Materials Risk

In markets, we often hear of these precise levels, beyond which everything is said to unravel.  The so-called “psychologically important level” or “breaking point.” Their allure is undeniable. If these levels could be relied on then one could fully prepare for it in advance, exiting unscathed before the stampede of the masses.

The power of belief goes some way in explaining why these levels appear to exist. Jonathan Kingsman, in his book “The Sugar Casino”, argues that although individual human beings are irrational and emotional, group behaviour becomes repeatable and predictable. Humans use their experiences of past events to show them how to react to current ones. With enough technical traders with sufficient collective experience of the market, you might get repeatable price patterns.

One argument against relying on these levels and the broader field of technical analysis rests on what its based on – the price. It’s especially hard to put a price on an asset that doesn’t produce income. It’s hard to say what the right price is for a commodity like oil and, thus, when the price is too high or too low. Was it too high at $100-plus? Was it an unsustainable blip? History says “no”: it was that price for 43 consecutive months leading to August 2014. And if it wasn’t too high then, is it too low today? The answer is that you can’t say. Ditto for whether the response of the price of oil to the changes in fundamentals has been appropriate, excessive or insufficient. And if you can’t be confident about what the right price is now, then you can’t be definite about whether the price was correct six months ago, a year ago or ten years ago.

Much as we are told that markets always reflect the collective demand and supply of a particular asset, that isn’t actually true, at least not all of the time. Markets much like wider society are arenas in which the most motivated participant is omnipotent. And this is especially important during periods of sharp reversals or periods of price congestion followed by a break-out.

Psychologically important levels do exist. The question is always do those same levels still exist now? The motivated buyer or seller that drove the price action at that last price level may not be as motivated anymore, he or she may not even be in the market anymore!

This is why positioning analysis is so important. It can offer insights into whose done what in the past, and what happened when they did too much of it and how much positioning then relates to other factors like price, curve structure and fundamentals.

Related article: Positioning analysis in commodity markets: An interview with Mark Keenan

At first sight the confluence of major market peaks, extreme but apparently unrelated events followed by subsequent market reversals may seem like just a coincidence. Often though the best contrarian indicators in financial markets are those that are either completely ignored or ridiculed.

Peter Atwater of the research firm Financial Insyghts offers some compelling examples of recent instances where confidence in the markets is at extremes and the timing has been reflected by desperate acts. Atwater believes that when our mood is high, we take bold chances, underestimating risks and discounting all potentially negative consequences.

The first of two recent examples Peter gives are earlier this year when former Russian spy, Sergei Skripal, was nearly assassinated — investigators suggested that his poisoning was the work of the Russian government. This coincided with multi-year highs in the Russian stock-market.

The second example came just days after Brent crude prices also hit a multiyear high. This time Jamal Khashoggi was killed in the Saudi Arabian consulate in Turkey.

Its not just Atwater that believes that broader confidence in the world around us affects behaviour. Back in May 2011, writing for the “The Socionomist, Mark Galasiewski shared:

The assassination of al-Qaeda head Osama bin Laden on May 1, 2011 was a result of the cooperation and success accommodated by the positive social mood trend underlying the global stock market advance since 2009. Bin Laden had been fighting two inverse trends: the increasing commitment of the intelligence analysts pursuing him and the decreasing commitment of his own followers. The increasingly positive social mood behind the stock market advance encouraged those trying to find bin Laden, while the waning negative mood deprived him of many of his traditional sources of support, thereby undermining his security.

These extreme events also relate to the common knowledge game. The basic idea is that there is private, public and common knowledge. Private knowledge as it suggests is what only a small sample of people know about something. Public knowledge is when everyone knows it. Common knowledge is public knowledge with a twist. Common knowledge is when everyone knows that everyone else knows.

This concept is central to game theory but once you understand it you see it in all aspects of our lives from financial markets to celebrity scandals. For knowledge to make the transition from public to common you typically need a mouthpiece (the media for example) or an event that pushes it into the public consciousness so that no one can be in any doubt that everyone else now knows it too.

Why does this relate to the over-confidence brought on by financial markets given in the examples above? Well, emboldened by the notion that “this time is different” the chief protagonists push things too far, make a mistake, talk to the wrong person.

As sentiment becomes stretched sophisticated investors on the other side of the market look for evidence of a shift. The common knowledge game illustrates how that shift can take on a life of its own — everyone now knows that everyone else knows that sentiment is extreme, and markets start to reverse.

For investors these mood connections are critical to understanding the world around us. Extreme events suggest extreme sentiment, cautioning that a major trend reversal is likely.

Also published on Medium

First observed in the 19th century by Peruvian fishermen, the recurring weather phenomenon is known to affect Australasia as well South America. Its climatic effects can reach as far as West Africa triggering downpours or droughts. Previous episodes have had a significant impact on crop yields and the price of agricultural commodities as well as metal and energy prices.

El Niño events tend to develop between April and June and reach their maximum strength during December and February. According to Columbia University conditions usually persist for 9-12 months, but can occasionally last for up to two years.

Two factors, in addition to its severity, will influence the impact that El Niño will have on crop yields and prices. The first is the timing of El Niño event. The impact of which will vary depending on what stage of a crop’s lifecycle (e.g. sowing, growing, harvesting) it occurs at. As the two maps below illustrate the impact of El Niño varies considerably depending on whether it occurs during the summer or winter months (see maps below). The current outlook suggests that if it does occur El Niño will reach its maximum strength towards the end of 2017 – figure 2 below.

The second factor that determines the degree to which commodity prices are affected by El Niño is the degree of geographic production concentration. Some crops, like palm oil, are grown in one specific region whereas others are grown globally. The main commodities to be affected by El Niño are typically those ‘softs’ that are located around the tropical regions.

Coffee – The warm weather that El Niño brings in June to August aids the Arabica coffee harvest as the crop solidifies and warmer weather protects against the spread of the roya fungus (which thrives in wetter conditions). However, drier El Niño weather in December to February may have negative impacts on the next Arabica crop, helping to support coffee prices as the event continues.

Cocoa – Cocoa output has been volatile regardless of El Niño due to the majority of its production occurring in west Africa which has geopolitical, funding and energy issues.

Palm oil / soybeans – This is perhaps the crop with the biggest exposure to El Niño on account of 90% of production occurring in Indonesia and Malaysia. Whilst palm oil plants are fairly resilient during an event, dry weather tends to impact production growth and yield trends in the following 12 months. Though any increase in palm oil prices tends to be capped by increased soybean production, as palm oil is substituted by soy oil.

Sugar – El Niño’s impacts on sugar production are greatest when it brings too much rain to Brazil and drought to India (which, together, produce 38% of the world’s sugar). India’s sugar production is for its domestic market as it has the highest per capita sugar consumption in the world (consuming 15% of the world’s sugar). In Brazil, El Niño means fewer days for crushing and causes lower sugar content in the cane as the wet conditions cause the plant to store less sugar.

Perhaps surprisingly though the commodity that has typically seen the biggest impact on price during the 20 year period to 2015 has been nickel. This has been because dry weather in Indonesia lowered the water levels in canals, preventing the metal from being exported.

Other metals may also be impacted by the arrival of adverse weather. In Peru for example heavy rains have flooded zinc mines in the past triggering price spikes. Gold demand may also be hit if a weak monsoon results in a poor harvest. Indian farmers are large buyers of gold and so any fall in their incomes could hit purchases of the precious metal.

Globalisation of markets and trade should, all else being equal, diminish the impact of any region-specific decline in output. For this reason grains such as wheat and corn tend not to see a significant weather related impact on yields from El Niño. That being said, regional weather conditions may still result in prices responding violently to a perceived or actual threat to output.