April 30, 2011 

Written July of 2009


The demands to end speculation and manipulation in the oil and commodity markets have surfaced again.  Let there be no mistake, we have had, and always will have, speculation in markets.  Speculation is actually a good thing, in that it helps the markets to clear, it provides liquidity to markets, and it provides price discovery.  Speculation is perfectly legal but it is dangerous. 

For example, in the options market, speculators know that 8 or 9 out of 10 trades will be losing trades.  Yet, they take a position based on the fact that if they are right they can make a killing.  They know going in that they best not bet any more than they are prepared to lose.  Speculation is usually a losing proposition.  And it is dangerous to society as well, if and when it leads to panic buying or panic selling.  It has the ability to distort markets and disrupt commerce.  As such speculation takes a lot of heat from government when things go wrong.

But, speculation is not only sponsored by capitalists who create these markets, it is advocated and pushed by the governments who condemn speculators.   If you don't think governments sponsor speculation, how do you explain almost every state government running a lottery?  Governments know when they sell you a lottery ticket that the odds are totally against you winning anything.  And we as buyers know the money we put out is most likely lost forever.  Yet, the government promotes this speculation and counts on the buyer’s hope that they might get rich.  So, what do we hear today?  The government will be looking into commodity speculation (for the umpteenth time) to weed out "greedy speculators" causing the price of oil to rise.  (Note: a rise in oil is speculation.  A fall in oil is not.  There is no such thing as "short selling speculators" in the government’s book.)

The motive is not to save speculators from themselves -- believe me.  The government’s motive is control and regulation of markets-- plain and simple.  Nothing will be achieved.  In countries where speculation is prohibited by law, you end up with black markets instead.  And prices in black markets are always higher than in the "speculative" free markets.

Now, manipulation is another story.  Manipulation has to do with deceit and fraud.  Is there manipulation in the oil market?  The government is going to investigate this, and hopefully maintain a straight face while doing so.  It reminds me of Claude Rains walking into Rick's Place in Casablanca and proclaiming  "I'm shocked to find there is gambling in this establishment"!  Of course there is manipulation!  How do you spell OPEC for starters.  This Cartel exists to manipulate the price of oil.  It artificially reduces or increases production in order to achieve the price it wants in the market.  Is the US government interested in abolishing this Cartel?  Not at all.  Just as taxes are legal plunder, OPEC is a legal manipulator. They are more interested in blaming investors that might be manipulating the market than going after the governments they know are manipulating the market.  Why?  Again it is not manipulation they are really against, it is control and regulation they are for.  And again, nothing much will change.

Personally, having been a part of these markets for my entire life, my view has always been that speculation and manipulation is a part of the markets.  Deal with it!  I have always assumed that governments all over the world will at times enter the market to exert control -- over commodities like gold, currencies, and oil.  To think otherwise is naive.  Government intervention, together with individual speculation and manipulation is always a part of the market to one degree or another.  If you think markets are free of corruption, you should not invest your money in the various markets.  If you think this is a revelation, you should not spend time investigating conspiracy theories to prove this, since it is not a conspiracy that stocks, financial instruments, and commodities are manipulated -- it is a fact of life.  It may be fraud, but like crime, it exists.  It's part of living in a society.  Get over it, move on, or move out of the way. All we can do is to do our best to lessen crime and fraud.  But, always take into account that unseen forces are at play.  Good investors do this and are not blind-sided by "irrational and unforeseen" movements in the markets.

Having said all this, I want to reiterate a point I made a couple of years ago.  The creation of ETF's (exchange traded funds) and index funds should be looked into.  I personally love ETF's as an investment vehicle.  It is without a doubt the best hedging tool, diversity tool, and shorting tool, I've ever seen.  They give me the ability to make money that I could never have the chance of making otherwise.  I can now buy stocks in China, India, or any other country in a diversified way with the click of a button.  I can buy almost any commodity, group of commodities, or currency, without having to buy futures. I can by them in my IRA, which means I can short the market and with leverage if I choose.  And I can now buy entire sectors with one commission rather than an entire group of stocks.  ETF's give me leverage if I want it, or safety if I prefer.  They give me choices I've never had before.  They give me flexibility and diversification.  And in doing so, they allow me to protect myself -- from speculation and manipulation.  These are one of the best derivatives out there.

But, what is good for an individual is not necessarily good for the system as a whole.  There might be a problem with the creation of some ETF's.   Commodity ETF's and Index Funds buy commodities they have no intention of using.  Some, especially perishable Commodity Funds, buy futures contracts that lay claim to the underlying commodity.  Normally, a commodity is bought to consume.  Now commodities are being bought as a store of wealth.  Some are being bought as an investment.  This was never the purpose of the futures market.  It was to hedge or to speculate in, which provided price stability, predictability, and price discovery.  It was a risk management tool, not a risk creating vehicle.  But now, individuals and funds are accumulating ETF's as a hedge against inflation or deflation.  As investors and speculators pile into these funds, prices of the underlying commodities move at a much greater speed and assent than normal.  And as they pile out of them the declines are equally dramatic.

It could be argued that this is the result of adopting an inherently unstable monetary system; that people are simply protecting themselves; that if we were on the gold standard there would be no need for this kind of protection.  Be that as it may, we are the world we are, and we need to deal with it as it is.  The problem arises that the entry and exit into these ETF's can cause huge price swings.  I give you the rise of oil from 10 dollars to 147 dollars and the crash back to the present 60 dollars as just one example.  There is little doubt that this would not be possible without the help of ETF's.  The question becomes: "is the swing worth it?" Should the world pay higher gas prices to accommodate the world’s speculators and hedgers?  Can it cause unintended consequences, such as structural damage to the financial system?  These are questions that need to be answered, and the potential problems associated with ETF's and Index Funds should at least be looked into.

Like most derivatives, ETF's spread risk and are a wonderful new tool.  But, not all derivatives are benign.  I am open to ways of regulating some new instruments such as Collateralized Default Swaps and the like.  It is being addressed voluntarily by exchanges as I write.  My first thought on this subject is that the key is in regulating leverage.  This together with open and transparent trading of all derivatives and the settlement of those derivatives daily, may be the way to go.  But that's just speculation on my part.

Paul Nathan

July 2009

Market Update
It has been an eventful week.  The stock market rose to recent high's.  The dollar fell to recent low's.  Gold and silver soared.  Resource stocks, including gold and silver stocks fell relative to the underlying commodities.  And interest rates also fell in the face of all of this.
My portfolio was as mixed up as the market action.  The most notable being the news that Amazon Mining voted to change it's name.  This puts the stock in limbo and makes it much harder to trade for a couple of weeks.  The stock fell.  Then came the news of tests that showed no noticeable improvement from using their synthetic potash compared to not using it at all.  The stock fell again.  By the end of the day it was sitting about 40% lower.
It reminds me of the the joke: how do you make a small fortune in the stock market?  Answer: You start with a large one.  Well, what was once a sizable profit was wiped out and I now sit on a small gain. 
I do not put stops in on thinly traded stocks.  It only assure that I will get the worse possible fill.  I am committed to the story of the company and the next day the company put out an explantion.  They argued that the delivery method of the potash was in granular form, much to large to be ingested by the crop it intended to fertilize.  It needed to be reduced to a finer form, which was the case in the previous successful tests.  This explanation resulted in a pop in the stock but it remains much lower than it's recent high as a cloud now hangs over the efficacy of the product.
Meanwhile, I took a major position in TCK and rode it from 53 to 55, then converted to CDE as silver spiked after the Fed's announcement which indicated monetary policy would remain unchanged.  I sold on Friday as it was becoming painfully obvious that a divergence was developing between resource stocks and their underlying commodity.  This is an ominous occurrence and usually signal's caution.
Anyway I picked up my marbles and went into the weekend over 50% in cash.  Next week we will start fresh, with a keen eye on market action.
Portfolio by weight:

Cash (defined as gold, silver, and dollars)
Verde Potash (Formally Amazon Mining)

US Silver

Copper Fox