Materials Risk

Fears of Chinese export cuts has sent the price of many rare earth metals up sharply in recent weeks and the share price of miners digging for the metals soaring. Its worth remembering that we have been here before. Back in 2010 China cut exports following a spat with Japan. What follows is an extract from my book, Crude Forecasts: Predictions, Pundits & Profits in the Commodity Casino

In 2010, Molycorp sensed an opportunity to capitalise on the high prices for REMs that had resulted from the cut in Chinese exports. The company’s Mountain Pass mine was expected to be America’s flagship source for REMs. The economics of Mountain Pass were built on extraordinarily rosy expectations of future prices. The Molycorp share prospectus included an assessment of current and future demand and supply for REMs and the implication for prices. Even accounting for the Mountain Pass facility starting production, prices for many of the metals were forecast to rise by 20–50% between 2010 and 2014, with prices forecast to double through to 2030. Nowhere in the prospectus was there any mention of the downside risks to prices, except this one line caveat in the footnote to the price forecast table, “that there will be no major changes to China’s rare earth strategy and no new application(s) that will have a material impact on demand.”

What concerns me looking at the prospectus, and should also have concerned any prospective investor at the time, is that there was no attempt to quantify the risks that the REMs market presented. No thought into whether substitute sources of REMs would be developed and no thought into whether the high prices would encourage manufacturers to substitute REMs with some other much cheaper product or at least reduce the amount they required.

Were investors emboldened by the stratospheric and parabolic price of REMs and the story that the demand for REMs would continue to grow sharply due to growth in demand from defence and the tech industry? Maybe. Did they think that China would continue to restrict supply indefinitely? Maybe. However, a cursory look at the history of other commodity markets should have given enough evidence to suggest that what goes up, inevitably goes down, eventually.

After REMs prices fell sharply post-2011, and due to the high level of investment required, Molycorp was eventually forced into bankruptcy. Investors in Molycorp were by no means the only suckers to fall for parabolic price increases as a trend. According to Chris Berry, many other REM mining companies were using three year trailing averages to justify their expectations of future prices. These price expectations then enabled what should have been a marginal project to get a valuation of over a billion dollars, and enabled many funds to be raised.

To an extent, it’s all about incentives, especially when it comes to early stage mining or exploration companies. In the early stages, running one of these companies is often more about salesmanship – convincing others to invest in your ideas – than geology. Executives spend all their time looking for financial resources, rather than those in the ground. And here there is the incentive to present the best possible story of how the future – prices, in particular – may pan out.

One final word from Chris Berry on the dangers to investors: “Beware narratives of limitless demand and limited supply which is nonsense junior mining companies excel in propagating. Any supply shocks will usually be met by some combination of recycling, thrifting, or technological advancement which displaces these unique materials.”

The ability to form accurate beliefs about what is happening in our world is key to our success as citizens, consumers, and of course as investors. Still, our ability to form and update beliefs sometimes goes badly wrong.

Misinformation and fake news has been getting plenty of attention following the election of President Trump. The impact stretches much wider. It affects political developments elsewhere in the world and matters a great deal in commodity and other financial markets.

Fake news is completely made up and designed to deceive readers to maximise traffic and profit. But the definition is often expanded to include websites that circulate distorted, decontextualised or dubious information that doesn’t reflect the facts of the story, or undeclared bias.

There is nothing new about fake news. Elaborate hoaxes designed to sell newspapers emerged in the US press in the 19th century. In 1874 The New York Herald gave an account of a bloody escape of wild animals from the Central Park Zoo. The article reassured readers by wrapping up with: “Of course the entire story given above is a pure fabrication.”

High quality media outlets compete to provide high quality journalism, fast. They also face a reputation cost and so invest resources to ensure they are perceived as high quality.

Producers of completely fabricated news are different. They have no need to make any investment in ensuring that their reporting is accurate. All they need is a vivid imagination. Unlike the story of wild animals escaping from Central Park Zoo modern fake news doesn’t tend to come with the same footnote warning of its fabrication!

Media consumers cannot always distinguish between high and low quality media providers. Articles are often tailored to pull on the readers psychological utility – whether that is political bias, fear or greed related to the markets or pure entertainment.

The motive behind most fake news is to cause a spike in web traffic and capture the resulting advertising clicks. The motive behind fake financial media could be to ‘pump-and-dump’. Build up a position, spread fake news that is likely to spike the price, and then sell into it.

The motives behind fake news may be much more nefarious than increasing traffic to a website and moving the price of assets. To sway the direction of elections, cement the power of those in position of power, and to destabilise those who others wish to weaken. The first casualty in war is usually the truth with the first skirmishes often used to justify use of greater force in retaliation.

That leads us to the events of 12th May. On that Sunday reports began to emerge of explosions from four crude oil tankers near the port of Fujairah in the UAE. Initially reported by websites with a reputation for spreading propaganda and then by other media networks in the region.

Conflicting reports began to emerge of what happened. While the port authorities in Fujairah denied the reports, UAE authorities disagreed, suggesting that there had indeed been sabotage. Reports from Saudi Arabia meanwhile indicated that two of the vessels were Saudi.

‘Officials’ from the US and neighbouring countries were quick to blame the attacks on Iran. Headlines around the world proclaimed that Iran was behind the attack. Eyewitnesses reported seeing huge explosions. Brent crude prices jumped over a dollar to over $72 per barrel when markets opened on the Monday morning.

Despite the uproar there was little or no evidence to support any of the claims. The most telling of all was satellite footage of the area which showed zero sign of any explosion. Samir Madani from Tanker Trackers picked up the story, outlining the evidence – or lack thereof. Check out Samir’s summary from 12:30 below.

Propaganda has always been a tool for political powers to bend the consent of the people to their will. That will never change. Yet the events of 12th May offer an important lesson in how participants (whether active or passive) should react to events which could have wide ranging political consequences. One that we should all be very careful to guard against.

An increase in the supply of fake news has a detrimental impact on the supply of legitimate news. The economist George Akerlof illustrated how a dodgy used car market can infect the market for well functioning cars. The same can happen in the market for news. In a market where buyers have imperfect information (your typical trader or investor), while sellers possess a profit motive the markets tend to be thin, insubstantial and poor quality. Investors could then become more sceptical of every piece of news.

This is exactly what a recent study by Yale University found. Researchers examined the financial markets reaction to fake news published on crowd sourced financial media platforms Seeking Alpha and the Motley Fool. The revelation of the existence of fake news resulted in an immediate decrease in the markets reaction to all news published on social media platforms, even if it was a legitimate report. Encouragingly they found that trading activity didn’t decline in response to news published by authoritative sources.

So what are some of the ways that you can increase your chances of spotting misinformation and fake news on “FinTwit”, other social media and in the mainstream financial market media?

• Find out about the source: Look at the website where the story comes from. Is the story well-presented? Are the images clear? Is it well written without any spelling errors or exaggerated language (e.g. capitalised text)? If you’re not sure, try clicking on the “about us” section, and check that there’s a clear outline explaining the work of the organisation and its history.

• Look at the author: To check if they are real, reliable and “trustworthy”, look for other pieces they have written and what outlets they have written for. If they haven’t written anything else, or if they write for websites that look unreliable, think twice about believing what they say.

• Check for linguistic traits associated with honesty: Truth-tellers tend to use more self-reference words and use longer sentences compared to liars. When people lie, they tend to distance themselves from the story by using fewer “I” or “me” words. Liars use fewer insight words such as realise, understand, and think, and include less specific information about time and space. Liars also tend to use more discrepancy verbs, like could, that assert that an event might have occurred.

• Check for references: Authoritative articles should link to other news stories, articles and authors. Click on the links and check if they seem reliable and trustworthy. Reports of an official or an anonymous source could, and probably are made up.

• Check the dates: Have the articles been edited or changed in some way? The emphasis of a story may change significantly from how it was originally published. This doesn’t necessarily mean that it is false, but it could mean that you should be cautious about the motives of the media outlet.

• Do a Google Reverse Image Search: Check to see all the other web pages that have similar images. This then tells you the other sites where the images have been used – and if they’ve been used out of context. Beware that some websites may use old photos as evidence.

• Social media check: Look up the source on Facebook or Twitter. Do they use misleading, sensational or provocative language? If yes it may mean they have exaggerated the ‘truth’ in the story.

• Trust, but verify: You will find plenty of honest, hardworking experts on Twitter trying to uncover the truth and share it with the wider world. Unfortunately, you also find people that look to spread misinformation and propaganda too. So be careful who you trust.

• Check if the story is being shared on any other mainstream news outlets: If it is, then you can feel more secure that the story is not fake news. Organisations such as the BBC take special care to check their sources and very rarely publish a story without having a second source to back it up. Although everyone makes mistakes sometimes.

• If you have any doubts about the credibility of a story there is something you can do about it. Don’t share it: By sharing it you automatically give it a wider audience, but you also lend it a little extra credibility.

Let me tell you the story about three economists from history. These three men stand out as having the distinction of writing erudite works on economic theories while also amassing a fortune (and for some then losing it). Each of them has their own lessons in how to be a great investor, and why some but not all economists fail at investing.

1.David Ricardo

When David Ricardo started out in business at the age of 21, his property base amounted to £800. By the time he died in 1823, a mere thirty years later, his estate was worth an unimaginable £675,000 to £775,000, from which he enjoyed a yearly income of £28,000. No other economist has reached this level of affluence.

Ricardo made most of his money early on as an arbitrager of government debt. Nevertheless, historians have debated the extent to which Ricardo profited from insider dealings and stock manipulations. Ricardo never wrote down his trading techniques, but business associates said that he held scrupulously to his two “golden rules”: “Cut short your losses” and “Let your profits run on.”

Ricardo’s budding financial career took a gigantic leap forward when he began bid-ding as a loan contractor for the government. During the Napoleonic wars in the early 1800s, the government relied on the Stock Exchange to finance its burgeoning expen-ditures. The successful bidders received a special bonus from the chancellor of the exchequer. Ricardo and company were so successful in their bidding that they obtained every government loan during the war years of 1811 through 1815.

The last and biggest loan of the war (worth £36 million) was raised on June 14, 1815, just four days before the Battle of Waterloo. The price of the bonds was extremely depressed because of the size of the loan and the uncertainty of the outcome of the war. There were four bidders for the loan contract, but Ricardo’s firm won.

Ricardo bravely held onto his position in the deeply depressed bonds, his biggest gamble ever. Other more timid investors sold early, before the Battle of Waterloo but not Ricardo. After the news arrived that Wellington had won the battle against Napoleon the government consols sky-rocketed and Ricardo became an instant millionaire. The Sunday Times reported in Ricardo’s obituary (September 14, 1823) a popular rumor that during the Battle of Waterloo Ricardo had “netted upwards of a million sterling”.

Ricardo fell short of being counted as one of Britain’s 179 millionaire, but was one of the 338 who had at least half a million pounds. It was then almost by chance that Ricardo turned his attention to economics eventually developing a theory of comparative advantage and cementing his place as the father of international trade.

Lessons for investors:

-Cut short your losses and let your profits run on.

-Stick to those areas where you know the knowable. Although it can be argued that Ricardo profited from insider dealing he stuck to the area that he had an edge.

2. Irving Fisher

Fisher invested heavily in the stock market during the 1920’s favouring start-ups with innovative products. To juice his returns he borrowed heavily in order to leverage his capital. As the market carried on rising he accumulated $10 million. The danger of course with leverage is that it also works in reverse, multiplying your losses when the market falls. In 1929 when the stock market crashed Fisher was brought to financial ruin.

In October 1929, shortly before the crash Fisher declared that the stock market had reached a ‘permanently high plateau’. In the weeks after the crash he told an audience at the National Association of Credit Men that he believed nothing fundamental had changed at that they should ride out the storm in the markets.

The irony was that Fisher had pioneered the development of economic data (The Index Number Institute published weekly and monthly economic indicators), and so would have been well placed to observe the imbalances and vulnerabilities building up in the economy.

After his death the net value of his estate was estimated at just $60,000.

Lessons for investors:

-Avoid confirmation bias. Fisher wrote extensively in the build-up to the crash in support of rising markets. He was a proud man and hated to be proved wrong. You could argue that his sense of self was so wrapped up in rising markets that to sell out would have (in behavioural economics speak) given him cognitive dissonance.

-Understand your motivations. Fisher was constantly trying to amass a large fortune to prove his worth.

-Data by itself doesn’t mean you are a better investor.

3. John Maynard Keynes

Keynes, like Ricardo and Fisher before him was an investor. In 1936 he was worth over £500,000, he then nearly went bankrupt in the 1937–38 recession having been heavily leveraged. At his death in 1946 he had an investment portfolio of £400,000.

His observations of speculators prompted him to shape his famous ‘animal spirits’ description of investors. He defined animal spirits as ‘a spontaneous urge to action rather than inaction and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities’.

This framed his view of investors:

“Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that teach competitor has to pick not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgement are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligence’s to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”

Lessons for investors:

-Investment is not just about interpreting the data, its about interpreting how every other investor interprets the data and how every investor responds to the actions of other investors.