Commodities: High Volatility, Dumb Money....and A Rebalancing Bonus

I noted last week the large daily moves in commodities as an example of "irrational markets:. The WSJ reports on that volatility

Prices of everything from gold to copper and cotton leapt to new highs, only to be slapped down just as quickly. Trading volume in many commodities roared to records, including for silver, cotton and corn. Since the beginning of October, the Dow Jones-UBS Commodity Index's 30-day realized volatility has doubled to 25%, the highest since September 2009.

For commodities, the overarching reason for the volatility is the outsize reaction to new signs that China has stepped up its moves to tighten credit and contain inflation. But the huge amount of money flooding into commodities markets appears to be helping exaggerate those moves.

The reason for those movies "hot money" no doubt some of it "dumb money" that bought in late in the rally and liquidating at a loss on the selloff, while others get whipsawed buying high selling low in the volatile markets. Even if the actual buying comes from money managers it can reflect retail flows into commodity funds.

With that money has come a new breed of investors more focused on trading in and out of commodities to profit from price moves rather than the standard producers and consumers relying on the market to manage their risks.

Since August, money managers, such as hedge funds, have raised their bullish bets on oil, copper, soybeans and many other markets. These funds' total net-long positions all peaked in the week ended Nov. 9, before being cut in the past week, according to the Commodity Futures Trading Commission.

All this suggests volatility will at least be around, if not increase, in the short term, even if many people believe commodities overall have a lot further to rally.

"When you have this large [speculative] exposure built up, you do run a risk," said Tim Evans, a commodity analyst at Citi Futures Perspective, a commodity-research arm of Citigroup. Because "you've used up your potential to draw in more new money—that's the time when you are vulnerable to a reversal."

in other words "dumb money" coming in late and getting burned on the short term market reversal.

Investors "are getting more and more nervous as we get close to year end," said Andy Smith, senior commodity strategist at Bache Commodities. They are "not sure whether they should take the money off the table and run for the year or stay in the game."

 In contrast to the the nervous short term investor in commodities trying to market time, ook at the above from the perspective of the long term investor. That long term investor  has an allocation to commodities and a policy of rebalancing to target, The volatility of a  sharp rally followed by a reversal in the midst of a long term uptrend is just what he wants. He can sell off part of his position at a product to get back to his target allocation and buy more on the dips when he becomes underweighted. If the long term trend is positive he adds a "rebalancing premium" to his gains on the commodity position,

Burton Malkiel Speaks And His View is Updated A Bit

Burton Malkiel is doing the rounds to propmote the 10th edition of the classic Random Walk Down Wall Street. His core view that investors should index and not time still holds, not surprisingly. Here are his current thoughts. I couldn't agree more:

Here he gives some advice in of all places the motley fool and urges its followers to limit their individual stock picking, if they feel they must do it at all:(my Bolds). I think he is being polite to his hosts in  his opinions of the kind of approach advocated at stock picking sites like motley fool.

Hill: How has your investment philosophy changed since you first wrote the book in 1973?

Malkiel: I'd say the one change; it is not really a change, but the one thing I emphasize far more than I did before is international diversification. In the '70s, the U.S. was really the sort of main stock market of the world. Today, the United States is only about 42% of the world economy. The rest of the world is growing more rapidly. By "the rest of the world," I don't mean Europe. What I mean is the emerging markets -- particularly economies like China, India, Brazil -- are growing much more rapidly than the United States.

So I think one of the things that I have emphasized more, particularly in the latest edition, is a tendency for investors to have a home country bias. That is to say, to simply invest in stocks in their own home country. I think that is a mistake. I think people are generally not sufficiently diversified internationally, and in particular, I don't think that they have the kinds of positions that they should have in the most rapidly growing emerging markets.

I'd say the other thing that probably has changed, and this is sort of one of the reasons why there are sort of new editions coming out all the time, the instruments available for investors are vastly different from what they were when I first wrote Random Walk. For example, I had mentioned earlier, index funds didn't exist when the first edition came out. Now there are lots and lots of index funds; there's a lot of competition and expense ratios have gone down.

But the other thing that you find now is you have exchange-traded funds. I am a great believer in exchange-traded funds for the long-term investor. I don't think that you ought to trade these things. I am not sure that I would use them for speculation, but expense ratios are rock bottom on the exchange-traded funds and so these kinds of new instruments are very important for people in putting their portfolios together and I don't think it is a change in philosophy, but it is a change in the kinds of instruments you can use to follow the philosophy.

Market Myths

Hill: What do you think is the biggest myth about the stock market?

Malkiel: I think the biggest myth about the stock market is that there are expert investors who can consistently beat the market. It just isn't true.

Now my view would be, because that isn't true, at least the core of every portfolio ought to be indexed. Now fully understand that telling an investor that you can't beat the market is like telling a 6-year-old that Santa Claus doesn't exist. And anyone with a speculative temperament is going to say, "Look, I want to go and pick some of my own stocks." And I think that is fine, and you can do it with much less risk if the core of your portfolio is indexed.

So I think things like the stuff that comes over the transom from The Motley Fool, with suggestions about individual stocks, I think this is fine for people, but I think what they ought to do is have the core of their portfolio, however, indexed. Then you can go and speculate on individual stocks with very much less risk than if it was your entire portfolio.

In a Forbes interview he is even more specific about his views on international allocation, and by international allocation he is referring to emerging markets. I'm with him

When you were talking before about putting a significant part of your portfolio into emerging markets, how do you define significant? That seems to be a number that varies widely across the Street.
Here's a guide: The U.S. is only a little over 40% of the world economy. So I would first of all say that at least half of your money ought to be overseas. Secondly, with respect to being overseas, the emerging markets are at least half just in terms of their GDP, their economic importance is at least half of non-U.S. markets. So just as a rough rule of thumb with ones equities, because this will give you the percentage that I'm in and that I've recommended, suppose you put 50% in the U.S., and I'm a little over in the U.S. because when you buy a stock like General Electric ( GE - news - people ) or Coca-Cola ( KO - news - people ), they have a lot of international exposure because they do a lot of business over there. So the allocations I've used would be, this is a rough rule of thumb, 50% U.S., 25% foreign developed and 25% emerging markets, including making sure that the growing ones like China, India and Brazil are in there.

Bernanke's Speech Today Attention Should Be Paid

Much attention is correctly being paid to Ben Bernanke's speech in Germany this morning. It's worth reading the full text on the fed's website which includes the graphs.  No Greenspan type doublespeak here. He pulled no punches in calling for surplus countries to allow their currencies to appreciate to reflect their massive trade surpluses (with china at the head of the pack). Most of the analysis is being devoted to the currency issues. But I found this comment, which seems to have received less attention, even more interesting

In sum, on its current economic trajectory the United States runs the risk of seeing millions of workers unemployed or underemployed for many years. As a society, we should find that outcome unacceptable. Monetary policy is working in support of both economic recovery and price stability, but there are limits to what can be achieved by the central bank alone. The Federal Reserve is nonpartisan and does not make recommendations regarding specific tax and spending programs. However, in general terms, a fiscal program that combines near-term measures to enhance growth with strong, confidence-inducing steps to reduce longer-term structural deficits would be an important complement to the policies of the Federal Reserve.

Buy and Hold : Don't Bury It Yet

I truly had planned to write an article on this subject inspired (sic) by articles like this one in the weekend WSJ that proclaimed       and by the profusion of new mutual funds designed to "make money in up or down markets'. But the esteemed Prof Burton Malkiel beat me to the bunch in a great article in the WSJ today. If you read one article about personal investing this year this is the one to read. I may have some quibbles and implement slightly differently but no one could go wrong following the advice.

from the article:

Many obituaries have been written for the investment strategy of buy and hold. Of course, investors would be better off if they could avoid being in the stock market during periods when it declines. But no one—either professional or amateur—has ever been able to time the market consistently. And when they try, the evidence shows that both individual and institutional investors buy at market tops and sell at market bottoms.
Money poured into the stock market at the peak of the Internet bubble during the first quarter of 2000. Stocks and mutual funds were liquidated in unprecedented amounts at market bottoms in 2002 and 2008. Professional investors had large cash holdings at market bottoms but tended to be fully invested during market tops. Buy and hold investors in the U.S. stock market made an average annual return of 8% during the 15 years from 1995 through 2009. But if they had missed the 30 best days in the market over that period, their return would have been negative. Market strategists called for a sharp market decline in late August 2010 as technical indicators were uniformly bearish. The market responded with its best September in decades

A few key points Malkiel makes, several of which I have made in the past in making the case for a diversified portfolio of low cost index funds or etfs.

• Diversification does work no investor should be 100% US stocks
• Investors should have  a good sized allocation to emerging markets
• There is a rebalancing premium over a period of 1996 - 1999 was between 1 and .33% a year
• Even in the "lost decade" of the 2000s a well diversified portfolio rebalanced would have generated posiitve returns. His sample portfolio is graphed below vs 100% stocks.
• Timing can be devastatingly costly. Missing only a few trading days can cut massively into long term returns.

He concludes:

The chart nearby illustrates how someone who invested $100,000 at the start of 2000 and, following my advice, used index funds, stayed the course and rebalanced once a year, would have seen that investment grow to $191,859 by the end of 2009. At the same time, someone buying only U.S. stocks would have seen that same investment decline to $93,717.

The recommended index-fund portfolios contain bonds, U.S. stocks, foreign stocks (including those from emerging markets) and real-estate securities. The diversified portfolio, annually rebalanced, produced a satisfactory return even during one of the worst decades investors have ever experienced. And if the investor also used dollar-cost averaging to add small amounts to the portfolio consistently over time, the results would have been even better.

If you ignore the pundits who say that old maxims don't work and you follow the time-tested techniques espoused here, you are likely to do just fine, even during the toughest of times.

Malkiel's Graph

I ran some numbers on a portfolio of indices with a 65/35 stock bond mix and a globally diversified stock portfolio with a tilt toards value stocks small and large. Not surprisingly my results also did not spell the end of buy and hold.

Ten Year return rebalanced annually 5.8% annualized return $100,000 would have grown to $181,000

without the rebalancing the return was cut to 5.13% with a final value $169,000

As for the recent "disaster years" for buy and hold an investor with an etf portfolio that rode the roller coaster since Jan 0f 2007 would be positive for his portfolio with $100,000 intiial investment worth $106,900 The chart compares the portfolio (green) with the 100% sp 500

The investor who had "given up" and gone 100% tbills would see an account balance of $102,100

Perhaps not a big difference but remember this was a "black swan" three years and the buy and hold investor did better.

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The Convoluted Logic Of The Mutual Fund Industry

The WSJ/Marketwatch report on the efforts by regulators to put limits on 12b-1 fees which are fees ostensibly used for marketing expenses and add to the costs of mutual fund investors who pay management fees as well. Most of thos 12 b-1 fees are used to pay brokers to incentivize them to market these funds over those with no such fees. The net result is higher cost to invesors.

The article reports

There’s an economic equilibrium that’s been in the marketplace, and government isn’t going to be able to change that by fiat,” said Paul Stevens, chief executive of fund industry trade group the Investment Company Institute, in an interview. “Is government supposed to put price controls on mutual funds?,” asked Barbara Novick, vice chairman of BlackRock Inc. (NYSE:BLK) , the world’s largest asset manager by assets. “I don’t think so; we see a fair number of investors who vote with their feet.”

Stevens also took issue with the timing of the proposals, arguing that the regulatory changes due to new financial legislation, not least the question of whether brokers should be held to a fiduciary standard, should be first addressed.....

Ah yes the industry still has a problem with the fiduciary standard which requires that brokers put the clients interests firtst.

The criticisms were focused in particular on the proposed limits to sales charges and plans to let brokers set their own up-front charges. The SEC plan suggests that rather than have funds set sales charges, brokerage firms could compete on price.
BlackRock was one of many industry players to argue that letting brokerages set prices may lead to less competition.

Sorry if I don't follow the logic that letting brokerage firms compete on price  is the same as price controls. But then again I often don't understand the arguments presented by the mutual fund industry either on their strategies for new products or their arguments against regulatory reform.

Novick said larger firms would be able to undercut smaller rivals because they can better absorb the administrative costs that come with each account. This, she said, would lead to less choice for investors as the larger firms would dominate the market.

Question for Those Advocates of A Gold Standard

Like Seth Lipsky of the wsj. I guess he's not aware of the inforrmation in this article (below)

Funny, I thought a key goal of american economic policy was to reduce dependence on the Chinese. This data means that the money supply in the United States would be determined by the gold mining and sales policy of the Chinese government. So if they wanted a "strong dollar" against their currency they could just pull back on  the amount of gold they put on the market. But US policymakers are trying to get the chinese to weaken their currency against the US dollar.

So unhappy with the Fed and want to replace it with the gold standard meet your new main central banker.

from the English version of the official People's Daily

China's gold production to exceed 320 tons this year

With imbalance between supply and demand in the global gold market, the world's gold production leader China is expected to continue to increase production. Deputy General Manager of China National Gold Group Corporation Du Haiqing predicted in Tianjin on Nov. 17 that China's gold output this year will be greater than 320 tons.

China's gold production surpassed South Africa in 2007 and now ranks first in the world. China's gold output has been increasing for three consecutive years along with the rising prices, and China has remained the world's largest gold-producing country.

According to the China Gold Association statistics, China's output of gold in 2009 totaled 314 tons, an increase of 11.34 percent.

China imports about 100 tons of gold each year. Adding 100 tons of imports to China's output of roughly 314 tons last year would yield a total supply of about 414 tons.

This year, gold output has consistently exceeded figures for 2009, at least until August, the latest month for which figures are available. In the first eight months of 2010, gold production was up 8.85 percent from the same period of 2009, at nearly 218 tons.

China is finding new gold reserves faster than it is producing the precious metal, so there is no danger of the country exhausting supplies.

China electrified the gold market last year when the State Administration of Foreign Exchange, part of the People's Bank of China, revealed that state reserves had jumped to 1,054 tons since the last such announcement in 2003, when it had 600 tons.

Joining those determining US monetary policy would be the rest of the world's top gold producersListed in order they are:: Australia, South Africa,Russia,Peru,Canada, Australia. Don't like the Fed:  ? meet your new central bankers under a gold standard.

Of course you wouldnt have to be a gold producer to control the supply of gold and the US money supply by manipulating the amount of gold in circulation and the price. A wealthy country like Saudi Arabia could simply buy up much of gold (or simply flood the futures or etf market) creating that massive inflation in the US everyone thinks a gold standard would prevent. The price of gold would pull up the prices of all the worlds commodities. If they wanted to create  massive deflation  they could simply drive down the price of gold effectively wiping out the savings of all americans as they found their savings accounts buy nothing.

Funny I thought a major goal of the US to reduce dependency on wealth potentially unstable states in the Middle East. Under a gold standard not only would our economy be dependent on their oil production it would be dependent on  whether they chose to use their healthy reserves to manipulate the gold market.

Still think the gold standard is a good idea ?