Obama on Bernanke - the impact on financial markets

In an interview with talk show host Charlie Rose, Obama compared Bernanke to departing FBI Director Robert Mueller, saying, "He's already stayed a lot longer than he wanted or he was supposed to."

This had the expected effect of increasing the level of uncertainty in the financial markets. This makes Chairman Bernanke a lame duck waiting to be replaced. It is hard to think about the end to QE3 or cuts in bond purchases until we know who will be taking the place of Bernanke.

Luck versus skill

Can we tell the difference between luck and skill? This is not an easy task, yet it is critical for separating good from bad managers. The worst combinations for investment decisions are cases of the poor manager who gets lucky and the good manager who get unlucky. In both of these cases, there should be mean reversion in returns which will affect portfolio performance for the negative. Lets take the simple case if you make the wrong choices of managers. In the case of a poor manager who is lucky added to a portfolio, performance will suffer as the returns move back to the longer-term true mean. The mean reversion from the good luck will lead to future lower returns. In the case of a good manager who faces bad luck, there will be under performance in the portfolio because of exclusion. The bad luck will filter out what could be a good manager. The portfolio will not get the bounce back to the true mean.

Luck creates noise in a performance numbers. There is a true distribution of returns for a manger based on his skill. The addition of luck will increase the span of the distribution. It will create error in measuring the true distribution. Over a short time period, it creates sample error. There will be greater volatility which will drop the information ratio of the manager and make him less attractive. The increase in the spread of the distribution will also mean that the sample properties may not match the true distribution. You will need more data to determine the true distribution. Luck is bad for the skill manager since it masks the true distribution of performance.

One could argue that all market participants face good and bad luck so everyone is affected the same. Other will say that skill managers can have a better chance at making good luck which makes sense at a high level but in reality is a somewhat empty comment. However, it can be put differently by asking whether some markets are more prone to luck versus others. Or, are there strategies that can reduce the impact of luck?

We can go back and look at the fundamentals of active management. We can say that more trading can reduce the chance of luck driving returns. If there are more trades, there will be a greater sample of trading behavior. Les trading means that any one trade could be lucky. Chance will be reduced if there is more activity. Of course, there is a problem that effort and work can be confused.Still, looking at trade level behavior helps to answer the luck skill problem.

Commodities in the long-run - more complex

David Jacks of Simon Fraser University has done a very good job of collecting long-run price series in commodities to explain the behavior of real prices across the last century and a half. He made some interesting observations on the differences in real prices. Those commodities which are in the ground are more likely to see long-term real price gains.There is a finite amount of these resources and they are not renewable. Hence, there is likely to be greater increases in price. For those commodity markets which are grown or renewable, there is more likely to be controlled prices or real price decreases based on new technology and the fact that higher prices will lead to more planting. The table shows that energy markets have generally seen price gains. Agricultural prices have shown declines. There are also long cycle differences in demand, for example, the oil age. Agriculture has been affected by the green revolution of technology.

Jacks also noted that the commodity cycle usually lasts about 15-20 years. The consensus form nay is that the commodity cycles are between 10-20 years, so his work is consistent with other cycle research.

Drawdowns and commodities

Commodities markets do not move together. In fact, they can move in very opposite directions. Additionally, they can move in directions that are very different than other asset classes because they will respond to different fundamentals. 

A look at the current drawdowns across many of the markets in the DJUBS index shows the significant diversity in these markets.The table below shows the markets in drawdown over the last year, two years and three years. We are looking at a set of 22 markets across metals, agriculture and energy sectors. First, currently just over 1/3 of all markets in the major index are in drawdowns of over 20%. For the two and three year period, the number of markets that are in a 20 percent drawdown are 2/3 rds of the total. Second there are some markets that have over 50% drawdowns over the last two and three years. 

Where are the drawdowns centered? None of the energy complex markets are in large drawdowns. In the agriculture markets, 5 of 11 markets are in 20% drawdowns in the last year. In the metals markets, 3 of 6 markets are in 20% drawdowns with both of the precious metals in large drawdowns. Over the longer three year period, we have the majority of metals and agricultural markets in drawdowns. the outliers are the energy markets outside of the natural gas markets which is driven by the structural changes in shale discoveries. 

This commodity price behavior is in direct contrast with the equity markets which have shown strong gains over the last three year. commodity markets will follow longer-term cycles and show more mean reversion.  Agricultural markets can go through cycles based on longer-term planting behavior by farmers. If farm income is strong from high prices, there will be continued planting until prices have an impact on farm income levels which then change farmer behavior. In the case of metals, there is a long lead time with mine development. Hence, there will long cycles in these markets as new supply comes to market and forces prices lower. Metals markets will also be affected by the business cycle. Oil price seems to follow a different pattern given the control of oil by state companies and the strong surges in demand from the emerging markets. The energy sector cannot be viewed as a long-term storable commodity markets.

The drawdown analysis suggests that commodity markets have to be viewed as very independent and cannot be grouped together in the same way that is seen in other asset classes like equities or fixed income.

Drawdowns	1 year		2 year		3-year
silver	-38.59%	coffee	-58.71%	coffee	-61.49%
coffee	-36.19%	silver	-50.58%	silver	-55.87%
sugar	-31.85%	natural gas	-45.17%	natural gas	-54.97%
wheat	-27.91%	sugar	-44.25%	cotton	-53.17%
KC wheat	-25.77%	nickel	-42.88%	nickel	-51.22%
gold	-23.68%	cotton	-39.46%	sugar	-45.06%
nickel	-23.19%	aluminum	-36.17%	wheat	-39.37%
corn	-22.38%	zinc	-31.20%	aluminum	-38.64%
		KC wheat	-30.83%	KC wheat	-36.47%
		wheat	-28.64%	zinc	-34.75%
		copper	-28.62%	copper	-31.07%
		gold	-28.05%	gold	-28.05%
		soybean oil	-24.96%	soybean oil	-27.12%
		corn	-22.38%	corn	-22.38%
	36.4%		63.6%		63.6%