Lately, many observers and pundits are glued to the rear-view mirror, fixated on the implosion of residential real estate and excessive leverage, the last two market bubbles, wondering how in the world we could not have seen them developing. At the same time, investors are dumping financial assets they never understood in the first place – often in fire sales, regardless of the assets’ fundamentals – in fear of further market declines. Yet has anyone taken a step back and looked at where these tremendous money flows are ending up?
This article from today’s New York Times titled “Odd Crop Prices Defy Economics” describes an incipient bubble in the world’s financial markets:
Money is flowing rapidly out of many stocks and bonds, and into futures contracts on primary commodities such as gold, crude oil, and agricultural products like wheat and corn. The rationale is that these so-called “hard assets” are positively correlated with inflation and viewed as a safe haven for one’s wealth during a time of a deteriorating U.S. currency and volatile financial markets.
Granted, there is very compelling evidence for a continued long-term bull market in many of these commodities. But as the article makes clear, several of them are becoming dislodged from their underlying fundamental values, especially since the credit crisis began.
The answer to the question about why futures prices are expiring above cash prices is clear: investors are disregarding market fundamentals. This happens at the beginning and throughout every financial bubble.
In terms of an information cascade, this passage is telling: “The market sends a sell signal, but they don’t sell,” said Kendell W. Keith, president of the National Grain and Feed Association. “So the markets are not behaving the way they otherwise would – and the pricing formula for the industry is a lot fuzzier and a lot less efficient than we’ve ever seen.”
This is because the demand for commodity futures contracts, a liquid financial asset, is at an all-time high; and being driven by hedge funds, exchange-traded funds, sovereign wealth funds and any other esoteric fund that you could come up with. But on what information are these various actors basing their decisions? How many people really know the economic fundamentals of soybeans, palm oil, palladium and pork bellies?
Yet these arcane assets are where an unprecedented quantity of funds is flowing into. As for why arbitrageurs don’t exploit such market inefficiencies, here is an excellent article on financial bubbles by economist Alan Krueger:
http://www.iht.com/articles/2005/04/28/business/bubble.php
It is important to note that the commodities market has outperformed the stock market for nearly a decade. And sophisticated investors, such as Jim Rogers, co-founder of the Quantum Fund with George Soros, have been raking in massive profits from commodities this entire time. Warren Buffett was betting on higher energy and silver prices ten years ago, back when less-enlightened investors were dazzled by dot-com stocks. And throughout the mid-2000s, a significant portion of hedge fund and Wall Street trading profits were driven by the commodities boom.
But now, with surging prices as front-page news, those same follower speculators from the tech-stock days are piling into commodities. Their signal is not a compelling fundamental value relative to price, but an increasing price regardless of fundamental value.
What the wise do in the beginning, fools do in the end. And as we know well, financial bubbles do not end nicely.
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