Tag Archives: commodities

Benefits to Trade

What’s your favorite business movie?

Fair Use. Source: Wikipedia

One of the best is “Trading Places,” a modern take on Mark Twain’s Prince and the Pauper starring Dan Ackroyd and Eddie Murphy. It tells the story of a privileged commodities broker and a homeless street hustler who are thrown together when they are made the unwitting subjects of an elaborate bet. Apart from a minor role by now-Senator Al Franken, it also includes a fairly accurate description of the commodities business, with scenes from the open-outcry pits at the New York Mercantile Exchange, formerly located in the World Trade Center.

The Nymex floor used to house precious metals, cotton and sugar, petroleum futures, and – the subject of this movie – frozen concentrated orange juice. Contrary to the story, “FCOJ” was never a major contract. That would have been gold and crude oil. But the movie’s plot-line – involving secret crop reports, the US Department of Agriculture, and circus animals – made for some entertaining scenes, including ones with the Minnesota Senator.

The open outcry system isn’t around anymore. Most futures pits closed in 2015 – a result of computerized screen-trading. Electronic systems were faster and less expensive. They started replacing the open outcry system in the early 00’s. Options trading, which is more complex, still took place in the commodities pits, but that was replaced by automated exchanges late last year. The main reason big stock exchanges still have physical trading floors now is marketing – offering listing firms (and others) an opportunity to “ring the bell” to begin trading on a special day. Open outcry trading now serves mainly as a backup for when computer systems go down.

Source: CME, WSJ

Commodities used to be the other side of the tracks – where someone with ambition and hustle could make it without having to go to college. They also provided a great backdrop for a funny movie. Now, graduate degrees in math, physics, or computer science seem to be necessary. The quantitative, scientific approach to trading has reduced costs and increased market efficiency. But I wonder what we have lost?

Douglas R. Tengdin, CFA

Apples, Banks, and Money Management

Can the market for apples teach us about money management?

Photo: Arly Flo. Source: Wikimedia

Like many people, I grew up with the saying, “An apple a day keeps the doctor away.” Apples are supposed to have all kinds of health benefits—from helping your digestion to reducing cholesterol to improving your memory. And—unlike a lot of healthy foods—they taste pretty good. But I was never really keen on apples. You see, when I was young, pretty much every apple looked and tasted the same. It was a bright, somewhat mealy variety called “Red Delicious.” And they weren’t very delicious.

When I had an apple in my school lunch, I would eat it. But I didn’t enjoy it. The flavor was—um—okay, but nothing to write home about. Apples may have been good for you, but that’s about all they were. And if you went to the store, there wasn’t much choice. There was either Red Delicious, Golden Delicious, or green Granny Smith.

This wasn’t good for consumers, and it wasn’t good for producers, either. Apples were a commodity. One apple was pretty much identical to another. And like all commodities, only the lowest-cost producer makes any money. Any commodity business is brutal. Smaller apple orchards around the country were shutting down. Production was shifting to mega-farms in Washington State, which used mass-farming techniques to become more efficient. In the mid-‘80s, there was a health scare involving Alar, a chemical sprayed on apples to regulate their growth. It seemed like everyone was losing out: producers were going out of business, and consumers got generic, mealy apples grown with toxic chemicals.

Source: Canada Department of Agriculture.

Around that same time, some scientists at the University of Minnesota discovered a better apple—one that really stood out. They called it Honeycrisp, and some farmers started raising them. Hey, they thought: if I’m going to go out of business, I might as well do it raising something tasty.

And consumers loved them. Honeycrisp apples could sell for twice the price of generic Red Delicious. The farmers were able to survive, and even expand. Soon, new breeds were discovered. Now, when you walk into a store, you see dozens of varieties: Gala, Jazz, Winesap, Macoun, Braeburn. Everyone has a favorite. Some times of the year, apples are the top selling item in the store—more than chicken or milk or cereal.

There’s a lesson here. When a market is dominated by a commodity-type product, only low-cost producers can thrive. But pressures mount to ramp up production to take advantage of economies of scale. After all, someone else might sell their goods for just a little less. Amid that pressure, corners will be cut. In this light, it’s no surprise that the largest retail bank in the country had an ethics scandal involving generic banking products. Money is a commodity.

The same pressures are mounting in the money-management industry. Generic index funds are growing and growing and growing. Over half of the publically traded stocks in the US are held by five giant mutual fund families. And they’re efficient. You can now own $100,000 portfolio of blue-chip equities and pay $40 / year in fees. It’s likely we will soon see “free” products created and marketed, the same way consumers can get free brokerage and free checking. Who knows? Maybe some aggressive fund companies will adopt negative management fees—like negative interest rates—making money on the order flow.

But you get what you pay for. Generic products lead to generic performance—the equivalent of Red Delicious portfolio products. And mass-produced goods always come with issues, whether you can see them (yet) or not. People and institutions need customized financial guidance. Everyone is unique—with their own assets, liabilities, income, and tolerance for risk.

The solution for money managers isn’t to become cheaper, it’s to provide a tastier solution. Smaller producers can survive, and everyone can be better off. But only if they embrace innovation.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Curse of Plenty

Why are resource-rich countries so poor?

Photo: Walter Siegmund. Source: Wikipedia

“All that glitters is not gold,” Shakespeare wrote. And it’s true: countries endowed with abundant natural resources–like gold, oil, or diamonds—grow more slowly than countries that don’t seem to have these natural gifts.

There are three reasons. First, a commodity-based economy is tied to a boom-and-bust cycle. We’re seeing that now, with oil. In the flush years, extra cash leads to malinvestment, wasteful spending, and too much debt. In the bust years, financial crises and budget-cuts overwhelm the economy.

Second, the massive trade surplus that a resource-rich economy enjoys leads to an elevated exchange rate. This depresses the domestic economy because imports are so cheap. Protecting domestic industries paradoxically weakens them further, because those tariffs become items of political patronage. This is sometimes called “the Dutch disease.” It afflicted Holland in the 1960s, after discovery of large natural gas fields elevated the value of the Guilder. This depressed the rest of their economy.

And the third and perhaps most important aspect of the resource curse is governance. All that cash from the commodity tends to corrupt the political system. It’s been shown that authoritarian resource-rich countries are far less likely to move towards democracy than resource-poor authoritarian regimes. And democratic institutions like education and a robust meritocracy are the surest ways to develop a country’s true source of wealth: the labor, management, and innovation of its own people.

Resource rich countries–and families–only thrive over the long haul if they nurture the potential of their people: their minds, spirits, and creative energy. That, as Shakespeare says, is the greatest resource.

Douglas R. Tengdin, CFA

Chief Investment Officer

Looking Forward, Looking Back (Part 2)

So what is the lesson of last year?

Source: Wikipedia

Janus was the god of new beginnings, of transitions and portals. He had two faces: one looking forward, and one looking back. We’ve noted some of the surprises of 2015. What does 2016 have in store?

In many ways, 2016 will look like 2015. Oil and other commodity prices should remain weak, held down by global oversupply. But prices can’t stay down here forever. We’re not replacing the oil and iron ore we’re taking out of the ground—prices are too low to justify the capital investment. So commodity prices will gradually rise. But in the meantime, consumer spending should remain strong, supported by low energy prices.

Healthy consumer spending will help retailers, but it won’t help the capital sector. This bifurcation will create winners and losers: consumer-oriented tech companies should do fine, while makers of heavy equipment continue to struggle. These companies are suffering under a double burden: weak commodity prices and a strong dollar. The Fed’s widely anticipated rate increase has lifted the trade-weighted dollar by 20% since mid-2014. That’s been a drag on US exports and the earnings of globally-oriented US firms.

Source: Dept of Commerce, Bloomberg

But the strong dollar has lifted the prospects for Europe and Japan. So while those markets have struggled in dollar terms, they’ve been quite healthy in their own native currencies. Many people are surprised to hear that the strongest market in the world last year was Russia—at least in Rubles.

I also believe that global terrorism, cyber-crime, and geopolitical turmoil will continue to roil the markets. There are over 4 million refugees from the Syrian Civil War—most of which are in Turkey, Lebanon, and Jordan. And over 6 million Syrians are displaced within their country. This is, by far, the most significant humanitarian crisis in recent memory. Mass migrations of this sort can affect economies and markets for years.

Syrian Refugee Camp in Jordan. Photo: State Department. Source: Wikipedia

In many ways, 2015 was like 2011—a flat year for the market that followed a couple of strong years. The next year—2013—resumed the upward trend. But markets don’t work like clockwork. There’s always something new that changes the landscape. Nevertheless, we believe that the global economy remains solid—for all its challenges. And a growing global economy should continue to lift markets around the world.

Physicist Niels Bohr once quipped, “It’s exceedingly difficult to make predictions, especially when it’s about the future.” But since asset prices reflect the present value of future cash flows, they depend on the future state of the economy, financial innovations, and investor behavior. Predictions about the future are exactly what markets are making. That’s what makes watching them so fun.

Douglas R. Tengdin, CFA

Chief Investment Officer

Digging Deeper

Why do commodity prices keep falling?

Photo: Pedro Perez. Source: Morguefile

The world is awash in oil right now. And it’s the same story for copper, zinc, and a host of other industrial materials. The price of oil is down 60% from its peak last year; a broad-based index is down almost 30%. What’s going on?

Part of the answer has to do with the dollar’s status as a reserve currency. The US is doing better than the rest of the world, so interest rates are going up here, while they’ve been falling almost everywhere else. Most commodities are priced in dollars, so in order to compensate for the dollar’s rise, their prices have to fall—just to keep from going up in non-dollar terms.

Part of the explanation has to do with China. For the last three decades, China has developed at an amazing rate—using exports to leverage its economy on the rest of the world’s growth. But China is now a $10 trillion economy. Unless they find interstellar markets for their goods, there are limits to how much they can sell outside their borders. They have to transition from an outward-oriented manufacturing economy to an inward-focused service economy. That leaves a lot of capacity—that previously fed China’s growth machine—looking for new markets. And those firms have been cutting their prices.

China GDP. Source: Bloomberg, World Bank

And part of the fall in metals prices has to do with the entrepreneurial nature of a capitalist system. When prices fall, production is supposed to fall as well. But this doesn’t happen right away. A lot of large and small companies borrowed money to expand capacity when prices were high. When prices fell, smaller companies increase their output, trying to bolster revenues in order to service their debt. And bigger companies—with less debt—hope that by driving prices lower they can put their smaller competitors out of business—and maybe scoop up their assets in bankruptcy court.

Eventually, these transitional factors will reverse themselves, and production will fall. Supply and demand have to balance; markets eventually clear. Short-term effects are not the same as long-term effects. But suppliers will have to get through the short-term storm to reach the growing global market that is over the rainbow.

Douglas R. Tengdin, CFA

Chief Investment Officer