed a lot, but he has never given a date earlier than 1992.? His associate, DiPascali, suggested it may have started in the late ’80s.? There is some evidence that it may have gone all the way back to the ’60s.

I find DiPascali’s words to be more reasonable than Madoff’s.? The late ’80s were more desperate than the early ’90s.? If you could survive ’87 and ’89, you could likely survive ’92.

Recoveries?

When the Ponzi was revealed, few thought there would be any significant recoveries. But now, net losers from the Madoff Ponzi may get back over 50% of their money.? Why?

The Picower family gave in, and released their profits from the Madoff scheme.
Many large financial companies played small roles in the scheme, and they will all probably pay something to make the lawsuits go away.
Some net losers were involved in money laundering and are unlikely to pop their heads above water to make a claim on their ill-gotten funds.? More for the rest.

In one sense, the slowness of the Madoff Ponzi allowed for a less wasteful class of investors to be bilked.? Including Madoff, these were not the sorts of people that were big spenders as a fraction of their income.? Many investors were buy and hold with Bernie, and indeed, he encouraged that.

So the endgame may not be as bad as expected.? Many will get a large portion of their net investment back.? There will still be regrets, but they will be much reduced.? Good for them.

The Rules, Part XXI

Posted on 28 May 201129 May 2011 by David Merkel

Before I start this evening, I have a request for readers, and a comment for new readers.? (Note: if you are reading this anywhere but directly at my blog, please realize that you have to come to my blog for me to hear what you are saying.? I do not read comments anywhere else but at Aleph Blog.)? First the request: I would like to test the robustness of the Impossible Dream TAA model on another country.? If any of you have data on any non-US market, which would require the following:

Index price series
Earnings series
Dividends series
And a fixed income return or yield series

Contact me, and we can discuss whether you should send me the data or not.? Monthly data would probably work best, but I am open to other periodicities.

Second, for new readers, welcome to my blog.? Why do I write this after 4 1/4 years of blogging?? May 2011 is my biggest month ever, largely because of the “Impossible Dream” pieces.

For new readers, here is what you have to understand about me: I write about a lot of different things.? I have lots of interests.? I almost named this blog “The Investment Omnivore” but didn’t, because I planned on creating a firm called Aleph Investments back in 1996.? It eventually happened — 14 years later.

So, if I don’t always write about investment strategy, or any other single topic (all crisis, all the time) please don’t get disappointed.? I write in proportion to what is of current interest, and what discoveries I have been making.

So, travel with me on this trail where I cover everything from the global macroeconomy to personal finance issues.? My goal is to help you learn to think about economic/finance/investment issues, and help you see the interconnections between markets, so that you can develop your own perspective on the markets, and not just parrot me.? (Not that many do… 😉 )

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All assets represent future goods.? The prices of assets represent the trade-off between present goods and assets.

I wrote a piece recently called Inflation Speculation.? The idea was to explain how it is difficult to save for the future in a way that will transfer today’s purchasing power to the future without diminution, particularly when you have a central bank trying to stimulate the economy through the creation of credit, and the nation as a whole is overindebted.

So, if the Fed is patting itself on the back for:

lowering corporate yield spreads
rising stock market prices

I would tell them: it is easy to change the discount rate, but hard to change the cash flows.? Yes, as you flooded the market with credit, the values of risky assets rose.? Big deal.? Most executives are smart — they still see that demand is punk, and won’t do any real creation of plant and equipment that they weren’t already planning to do.? Little new investment took place, the value of existing assets got revalued up.

When asset prices are high, it means that money today will not buy a lot of future goods.? High P/Es, low interest rates tell us that new investments will have low yields, absent some amazing transforming technology that improves productivity dramatically.

Some people will say to me, “I need more yield today.? Yields are so low.”? I say, “When yields are so low, it is time? to avoid yield and preserve capital.? The time to seek yield is when yields are high, and no one wants to part with money to lend to them.

In March of 2009, I helped to rescue the firm of a friend.? He needed cash in the midst of the crisis, and a few of us lent to him at rates exceeding 10%, with warrants, realizing that he might be bankrupt in short order.? But things turned, and not only did he survive but he thrived.? I am still receiving interest, but will likely be redeemed soon.

Maybe that’s not such a good example.? I put 40% of my congregation’s building fund into high yield and low investment grade debt in late 2008 — made up for a lot of 2008 losses.

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Think of it a different way: shares in corporations are a proxy for the future well being of the country.? When P/Es are low, the potential for capital gains is large, as is the ability to keep up with inflation.? When P/Es are high, the potential for capital gains is small, as is the ability to keep up with inflation.? Same for bond yields — better to be aggressive when rates and spreads are high, and defensive when they are low.

Thus I would tell Ben Bernanke to lay off the quantitative easing.? It has not helped.? Yes, you have pushed asset prices up, and interest rates down, but has not created any significant new economic activity.? And why should it?? Consumers are still overindebted, and 30% of those with mortgages will lose money on a sale.? The real problem was the debt overhang, and you did nothing to to address that, not that you could, or should.

Buffett once said that most people should not be glad when they see asset prices rising, because they will need to invest more in the future, and will now have to pay higher prices.? Thus times like September 2008 offer the future at a discount to those who have ready liquidity, whereas 2007 offers the future at a premium price.

To the extent that you can, commit capital when it is most needed, and avoid chasing markets up.

Inflation Speculation

Posted on 13 May 2011 by David Merkel

When currencies do not serve as a long-term store of value, economic actors search for ways to preserve future purchasing power, which often mean purchasing commodities. But most commodities are not cheaply storable over long periods, so actors get forced into the few that do: gold, silver, etc. There is a problem here, stemming from dumb money. When dumb money shows up for purchase of generic “commodities” distortions follow: backwardation, large storage demand, and warped market incentives.

Eventually overproduction catches up, but the volatility when it breaks can be huge and self-reinforcing, with c0unterparties raising margin to protect themselves.? Extreme volatility causes exchanges to raise margin requirements substantially, which reveals which side of the trade is inadequately financed, which typically is the side that was winning, which leads to a reversal in price action.? The dumb money is revealed.

Now after a washout, the dumb money often assumes that powerful entrenched interests colluded against them to deny them their long-deserved free ride to prosperity through speculation.? The exchanges are in cahoots with the other side.? Well, no, the exchanges have two interests, which are solvency and transaction volume, which drives their profits.? Solvency is a more primary goal for an exchange, because the second goal can’t exist without it, and exchanges are not thickly capitalized.

Many different types of financial systems are subject to these risks.? Think of AIG: they were rendered insolvent by rising margin requirements as their creditworthiness was downgraded, largely because the rating agencies concluded they were going to lose a lot of money off of their many bets on subprime residential credit.? Think of all of the mortgage REITs that got killed as repo haircuts rose on all manner of mortgage-backed securities at the time that values for the securities were depressed.? Alternatively, think of Buffett, who entered into derivative trades where he received money and bore the risk, but his agreements limited the margin that he would have to post.

Commodity-linked exchange traded products serve four functions:

Allow sponsoring financial institutions to get cheap financing through exchange traded notes.
Allow sponsoring financial institutions to inexpensively hedge their commodity risks.
Allow commodity producers to have cheap financing of their inventories via backwardation.? (And indirectly allow more clever speculators to earn extra profits from gaming the rolling of futures contracts.)
Allow retail speculators who cannot access the futures market to make or lose money.? Scratch? that, that should probably read “lose money in aggregate.”

Wall Street does not exist to do small investors/speculators a favor.? It exists to make money off of the issuance of securities, and their trading in secondary markets.

As Buffett put it, “What the wise man does in the beginning, the fool does in the end.”? Yes, there is monetary debasement going on.? We should expect gold, crude oil, and other commodity prices to rise to reflect that.? But rises can overshoot, particularly in smaller markets like gasoline and silver.

So in answer to the question, “Which came first ? the margin call or the commodities mayhem?” my answer is simple: The cause of the bust is found in the boom, not in the bust.? The boom happened because of loose monetary policy, which led many people to adjust their risk posture up, whether in commodity speculation, or in high yield debts.? (Oh wait, there are ETFs for that now too.)? Eventually self-reinforcing booms have self-reinforcing busts.? The elites think they can tame this, but they can’t, because you can’t change human nature, which means you can’t change the boom-bust cycle.

James Grant, at a recent meeting of the Baltimore CFA Society said that we had exchanged a “gold standard” for “Ph. D. economist standard.”? And indeed, the value of our currency is manipulated by that intellectual monoculture at the Fed, who pass Einstein’s test of insanity: doing the same thing over and over again and expecting different results.? I say that because the Fed thinks that it can produce prosperity by reducing interest rates.? All that their policy does is produce an asset bubble, or price inflation in goods and services.

The Fed drove us into this liquidity trap through increasing application of an easy money policy.? It will take different ideas and different people, and a lot of pain to get us out, because the Fed is blinded by their bankrupt theories.