1. James August 18, 2008 @ 3:00 pm

    i agree that the concept of supply and demand will only determine the price of goods in a society where the government does not meddle with any activity that should affect the economy… very insightful piece…

  2. Sumit Ojha August 25, 2008 @ 3:45 am

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  3. TigerTom September 2, 2008 @ 2:25 pm

    Two words: herd behaviour.

Why fundamental analysis of commodities is wrong, and irrational

Economics Comments (3)

I have discussed in several articles my position that gold is just another commodity subject to the ebb and flow of speculative money. Today I will talk a little bit about oil and why I think all the fundamental analysis are fundamentally wrong.

If I write that we are experiencing peak oil price rather than peak oil, hordes of very smart people will crush my humble argument with tons of data. That’s fine and dandy, and wrong.

Back in 2004/2005 I would argue with friends that the real estate market in Florida was over-inflated and a correction was more likely than the continuous rise in prices. They would argue back that the Florida population was growing rapidly, that people prefer to live near the sea and that the room for real estate development in Florida is limited. All very valid points, and all wrong.

Today, if I make the argument that oil is over-inflated, very smart people will get back at me with figures of barrels of oil being extracted, increase in oil demand with flat supply, peak oil and many other very valid arguments. Very wrong arguments.

The problem is not with the arguments. The problem is that the economic theory in which fundamental analysis is based is wrong. The theory of supply and demand is only valid in either an idealized capitalist society or in the small production society analyzed by Adam Smith. Again, for the price of goods to be related to supply and demand you need a capitalist laissez-faire society with very little or no government intervention. That’s hardly the case of the capitalist society post WWI.

Starting with the creation of money and credit, to the environmental regulations, to the labor regulations, the price of goods is completely divorced from the supply and demand equation. Supply side economics, does not answer to this issue but in actuality implies more government intervention in the economic affairs of the people.

If we focus our attention on the flow of money, supply side economics (the theoretic basis for the tax cuts) aims to create liquidity by reducing the amount of money the government takes from certain social actors. No matter that it never worked, what’s more important is that direct government intervention in the supply of money is incompatible with prices based on supply and demand. The basic issue being that excessive supply of money will create an increase in prices regardless of the needs for the goods. Too much money will go after the same amount of goods.

The solution for this is to create an idyllic capitalist society with little or no government intervention and a supply of money based on the productive capacity of the nation (the gold standard was one of the solutions, not the only one). No that there weren’t gold deflations and gold inflations compared with other commodities, and that during the gold standard era the economy was marked for deep cycles of boom and bust (but the gold bugs will never let reality interfere with their ideas).

For supply and demand to work, you need free markets and the global markets are anything but free. Without going too deep, the oil, gold and money markets are in the hands of a group of institutions and companies small enough as to constitute a de-facto monopoly. The only way a monopoly would not exist, is if it were possible for new players to enter the market with competitive products. Since it is impossible today to go somewhere with a shovel and a donkey and produce gold or oil in enough quantities as to affect the price, there is an effective monopoly, whether or not collusion can be proven (which will be).

The other incorrect idea behind fundamental analysis is the efficient markets hypothesis. No matter that the efficient markets hypothesis was proven wrong by the practitioners of value investing, it is still prevalent on the social consciousness. By the way, value investing still uses fundamental analysis.

So, how can the fundamental analysis of the price of commodities be correct when the two theories in which are based are wrong? The answer is, it is not. Fundamental analysis is a rationalization of feelings, nothing more, nothing else. It works well for fund managers when they are right, because they have a good story to tell prospective customers, but it is just that, a story.

When more and more influential people start believing the story, it reinforces the believe by a process of self-fulfillment. The result is that at some point, the returns on the investment start turning negative compared to the cost of the leverage and the players have to exit, producing an avalanche in prices. Scientifically timing the top of a market is difficult and I am not saying that we have seen the top yet. There are only two things I can be certain of right now: we are closer to the top than to the bottom and when the top is in place we will see loses that exceed 50% from the top.

Franklin @ July 30, 2008

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