Speculating Like an Economist

Methods for Analyzing and Making Sound Predictive Hypotheses in Commodity Markets

In these turbulent financial times, I have had a considerable number of friends and family ask for my advice on speculating, investing and general financial tactics. I have intensely studied the field of economics for nearly a decade, since I was 14, and through the power of social media, (and the Praxis community), I have become connected to several professional economists, esteemed economics professors, and financiers. Because of all this, I seem to possess very particular knowledge on navigating financial markets. I have decided to explain everything I know over the course of several articles, and my goal is to be as transparent and understandable as possible.

In this article, I will explain why I like investing/speculating in commodity markets, and the tools that can help you make predictive hypotheses about these markets. I will also share a few timeless principles that every investor should keep close to heart. This article is best suited for those who have the time to rigorously analyze charts, data, and news articles to make very specific investments — this can be more risky than say… investing in an index of assets, where you’re more protected by diversity, but it also has the major benefit of generating much greater returns.

Also understand that I would never advocate investing or speculating in anything risky. I don’t put my money anywhere until I am quite certain I’m right. It is because of that personal code that I don’t actually speculate often, and I don’t believe you should either.

Timeless Principles

Let me first start by sharing a few timeless principles that every investor will benefit from:

1. Invest in what you know. You should have some understanding of what you’re putting your money into. You will have the best chances of success in the markets you’re closest to or have the greatest knowledge of… If you have worked your whole adult life at a grocery store, you may notice that in some parts of the year, the prices of certain goods are higher than in other parts of the year; this is knowledge you can take advantage of. Or maybe you have a particular understanding of how tech businesses function, in that case, you would have greater chances of making sound investments in tech businesses. There’s money to be made in every part of the market. Specific knowledge is what means most in this game.
2. Buy stocks how you buy your groceries. This is likely one of the greatest and most underappreciated gems of wisdom in finance, and it comes from the great Benjamin Graham himself. Buy low, sell high, is always the point of this game. Many people, especially when they’re new to finance, tend to stuff their money in the most popular companies — the companies that have already done well. (Amazon, Facebook, Netflix, Google, etc.) Sure, these companies have done well, but consider the following thought experiment… Let’s assume Amazon has a price of $150, and any of the best-performing stocks in Brazil have a price of $1, (Amazon is such an expensive stock that this is a fairly accurate analogy). Now, what is more likely to happen over the next 10 years? Amazon goes from $150 to $300? Or that any of the best-performing stocks in Brazil goes from $1 to $2? Both are a 100% increase, but it’s far more likely for a quality, cheap stock to exponentially gain value compared to an expensive stock, whose prices are less sustainable. And it’s simply easier for a stock price to traverse the gap of $1 rather than $150. Cheaper stocks can also be more advantageous in that you can buy a higher number of shares, potentially increasing your overall return. In the same way that you buy your groceries, you’re looking for deals, not luxury.
3. Think in periods of 10 years. It is very hard to predict how the market will perform tomorrow, but if you think about it, it’s actually not so hard imagine what the world might look like 10 years from now. I can’t predict how Tesla will do over the next year period, but there’s a very good chance electric cars will be more widespread, much cheaper, and more practical 10 years from now.

Commodity Speculating vs Traditional Business Speculating

Although I believe there’s nothing inherently wrong with traditional business stocks, I think commodity assets have three major benefits. It’s generally easier to predict commodity prices, I believe they can, in certain circumstances, be safer, and you can potentially make greater returns. My personal reason for investing in commodities is simply because I have a better understanding of this game, but as I will explain soon, this game is surprisingly straightforward. There is another point that I will quickly address here. At the moment I am writing this, December 2018, the market is poised to …and there is no polite way to put this… collapse anytime soon. I have written for years about this coming financial storm and I will not spend more time here talking about it. Commodity investments don’t react to recessions the same way that traditional business investments do; they tend to be more predictable. There are some commodities, particularly the precious metals, that nearly always do very well during economic downturns, and other commodities that tend to do very badly in economic downturns, oftentimes oil. For this reason, I think learning how to trade commodities is a great skill to have for defensive investing as well.

I should probably explain exactly what commodities are. Commodities are the raw materials that make up all the products in any business produce. From lumber to aluminum to neodymium magnets, these things are so necessary to functioning society that they have some inherent value, sometimes called the intrinsic value. Now there is some debate of whether the idea of intrinsic value is even a sound concept, and there is some merit to those arguments. But the simple, practical fact of the matter is this: commodities are far less likely to go to 0 than a business is. Businesses fail all the time, but there is always demand for raw materials. Even lead, despite it being discovered that there is no safe threshold for human lead exposure in the 1970s, still reached all-time highs in 2007. Lead still has a vast array of practical uses, such as automobile manufacturing and weightlifting. On the contrast, the businesses that were found using lead in unsafe manners, the vast majority of them do not exist any longer.

Update January 1st, 2019

I should add this disclaimer: commodity markets behave differently to business stocks. There are some business stocks that you can invest your money in, never touch it again, and in 30 years, you’ve made a substantial return. Commodities tend to have cycles of 8–10 years, so although commodities are more predictable, your traditional business stock investment may be a better long-term strategy. And there’s nothing wrong with using both strategies.

I also believe that commodity trading is, in general, easier. When investing in a business, I really have to do my homework. I need to research their management, their business model, analyze their balance sheet and contrast it with their competitors, compare P/E ratios, etc. When investing in commodities, I only need to know two things: is there too much of it, or too little of it? Supply and demand. If I can find an answer to that question, I know where the price is going to go. Of course, answering that question is often easier said than done — you’re not always going to get a clear answer, or the right answer, but at least you only have to answer one question.

Making Sound Hypotheses

Let me walk you through an example of how you can make sound hypotheses for commodity prices. Earlier this year, I was browsing through COT charts, (Commitments of Traders Chart), and I noticed something strange about coffee.

You can check out more COT charts are barchart.com

A COT chart graphs who is buying what asset. This above COT chart screenshot was taken in February earlier this year. It is divided into three rows: the large, main row is the price of coffee, the second and third rows break down what kind of groups have positions in coffee. The word position here means what kind of investment they have in the asset, either long, (for long-term value investment), or short (for the various kinds of short-selling — the people who believe the price will decline and want to capitalize on that decline). Take a look at the legend of the second row, positions are divided into three groups: large speculators, small speculators, and commercial speculators. And then, in the bottom row, you will see positions are divided into four groups: producers, swap dealers, managed money, and other.

There’s a good bit of information here to digest, but I put the vast majority of my focus on the green line of the second row, the large speculators. These are the people who really move markets — the fat cats who can single-handedly cause a low or high day. It’s also wise to assume that these large speculators have better knowledge than you do, they’re likely closer to the problems of these industries and have access to much better information. This is not to say that you should blindly follow the green line, these large speculators can afford to lose a lot of money; you can’t.

You’ll notice that the red line, the commercial speculators, is almost always in the direct opposition of the large speculator. These commercials tend to have an interest in the price staying the same, or at the very least, not becoming too volatile — in this case, they are likely producers of coffee themselves, and they want to hedge against large speculators influencing their prices. The large speculators tend to win these battles, they account for about 70–90% of open interests in the futures market. For learning more about COT charts in better detail, here’s a great resource.

In February, I noticed that the large speculators had shortened their positions dramatically. On further investigation, I found that their positions were the lowest in 20 years. The following is the same graph from above, from the same time, simply zoomed out to see a 20 year period. Notice the green line down by -50,000.

This was very strong evidence that the price of coffee was going to fall. Obviously, the large speculators found reason something was going to crash the market, and they moved their positions accordingly. Upon further investigation, I found a vast array of articles outlining an extreme surplus in coffee. And sure enough, over the past year, coffee has suffered an -18% decline in futures prices. I took a screenshot of the following chart just a few days ago.

Now you’ll notice that last little jump near the end of September. This is likely an example of what’s known in the trading world as a dead-cat bounce. In markets that are declining heavily, there’s often what looks like a last hoorah, and there may even be several of these spikes. These are likely the short sellers who are covering their shorts. Here’s a great resource that explains how short selling works. It’s good to know how short-selling works, but be careful — short-selling has unlimited risk because the price of an asset can theoretically go upwards forever. Making a bad short sale could mean disaster.

Now obviously this is powerful information, but what’s the best way to capitalize on it? When I’m looking to invest, I scout out low prices. The name of the game is always to buy low, sell high. For virtually every commodity, there’s an ETF that tracks its price and you can trade ETFs just like a stock. For coffee, the major ETF is JO. Sometimes there are businesses that deal directly with the production of raw materials, and those stocks tend to trade in direct relation to the price of the commodity they produce. Gold mining stocks are a good example of this relationship. In coffee’s case, this would be good information for companies like Starbucks, who would profit from low coffee prices, (and seemingly have).

Although I have mentioned coffee a great deal in this article, I’m only halfway sold on buying into it myself. I’m not so sure how it’s going to do over the next decade. But this was an example of the market clearly making sense, and it looked like a potential trading opportunity.

At the moment, what has my attention the most is, oddly enough, uranium. Now I don’t know much about uranium compared to other commodities, but I plan to dive much farther into it. Unfortunately, I cannot find a COT chart for uranium, but the price is fairly low at the moment. From what I’m reading from several articles, the price is not sustainable, especially with the potential for a uranium tariff by the Trump administration. (Commodities, in general, are poised to rise with these new Chinese tariffs; China is the largest producer of raw materials by a large margin). If I were to get into uranium, and it seems like I might, I would likely invest in Cameco Corp (CCJ), which seems to track the price of uranium pretty well. Again, I like to know I’m right before I do anything; I purposefully make it a slow process.

So in short, the signs I tend to look for are in a potentially profitable commodity investment are:

1. Suspiciously low prices.
2. Evidence that those low prices aren’t sustainable.
3. Ability to easily invest in an asset that clearly tracks the price of a specific commodity, and in a way that I have sufficient control, (ETFs, closely related businesses, or being able to buy the commodity itself — for example, I do this with gold & silver).

When to Get Out

Equally important is when you should decide to get out of a trade. My general rule of thumb is to cut your losses quickly. However, don’t take this too literally. The general consensus in finance is that when you’re negative, you should just wait it out, the market will always go back up eventually. That’s not the case with commodities, and it’s not even really the case for traditional business investments either. The US stock market saw a 16-year bear market after the 1973 collapse. So use sound judgment here, if you have reason to believe that an asset will rise in price, but it may take a decade, wait it out. But if you’re overall prediction seems to be failing, and your position is clearly not making money, cut the losses. What you should absolutely not do is fall victim to the sunk cost fallacy.

Another general thing to look out for is a mania. Mania’s are easy to spot. The general rule of thumb: when the average person, someone who has no prior investment experience, upon seeing how well an investment is doing makes it known that they’re interested in investing in that asset, it’s time to get out. When it becomes popular, that’s it, that’s almost always the end.

I hope you enjoyed this article. I’d like to hear what you have to say. Feel free to comment and I will happily take time to address your questions, concerns, and criticisms. I am planning to write an article on more passive investments very soon.