Wednesday, May 28th, 2008
parabolic dreams

Many commodities have that look of late — a strong increase in price that causes speculators to salivate, those prone to worry to be on tenterhooks, bubble-watchers to proclaim a sighting, and producers and consumers to reassess their actions.

Each episode of this type stems from a confluence of factors. A pyramid often works to illustrate the foundational nature of such a price move, with one force building directly upon another. Or a time line can demonstrate how the developments phased in, especially in situations like today’s, where the underinvestment in some commodities in years past plays a big role in the strength of the move.

For our purposes, a simple image (in this case oriented to the corn market move in the last year) provides a way to think about how some of this came to be.

So, as is always the case, we have a mix of fundamental and technical elements, with the emotional component playing its usual role of amplification.

And what is “KUJ”? Keeping up with the Joneses. There have been a variety of academic studies that have investigated the economic tendency to herd, some of which refer to KUJ in their analyses.SSRN | Subsequently published in the Journal of Financial Economics, this is a working paper by DeMarzo, Kaniel, and Kremer, an example of such academic work, this one focusing on technology bubbles. Anyone with practical experience can attest to the fact that KUJ is a very powerful phenomenon within and between investment organizations, as well as with the investing public at large.

And so, stuck in the middle of such a price move, what do we do? At the most basic level, it involves listing the elements supporting the move and understanding the interplay of them with each other and the changes at the margin. Doing so quickly reveals that there are gaps in the image as drawn above when it comes to a detailed understanding of the supply and demand forces for corn. And, ultimately, that’s what will make the difference, as economic theory predicts.

But all of the other things pushing on the price can dominate for longer than expected, or have a greater impact than seems possible, as anyone who has been caught on the short side of a parabolic move can tell you. Especially in commodities, the moves can be stunning.

We could debate whether this or that is a bubble, or talk about how supply is unleashed by such price action in ways that provide for unique long-lasting benefits to our economy, but those issues are best left to economists and pundits.

Instead, we should focus on different questions: How have our views of the world changed with these price developments? How likely is it that those views are dominated by analysis versus emotion? What dislocations have occurred within our firm as a result of the changing environment? Have we been increasing our exposure to the price move and instruments related to it (even tangentially) across asset classes? How do we balance the goals of individual decision makers (within our incentive structure) with the need to manage risk?

Actively considering such issues will help to avoid unwarranted extrapolation, the investing equivalent of the common cold, which regularly infects amateur and professional investors alike.