The Efficiency Capital Bear Market

8/6/2019 The Efficiency Capital Bear Market

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The Efficiency Capital Bear Market

Earlier this week, I was invited to speak at a hedge fund conference in Hong Kong. My briefwas to present some original thoughts on the current credit crunch and the various forces cur-rently unsettling the global markets. Rather than come up with my own ideas, I decided to belazy and just plagiarize the ideas of my much-missed friend Hunt Taylor (see ThePrudent

Man vs the Sophisticated InvestorandWhat Purpose Do Hedge Funds Serve) and my part-ner Anatole Kaletsky. Please see below.

***

Voltaire once said that you can tell a persons intelligence by the questions heasks, not by the answers he provides. So, with this speech, I will try to makemyself look smart and ask a lot more questions than I have answers. And the

first question that haunts me is a simple one: why do all the people in thisroom, myself included, make money?

And I dont mean how do we make money, but why? I do not mean to soundgratuitously offensive, and this is a serious question, so let me put it another

way. What is our value proposition? What function do we serve?

Virtually every industry, every business, everything that makes money, does sobecause it makes our lives better. Microsoft makes money because it helps usmanage information. Sony makes money because it entertains us. Tiffanysmakes money because it sells things which allow us to come back into our

wifes good graces after weve invariably disappointed them. Toyota and Boeingget us from place to place and Sun Hung Kai builds our homes and offices. Ab-sent a societal function, it is hard to understand why an industry should makelarge amounts of money for a long period of time and, as all the names onthis sponsorship board behind me can attest, the financial industry has made alot of money for a very long time.

Now it is obvious that we all need shelter, food, clothing, transportation, etc.,and we will pay the entities that provide them to us for our satisfaction. Whichbrings me back to my first question: what value do hedge funds and invest-ment banks provide to society? And how can we invest in them, or work forthem intelligently if we do not know the answer?

I believe that the answer lies inside the structure of the capital and derivative

markets. Thankfully, we live in a free-market economy. The reason Starbucksbrings us so much Frappucinno is that investors are able to provide them withso much capital via the financial markets. And the provision of investment capi-tal is a vital function in society. Is that the function hedge funds and investmentbanks provide? Well, no. Not really. For all I know, you are short Starbucks.

Providing investment capital is mostly the function of the long-only world,which searches out undervalued or growing businesses and either lends themmoney or takes a stake in their equity. If those funds can own their investmentfor years, so much the better. Thats why society rewards the long-only investor;at least the good ones. They get paid for providing investment capital so the

world can fund and grow businesses.

Hedge funds and investment banks on the other hand, are both long andshortand long and short and long and short and long and short ad infinitum.

And thats just the stocks. They are also long and short and long and short theoptions, and the stock index futures, and the corporate bonds, and the creditdefault swaps, and the collateralized debt obligations, and the convertible

Friday June 6th 2008

GaveKal Ad Hoc CommentAsset Allocation & Economic Research

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Page 1/11GaveKal Research

Author: Louis-Vincent Gave
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GaveKal Ad-Hoc Comment

What purpose do hedgefunds and investment

banks serve?

They make markets moreliquid, and less volatile.

At least thats the theory.

Recently, through excessleverage, they havemostly made marketsmore volatile!

bonds, and the senior secured loans. And thats just in corporate capital struc-tures. We still have interest rates, commodities and currencies to think about...

So, if your function is not to provide investment capital, then how are you mak-ing my life work better? Let me suggest this: you may not provide investmentcapital, but you still make the capital markets work better. You make them moreliquid. As speculators, you take the other side of derivative contracts from hedg-ers who need to transfer risk to someone willing to take it on for a price. In

short, you make markets more efficient.

1 The Business of Market Efficiency

The business of market efficiency has a history that is as long and lucrative as themarkets themselves, and liquidity providers have always been paid, and paid well,for their services. Its just that, traditionally, they existed inside a different set ofpartnerships than they do today.

Dont kid yourself that the liquidity business is somehow trivial. This was a club where the membershipsseats on exchanges and partnerships at investmentbankscost millions and, until recently, were only typically available throughbirthrights (or sometimes marriage). The business of liquidity is what put the gold

in Goldman Sachs and the more in JP Morgan. Investment banks and theother great trading partnerships of their day did not attain their wealth by provid-ing investment capital to those who needed it. They attained it by facilitating theprovision of investment capital to those who needed it.

Their function dates back to the Middle Ages, when the first merchant banksoriginated in Italy to facilitate the grain trade. These merchants used to set upbenches in the piazzas to lend against the crops (bank is a corruption of theItalian bancafor bench, and bankrupt is a corruption of the Italian banca rotta, orbroken bench). Soon they took to settling the grain loans held by others, dis-counting the interest charged as a means of getting around the severe sin ofusury. In short, they made their money from making the grain market more liquid

and efficient.

The practice spread to Germany and Poland, and from there came the greatEuropean houses of Schroders, Warburgs, Rothschilds and Barings. In theUnited States came Goldman Sachs and Morgan Stanley. In Asia there was Jar-dine Fleming. All of these great houses made their money by facilitating the pro-

vision of investment capital to wherever it was needed at the time, from railroadbonds in the 1880s to Japanese warrants in the 1980s. They were getting paid toprovide liquidity and risk capital.This is what I will call efficiency capital.

These houses all set up proprietary trading operations to help make their variousfunding operations more liquid for their clients benefit. They would make short-

term markets in government and corporate debt instruments of any maturity toallow their clients market access. They would buy and sell securities relating toIPOs. They would help their clients manage their currency exposures by makingshort-term markets for them. As time went on, they created new and powerfulinstruments for managing and diversifying financial risk and made markets inthem as well. Things like interest rate swaps, credit default swaps, mortgage-backed securities and collateralized debt obligations. And in so doing, they were

well compensated. And that is as it should be. Making markets efficient is quite alegitimate function in society and passes my make your life better test.

The reason that, until recently, you could walk into your bank and ask for a 15-year mortgage fixed to Libor, except for nine hours on your wifes birthday every

July 20th, is that there was a deep and liquid market in fixed-income securities ofall shapes and stripes. Until recently, we had deep and liquid markets in every-thing from crude oil to corporate credit, with a wide selection of hedging and fi-nancing options available.




The collapse in the vola-tility of growth is one ofthe more important de-velopments of the pastthirty years.

Lowe volatility allows formore risk in the system.

2 The Efficiency Capital Bull Market

As efficiency capital got, well, more efficient, the volatility of economicgrowth collapsed. Efficiency capital took all kinds of risk the rest of us did not

want, did so for nice rewards, and in the process made our lives better. Indeed,the collapse in the volatility of growth is easily the most important developmentof the past twenty years.

The collapse in the volatility of growth allows the entrepreneur to project himselffurther into the future and take more risks. It allows governments to plan moreaccurately for budget receipts and thus borrow at a lower cost. It allows workersto not lose their job at the bottom of the cycle since the cycle is now less deep.

And of course, and most importantly for most of us in this room, a lower volatil-ity usually means higher PEs (and vice versa):

U S A G D P Q u a r t e r l y S t a n d a r d D e v i a t io n O v e r T i m e

U S G D P S ta n d a r d D ev i a tio n O v e r T im eS o u r c e : R e u t e r s E c o W i n

6 8 7 0 7 2 7 4 7 6 7 8 8 0 8 2 8 4 8 6 8 8 9 0 9 2 9 4 9 6 9 8 0 0 0 2 0 4 0 6 0 8

Index

1 . 0

1 . 5

2 . 0

2 . 5

3 . 0

3 . 5

4 . 0

4 . 5

U S A Y o Y % C h a n g e i n I n d u s t r ia l P r o d u c t i o n

c m a 1 3 , c .o . p 1 2 o b sS o u r c e : R e u t e r s E c o W i n

5 5 6 0 6 5 7 0 7 5 8 0 8 5 9 0 9 5 0 0 0 5

- 1 0 . 0

- 7 . 5

- 5 . 0

- 2 . 5

0 . 0

2 . 5

5 . 0

7 . 5

1 0 . 0

1 2 . 5

1 5 . 0

V o l a t i li ty o f i n d u s t r i a l p r o d u c t io n s h r in k s

U S A S & P 5 0 0 P / E R a t i o

m e a n s t d .d e v . + c o e f . 6 8 .3 s t d .d e v . - c o e f . 6 8 . 3

S o u r c e : R e u t e r s E c o W i n

5 5 6 0 6 5 7 0 7 5 8 0 8 5 9 0 9 5 0 0 0 5

Ratio

5

1 0

1 5

2 0

2 5

3 0

3 5

4 0

4 5

5 0

L o w v o l a t il i t y = h i g h P E s

H ig h v o l a t il i t y = l o w P E s




Two decades ago, thebusiness of efficiencycapital was a small club.

But now, the business ofefficiency capital is sim-ply massive.

As of about 20 years ago, the world was a simpler place, economically speaking.You had investment capital, and you had those who earned their return by pro-viding it. They were the clients of the brokerages (retail and institutional), the mu-tual funds and the commercial banks (who were lenders). Then you had effi-ciency capital, which was provided by the investment banks in the OTC markets,the specialists on the stock exchanges and the locals on the commodity ex-changes.

Twenty years ago, however, two things were very different from today. The ratioof investment capital to efficiency capital was much, much greater. And the worldof efficiency capital was members only. The initiation fee was a seat on an ex-change or a partnership at an investment bank. But a significant developmentchanged the then-prevailing natural order of things, namely the widespread adop-tion of the limited-partnership structure with the payment of incentive fees forperformance: the garden variety hedge fund.

Though few could foresee it at the time, the creation of the hedge fund wouldallow investors to outbid the club members for their top trading talent. Suddenly,the head of the arbitrage desk at Goldman was no longer alone at the top of thefood chain. No matter how many millions the payout was in a good year at Leh-

man Brothers, 20% of the gain on $500 million (then $1 billion, then $2 billion,then $15 billion ) was better. And you could wear jeans to the office, no less.By the mid-nineties, the prop desks had become the equivalent of boardingschools, feeding their top students into the hedge fund industry.

So, by the end of the nineties, we had a wholesale migration of efficiency capital,from one set of partnerships to another. From Goldman Sachs, Jardine Flemingsand Salomon Brothers to Moore Capital, Citadel, Marshall-Wace and hundreds ofothers built in their image. We had restructured the way the world financedthe business of liquidity.

The way I see the world, we still have two basic functions for money

investment and efficiencybut in recent years, hedge funds started to compete with investment banks as the primary source of the worlds efficiency capital.And, all of a sudden, we entered into a world with lots and lots of efficiency capi-tal. More than the world has ever seen.

How much? Well, hedge fund assets today are estimated at US$2 trillion. How-ever, that $2 trillion of efficiency capital acts very differently than $2 trillion ofinvestment capital. Remember, investment capital is long-only, unleveraged andpatient. But efficiency capital? Well, for starters, its leveraged. There is no way toknow precisely how leveraged it is, but 3x would not be close to pushing the en-

velope. So that makes it act like $6 trillion. And it is very active capital. Again,there is no way to know how much, but lets say the global book turns over four

times a year. Now it starts to look like $24 trillion. In the financial markets, thatmakes for a very large footprint. No wonder the investment banks are fond ofprime broking! This is not a growing asset class. This is a new world order. Thishas changed the rules of engagement for investors.

Of course, as we now know, the investment banks did not take the challengefrom hedge funds exactly lying down. After all, the business of efficiency capi-tal had always been their bread and butter so they had to try their best to defendit. And defending it meant increasing wage bills to keep key personnel (in mostbanks, the personnel costs have been well over 50% in recent years) and increas-ing their leverage massively. This explains why a Bear Stearns could be so leveredas to collapse in a liquidity squeeze, and yet have a returns on equity of below20%!

But then, of course, with all this leverage and this pouring of money into effi-ciency capital comes the question of whether the pressures of monthly positivereturns on trillions of US$ was realistic? And whether the world could handlethat much efficiency capital?


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The business was simply

too profitable to stay,well, so profitable.

Once the barriers to en-try fell, it was bound toattract talent and capital.

The answer was to pourexcess capital into realestate.

At this stage, it is probably time for me to stop trying to impress Voltaire, stopasking so many questions and, start answering some of them instead.

To do this, I will ask you to take a step back and imagine a world with: a) a lowcost of funding and b) an industry with high returns. In such a world, one couldprobably assume that capital would flow easily to the industry with the high re-turns. But unfortunately, as the history of every economic cycle has shown, theinflow of capital into the high return industry would then lower overall returns.

Over time, the industry in question would become increasingly indebted (sincereturns are high and the cost of capital is low) and moves towards overcapacity.Returns would then fall further.

The history of most economic cycles also shows that the above law of diminish-ing returns (structural in nature), tends to collide with a rising cost of funding(which is more cyclical). At some point, the cost of money moves above the fal-ling rates of ROIC. When the cost of capital moves above the returns on in-

vested capital, the leverage, instead of adding to returns, starts subtracting fromreturns, and this precipitates a further rapid fall in the rate of return in the indus-try in question. In turn, this forces the liquidation of the most heavily indebtedplayers and triggers precipitous falls in assets prices. And then, all hell breaks

loose. We enter the liquidation/fire-sale of assets time of the cycle.

And very simply, this is what we are living through today: a massive efficiencycapital bear market which was triggered by the smallest of rate increases (a tes-timony to the amount of leverage in the system).

Now where did the efficiency capital deploy its excess capital? I think we all

know the answer to that question: real estate. The solution for the efficiencycapital industry excess of capital was to find assets offering a long and stablereturn and to leverage these assets to the hilt. The asset of choice was real estate

in general and US housing in particular. Indeed, since real estate was supposed togo up by +7% YoY, the solution was to issue as many mortgages as possible andto leverage as much as possible. As long as the YoY return remained above +7%,and as long as the cost of money remained below, the game was on. Real estate

was viewed as a stable asset, which could only go up. So credit went into real es-tate, and not companies:

U n i t e d S t a t e s : F e d F u n d R a t e s & 1 0 Y e a r B o n d Y i e l d s

P o l i c y R a t e s , F e d F u n d s T a r g e t R a t e G o v e r n m e n t B e n c h m a r k s , B i d , 1 0 Y e a r , Y i e ld , C l o s e

S o u r c e : R e u t e rs E c o W i n

8 8 8 9 9 0 9 1 9 2 9 3 9 4 9 5 9 6 9 7 9 8 9 9 0 0 0 1 0 2 0 3 0 4 0 5 0 6 0 7 0 8

Percent

1

2

3

4

5

6

7

8

9

1 0

a n e f fi e n c y c a p i t a l b e a r m a r k e t

T h i s r i s e i n r a t e s w a s e n o u g h t o t r ig g e r




So what kind of bubblewas the efficiency capitalbubble?

One thing is sure: theimpact on the economyis very large.

In July 2007, it became obvious that house prices were not going up any more, letalone by +7% YoY. In addition, the price of money to continue financing theleverage rose quite sharply, or even worse, money simply became unavailable.

The bell for the end of the efficiency capital bubble was ringing.

3 The Efficiency Capital Bubble Implodes

Now I tend to believe that there exist different kinds of bubbles. The first kind of

bubble takes place on non-productive assets (typically land & real estate). Thesecond kind of bubble takes place on productive assets (railroads, telecom lines).When the bubbles burst, in the first case, we are left with no more land (or gold,or oil) than what we started with.

In the second case, we have put into place productive capital which can still beexploited, either by current owners, or by a new set of owners. An example of thefirst kind of bubble would be the tulip-mania of 18th century Holland. An exam-ple of the second is the US and UK railway bubble of the 19th century or thetelecom bubble of the late 1990s.

Another difference between bubbles is in the way that they are financed: If thebubble is financed by banks, when the bubble bursts, the banks capital disap-

pears and the velocity of money collapses. If the bubble is financed by capitalmarkets (corporate bonds, junk bonds, and equities) those owning the overval-ued assets take a beating. If they hold those assets on leverage, then the assets gettransferred to more financially sound owners. Otherwise, the buck stops with theoverpriced assets owners.

So the worst possible bubble is a bubble in unproductive assets (gold, land, tu-lips) financed by banks. The best possible kind of bubble is a bubble in pro-ductive assets, financed by capital markets. The Japanese bubble of the late 1980s

was mostly in real estate and was financed by Japanese banks. By contrast, the USbubble of the late 1990s was in technology and was financed by capital markets(junk bonds and equities). But what of todays efficiency capital bubble?

Undeniably, part of the growth in the hedge fund and investment banks assetshave come thanks to an expansion in the banks balance sheets (either throughprime brokers, leveraged fund of fund or lending to private clients to buy hedgefunds). And the amount of money that has been invested in hedge funds in re-cent years has not really contributed to an expansion in our overall system of pro-ductions. So one could argue that the efficiency capital bubble has thereforebeen the worst kind of bubble.

But it is also a highly original kind of bubble. Indeed, looking back throughhistory, bear markets typically occur because of problems in the investmentcapital, and, from there, spread (or not) to efficiency capital. It also means

that the long term investment implications may not be as dire as so many believe.Now I do not mean to say that the pain of this efficiency capital bear market isnot acute. It is. As a percentage of GDP, this crisis already ranks above the USsavings & loan crisis of the early 1990s.




Still, thanks to all themeasures taken, velocityis now coming back.

And, of course, the concern amongst investors is that bank balance sheets areseverely compromised, and when that happens, the whole system risks collapsing.

After all, if money is the blood of our financial systems, then the banks are thehearts which allow the money to flow through. And lately, we have been experi-encing nothing short of a heart attack. Though arguably, things could now begetting better.

And things could be getting better for the simple reason that the right remedieshave been put into place. Indeed, in recent years, we have experienced a fair shareof banking crises: the savings & loan crisis in the US in 1990; the Scandinavianbank meltdown in 1992; the Debit Lyonnais blow up in 1994, Thailand andSouth Korea at the onset of the Asian crisis in 1997; and, all the while, Japan hasstruggled with its crisis for the last 15 years.

In hindsight, I would note that the remedies for all of these financial crises seemto be the same, namely:

A Currency Collapse:This supports exports and, more importantly, helps toattract foreign capital.

A Recapitalization of Balance Sheets: Even if rates are low, if the banksbalance sheets are destroyed, the banks will sit on their hands. We havelearned this much from fifteen years of studying Japan.

An Easing of Monetary Policy and a Steep Yield Curve: For markets toclear in the aftermath of a crisis, they need liquidity.

T h e G a v e K a l V e lo c i t y In d i c a t o r

T h e G av e K a l V e lo ci ty In d ic a to r 0 T he G a ve K a l V e lo ci t y In d ic ato r [m a 2 6 2]


9 9 0 0 0 1 0 2 0 3 0 4 0 5 0 6 0 7 0 8

Percent

-2 5

-2 0

-1 5

-1 0

-5

0

5

1 0

1 5

2 0

2 5

U S $ T r a d e -W e ig h t e d : T h e U S $ B r e a k s D o w n


9 0 9 2 9 4 9 6 9 8 0 0 0 2 0 4 0 6 0 8

8 0

9 0

1 0 0

1 1 0

1 2 0

1 3 0

1 4 0

1 5 0

T h e U S $ b r e a k s d o w n




The speed with which USpolicymakers, and theboards of companies,have dealt with pressingissues has been impres-sive.

One of the amazing de-velopments of recentmonths has been theconcomitant slowdown ingrowth with the spike incommodities.

In the past, it has taken at least two to three years for all of these developments

to materialize. However, in the US today, the three-step program seems to behappening in a matter of months: 1) The US$ has already collapsed, and 2) TheFed has cut very aggressively in a short period of time and 3) Banks are pluggingholes in their balance sheets as fast as they can.

And all this is good news since the seizing up of the efficiency capital worldhas led to consequences that, very frankly, more than surprised me. I mean, hon-estly, if I had come here a year ago and announced that the world would see aliquidity crunch such as we have never seen before, that Bear Stearns, Country-

wide (a company which at its height issued 20% of US mortgages) and NorthernRock would all hit the wall. That UBS, that previous paragon of safe banking,

would write off years of profits in just one quarter. That economic growth would

slow so much that miles driven in the US would see year-on-year declines such aswas not recorded since 1982 And still, despite all this, that almost all commod-ity prices would rise by 100%, 200% and sometimes even 300%, a lot of you

would probably have laughed at me!

Source: ISI Group

So is the recent spike in commodities linked to the concomitant arrival of peakoil, peak rice, peak wheat, peak copper etc or is the spike away from the recentcommodity bull market trend linked to the efficiency capital bear market?Afterall, the strangest paradox of the credit crunch has been its relationship

with the global surge in commodity prices. With the world economy slow-ing, commodity prices should have fallen, so why has the opposite oc-curred?

Y i e ld C u r v e s H a v e S t e e p e n e d , E n c o u r a g i n g R i s k T a k i n g

U S G o v e r n m e n t B o n d Y ie ld C u r v e - F e b 1 3 t h 2 0 0 8I B O R S w a p R a t e s Y ie l d C u r v e - F e b 1 3 t h 2 0 0 8U S G o v e r n m e n t B o n d Y ie ld C u r v e - J u n e 3 0 t h 2 0 0 7I B O R S w a p R a t e s Y ie l d C u r v e - J u n e 3 0 th 2 0 0 7

S o u r c e : R e u t e r s E c o W i n

Y e a r

0 5 1 0 1 5 2 0 2 5 3 0

Percent

1 . 5

2 . 0

2 . 5

3 . 0

3 . 5

4 . 0

4 . 5

5 . 0

5 . 5

6 . 0

3 M

2 Y

5 Y

1 0 Y

3 0 Y

3 M

2 Y

5 Y

1 0 Y

3 0 Y

2 W

3 M

1 0 M

1 1 M2 Y

3 Y

4 Y

5 Y

6 Y

7 Y

8 Y

9 Y

1 5 Y

2 0 Y3 0 Y

1 D

2 W

1 0 M

1 1 M2 Y

3 Y

4 Y

5 Y

6 Y

7 Y

8 Y

9 Y

1 5 Y

2 0 Y3 0 Y

3 M2 Y 4 Y

5 Y 6 Y 7 Y8 Y 9 Y 1 0 Y

2 0 Y3 0 Y

3 M2 Y 4 Y

5 Y 6 Y 7 Y8 Y 9 Y 1 0 Y

2 0 Y3 0 Y

1 1 M

1 D

1 W

3 M

1 0 M2 Y 3 Y

4 Y 5 Y6 Y 7 Y

8 Y 9 Y

1 5 Y2 0 Y 3 0 Y




The Fed has managed todevalue the US$ withoutprinting money.

Interestingly, gold hasnot been a star per-former since the BSCbailout.

4 Commodities & The Efficiency Capital Bear Market

The standard explanation is that soaring commodity prices reflect a global panicabout inflation, as the Fed prints money like wallpaper. But this explanation doesnot make much sense. Firstly, because inflationary pressures in America are al-ready subsiding and will soon decline a lot further as a result of falling employ-ment and tame money growth (i.e.; the Fed is not printing money like wallpaper!).

Secondly because the ECB, BoJ and the Bank of England have shown few signsof following the Feds aggressive rate cuts, yet commodity prices are soaring in

Yen, Sterling and Euros as well as in dollars.

Thirdly, because the commodities that have recently been rising fastest have notbeen silver and gold (gold made its highs on Bear Stearns Monday and hasbeen falling ever since) but rice, corn and pork bellies, i.e.; commodities that canhardly be used as long-term stores of value. This suggests that the price in-creases must reflect immediate imbalances of supply and demand.

Does this mean, then, that the recent surge in prices reflects the growing afflu-ence and population in Asia? This explanation makes even less sense. After all,the Chinese and Indians are not suddenly eating more rice than they were threemonths ago. Sadly, their consumption has probably declined, as tens of millionsof their poorest citizens are now going hungry. What, then, might explain thesudden imbalance between supply and demand?

US Short Rates & US Monetary Base

United States, H.3, Res Dep Ins t, Monetary base, SA, USD12 Months Changes in Short Rates (Absolute) INVERTED

Source: Reuters EcoWin

82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

YoY%Change

-5.0

-2.5

0.0

2.5

5.0

7.5

10.0

12.5

AbsoluteAnnualChanges

-7.5

-5.0

-2.5

0.0

2.5

5.0

7.5

Short rates pushed forwards 9 Months

W o r ld , P r e c i o u s M e t a ls , G o l d , S p o t , U S D

C l o s e , H i g h , L o wS o u r c e : R e u t e r s E c o W i n

D e c e m b e r

0 7

J a n u a r y

0 8

F e b r u a r y M a r c h A p r i l M a y J u n e

USD/Ounce(troy)

7 7 5

8 0 0

8 2 5

8 5 0

8 7 5

9 0 0

9 2 5

9 5 0

9 7 5

1 0 0 0

1 0 2 5

1 0 5 0




So what is driving com-modities?

Could the spike be linkedto the efficiency capitalbear market?

As in the last great commodity inflation period in the 1970s, the key factor isprobably momentum-driven panic buying, not only by traders and investors, butalso by final consumers. If each citizen of China and India buys an extra 2 kgs ofrice (which is the weekly per capita consumption in China), that is 4bn kgs or4mn tons of apparent consumption. This compares with total global rice exportsof around 30mn tons a year. Now suppose every Asian family stockpiled an addi-tional months worth of rice consumption. The resulting 16mn ton surge in ap-

parent demand would make a doubling of international rice prices easy to explain.If consumer hoarding seems a farfetched explanation, recall that the main reasonfor oil rationing in America and Europe in the 1970s was not OPECs brief oilembargo. It was the determination of drivers to keep their tanks as full of petrolas possible just in case. And the oil panic of 1973 was soon followed by similarbuying panics, along with resulting shortages, in coffee, sugar, cocoa and eventoilet paper (in America, this last, and most inconvenient, shortage was appar-ently triggered by a joke on the Johnny Carson Show which panicked 20mnhouseholds into buying up an entire months national production of toilet paperby noon the following day.

Now let me return to the very first efficiency capital providers, the Italian

lenders who set up benches in the piazzas to lend against the coming crop.Where are they today?They have disappeared and I think their disappearanceprovides a possible link between the credit crunch and the commodity spike.

Indeed, what I have described above is a momentum-driven price spiral of thekind which is very familiar in speculative financial markets. As the price goes up,trend-following speculators buy more of the commodity in question, the onlydifference being that in this case the speculators are not just financial investorsbut also final consumers. Normally such self-sustaining speculations are reversedby value-oriented investors and producers, who start to trade against the trend.In present conditions, however, counter-trend speculation is much moredifficult than usual because time-horizons have shortened and liquidityhas dried up.

Several American grain wholesalers, for example, have been pushed towardsbankruptcy because they sold futures against their forward grain purchases fromUS farmers. When local Midwestern banks refused to finance margin calls onthese temporary short positions, the grain elevators were forced to cover theirshorts, triggering a further sharp rise in prices. The resulting price spirals causedchaos in US agriculture and, ironically, may have led to reductions in plantingas farmers have been unable to finance their working capital by using thefutures markets or making forward sales. The CFTC has started an emer-gency inquiry into this market dislocation, and this has helped to restore a sem-

blance of normality to US grain trading. Chicago wheat futures have fallen 40%from their peak, partly as a result. Hopefully, other commodities will soon suffera similar fate as market conditions gradually return to normal.

W o r l d , G r a i n s , W h e a t , F u t u r e s 1 - P o s , C B T , C l o s e , U S D

S o u r c e : R e u t e rs E c o W in

9 0 9 2 9 4 9 6 9 8 0 0 0 2 0 4 0 6 0 8

WheatFuturePrices

2 0 0

3 0 0

4 0 0

5 0 0

6 0 0

7 0 0

8 0 0

9 0 0

1 0 0 0

1 1 0 0

1 2 0 0

1 3 0 0


11/11


If so, how much informa-tion is their in prices?

When the efficiency capi-tal bear market ends, theopportunities may wellbe found on the arbi-trage side.

I guess what I am trying to say is that, because of the liquidity squeeze, we have,in recent months, witnessed an absolute dearth of sellers in the commodity mar-kets; a sellers strike. Today, no-one but the best capitalized of producers are ableto sell forward their oil, copper, or wheat production. Meanwhile, on the otherside, the natural buyers (Nestle for wheat, British airways for oil) are forced tocome in and continue to hedge away their commodity needs.

The fact that producers can no longer afford to use the futures markets (unless

said producer has a very solid balance sheetand few do), leads me to the con-clusion that there is probablya lot less information in the current price thanmost people seem to make out. The current price is not the price between aproducer and an end buyer (most producers would likely love to transact at thisprice but they cant, out of the fear of margin calls); the current price is nowsimply the price as agreed to by financial speculators and it is completely re-moved from any underlying reality (i.e., the cost of production, or the amount ofproduction expected to hit the market next summer, etc...). And this, in my view,is a direct consequence of the efficiency capital bear market.

5 So What Do We Do Now?

It also helps explain one of the big quandaries with which a lot of our clientshave been struggling in recent months, namely the big disconnect between theparabolic increases in the prices for stuff and the equity market performance ofcommodity producers. Indeed, while the performance of commodity producershas been more than honorable, the share price performance has hardly kept up

with the increases in profitability triggered by the higher prices for commodities.But then, if producers are reduced to selling their crops in the cash market andhave lost the ability to sell their production forward, then although their earningsare going to be very good this year and maybe next year as well, the visibility offuture returns is plummeting. As an investor, reduced visibility does not go at apremium; we may thus need to see a drop in the volatility of commodity prices

before the bull market in commodity producers can start again in earnest. Andcan this be achieved without efficiency capital returning to the market?

I have spoken for a long time and need to pass on the microphone but I wouldlike to leave you with one final parting thought. At the end of a normal bearmarket, the opportunities tend to be on the long side. But this is no ordi-nary bear market. It is an efficiency capital bear market. The opportuni-ties may thus be on the arbitraging side. And, for me, one such arbitraging op-portunity is between the price of commodities on the one hand, and the produc-ers of the stuff on the other.

By and large, weak hands have had to sell indiscriminately their positions, so wemust have incredible opportunities to buy very cheap assets of a very high qualityand sell the low quality selling at the same price. Around the world, you still havetoday a lot of prices that are completely out of whack. The bear market inefficiency capital is so severe that I have no doubt that the returns are going tobe quite phenomenal for the efficiency capital providers that will still bearound at the end of the crisis. Of course, the question investors need to answeris whether this will be Goldman, Lehman, Deutsche etc who will be able toarbitrage away the out of whack prices? Or whether it will be the well capital-ized hedge funds and private equity firms that clean up?

Still, the good news is that, in recent years, efficiency capital has had to apply stu-pid amounts of leverage to post the kind of returns investors expected. Given the

recent dislocations, there should be returns to harvest without having to take onstupid amounts of leverage. Efficiency capital is thus a far less risky game todaythan it was two years ago. This is a pleasant thought: efficiency capital still has arole to play in our economies. Which means that each one of us in this room stillhas a purpose to serve, and value to add to our system.

Documents

The Efficiency Capital Bear Market