Good comments VT, I agree that the gold market is not a good place for short term investors, or speculators without a sense of value. This isn't for thrill seekers, as it takes fortitude to buy low at give away prices and then wait patiently for prices to rise (more permanently). To me this feels like the late 70's and early 80's in equities. It was a process, but wow what a rare opportunity. The big score may take a month or it may take three years. To me in the end it doesn't really matter, as I'm confident there's a time bomb ticking away. And what the heck, I come from good genetic stock, and expect to be around to enjoy the fruits.
Few things to keep in mind about gold. It is a thin physical market dominated by paper trades. This fractional gold banking has allowed small amounts of actual gold to multiple into options, swaps, futures, repurchase agreements and loans. This "banking" is also lethal leverage, an accident waiting to happen. I don't know if many of you have done the math, but despite the talk here about "excess" production, all the gold produced in the world annually amounts to a mere $21 billion. By comparison just one mutual fund, Fidelity Magellan has $87 billion. The market cap of Exxon-Mobil is $300 billion.
In many respects gold is a cornered market, in that a few big institutions totally dominate the action. I am going draw some comparisons to LTCM and especially Metallgesellschaft. This is from the recent Puplava piece I posted yesterday. Gold investors that connect dots well, will see the similarities. The circumstances were different as they were long not short, but the overly aggressive and leveraged bets that markets don't change was the same. Puplava calls it "trouble in the tail".
Metallgesellschaft’s Mistake
The German firm, Metallgesellschaft, had repeated many of the same mistakes of LTCM. Back in 1993 a subsidiary of the firm, MGRM in the U.S., made an aggressive move to become a major player in the U.S. oil market. They sold long-term oil contracts to independent dealers at fixed prices. MGRM hoped to make money through arbitrage between the spot oil market and the long-term market for oil. The firm sold contracts of oil to independent dealers at fixed prices going out ten years. These financial maneuvers resulted in a mismatch between supply and demand, making the firm vulnerable to the vicissitudes of the market. MGRM’s customers went long while the firm went short. MGRM covered its position by buying near-term contracts in the futures market and rolling them over each month. This was their undoing.
Their strategy worked as long as the markets remained in normal backwardation. The firm was selling long-term contracts at higher prices while hedging with short-term prices. However, in 1993, the oil markets reversed into contango. (See graph for visual explanation.) The firm made money as long as the markets remained in normal backwardation. The moment they went into contango, the firm began to lose money. MGRM's traders were betting that the market structure would remain stable and that prices would follow historical patterns. They were also counting on maintaining their hedging practice. The problem arose because in futures markets, losses and gains are immediate. A firm must mark its positions to market. Losses require cash payments to maintain margin. However, gains or losses on delivery contracts appear only at the time of delivery.
The problem for MGRM was that they were covering their long-term commitments with short-term hedges. Their traders made a sophisticated bet that markets in oil would remain in a constant pattern. In other words, the markets they were betting on would fall within the normal probability of the existing state of the market or backwardation. As long as these conditions remained, MGRM made money from the spreads between the expectations of the long and short end of the market.
However, the markets didn’t remain the same. In fact, because MGRM’s short-term hedges were so large, they in effect contributed to the contango. At one point, they made up close to 20% of all open interest outstanding on the NYMEX. By taking such a large position and having to roll it over each month, the firm created its own death warrant. The firm’s position was so large, it began to work against itself. Like vultures swarming to the bloodbath, traders took advantage of MGRM vulnerability. By November of the following year, the firm’s trading losses mounted to $1.75 billion wiping out all of its capital. By February, those losses grew to $2.2 billion. The parent company pulled the plug. Ironically, had the firm enough capital to weather the storm, the markets eventually went back into normal backwardation.
MGRM became a victim of its own circumstances. A large long position contributes to backwardation of the markets. A large net-short position turns the markets into contango. The very size and nature of its position flipped the markets from the position they were betting on into a position that was bet against them. Like LTCM that would come after it, the traders at MGRM were relying on predictable patterns. When exogenous events surface, markets turn upside down, patterns change, and large bets are turned into large losses.
4 Lessons From LTCM & Metallgesellschaft
Lesson #1 Investment Versus Speculation
The first lesson is found where sound investment strategies turn into speculation. Had MGRM matched its long-term commitments with long-term hedges, it would not have gotten into trouble. By offering its dealers long-term contracts on oil at a fixed price for ten years, MGRM’s traders became speculators. To make a commitment as long as ten years for a commodity like oil, without covering, was an unsound business practice. As dynamic as the commodity markets are, they are prone to exogenous events like weather and geopolitical events. To assume that oil prices would remain in permanent backwardation seems incredulous today. Another lesson on investing versus speculation deals with the size of positions. Both MGRM and LTCM backed themselves into a corner by taking oversized positions within a market. In essence, they became the market. The size of their positions made them illiquid and vulnerable.
Lesson #2 Leverage Can Be Lethal
The two-sided nature of leverage is an old lesson. It can magnify returns on the upside, but on the downside, it can be lethal. The size of most derivative contracts allows investors or commercials to leverage their position by commanding a much larger position. That in itself is a form of leverage. When you add debt into the equation, the position of leverage is further magnified. In the case of LTCM, it was leveraged close to 100:1 towards the end. A position this leveraged allows no room for mistakes. Just as that leverage turned a 1% gain into a 59% return, it also magnified losses on the downside. In its final days, Long Term Capital would lose half a billion dollars – a loss of 20% of its equity base – in a single day. When you aren’t in debt, you can’t be forced to sell. You can afford to hold your position long-term. The partners’ view that all markets eventually revert to the mean was meaningless when large amounts of leverage were involved. Leverage makes you vulnerable. It can force you to sell when you don’t want to. It removes the element of time out of the equation. LTCM’s mistake was defining risk as a function of volatility. Not enough consideration was given to leverage. Leverage by its very nature implies risk. To ignore the role leverage plays within the derivative market is perilous.
Lesson #3 Corporate Governance & Accountability
The role of corporate governance, both within organizations and outside them through governmental bodies, establishes the ground rules. In the case of LTCM, there wasn’t any governance. There were no independent risk managers watching over the traders. The partners monitored themselves and were accountable to no one. The same lack of supervision was also apparent in the case of MGRM. In most of the derivative mishaps like MGRM, LTCM, Orange County, Bankers Trust, Sumitomo Bank, and Barings Bank an institution healthy one day would appear insolvent the next day. There have been too many instances were a corporate parent would suddenly discover one of its traders or an affiliate had amassed enormous losses. A lone rogue trader or small band of traders had put the firms’ capital at risk in all of these cases.
Derivatives are complex instruments. They need constant monitoring. The fact that most of them are over the counter (OTC) makes them less liquid and more prone to credit risk. The fact that regulators allow this market to continue to expand without some form of supervision or prevention means we will have more LTCMs. The occurrence of losses is what discourages imprudent risk taking. Essentially, the actions of regulators have done just the opposite. They have indirectly encouraged more risk taking. By bailing out one firm after another, they have introduced a moral hazard in the marketplace. By its intervention, the Fed shielded well-heeled speculators from their mistakes. This only serves to encourage more risk-taking. A case in point: after the LTCM bailout, Meriwether was back in business fifteen months later.
Under Greenspan, the Fed has joined forces with the big banks in fighting against proposals for tougher disclosure. Instead of acting as sheriff, the Fed has worked to encourage and enlarge the market. Banks have been allowed to run up their exposure without regard to their long-term consequences, knowing “Big Brother” waits in the shadows to bail them out. While government supervision and disclosure requirements have served the securities market well, it is sadly absent in derivatives market. The current disclosure and monitoring rules in the securities industry were brought about by the lessons learned from the stock market crash of 1929. Perhaps it will take another tragic event to awaken regulators from their slumber. The current misguided view is that intervention rather than prevention can solve any crisis. Maybe the Fed also believes that markets will always revert to the mean.
Lesson #4 Rogue Waves Exist
The final lesson is the occurrence of rogue waves. These exogenous events happen more frequently than mathematicians would like. In the world of derivatives, they lie at the tail end of the curve. These remote and improbable occurrences wreck havoc on the models of certainty. If there is one lesson to be learned in investment markets, it is that change is a constant. Patterns emerge, become dominant, and then are abruptly replaced by other patterns. Each pattern is independent of the other.
Rogue waves are events that nobody foresees. An archduke is shot. Bombs are dropped at Pearl Harbor. North Korean troops cross the 38th parallel. Saddam’s tanks roll into Kuwait. In the twinkling of an eye, the world changes suddenly. A crisis is born and markets are disrupted. Only in the computer-lighted rooms on Wall Street are such events considered to be a statistical aberration. They are non-events or acts of God outside the scope of reality. It is funny how often God has a way of showing up. There usually comes a day when, without warning, that rogue wave appears. On that day, random events turn into chaotic disorder. Investment patterns go off the charts. Money is made and money is lost. The difference in successfully riding the wave is one of anticipation.
The real danger in the derivatives market is that the models used to drive it are based on mathematical certainty when in fact the markets are inherently uncertain. How does one anticipate a country suddenly defaulting on its bonds, a remerging OPEC, the mind of a dictator, a madman, or a terrorist? You can’t. Markets will continue to remain uncertain. The fallacy lies in thinking they are certain. Models fail because they are based on the past. They continue to work until events change them. They fail at moments when they are needed most – when a rogue wave appears. In cash markets, rogue waves aren’t a problem. When there is no leverage, you can ride them out. You have the luxury of time to revert you back to the mean. When leverage is introduced or when positions are outsized in markets, rogue waves present problems. At its own peril, these are the lessons that Wall Street continues to ignore. |
