Wednesday, November 17, 2010

QE2, QE3? - Ari Paul

On November 4th, the Federal Reserve announced a second round of quantitative easing (QE2). Bernanke will buy an additional $800 billion in treasury bonds; this represents roughly 100% of all new treasury issuance. Over the following week, equities rallied about 3%, while gold and most commodities surged higher out of inflation fears. China and Germany loudly criticized the US for deliberately debasing the dollar in a currency war. The newly elected Republican majority in the House began applying political pressure to prevent the Fed from printing more money. Will the combination of external and internal political pressure be enough to reduce the Fed's credit easing? Over the last few days, equities have sold off moderately and commodities have collapsed as interest rates have risen. Some market participants are speculating that either the Fed's easing will be insufficient, or they will not be able to continue easing for political reasons.

The other big story has been the continuing collapse of the EU. It never ceases to amaze me how for most people, "out of sight" equals "out of mind." Early in the year there was widespread talk of how an EU breakup may be inevitable because of the huge differential in labor productivity across EU countries. The IMF announced a nearly unlimited bailout of the PIIGS and the talk vanished, but the fundamental problem remained. Now, Greece has already violated the terms of their bailout by running too high a fiscal deficit, and Ireland is teetering on the brink of bankruptcy. I continue to believe that there are only two feasible outcomes: a very sharp devaluation of the Euro, or a break up of the Euro. The third path that we are currently on would require a new massive bailout every few years. Eventually, German voters will get sick of continually providing "emergency" support to their neighbors.

Back in the last quarter of 2008, many pundits predicted imminent inflation, because the Federal Reserve had just doubled the monetary base. I quoted Milton Friedman who wrote that there's generally a 2 year lag between money printing and its effects. Well, here we are two years later, and we're starting to see significant inflation in just about everything. Food prices, gold, healthcare costs, rental prices etc, are all rising faster than the fed's inflation mandate. The official inflation gauge, the CPI, is a poor model at best and chronically understates inflation. Moderate inflation is here. Some brilliant hedge fund managers like John Paulson believe it will escalate quickly and become double digit inflation in the next couple of years. Others like John Hussman believe that moderate inflation is sustainable, while others like Chanos believe the world will soon experience further deflationary shocks.

My focus remains on the credit cycle. This time last year I thought the credit cycle was near its peak. I failed to anticipate that Bernanke would launch a second round of quantitative easing equal in size to the entire monetary base that existed in early 2008. At the time, the idea that the Federal Reserve would buy 100% of new treasury issuance seemed extremely unlikely to me for political reasons. Bernanke has proven his willingness to print an unlimited amount of money, so we return to the question, will the external pressure from China and Germany, and the internal pressure from the House Republicans, be enough to halt the credit expansion? Without QE3, and QE4, I believe the equity market and risk assets in general will perform poorly.

With 10 year bond yields still below 3%, we are likely much closer to the end of the credit easing cycle than its beginning. The trend of cheap money (and the desire to bid up risky assets that comes with it) is likely close to an end. Unfortunately, I have no particular insight into whether the tightening cycle began this week or will begin in two years. Even if credit expansion has peaked, there remains the risk that inflation could surge out of control and become self-sustaining.

Tuesday, November 9, 2010

Commodity Markets - Ari Paul

Commodity Markets
In this issue:
1) The Basics
2) The Players
3) Speculation and Manipulation
4) How to be Eddie Murphy from "Trading Places"

For a PDF version of this newsletter, please look here:

Dear Friends, Colleagues, and Investors,

In this edition of "Risk over Reward" I'll provide a primer on how commodity markets function and delve into the effects of speculation and manipulation.

1) The Basics
Commodities are fungible, physical products like gold, crude oil, sugar, and soybeans. Commodities can be traded in a few different forms. One common contract is the deliverable future. A deliverable future trades on an exchange with a specific expiration date. Let's say I buy 1 crude oil future for $80 with an expiration date of January 23rd 2011. On that date I will be obligated to take physical delivery of crude oil at a specific location at a price of $80. The contract specifies the quality of the product I will receive and the logistics of accepting the product. A deliverable future may change hands thousands of times on an exchange before expiration; most of the traders having no intention of dealing with the physical commodity.

Non-deliverable futures (also known as "cash settled futures") are similar, except that no product is ever delivered. Instead, the contract expires at a specific date and the holder receives the difference between the contract price and the price of the product. For example, if I paid $80 for the crude oil contract, and oil is now trading at $85, I will receive $5 from the seller of the contract. Another common type of commodity contract is the "forward." Forwards differ from futures in that they do not trade on an exchange. Instead, they are between two parties. This allows the contract to be more customizable but exposes both buyer and seller to counterparty risk.

For any given commodity, there are a series of futures with various expiration dates. For example, crude oil futures exist for every month from now through at least 2018. The contracts with nearer expiration tend to trade much more frequently. All of these futures taken together are called "the curve", because they tend to form a relatively smooth shape. Some commodities typically form an upward sloping curve known as contango. For example, a gold future with a later expiration date will almost always cost more than a nearer date. This is because the future with later expiration includes the price of storing and insuring the gold, as well as the cost of capital. If it costs me $1 a year to store an ounce of gold and another $1 to insure it, I would rather own the right to buy gold in a year for $1000 than buy it today for $999.50. Below is a graph of the gold curve.
Gold Curve

Some commodities frequently form a downward sloping curve known as backwardation. This generally occurs in commodities that are costly or difficult to store for lengthy periods. It can be caused by a short-term lack of supply, but may persist if producers hedge more than consumers. I'll discuss this at greater length in the next section. Below is a graph of the crude oil curve in 2007.

Crude Contango in 2007
2) The Players
Natural Sellers - The natural seller of a commodity is the producer. For example, a coffee grower must sell his coffee. He could eschew the commodity market and wait to sell his coffee until it is harvested, but that would be risky. In this scenario, he will invest in equipment and fertilize without knowing what price he will eventually receive for his product. Instead, he can enter into a contract to deliver his coffee in 3 years at a specified price. He will know today exactly what price he will receive in 3 years, so he can make smarter business decisions about how much to invest in production. He can also reduce his earnings volatility from seasonal weather fluctuations. The downside is that the farmer will not benefit from an unexpected increase in the price of coffee.

Natural Buyers - The natural buyer of a commodity is the consumer. For example, Starbucks is a massive consumer of raw coffee. Over time they can pass some price increases on to their customers, but their profit margins are still hurt by sudden increases in the price of coffee beans. To reduce their risk, they buy coffee in the forward market.

In some commodities, the natural sellers are more active than the natural buyers. This causes the commodity curve to slope downward in a condition known as normal backwardation. The future price of the commodity keeps falling until market makers or speculators believe they have a high enough expectation of profit to buy the futures.

Market Makers - The market maker effectively serves as a middleman between the natural buyers and sellers. The coffee farmer may wish to enter a contract to sell his harvest in May, while Starbucks may wish to enter a contract to buy coffee in July. The market maker will take the other side of each trade and bear the risk that the price of coffee moves significantly between May and July. Another service the market maker provides is in preventing temporary supply and demand imbalances. For example, let's say the farmer wishes to sell his coffee today and Starbucks will be buying tomorrow. The market maker will buy from the farmer today and sell to Starbucks tomorrow. In exchange for the risk and the time it takes to facilitate these exchanges, the market maker can expect to earn a profit by slightly underpaying the farmer and overcharging Starbucks.

Speculators - Traders at hedge funds, large banks, and commodity companies speculate on future price moves. These speculators generally have no interest in the physical commodity itself, they are simply betting on what the natural buyers and sellers will do. For example, a speculator may sell coffee futures as a bet that the weather will be conducive to a healthy coffee crop. If the weather is good, farmers will produce more coffee and have more to sell, so the price will drop. The speculator will be able to buy back his futures later at a lower price and earn a profit.

3) Speculation and Manipulation
Speculation in commodities takes many forms. The price of commodities is ultimately driven by supply and demand, so any factor that influences supply or demand is a potential source for speculation. In the previous section, I mentioned that speculators bet on how weather will impact the supply of an agricultural crop. Another common weather bet is to speculate on the extent to which hurricane activity in the gulf of mexico will decrease crude oil production.
Speculators also make longer term bets on both demand and supply. For example, a speculator may believe that global GDP growth will surpass expectations leading to higher than expected demand for commodities. Another speculator may wager that aggressive investment in production will increase supply and depress prices.

These speculators serve a valuable function of researching commodity fundamentals and sending price signals to the market. For example, crude oil supply and demand may be balanced at a price of $80 today. However, speculators may believe that in 5 years, demand will far surpass supply causing a severe shortage. The shortage may send prices flying up to $300 and reduce global GDP. The speculators bid up crude prices to $120. The price increases is noticed by oil executives, who respond by investing in new production. In 5 years, this increase in production could result in a crude price of $150 and mitigate the damage to global growth.
Commodities are generally believed to be an inflation hedge. Theoretically, they should rise at the same rate as inflation and produce a 0% real return. However, since many investors become attracted to commodities when they fear inflation, commodities tend to surge as inflation rises. A speculator may buy commodities on the expectation that inflation fears will soon cause other market participants to buy commodities. In the last year, gold surged 30% as investors desired a hedge against the effects of the US Federal Reserve tripling the money supply.

Other speculators try to profit directly from the trades of others. For example, a speculator may notice a pattern that at the end of every month, a corn farmer sells futures, resulting in a temporary decrease in the price of corn. The speculator will sell futures an hour before he expects the corn farmer to sell. An hour later, the corn farmer will still sell futures, be he will receive a lower price. The speculator will buy back his futures for a profit. The speculator's profit comes directly at the cost of the farmer.

In general, studies suggest that speculation reduce the volatility of commodities by reducing temporary supply and demand imbalances. However, a growing number of speculators are "momentum traders" who increase volatility.

Commodity speculation is generally short-term and performed by specialists. However, in 2007 and 2008, a large amount of new money began chasing commodities. Fund Managers and Mom and Pop retail traders looked at charts of commodities over the previous 5 years and decided they wanted to participate in the commodity rally. They bought commodity ETFs, which in turn bought commodity futures. This price insensitive buying pushed all commodity prices higher and caused a bubble. Crude oil was pushed up from a fair value of around $75 to $145. Like all bubbles, the commodity bubble soon burst and sent crude oil below $40.

Commodity markets are much less regulated than stock markets. There is no clear definition of "insider trading" and very few traders have ever been prosecuted for manipulation. "Manipulation" of some kind is a daily occurrence in the commodity markets. A minor example is of a trader pushing the market price of a commodity a few pennies to trigger stop market orders. A much more serious form of manipulation is cornering a market. In 1979, the Hunt brothers bought up 1/3 of all the world's silver, mostly on credit. By controlling such a large percentage of supply, they were able to control the market price of silver and drive it artificially higher. In 1980, the COMEX created a new rule that limited the purchase of commodities on credit, and effectively forced the Hunt brothers to sell a portion of their silver. This triggered a 50% price collapse over four days.

A common form of manipulation is forcing out the "weak hand." A trader puts on a position against a known counterparty. The trader estimates that if he pushes the position far enough against his counterparty, the counterparty will give up and close the position, pushing the bet further in favor of the trader. For example, let's say you bet that corn prices in 2013 will rise and I bet they will fall. If you control several billion dollars and I only control a hundred million, you can keep bidding up corn prices far longer than I can sell them. Eventually my loss will be so great that I will be forced to buy back my futures and drive prices up even higher. Whether you are right or wrong about corn prices in 2013 is irrelevant - you will earn a profit by forcing me out of my position.

4) How to be Eddie Murphy from Trading Places
In the movie "Trading Places", Randolph and Mortimer Duke try to corner the market for orange juice concentrate. They bribe a government official to get an early look at a critical crop report. Billie Valentine (played by Eddie Murphy) and Louis Winthorpe (Dan Akroyd) foil their plans by stealing the crop report and passing on a fake report to the Duke brothers. Even in the lightly regulated commodity markets, stealing a government crop report and using it to manipulate prices is illegal. So, unfortunately we won't be getting rich following Eddie's lead any time soon.

The closest we can come is trying to identify situations where a speculator is overexposed. The Duke brothers committed their fortunes to a leveraged position; when the futures began moving against them, they were forced to sell and this dramatically increased the volatility, and potential profit for a savvy trader. When Brian Hunter of Amaranth made an oversized bet on Natural Gas futures, another trader was ready to sweep in for the kill. John Arnold of Centaurus let Hunter push the market far from equilibrium and then swept in to take the opposite position. Arnold profited from Hunter's bust.

Your speculating trader,

Monday, November 8, 2010

Startup Reading List - The Best of It - Alpha

After reading dozens of books on startups, here is what I recommend. The books below are a great introduction into business thinking, experimentation, and how to invest (not just money, but time and other resources too).

– these books all have good information and complement each other – I recommend buying all four. You will read them many times.

ART OF THE START (Kawasaki): (basics for a tech startup – Kawasaki focuses too much on pitching to angels/VCs/funders as opposed to bootstrapping)

START SMALL FINISH BIG (DeLuca): (basics for all new business creation, from the Subway founder DeLuca – lots of great bootstrapping tips – how to get from small to very large)

DO MORE FASTER (TechStars): (more detailed basics for tech startups, from the venture incubator TechStars in CO/NY – most important tips are on how to create a good initial team and how to iterate quickly from bad ideas to products that sell soon – I think a committed team of people who trust and complement each other matters more than an initial idea for most startups)

REWORK (Fried): (conceptual basics from the 37 Signals founders on how to build a solid business and conceptualize a product – many new ventures face these issues)

“HOW TO MAKE WEALTH” (Graham): (the single best essay on startups and one of the best things ever written about business and wealth). Graham has written a few other excellent essays on startups:


ADVANCED READING – explore here as you need more specific information or some great inspiration – you can borrow these or consult them at libraries (I own them).

ENTREPRENEUR’S GUIDE TO BUSINESS LAW (Bagley): (basic info/guide to all the legal issues – you’ll never need anything else)

FOUR STEPS TO THE EPIPHANY – CUSTOMER DEVELOPMENT (Blank): (a great process/way to talk to customers and develop a product that they want iteratively – geared toward tech)

MADE IN AMERICA (Walton): (how Sam Walton built Walmart from one store to the largest US company by sales)

BEHIND THE CLOUD (Benioff): (how Marc Benioff, a serial entrepreneur, built Salesforce, with great tips on doing a tech startup)

DELIVERING HAPPINESS (Hsieh): (how Tony Hsieh, a serial entrepreneur, built his tech companies, and his vision of a company not just selling things but actually improving people’s lives, making them happier)

COPY THIS (Orfalea): (how Paul Orfalea built Kinkos from one store after graduating from college – lots of great stories and personal growth advice)

“THE GOLDEN GUT” (Kirkland on Adelson): (how Sheldon Adelson, a serial entrepreneur, built multiple businesses and sold them, getting bigger every time and taking smart risks and experimenting)

The Recent US Mid-term Elections Analyzed - Alpha

The mid-term elections were a big deal for two reasons. First, it’s the first time since the 1940s that the voters removed the party in control of the House for three consecutive elections (the GOP lost both houses in 2006 and the Presidency in 2008, only to win the House back in 2010). Second, it was the largest change in House seats since 1948. The GOP’s strategy of gridlock and non-cooperation worked.

The election results fell in line with consensus expectations. Basically, with unemployment stuck at 9.6%, voters kicked the Dems out of the House early due to the lack of JOBS.

The irony was that while the House was passing many bills, the Senate is where the bills went to die, thanks to the self-imposed filibuster, 60-vote Senate rule used by the GOP mostly (and some wavering Dems). However, voters left control of the Senate to the Dems, with 53 Senators and so a 3 vote margin.

While NBER dated the recession’s end to mid-2009, the flatlining jobs situation (and so stagnating income and skills) has made voters furious.

Jobs are a big deal. A landmark study in the Economic Journal followed 130,000 people for a few decades, allowing researchers to look at major life events, like marriages, divorces, births, deaths, and so on. It found that unemployment for over one year might be the only major life event from which people (esp. men) do not recover within five years. People were more likely to recover from the death of a spouse than from prolonged unemployment. See Clark, A.E. et al. Lags and leads in life satisfaction: A test of the baseline hypothesis. Economic Journal, 118(529), 2008, F222-F243.

By that measure, the US has a crisis on its hands. Politicians may say “Jobs!” while not actually doing anything, such as providing leadership, enacting pro-stimulus or pro-business policies, or reducing political risk and uncertainty for businesses to expand and hire.