VIEWPOINTS OF A COMMODITY TRADER

 
Common sense is the knack of seeing things as they are, and doing things as they ought to be done – C.E. Stowe 
 

The American media is officially obsessed with sensational terminology when describing the financial markets these days. Nothing trends, it either explodes higher or melts down. We have “flash crashes”, a “new normal” and the frightening “double dip”. We also see bubbles about to burst everywhere.

I would like to know when we un-dipped in order to double dip. It seems to me very little has changed since we began this crisis. Regular folks still have a depressed house, a 401-k that’s cut in half or so, and less income if they have a job at all.

Also, let’s keep in mind that these people who are predicting the next big event are the same ones that were clueless when staring straight in the face of the real bubbles of the 2000 stock market top and the housing crisis.

In any event, in order to attract ratings and circulation something needs to happen for the media every day, even though in reality a crisis of this magnitude will take quite some time to unfold. According to them, we melted down, then recovered, and now are in jeopardy of melting down again. You could get dizzy, not to mention poor, if you don’t stay focused on reality. I wonder if there will be a triple dip.

The U.S. bond market is the “new bubble”, and although I personally would not buy bonds here, I certainly can see why they might continue to perform relative to stocks and real estate. It is not irrational.

If we continue to de-leverage, bonds will stay well bid for years, and even though low coupons are not exciting, there is still safety in a return of principal at maturity, and a positive real rate of return after inflation. As the Taipan Publishing Group points out “government bond yields were characterized as “rock-bottom” and “criminally low.” But those descriptions might have been too strong, as the chart below from Bespoke Investment Group shows.

“Looking back to 1962, ten-year yields in “real terms” — adjusted for core CPI — are not shockingly low. As you can see, in the 1970s, the real yield went sharply negative because reported inflation ate up the entire yield and then some.”

The media has also been quick to show us the “massive” inflow into bonds in the past year or so implying that there is overexposure. They also are implying that this is irrational behavior.

The reality is that U.S. investors don’t have nearly the exposure to bonds as they do stocks or real estate.  According to recent data from David Rosenberg, the American household has about 6% of their assets in bonds compared to 27% in real estate and 27% in stocks. The real exposure to the U.S household is in real estate and stocks. Combined, it represents over 50% of their assets.

On the other note, “The rationality of the message runs completely against the grain of how bubbles typically work. Consider two bubbles of recent vintage, the dot-com bubble and the housing bubble. In both cases, the message sent at the height of these bubbles was NOT rational. It was flat-out nutty. In the case of the dot com bubble, we were supposed to believe that fly-by-night companies with huge burn rates and zero earnings, founded by college kids and touted by sock puppets, were supposed to be worth triple-digit multiples on their way to dominating the world. In the case of the housing bubble, we were supposed to believe that home prices would never fall… that 50-year mortgages were the new thing” says the Taipan Publishing Group.

I think Felix Zuluf articulated the rational message of the bond market quite well in his latest commentary. “When an economy shows the weakest recovery on record despite one of the biggest monetary and fiscal stimuli on record, something is definitely different from previous cycles. In our view, it is debt deleveraging. So far, the US consumer and financial institutions have undertaken steps and decreased leverage to some degree but we are nowhere near the end of this process. At the very best, it will take another 2 years but most likely longer until that process is complete. In the meantime, household income growth or the lack thereof will become the decisive factor. At present, it does not look very encouraging as it is stagnant in most countries or anemic at best. Moreover, in the US, housing is an important balance sheet item for the average household and those prices continue to erode.”

As I said, I am not buying long bonds here but I can understand the message. I do think for safety reasons a position in short maturities still makes sense. Perhaps it’s a good time to tighten up maturities. I would also sell any long term bond funds as the return of principal does not exist there, and the fees will eventually eat up the low income distribution.

Everyone should be raising interest rates, they are too low worldwide,” Jim Rogers said in a phone interview from Singapore. “If the world economy gets better, that’s good for commodities demand. If the world economy does not get better, stocks are going to lose a lot as governments will print more money.”

So, perhaps interest rates are too low and a bond market top is in sight, who knows. Personally I agree with Jim Rogers that we are better advised to be long commodities and hard assets as opposed to paper assets such as stocks and bonds. On the other hand to have a position at the short end of the yield curve as a safe haven for future investment still makes sense.

I am sure of one thing. It always pays to maintain an “anything can happen” posture. It is only good planning to stay flexible and realize that several outcomes are possible. The most important thing is that our risk management strategy allows for the fact that we can be wrong yet live to fight another day.

Imagine that.
 
 

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If you can tell me something else where the fundamentals are so attractive…I’d be happy to put my money there, but I don’t know of any other place – JIM ROGERS ON AGRICULTURE
 

In my last post I talked a bit about the most recent developments in the agriculture market and how I thought it could be a great place to invest in the long term.

The case is really built on some basic facts that are practically impossible to change. First, in order to grow good crops we need good soil, water and the sun. Second, we need ample supplies to meet growing demand if we want to have stable prices.

But is that what’s going on? No.

The reality is that we have some problems with land, water and perhaps the sun. In addition it comes at a time where we are seeing the world’s population growing faster than food production.

The United Nations Food and Agriculture Organization said recently “that worldwide food production will have to rise by a staggering 70% by the middle of this century to satisfy demand growth and that “almost 400 million people will face famine unless food production is dramatically and urgently increased.”

That’s a lot of people in a very compromising position yet production has only increased about ½ of 1 % over the last 20 years to aid the situation. This certainly falls short of the United Nations forecast and in order to meet that forecast, production would have to rise threefold over the current levels. That could be tough.

If that’s not enough, see the chart below where stockpiles are already at record lows for wheat, rice, and coarse grains:

Also as I pointed out in a December post, arable farm land that is properly irrigated is in short supply in the countries that need it most. China used to be one of the largest exporters of soybeans, but now, China is the largest importer of soybeans. I would guess that the culprits here are increasing demand, deteriorating arable land mass and poor water supplies. China and India are well below the world’s average for water supplies yet these are the very countries where the populations are expected to grow the fastest.

Finally, the sun is entering a period where we are likely to see cooler temperatures, more droughts, and other less-than-ideal farming conditions. We’re just entering the low part of the sun spot cycle and this will mean lower crop yields and higher crop prices.

Andrew Mickey, the Chief Investment Strategist at Q1 Publishing pointed out that “Despite all the technological advancement, farming is still a very basic process. Crops still need soil, sun, and water. And one of those important factors is where the problem lies. The lack of quality soil can be offset, to a point, with fertilizer. And there’s also the modernization of the still fertile fields of Eastern Europe and Russia, which opens up a bunch of other issues.” This is why BHP is desperately trying to buy out Potash. They recognize just how profitable a large integrated fertilizer and related feed products company will be down the road.

Mickey also stated “As for water, modern irrigation systems can transport water much farther and distribute more efficiently. Granted, water tables are falling and there are other issues, but for now, there’s enough water in most key agriculture areas.” There may be enough water for now but what about the future. It seems to me the countries with the fastest population growth are the same ones with extremely low water supplies.

In any event, he makes a great point about something most of us don’t think about. What a big role the sun plays in crop production.

“The sun will turn out to be the problem. As we’ve been covering for a long time, the sun is entering the dormant period of the sunspot cycle. This means generally cooler temperatures, more droughts, and other less-than-ideal farming conditions. We’re just entering the low part of the sun spot cycle and this will mean lower crop yields and higher crop prices. The relationship of the sun spot cycle to agriculture is not some new-fangled theory though. In his book Financial Astrology, David William’s states, “In 1875, English economist William Stanley Jevons…announced a correlation in the fluctuations in the prices of wheat, barley, oats, beans, peas, vetches, and rye with [the] sunspot cycle.”

The chart below shows the history of sunspot cycles:

As Andrew so aptly sums up, “The combination of rising demand, low stockpiles, and falling production are creating the very real risk of an imminent “Agrastrophe.”

“Add in the upside potential of commodities and you’ve got a tremendous investment opportunity. There’s one other very important factor here though. If and when agriculture commodities start to run up, people will start stockpiling food. That will only exacerbate the supply/demand imbalance.”

“That’s what happened in late 2007 with the Asian rice riots and it’s still happening all around the world. There have been a total of 70 food riots in the past three years. That’s what makes a strong bull market in agriculture commodities different than others. When it does eventually peak, the run in agriculture will be driven by fear and greed. Those are two forces which by themselves are tremendously profitable for early investors, but are downright explosive when combined. The big run in agriculture is coming. It may not be this month or next month, but everything is in place. And, quite frankly, it’s tough to imagine a scenario where you won’t regret owning agriculture stocks in the next five years.”

And finally Jim Rogers had this to say on his blog August 19th, ”The fundamentals for agriculture have gotten better. The inventories are now at the lowest they’ve been in decades, not years. Sometime in the next few years, we’re going to have very serious shortages of food everywhere in the world and prices are going to go through the roof.”
 
 

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If you can tell me something else where the fundamentals are so attractive…I’d be happy to put my money there, but I don’t know of any other place – JIM ROGERS ON AGRICULTURE
 

Back in mid December, I had posted a two part series on the agriculture sector. I tried to point out several developments that could lead to much higher prices down the road for the grains. The overhang of the de-leveraging that is going on in the global economy has kept prices in check, but it sure seems that things are changing. The grains have really taken off recently with wheat leading the charge.

I mentioned in the previous post that unlike some asset classes commodity prices can rise from increased demand over current supply, but they can also rise if supplies fall below stable demand. It is always interesting to see both in motion, where demand is increasing and supplies are diminishing. That’s what was happening last year during the price correction of 2008- 2009 and thus presented a good long term buying opportunity.

Now, with Russia’s (one of the world’s largest exporters of wheat) ban on exporting wheat, and the problems they have had with wild fires and droughts, we are looking at a more serious global supply disruption that could have a long lasting impact on global prices.

These new developments come right in the face of the worlds’ population more than doubling since 1950 ( from about 2.5 billion to 6.7 billion and is expected to hit 9 billion by 2050), and the fact that most of this growth will occur in China and India the very places where it is most difficult to increase the production.

So, it only stands to reason that we will need more food.

The United Nations Food and Agriculture Organization (FAO) predicts that worldwide food production will “have to rise by a staggering 70 per cent by the middle of this century if food riots are not to become commonplace…Almost 400 million people will face famine unless food production is dramatically and urgently increased.”

“World agriculture production has increased a paltry 12% in the past two decades. That’s an annualized growth rate of 0.56% per year”, says Andrew Mickey at Istook Analyst.com. “That’s just not going to cut it. In order to meet the Food and Agriculture Organizations statement, agriculture production must grow by 70% in the next 30 years and would require an annualized growth rate of 1.6% – almost three times faster than the rate over the past 20 years.”

I guess over the longer term we can conclude that demand will out run the current production, and prices will rise, unless we increase supplies dramatically.

That doesn’t seem to be happening though (see chart below).

As I pointed out in the December post supplies are steadily decreasing. Stockpiles of grains have been falling since 2002 or so. In fact, wheat, rice and coarse grains are near record low supplies and surprising as it seems, prices have fallen along with supplies (until a few weeks ago).

Well, the Russia scare seems to have been the catalyst to wake the world up a bit. Traders are now wondering what this may mean for grain prices in the future. Right now we are in the midst of one of the strongest rallies in wheat since the late 1950’s. December wheat closed around 5.00 on June 1^st and is currently trading around 7.27.That is a 45% rise in a few months. Now, that’s quite a rally for a few months and might be overblown in the short run……. but it also might be a sign of what’s to come longer term.

So, what can world farmers due to increase supplies to meet the changing demand? What’s needed to get the job done?

Well two things for sure are arable land mass and good water supplies. The reality however is that water is a major problem in the very countries that are growing the fastest. India and China’s water supplies are disturbingly below the global average and the available arable land mass to increase production is low in China and non existent in India.

Thank goodness for Brazil who is rich in both water supplies and available land, but can they carry the rest of the world in increasing supplies to meet the future demand?

Stay tuned for part two of “Water Water Everywhere” when we will explore more of why we think investing in agriculture could be one of the best investments in the coming decade.
 
 
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Victor Sperandeo is a very well respected trader in the Wall St. and Chicago circles. According to Wikipedia, the free encyclopedia, ““Trader Vic,” is a trader, index developer and financial commentator based in Dallas, Texas. He has over 40 years’ experience trading both independently and for the likes of George Soros and Leon Cooperman.

Mr. Sperandeo was featured in the best-selling The New Market Wizards and Super Traders, has been profiled in Barron’s, The Wall Street Journal and Stocks & Commodities, and has appeared on CNBC, CNN, Fox and other networks.

Mr. Sperandeo has authored two books detailing his philosophy: Trader Vic – Methods of a Wall Street Master and Trader Vic II – Principles of Professional Speculation. John Wiley & Sons released Mr. Sperandeo’s third book on trading in 2008. It is entitled Trader Vic on Commodities: The Unknown, Misunderstood And Too Good To Be True.”
 
 
Here is a recent video on his outlook for inflation and how one should play the possibility of hyperinflation:
 
 

 
 
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“Why are the debates in academia so bitter? – Answer:  because the stakes are so low.”
 

John Hussman of the Hussman Funds has a Ph.D. in economics from Stanford. He used to be a professor of economics and international finance at the University of Michigan.  Now, he’s a highly successful money manager. John tells a story about how Paul Krugman once gave a talk at Stanford about a model of economic development which caused him to leave academia and become a money manager.

“Paul drew a diagram on the board,” John said, “and as he described it, he drew a few little arrows indicating migration of businesses from one area to another. A respected economic theorist at Stanford, Mordecai Kurz (who never drew an arrow without a differential equation), immediately jumped up and shouted “You haven’t described the dynamics!!” to which Paul responded that he was indicating a general movement of economic activity toward one place to improve efficiency. Dr. Kurz pounded the table and screamed “Then erase the arrows!! ERASE THE ARROWS!!” and then stormed out of the room and slammed the door behind him. I think that was probably the exact moment that I decided to go into finance.”

In a recent interview John reiterates on how an academic look at the markets can be misleading and potentially very dangerous for the simple reason that “it doesn’t work that way in the real world.” No amount of talk, no amount of writing things on a blackboard or quoting theories from textbooks or lectures is going to be a match for reality. We are being sold one of those textbook looks at the stock market right now (The new normal) when in fact, reality looks quite different. Here are a few important observations from his most recent letter.

“On a valuation basis, the S&P 500 remains about 40% above historical norms on the basis of normalized earnings. The disparity between our valuation assessment and the putative undervaluation being touted by Wall Street analysts is so great that a few remarks are in order. First, virtually every assessment that “stocks are cheap” here is based on the ratio of the S&P 500 to year-ahead operating earnings estimates, and often comes with a comparison of the resulting “earnings yield” with the depressed 10-year Treasury yield. What’s fascinating about this is that this is the same basis on which analysts deemed stocks to be about 40% undervalued just prior to the 2007 top, following which the market plunged by more than half. There’s a great deal of analysis regarding forward operating earnings that I published in 2007, but probably the most comprehensive piece was Long Term Evidence on the Fed Model and Forward Operating P/E Ratios from August 20, 2007.”

“To properly understand the price-to-forward operating earnings ratio, you have to recognize that operating earnings exclude a whole host of charges – what some observers correctly call “recurring non-recurring” charges. These include large and often quite regular losses that the companies deem, often on the thinnest basis, to be detached from their core business – even if the losses are directly related to their core business. Items like enormous asset write offs come to mind. Moreover, the “forward” means that these are year-ahead analyst estimates, which are typically substantially higher than trailing 12-month reported earnings.”

“Think of it this way. Suppose your poodle is 40% overweight. Someone sells you a scale where every pound shown on the dial represents 1.4 pounds of actual weight. Guess what? Your poodle will step on that scale, and the dial will pleasantly report that your dog is at its ideal weight. That may be comforting if you don’t like to face reality, but the truth is, you’ve still got one sick puppy.”

When you hear analysts say that the historical average P/E ratio is about 15, you have to recognize that this is the normal P/E based on trailing 12-month earnings after subtracting all write offs and other charges. Forward operating earnings are invariably much higher, and it turns out that the comparable historical norm, as I discuss in that 2007 piece, is only about 12. If you exclude the late 1990’s bubble valuations, you get a historical norm closer to 11.5. The 1982 and 1974 market lows occurred at about 6 times estimated forward operating earnings.”

Now in addition to the Hussman “real world” historical norm PE of around 12, let’s look at bear market low PE ratios.  The last five major bear markets going back to 1920 reveals the average PE at the bottom was 6.84, a far cry from the 19.9 x earnings today and the norm of 11.5-12.

Perhaps the February bottom at 14 x earnings was an interim low and not the final bear market low. Bear markets last a long time and have many temporary bottoms, but only one final bottom. Even if we give the benefit of the doubt that earnings will rise from the current $51 to $75 but that the multiple trades at the average of the major bear market bottoms of the past (6.84) the S&P would be valued at around 500. This would be down over 50% from current levels.

Another way to look at it would be to ask what earnings are needed to validate the current 1100 S&P at various PE ratios.

We would need earnings to grow to $78 to substantiate a valuation of 1100 at the February low of 14 x earnings. Earnings close to $92 would be needed to validate the 1100 S&P level at 12 times earnings (the historical PE ratio) and a whopping $160 (a threefold expansion) to substantiate a valuation of 1100 at 6.84 x earnings (the average of the 5 major bear markets).

Considering the shape of the economy these are some very tall orders to fill.
 
 
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With all the conflicting forces in the markets today it is difficult to see where real long term value might be hiding. No one is hard pressed for opinions about what to buy or sell, but a large percentage of those opinions are based on short term momentum ideas and not long term value.

So where is long term value? Is it in the stock market…. or are we headed for the dreaded double dip recession or worse, a depression under the weight of deflation? Is it bonds…. or is this the calm before the inflation storm? Maybe it’s cash. Even though there is no yield, at least it’s safe. I think.

Honestly, I don’t know how the experts can be so sure of their opinions on the inflation/deflation debate. There seems to be forces on both sides of the argument that imply either or both could unfold. Not a very comforting thought, but there is clear cut evidence of the two forces at work. For example, when is the last time you saw Gold and Bonds go up together for any length of time? The deflationists lean on unemployment and the weak housing market while the inflationists talk of the massive easy monetary policy, and the trillions of dollars of spending by the current administration.

The Nobel Prize winning economist Paul Krugman recently said in the New York Times, that we are entering the Third Depression. Meanwhile, John Paulson the famous hedge fund manager has taken the opposite stance and positioned his money behind a huge bet on gold. Krugman says unemployment and housing continues to weigh on a recovery and will keep inflation at bay. He noted where May 2010 was the worst month for new home sales in America since records began in 1963. Paulson says there is “less than a 10%” chance of a double dip recession. The list of good thinkers goes on with Nouriel Roubini and Robert Precter behind deflation and Jim Rogers and Nassim Taleb backing the inflation horse. Who knows? I’m confused.

Sometimes when I’m confused I look at which investments are doing well to confirm which forecast is more likely to be accurate. This time that’s not working either. Deflationists who are short housing and long bonds over the last several years are doing well. So are the inflationists who own gold and some other commodities, yet stock investors are struggling.

The stock market has rallied somewhat in price from the lows but not really in value when looked at in terms of gold and not the dollar. The Dow divided by the price of one ounce of gold (the Dow / gold ratio) is currently 8.5 ounces of gold. In other words you can buy the Dow with 8.5 ounces of gold. In 1999 it took close to 45 ounces of gold to buy the Dow. So, when priced in gold, the US stock market has been in a severe bear market for the entire 21st century.

Gold on the other hand has been a great investment in the last several years but sometimes it’s hard to buy something that has gone up so much. Personally I believe gold is going higher in the long term but perhaps silver should be taken more seriously at this point. Silver might be a better investment for long term value when compared to gold, stocks or bonds.

In 1980 Gold traded at $800 per ounce and silver at $50 per ounce. Today Gold is around $1200 per ounce and silver is around $17. This baffles me as much as the bonds and gold going up together for years.

In 1980 it took about 16 ounces of silver to buy an ounce of gold (The gold/silver ratio). Now it takes 70 ounces of silver to buy an ounce of gold. If the ratio were 16 today silver would be $75 per ounce, a far cry from $17. In fact, silver could go up three fold just to reach the 1980 high, and that’s not adjusted for inflation.

Now, that of course is 1980 prices. The historical range of recent years has been more like 45-50 which would still put silver around $25 per ounce up from the current $17 which is still close to 50% higher than current levels. In any event either gold is very expensive or silver is cheap against gold. I think it’s more likely that silver is undervalued and the ratio should close favoring silver. Here is a chart that shows how far silver is below its inflation-adjusted peak reached in 1980.

Also there seems to be major demand surfacing in the silver coin and silver ETF markets. Jeff Clarke of Casey’s Gold & Resource Report points out that even though silver has underperformed gold it has still been strong compared to other investments. “This price strength from the “poor man’s gold” has spilled over into tremendous investment demand – especially so for silver coins. The U.S. Mint sold more Silver Eagles in the first quarter of this year – just over nine million – than any prior quarter in its history. The Royal Canadian Mint produced 9.7 million silver maple leafs in 2009, also a record. Take a look at the jump in U.S. Mint coin sales since 2007: Silver bullion ETFs are growing, too, experiencing a five-fold increase in metal holdings since 2006.”

So considering the alternatives, perhaps we should buy silver on any weakness. It has a good chance to perform in either a deflationary scenario as a store of value or as a hedge against a falling dollar and inflation.

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I think it’s time to talk about Natural Gas again. A few months ago I wrote on the possibility that Natural gas was nearing a bottom in spite of the record supplies. On April 1^st I wrote:

“Everyone hates natural gas right now and rightfully so. It has been in an extended down move for a long time. On the other hand, it has fallen below the critical $4.00, which has triggered buying on previous occasions, lending an underlying support to further declines. We are approaching (or have arrived) at the “its déjà vu all over again,” buy zone.”

Today, natural gas has once again held in the “buy zone,” and rallied out to around the 4.80 zone (Basis August). This lends more credibility to a longer term bottom and perhaps a very important bottom considering what is going on fundamentally.

I have mentioned before where Natural gas is the “natural” alternative to some of our energy problems, especially when one considers the BP spill and its influence on future deep water drilling in America. Perhaps the BP blunder does not stop us from drilling, but I would think it will certainly slow it down dramatically. Look what happened to nuclear growth after the Three Mile Island incident. It virtually stopped dead.

Now, I don’t think drilling stops dead, I think NG will be taken more seriously for transportation energy, especially when one considers that natural gas burns cleaner than oil. In the power generation world, NG emits 60% less CO2 than coal to create the same amount of electricity. Gas also emits far less of other pollutants such as sulfur dioxide and mercury. 

In addition, America has an abundant supply of natural gas and it works with the existing electrical grid. This makes it the fuel of choice for electricity generators looking to build new capacity amid uncertainty over carbon and environmental regulation.  The boom in natural gas will require more pipelines, processing, and storage facilities which will be supported by government loan guarantees.

I also mentioned in the April post that some of the Majors are recognizing NG as a good investment for the future. For example, ExxonMobil invested in a $41 billion acquisition of XTO Energy at the end of last year. I thought that “this kind of commitment is a major bet on the future of natural gas and could set the stage for a raft of future acquisitions by energy majors in the next few years.”

“In 1970, we imported 24% of our oil. Today, it’s more than 65% and growing. We consume 25% of the world’s oil with 4% of the world’s population and if that’s not bad enough we depend on countries that hate us for two thirds of it. We send between $400 to $500 billion dollars a year to foreign nations, that we are in desperate need of right here”.

At the end of the day there are two major fuels that power our electrical grid. One is coal and natural gas is the other. Most power plants can switch the fuels it burns to generate electricity depending on price. Right now natural gas fuels around 23% of the electricity generation in the U.S. and Coal supplies 45%. (Nuclear, hydro, and alternative-fuel plants supply the rest.).

According to Platt’s, which tracks the coal industry, “power plants began to switch from coal to gas in 2009 when gas fell to less than $5.50 per MMBTU (million British thermal units). The government places tons of restrictions on burning coal (and more are on the way). Coal soot is full of harmful stuff – sulfur, nitrogen compounds, and metals (like mercury and lead). The EPA strictly limits these compounds. So power plants face three choices to limit that pollution – install an expensive filter to capture the pollutants before they leave the smoke stack, burn cleaner (but less efficient) coal, or use natural gas”.

The potential for plants to move from coal to natural gas can also be seen in the NG to Coal Ratio.

According to istockanalysyst.com, “The coal-to-gas ratio measures the price of each fuel per MMBTU. So when the ratio is 1, the amount of coal needed to generate one MMBTU costs the same as the amount of natural gas needed to generate one MMBTU. When the ratio is below 1, burning gas costs more than burning coal. When the ratio exceeds 1, coal is more expensive. Typically, gas is too expensive relative to coal to justify the switch. From 1993 to 2002, the ratio bounced between 0.3 and 0.8. From September 2002 to October 2008, it stayed below 0.5. Then, in late 2008, the price of coal began to rise just as the price of natural gas tanked. You can see the big spike in the ratio in the chart below.”

Even though we have backed off of the highs of last year we are relatively cheap to coal, something to keep an eye on. This evidence may not be enough to see NG prices rise sharply, but it certainly lends support to the price floor underneath.

Other signs of a bottom can also be seen in the dynamics between the oil and natural gas markets. Gas producers are now switching to oil exploration as the ratio of natural gas to oil prices is at a near high of 21 to 1. This is simple economics. Producers make way more money exploring for oil these days, and the shift to explore for oil instead of NG will be seen in the NG supplies in the future.

Natural gas giant Chesapeake Energy for instance has recently leased 700,000 acres in the Rocky Mountains to drill for oil. “The economics just compel you to look for oil rather than natural gas right now,” said Chesapeake CEO Aubrey McClendon. Also gas producer SandRidge Energy announced a $1.5 billion takeover of oil producer Arena Resources. SandRidge CEO Tom Ward recently told analysts at a major energy conference that producers can make “10 times more money” drilling for oil compared to natural gas.

So, keep your eye on the new developments in the NG market. Increased demand, Competitive pricing compared to oil and coal, a cleaner abundant alternative to oil and coal, and possible lower supplies due to less exploration may very well lead to a good investment.

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A perfection of means, and confusion of aims, seems to be our main problem – ALBERT EINSTEIN 
 
 

In Part one we talked about how outlier events in the markets play such an important role in our final performance, yet how few are really aware of this fact. These events come out of nowhere, yet the experts concoct explanations for them after the fact, making them explainable and predictable and therefore unlikely to happen again, and besides, everything smoothes out in the long run. Well, these explanations might make us feel better at the time but are hardly useful.

So, what can we do to minimize some of this complex uncertainty?

One thing for sure, we should really take a strong look at “market timing” in the traditional sense. If missing a few good days can wreck your long term performance, timing the market has a whole other dynamic to threaten us. What would happen to our performance if we missed the 10 good days but were in for the worst 10 days? Or, what if we avoided the 10 worst days? I know this much, if a few periods can be so meaningful; it puts quite a strain on the timer.

We should also take a good look at the traditional long term buy and hold strategy like mutual funds, ETF’s and indexing. You may think your mutual fund manager has downside “outlier” protection, but is that true? He can’t afford to be out of the market while his competition is in. He might lose his job. Obviously ETF’s or Indexes have the same problem. So, if you stay exposed to reap the upside rewards you might get clipped, yet if you time the market, you may miss the upside and still be exposed to the downside. See what I mean about hard?

As trite as it sounds, the first thing we need to do is understand completely what we have invested in. Do we really know how it works, what environments it should do well or not? Next, we need to know what amounts to risk and still sleep at night if everything went wrong. I know this sounds rudimentary, but most people don’t give these things enough thought. I think they have a passing knowledge of what they invest into, and assume the advisor knows what to do. Well, I wouldn’t risk it.

I think we need to take on these responsibilities and stop assuming our advisors have. Since it is so difficult for them to predict the good periods, we should concentrate on what we can control, the downside outliers. We most likely won’t be smart enough to see those great periods coming, but we can protect ourselves against a catastrophic loss that we won’t recover from.

It is critical we understand the investment. It is critical to understand the relationship it has to the current financial climate, or otherwise how do we know how it will behave? It is critical to stay in liquid investments and have an “uncle point” where you call it a day. We are all aware of using a stop on a trade, but how many of us use a stop on a mutual fund or a money manager? We assume our advisor is doing that. Well, good luck with that.

Finally, it is critical to consider the impact on our overall net worth if it goes wrong, otherwise how will we behave? Look at the BP situation. You would think BP, of all the oil experts in the world, would have guarded against something as catastrophic as this spill. Now they are simply reacting, trying anything to stop the oil.

Once we follow the advice above, a reasonable application might be to get aggressive with a small % of the overall trading capital. This is a technique that I use all the time. For example, one could invest 15% of his capital into a fund, ETF or futures trading program and risk 100%. If the idea works out, the interest on the 85% cash position plus the aggressive 15% market position should give you a reasonable overall return yet with a definitive 15% downside. Also, since your worst case is identified, you should not be shaken out by volatility or outlier days.

Obviously the numbers can be manipulated to suit individual appetites for risk. Risk a 5% position in three ideas for an overall 15% exposure or a 5% position in six positions if you want to risk 30%.

This is not to be confused with a trade risk. In a managed futures program or mutual fund the individual risk on each trade should be much less.

I’m saying to risk the 15% on the success of the idea. If you control the unexpected downside surprises of your ideas you will eventually hit some upside outliers. If not, and all your ideas are just plain wrong, I suggest visiting with an Algiers voodoo doctor to remove the hex, or simply finding another line of work.
 
 
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A perfection of means, and confusion of aims, seems to be our main problem – ALBERT EINSTEIN 
 

Malcolm Gladwell in his book Outliers says an “outlier is a scientific term to describe things or phenomena that lie outside the normal experience”. In Florida for example, you can expect most days during the summer to be somewhere between hot and Africa hot. What if however, in the middle of August, the temperature dropped to forty degrees? That would be an outlier, but more importantly, we would be hard pressed explaining why it happened. We seem to have a good understanding of what is normal, but know a great deal less about the ”outlier”, in spite of the hind-sight explanations.

What role do outliers play in the markets? Are the returns in a buy and hold strategy in stocks reasonably distributed?  Do we really achieve steady returns over the long term like the experts say? I don’t think so.

As they say, the devil is in the details, and a closer look into long term returns paints quite a different picture than what we’ve been sold. It turns out that long term returns are anything but smooth and steady, or reasonably distributed. In fact, most of the upside (and downside) performance we see over the long term comes from a few outliers. 

In their book Dance With Chance, authors Makridakis, Robin and Hogarth, researched the standard deviation of returns for the DJIA from 1900-2007 with some surprising results. The time period reflects a rather large sample of just shy of 30,000 days with more “outlier” days than one would suspect. An outlier day is defined as three or more standard deviations from the mean (average) return for a day. This is a mathematical formula that determines when returns are outside the experience of “normal” returns.

Academically speaking, if returns were “normally distributed” there should have been about ninety days where the daily returns were more than three standard deviations from the mean. In the real world however, there were 429 days. That is almost five times as many as modeled. Even more surprising, there were 91 days where the returns (or lack of them) exceeded five standard deviations from the mean. According to the “The Normal Distribution” there should be essentially none at that extreme. If this were happening in my Florida weather example, we would have some very upset tourists shivering on the beach.

This characteristic of extreme measurements drives the academics crazy when modeling. As the Authors say “Typically, the attitude of financial forecasters and statisticians alike consider the 429 days outside the three standard deviation limits as “outliers” (somehow  external to the system) and the 91 days as outside five standard deviations as non-existent. Ignoring them allows analysts to use the nice, comforting properties of the normal distribution for making calculations”

Well, this may be O.K. if you measuring something more stable like heights and weights or smokers, but ignoring “outliers” in our field can lead to financial suicide. The October 1987 massacre for example was twenty three standard deviations below the mean (a drop of 22% in one day). If you’re not aware that something like this can happen, you’re likely to have a heart attack some day. The research proves that outliers have an enormous impact on long term performance and a few days here and there can mean everything.

 Javier Estrada in his paper Black Swans, Market timing and the Dow elaborates more on this concept when he pointed out that during this same period “missing the 10 best days in the stock market resulted in portfolios 65% less valuable than a passive investment, whereas missing the worst 10 days resulted in portfolios 206% more valuable than a passive investment”. In other words, if a person was lucky enough to avoid those 10 days he ended up with three times the money in his account at the end of the rainbow. 

So, what can we do with this information? Obviously, this is the tricky part. You have to be in the market to get the upside outlier periods but at the risk of the downside periods. You know, I’m beginning to think this investing thing is hard. There’s always something to worry about.

Check back soon for Part II where we explore some concepts that help us cope better with these uncertainties.
 
 
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The assumption that seeing is believing makes us susceptible to visual deceptions – KATHLEEN HALL JAMIESON
 
 
It is only human nature to make assumptions. In fact we don’t really give it much thought. We just assume our boss is impressed when we come in early or stay late. We assume our wife forgives us when we bring her flowers. We also assume that other people know what we may be thinking or doing.

The problem with assumptions is that we believe them to be true. Once we believe something to be true, we are not even considering the alternative. Perhaps your boss is actually planning to give additional responsibilities to a co-worker since you can’t get your routine work finished between 9AM and 5PM. Maybe your wife has just called a lawyer.

In essence, when we assume, instead of inquire, we invite problems.

One of the most generic assumptions in the trading / investing world is that “highly educated” people actually know what they are doing. We assume that if this guy graduated from the Harvard Business School, and has now written a book, or appears on CNBC, that he knows what he is talking about. I’m sure people thought in 1927 that H.M. Warner of Warner Brothers might be correct when he said “Who the hell wants to hear actors talk?

There are many smart people in the financial community whose opinions should demand respect. Keep in mind however, that in a profession where prediction is the dominant component, all we really have is educated guesses. King George III had many believers in 1773 when he went on and on about how the American colonies had little stomach for revolution. Oh, and let’s not forget that the Titanic was unsinkable.

Then of course there are the “highly educated” entertainers whom we should give less respect. Jim Cramer for example has openly bragged that he keeps 2000 stocks in his head.

Think about that for a moment. I have trouble following a handful.

I think it is a lot easier to become an expert in some fields as opposed to others. As I wrote in a previous post if you are an auto mechanic, you most likely know more about fixing cars than you don’t know about fixing cars. Also, errors are easily rectified. In this light, a good mechanic is an expert.

If you are a psychologist or an economist, I don’t think so. In fact, it’s practically impossible that your knowledge of the human condition would exceed your lack of knowledge of the human condition. Not to mention that mistakes can be catastrophic in these “big system” type professions. Plumbers don’t kill people but doctors do. Mistakes when predicting the weather, the economy, or the financial markets can and do ruin our lives.

So, are there really experts in professions that require prediction? Well, I guess some people are more expert than others in highly unpredictable professions, but I would be careful equating their expertise with that of the expert mechanic.   

It also seems to me that academic arrogance has escalated lately, particularly in our own government. It’s ironic how the policy makers, mostly academics, politicians and lawyers, have no real business experience, yet seem drunk on the delusion that they can fix things through more and more regulation.

I guess they can afford these risks more than the “real world” businessman, because in their world ideas don’t really have to work. In academia and government the solution for “bad ideas” is more research and more regulation. When you think about it, they stay in business whether they propose good ideas or bad ideas. How nice for them.

So what is a constructive way of dealing with all this?

Vincent Ryan Ruggiero in his book Critical Thinker points out that one way of avoiding assumption is to question. He says to train yourself to think in terms of exception. Once the “case” has been made, begin to run through your mind the exceptions that could upset the case. One exercise that I use all the time is to think in reverse. Whenever I feel very strong about a scenario, and find myself assuming I’m right, I take the exact opposite posture to see if there is a case there. The more exceptions that I can find, the less impact the original case has, and therefore the more cautious I am about my position. In the end it’s always about controlling the risk, so whatever it takes to keep us cognizant of risk, I am a fan.

So, the next time you want to assume that the expert’s opinion is correct consider that Lee de Forest who invented the cathode ray tube in 1926 said, “Theoretically, television may be feasible, but I consider it impossibility–a development which we should waste little time dreaming about.” Thomas J. Watson who was the Chairman of the Board at IBM in 1943 said “I think there is a world market for maybe five computers.”

The list goes on and on. In 1895 Albert Einstein’s teacher told his father “It doesn’t matter what he does, he will never amount to anything.” And my personal favorite was when Decca Recording Company rejected the Beatles in 1962 saying “We don’t like their sound, and guitar music is on the way out.”
 

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