http://www.nybooks.com/articles/21792 ----------------------------------------------------snip Finally, demand is reinforced by speculation that tends to reinforce market trends. This is a quintessentially reflexive phenomenon. In addition to hedge funds and individual speculators, institutional investors like pension funds and endowment funds have become heavily involved in commodity indexes, which include not only oil but also gold and other raw materials. Indeed, such institutional investors have become the "elephant in the room" in the futures market. Commodities have become an asset class for institutional investors and they are increasing their allocations to that asset class by following a strategy of investing in commodity indexes. In the spring and early summer of 2008, spot prices of oil and other commodities rose far above the marginal cost of production and far-out, forward contracts rose much faster than spot prices. Price charts have taken on the shape of a parabolic curve, which is characteristic of bubbles in the making.
So, is this a bubble? The answer is that there is a bubble superimposed on an upward trend in oil prices, a trend that has a strong foundation in reality. It is a fact that, absent a recession, demand is growing faster than the supply of available reserves, and this would persist even if speculation and commodity index buying were eliminated. In discussing the bubble element I shall focus on institutional buying of commodity indexes as an asset class because it fits so perfectly my theory about bubbles. Commodity index buying is based on a misconception. Investing in commodity indexes is not a productive use of capital. When the idea started to be heavily promoted, around 2002, there was a rationale for it. Commodity futures were selling at discounts from cash, and institutions could pick up additional returns from this so-called "backwardation," i.e., the amounts by which the spot price was higher than the futures price. Financial institutions were indirectly providing capital to commodity producers who sold their products forward—receiving a fixed price for commodities to be supplied at a future date—in order to secure financing for investment in additional production. That was a legitimate use of capital. But the field got crowded and that opportunity for profit disappeared. Nevertheless, the asset class continues to attract additional investment just because it has turned out to be more profitable than other asset classes. It is a classic case of a price trend giving rise to a misconception and it is liable to be self-reinforcing in both directions. I find commodity index buying eerily reminiscent of a similar craze for portfolio insurance that led to the stock market crash of 1987. In both cases, institutional investors are piling in on one side of the market and they have sufficient weight to unbalance it. If the trend were reversed and the institutions as a group headed for the exit as they did in 1987, there would be a crash. Index buying and speculation that follows trends reinforce the prevailing direction of prices, and have had a destabilizing effect by aggravating the prospects of a recession. The effect will be reversed only when the recession begins to take hold and demand declines, but it would be desirable to rein in index buying and speculation while they are still inflating a bubble. There is a strong prima facie case against institutional investors pursuing a strategy of investing in commodity indexes. It is intellectually unsound, potentially destabilizing, and distinctly harmful in its economic consequences. When it comes to taking any regulatory measures, however, the case is less clear. Regulations may have unintended adverse consequences. For instance, they may push investors further into unregulated markets such as trading shiploads of oil, which are less transparent and offer less protection. Under the current law that regulates managers of pension investments—the Employee Retirement Investment Security Act (ERISA)—it may be possible to persuade institutional investors that they are violating the "prudent man's rule" they are required by law to observe because they are "following the herd" just as they did in 1987. Fear of such a violation may lead them to adopt more sensible trading practices. If this does not work, the government could disqualify commodities—as distinct from the equities of commodity-producing enterprises—as an asset class for financial institutions that are regulated by ERISA. These institutions are serviced by investment banks like Goldman Sachs and Morgan Stanley, which are currently exempt from limits on speculative positions. The trade in commodity indexes could be discouraged by imposing such limits, but to make it effective, limits would have to be imposed also on trading and on shiploads of oil. Some are suggesting that margin requirements for commodity transactions should be raised. Margin rules determine how much in cash or Treasury bills must be deposited when buying or selling a contract. An increase in margin requirements would have no effect on the commodity index buying strategies of ERISA institutions because the transactions are in cash, not on credit. But such an increase could discourage speculation by investors other than financial institutions. Varying the margin requirements and minimum reserve requirements for loans by financial institutions are tools that ought to be used more actively, as market conditions warrant, in order to prevent asset bubbles from inflating further. That is one of the main lessons to be learned from the recent financial crisis. -raghu. -- The meek shall inherit the earth, if that's OK with you. _______________________________________________ pen-l mailing list [email protected] https://lists.csuchico.edu/mailman/listinfo/pen-l
