Saturday, May 31, 2008


I have a simple rule of thumb for resolving economic questions: whatever the loud guy shouting on CNBC says is wrong. Ergo, there is oil speculation.

This argument has been thrown out before: because the spot price is based on real oil, "paper speculators" (index funds that buy and sell futures to avoid actually ever having the oil) then the real price of oil (the spot price) can't be influenced by speculators.

To paraphrase the Simpsons, Rick Santelli makes a very loud point.

His argument is essentially that if there's a lot more people speculating on oil going up then down, then when those speculators defer receiving the oil, they'll pay a premium since no one wants the oil (supply and demand).

Of course, that is exactly what's happening: the market is in contango - that is to say, there is a cost to paying someone else to hold your oil for you (so you can lock in the speculative gains). The index speculators are paying month to month. (Of course, they are rolling from 2 months to 1 months, at least in the case of Barclays oil ETF.)

So how can the spot price be affected? Simple: oil producers are in a perfect position to make a killing off of the contango.

Imagine I drill for oil in my back yard and can produce a barrel of oil a month. I enter a futures contract (locking in a higher price due to contango) to deliver in two months and put the oil in my garage. At the end of the month I look at the market and see that I can make a profit by selling another two-month contract while buying a one-month contract.

That one-month I bought perfectly balances the one I sold (two months ago, so now it's a one-month) and the barrel of oil in my garage backs the new two-month. I make (for free and risk free) the roll yield the commodity indexes are losing.

Of course, I've shut my well down. Is this a big problem? It depends on what I'd rather have: oil in the ground or dollars (which I'm making anyway).

Of course I don't even need an oil well to play this game - I could just buy one barrel of oil, sell it forward, and start rolling the contract. Essentially contango pays people to store oil.

So when you invest in rolling oil futures, you really are hoarding oil - contango is the "rent" you pay someone else to do the dirty work of stashing your barrels somewhere. (But you most certainly have a real claim on a real resource - that's what a futures contract is. No one is going to do anything else with "your" oil until the contract is settled.)

So what about the spot price? If this is all about contango and negative roll yield, why are we paying $4+ at the pump? What ties the spot price to the futures price? (Santelli's argument is that since the speculators only play with futures, they can only move futures prices.)

The answer is arbitrage. In a situation where the prices of futures contracts have gone much higher than spot prices, oil producers can make a ton of money with zero risk. They sell less oil on the spot market and more using futures contracts. As long as the price difference is larger than the storage cost, the producers make a profit, and the spot price goes up (due to a lack of supply).

Wednesday, May 28, 2008

Yellow Books

I enjoy spotting the yellow "X for Dummies" books in Barnes & Nobles...the topics that the books hope to explain to dummies strike me as, well...ambitious. Still, "Currency Trading for Dummies" cracked me up.

By comparison, I thought "Hedge Funds For Dummies" was a fitting title - with the hedge fund manager taking 20% of the profits and 0% of the losses, how could a hedge fund be for anyone else? :-)

Wicked Good Eggs

I read The Omnivore's Dilemma and strongly recommend it. Even if you don't agree with Pollen's opinions on food culture (I do, but that's just my opinion, not something I would argue about) I believe the book is a good for its treatment of farm economics, something that city slickers like myself might not be aware of.

The factor that I think is now so relevant (with both high food and high oil prices) is the chain of subsidies and non-renewable inputs that goes into our food.
  • It starts with oil, something we can't make more of, and something we don't really have (to the scale that we require) in the US. I'll blog about oil some other time, but for now let's just say that starting the chain with oil gets us off on the wrong foot.
  • The oil is used to make fertilizers...basically you couldn't grow corn to the quantity we do without adding a lot of fertilizer, and that process requires energy, which in the US means fossil fuels. (I suppose that we could move some of our energy dependence to nuclear power - I am for this, and not just because I could then blog that the beginning link in a bag of Dorritos is Uranium!)
  • The farmers grow a pretty huge amount of corn - the Government pays them to do so, allowing them to spend more on production costs than the corn is worth.
  • That makes corn so cheap that we go feed it to cows who aren't even supposed to be eating corn (and get really sick from it).*
  • This ends with a Quizznos add telling us that for $5 we should get more meat!
  • Actually, it ends with us all getting really fat.
When I look back at the entire chain of events, it strikes me as completely absurd, and more importantly really inefficient! A lot of expenditure for something (in this case fast food) that isn't even that great. I'd like my taxes back, I can live without fast food, thank you.*

But it turns out that Polyface Farms, which is featured in Pollen's book, delivers to the DC metro area via buying clubs. So Lori and I signed up.

Now I do have to admit that while signing up makes my liberal conscience feel good, the amount of food we ordered is a drop in the bucket of our total callorie consumption - we're going to have to find sustainable sources for a wide range of other types of food.

But the point of this blog post is not that Polyface is sustainable, with almost no outside non-renewable inputs. It is that their eggs are magical.

Lori and I try to buy the freshest eggs we can, but Polyface eggs are in a different dimension. I found this out last night when making meringues and zabaglione; the meringues whipped in perhaps half the time normal eggs would and became so thick as to lower the RPM of the mixer. The initial beating of the yolks takes significantly more effort than with your regular store-bought yolks-break-by-looking-at-them variety.

Forget sustainability and the planet, I would like all my food to be farmed the Polyface way because the quality is unreal!

* There is now a fork in the road - we could go down a different path and use our cheap subsidized corn to make fuel...sort of like the fuel we used to make the fertilizer to grow the corn. I've read that the output-input energy ratio for Ethanol is 1.2 (that is, it's a slight win, prodcuing 20% more energy than it took to make) but 1.2 is still totally lame.

Tuesday, May 27, 2008

Bob Vila Would Not Invest in Fixed Income

Or would he? One of my friends told me he's only 10% in fixed-income in his retirement savings account; for the last two days I've been trying to write a blog post on why that's not a good idea for someone in their 30s, and each time have failed. The problem is I can tell you more about why any investment theory is built on shaky ground than I can about why any particular one is good.

I have some entertaining performance numbers from various investments over the last two years, but while they're good for a laugh, but not much else. If someone says "my investment strategy is to play the lottery" we'd call that person a moron. If the person then won would we go "no, you were smart all along"?

My gut feeling is that my generation doesn't adequately fear the stock market. Consider the following:
  • Periods of relative success increase risk. When things are quiet, we humans with our short-term memory think we can gamble more, until something bad happens. This is essentially what happened with the housing crisis: complex engineered fixed income investments were quiet and steady so people built more and more risk into them for less reward; when they went awry, the result was carnage.
  • Both bonds and stocks have return both on investment fundamentals (the coupon for a bond, dividend and earnings yields on a stock) and speculation (sell the investment on to someone who pays more). Since 1982 we've seen a huge increase in how much people are willing to pay for a stock with a given return. The results of this are two-fold: the investment yields on stocks keep going down, but along the way people make specualtive yield.
  • This means that the potential for future returns keeps going down (since the investment component is getting smaller) and yet we think that stocks do well because their past growth has been high (due to speculative yield). We have to see this for what it is: a pyramid scheme. The speculative component of stoc k yield cannot grow indefinitely, and the investment yield is low due to high prices. I'm not saying stocks won't make money, I'm just saying that when people say "the stock market returns 10%" they're throwing out numbers that were true from 1980-2000 but probably won't be from 2010-2030.
So here is some data, mostly food for thought.

Sometimes the Rules Change

This chart shows the relationship between stock earnings yields, stoc dividend yields, and bond yields. Note what happens in 1955: until then, bond yields have always been lower than stock dividends. In 1955, this relationship changes and it never goes back.

My point here is that sometimes the rules of the game change forever. Benjamin Graham said that in the short term the market is a voting machine, in the long term a weighing machine. Basically he was saying that in the long term speculation will wash out and your long term return will be based on fundamentals.

But I'd say: sometimes in the long term the rules of the game change and you don't win what you thought would be yours. If you made investments under the assumption in 1955 that the weighing machine would vindicate you, you'd never make your money back.

This has applicability to two cases:
  1. More strongly for "regression to the mean" or "value" investors - that is, investors who try to identify temporarily incorrect prices and invest to profit when they come back. This is often a good stragey, but it is not risk free - every now and then the rules change and you blow up.
  2. More subtly, but also more importantly, this also applies to arguments that "X has never happened in the past". For example, you'll find a ton of posts in the last year suggesting an over-weight in equities for retirement investors. The logic is: they return more and over N years they've never lost money" where N is long enough that the stock market recovered. There are specific problems with this argument I'll blog about some other time, but it's worth noting that in 1955 stock dividends had never been lower than bond yields, until that wasn't true forever.
Sometimes the Rules Don't Change

This is a graph of the Nikkei 225, that is, Japan's major stock market index. My generation is too young to really understand Japan in the 1980s I fear. Note that not only has it not made back its peak pricing, it hasn't even come close.

Whenever there is a bubble, you'll hear "this time it's different" - think dot bombs that lose money on every transaction but make it up in volume with $100+ stock valuations. Sometimes the rules change, but a lot of the time they don't.

The Nikkei provides a number of warnings about stocks:
  • If your underlying asset is subject to bubbles and heavy speculation, you might never get your money back. A diversified, balanced portfolio is a good defense to this.
  • When you invest really does matter...if you hear "99% of the time strategy X returned great results" ask yourself: what happened in the 1%? Would you take a drug that will fix your headache 99% of the time and kill you 1% of the time?
  • Stock markets don't "always go up". That's what they said about housing.
The Life of a Turkey

There is a wonderful graph in The Black Swan called "The life of a turkey" - it is a steadily increasing graph of the amount of food fed to a turkey on a given day, until right before Thanksgiving the graph abruptly plummets to zero.

The fundamental problem with a whole pile of the financial tools we rely on is that they look at past data to answer questions about the future. But, as the life of the turkey points out, before Thanksgiving there was no data in the Turkey's history that could predict what was going to happen.

Taking Stock

And this is where I recommend a certain amount of skepticism when approaching stocks. You will see articles like this one, but as you read, remember the life of the turkey! In no 30-day period in the turkey's life did our poor bird die once - and yet he was not immortal.

There is simply no guarantee that trends from past data will sustain themselves - the "30 year win" theory of stock investing does not make a stock investment safe. Stocks can and do lose money - we have to look at the underlying mechanism of the investment, not just what the numbers have done in the past.

Stocks do not become like T-Bills over 30 years just because their average peformance shows the same volatility over a long enough time frame!

To end with my favorite epistemologist, Donald Rumsfeld, there are known unknowns and unknown unknowns. Past stock performance might give us some insight into the known unknowns, but it does not tell us anything about the big unknown unknown: namely how and when have the rules of the game changed?*

Unfortunately we go to war with the investment analysis tools we've got, not the ones we want. I am not saying "put your money under the mattress", and I do believe that diversification is a damned good idea.

My point is this: when you look at "risk", consider whether scenarios exist where you would lose more money than you are comfortable with, not the average and typical outcomes. There is no guarantee that the average or typical will happen, or even that it really is likely. Today Modern Portfolio Theory has become gospel, but don't let the gospel keep you from thinking about the unthinkable.

* Of course, people now are saying the rules have changed because we will have "decoupling" of the US and Asian economies. This strikes me as even more ludicrous than past statements about dot.bomb valuations, but that's another blog post.

Sunday, May 11, 2008

A Good Podcast on Housing

Well timed for the week that we've spotted our first short sale in the neighborhood, "This American Life" (which you should listen to all the time anyway because it's great) did a really wonderful comprehensive one-hour show on the housing crisis. It should be mandatory listening for, well, everyone. Not only did they cover all aspects of the crisis, but they did so in a way that was both accessible to non-nerds and yet not dumbed down to ignore important details.

Last post I ranted about the issue of over-exposure...that is, in our attempt to own our own houses, most Americans are totally over-exposed to housing price changes with no diversification within the sector (real-estate); the equivalent of borrowing a million dollars and then investing it entirely on a single internet stock. (After a bubble bursts, it's a lot easier to see how stupid an investment idea is; I think an important lesson we all have to learn from the housing crisis is that if we're going to directly connect real-estate to the global financial system, the chaotic, non-linear, unpredictable nature of the financial system is going to infect housing prices.*)

A trend that you'll spot over and over when you look at the current financial crisis and how we got here is intermediation - that is, the ability of Wall Street to take something, process it like a TV dinner, and then send it back out to someone else. The effect of this "financial engineering" (financial processing might be more correct) on our system is about as healthy as eating heavily processed food is on our gut.

But John Bogle puts financial processing in the right perspective: Wall Street's profits are the fees they take on transactions. To the extent that their profits have grown faster than GDP (that is, their growth cannot just be explained by taking the same cut from more general economic activity), we can see that Wall Street is taking a bigger slice of the pie than they used to. Finance-geeks will give you all sorts of lines about increasing efficiency of the market, but this is crap; if the financial-sector's profits grow faster than GDP, they're simply keeping more for themselves.

Financial processing is how they do it. When you listen to the slice-and-dice game that financed the housing bubble, with a mortgage getting passed on over and over, you have to remember that the parties involved didn't just do it because they wouldn't be bearing the real risk. They did it because they got paid every time they made a transaction. Wall Street had a few years of huge profits, and those profits were a slice coming out of everyone's mortgage payments. Someone did get rich off this whole mess.

Another Case of Food Processing

A caller on Marketplace Money wanted to know what to do about his auction-rate securities. If you don't follow this kind of thing, basically the investment banks convinced very reliable long-term municipal borrowers like the NJ turn-pike authority to set their bonds up in an auction-like scheme where the bonds were constantly resold each week. (Normally the bond would be 30-year fixed rate, someone would buy it, keep it for 30 years and everyone goes home. Life is boring for 30 years.)

The rationale for this scheme was: by re-auctioning the bonds, the turn-pike would constantly be getting "the latest" interest rates, which were at the time very low. (When interest rates are down at 1%, it's basically impossible to convince anyone to buy a 30-year bond at that rate.) The theory was that by making a municipal bond look variable-rate instead of fixed-rate, the borrower could get the lower current variable rate (1%).

Investors in this were told that this was just about the same as holding cash, but for slightly higher interest; since the auction is every week, you can always sell your bonds off in the next auction.

If you get higher interest, you're always taking a risk, so it's good to know what that risk is. It turns out the risk here is that the entire auction system would break down when the investment banks who ran the system ran out of money. The poor caller needed to sell his bonds ASAP (his short-term funds were in the bonds) but the auction system had ground to a halt so he couldn't find a buyer. In the long term he's not going to lose any money; the odds of the Turnpike-authority defaulting is very, very low. But he needs his money now!

(These are long-term bonds that are resold in the short you can get your money now if there is an auction, or you wait 30 years if there isn't.)

Now you could say that this investor was chasing higher returns without knowing the risks, but I think we need to look at the roll of the brokers and investment banks. This poor guy got these bonds through a broker, who gave him some "good advice" - look at this clever way you can make more money. Look how clever we (the investment bank) is in creating this new trick to improve returns. Look how kind we are to let you in on this little secret. (Implicit message: returns are higher because not everyone knows about this. Truth: there are nerds on wall-street who control such large piles of money that if it's worth knowing about it, they know about it and buy it before you ever find out.)

There's a conflict of interest that was present in the dot-com bubble burst that's present here both in the housing crisis, and in all of the other instruments (like auction-rate bonds) that have started to break down as a result of the stress the housing crisis has induced. And that is the conflict of interest between profits for Wall Street itself and profits for the investors who are one set of Wall Street's clients (and the borrows who are the other)!

Auction-rate bonds turned into a deal that went ugly for both the investors and the borrowers. One might speculate that the only group for whom the deal was any good was the investment banks who ran it and got to collect transaction fees all over the place, without having to carry any of the risk themselves.

Good Advice

So if there is a common thread to this rant, it is: don't trust "advice" - see that any party that makes its money on transaction fees has an incentive that goes against your best interests. This would include:
  • Real estate agents. (See Freakanomics regarding agent selling practices for their own houses vs. client's houses.)
  • Mortgage Brokers. (See This American Life for poor recommendation on Mortgages.)
  • Stock Brokers. (See the dot-com bubble.)
  • Investment Advisers. (See the recent 401k kick-back scandle)
Of course if you believe any of what I've written, it does beg the question: why are you listening to some cranky blogger on the interweb?

* That's actually a bit disingenuous of me - real-estate has been subject to bubbles for hundreds of years; but connecting real-estate to hedge funds certainly doesn't make things better.