Saturday, May 07, 2011

Commodity markets and synchronized investment

John Kemp has a piece on the financial post titled Analysis: Commodity markets wobble | Investing | Financial Post. He argues that prices have diverged from fundamentals and talking heads are merely retrofitting explanation to reality.

Broadly, I want to add that such trend build-up is seen in many asset classes. The bubble-like behavior needs a sustained up move and as the move loses momentum, downward forces take effect. The downward action, in most cases, is swift leaving many (occasionally including yours truly) in the lurch.

I believe this is as much a result of group think as speculation. Algorithm-based trading, herding aided by technology (mass-emails) and lack of diversity of ideas probably causes synchronized money flows resulting in self-reinforcing behavior. Some fund managers interested in exploiting this behavior often talk about leading such trends or buying stocks not companies.

A typical trend comprises of four phases accumulation, discovery, bull-run and realization. Accumulation happens when prices are low for sustained period of time. At such times a section of population accumulates the assets leading to firming of its price. The group is led by fundamental investors and many others follow suit. Discovery happens as more and more people realize the downside resilience of the prices of that asset. Technical charts start suggesting potential for up-moves. Early speculators jump on the bandwagon and soon this phase moves into a bull-run. In bull-run the prices start accelerating, crossing the targets investors have in mind, but the move shows no signs of abating. The prices soon reach the bubble territory and often confidently march on prompting investors to re-look at fundamentals to see if they are missing something. As prices cross the bounds of incredulity, realization dawns about weak fundamentals and all the hell breaks loose. The synchronized move out of the asset creates more distress to prices that warranted by fundamentals.

While I am critical of this issue, the issue itself is not new. Such behavior is a reality of the market. It is merely exposed more during volatile times. In periods of stability the trends hide this behavior from public scrutiny.