Kub's Den

Are the grain and livestock futures markets "efficient" markets? That is, do they accurately reflect the actual prices of the assets? Or are they prone to irrational bubbles?

The people we should really ask are Eugene Fama, Robert Shiller, and Lars Peter Hansen, but they are all probably too busy drinking champagne and planning trips to Sweden to turn their attention to the commodity markets this week.

You see, those three are the winners of the 2013 Sveriges Riksbank Prize in Economic Sciences, a.k.a. the Nobel Prize in Economics. This is exciting news for the trading world. This is not one of those years when the prize goes to macroeconomists who have described something about firms and countries and trade patterns. Rather, the 2013 prize reflects our world's very understanding of how markets work -- efficiently, irrationally, or both?

I've read their work and will do my best to apply their theories to the agricultural commodity markets these days -- and what appropriate days they are. We still don't have a funded federal government, so we still don't have updated USDA data about the actual, recorded prices and volumes of physical grain and livestock being traded around the country. We have no single, official source of these markets' intrinsic values and, without that data, we have little to which we can compare futures' prices. It's hard to confidently say whether they have all been operating efficiently these past few weeks or not.

By definition, as Fama described in his Efficient Markets Hypothesis from 1965, an efficient market has large numbers of rational traders with access to important, current, freely available information about the market. The traders all compete for profit and the result of all their rational competing -- buying and selling -- automatically brings prices into line.

Therefore, technical patterns on market charts could never happen because an overpriced or underpriced situation would always correct itself before the pattern formed. Rather, the market price takes a "random walk" above and then below the intrinsic value of the asset, with no more likelihood of being overpriced than underpriced at any given point in time.

This hypothesis also challenges the idea that fundamental analysts could ever pick stocks for a mutual fund more efficiently than a random dart throw. "Thus," Fama said, "additional fundamental analysis is of value only when the analyst has new information ... or has new insights concerning the effects of generally available information. If the analyst has neither better insights nor new information, he may as well forget about fundamental analysis and choose securities by some random selection procedure." And thus, the rise of the index fund.

To bring it back to the grain markets, we all typically share some of the same basic information (government estimates of supply and demand), and when it's "new" it's new to everyone at the same time (those darn monthly WASDE reports). But we also compete via different observations of different growing regions and changing demand perspectives. It's the power of all our observations and trading activities combined that pushes the prices toward their "correct" levels.

So even without the USDA's constant stream of prognostications, I would think our grain markets are capable of behaving efficiently. And the grain markets do have a way to confirm their own intrinsic value, to which the futures are indeed still pretty nicely in line -- the DTN Cash Grain Indexes and the DTN Market Tracker, which shows the thousands of cash bids that DTN collects throughout the country. If someone is buying physical grain at those prices, some end-user must be able to find some economic value in the product at that price.

On the other hand, Fama himself was able to identify some markets which, empirically, were not taking those efficient, random walks. And more lately, Shiller has popularized a behavioral finance approach to explain why some patterns do indeed happen and repeat. Specifically, bubbles.

One concept that really stuck with me from Shiller's most popular book, "Irrational Exuberance," was the economic theory of information cascades. This is a group behavior (i.e. herd or mob behavior) wherein humans process information based on what others are already doing, such as buying an asset, and therefore motivate more and more of the same behavior from others after them. Information cascades help explain how traders can start behaving irrationally; that is, how markets can start behaving inefficiently and forming patterns such as bubbles or crashes. As Shiller writes, "Ultimately, all such information cascade theories are theories of the failure of information about true fundamental value to be disseminated and evaluated."

Well that jibes with the internet stock market bubble and crash -- there was a lack of information and understanding about the true value of those companies -- and also with the real estate bubble and crash because in an illiquid market a true fundamental value is harder to assign. Thus, the existence of the Case-Shiller Home Price Index.

Back in the agricultural commodity markets, we've certainly experienced moments like that, even when we were all working with the same equal access to broadly distributed fundamental market information from a singular official source. I'm thinking of the Minneapolis spring wheat contract's wild ride to $24 per bushel and back down again in 2008.

More relevantly, consider the feeder cattle contracts' exuberant flailing for a price right at this moment. Futures traders' inability to identify confident selling and buying levels right now may indeed be due to a lack of information from the one source that usually sits at salebarns and records prices and volumes (intrinsic value) and then disseminates that data to the market. So in the livestock markets, we may actually be seeing honest-to-goodness market inefficiency due to the breakdown in government funding. Way to go, Washington.

These behavioral patterns are harder to describe from a concrete mathematical perspective, and that's where the third Nobel prize recipient, Lars Peter Hansen, comes in. He created a really slick statistics tool, the Generalized Method of Moments, which makes it possible to convert complex, less-than-tangible variables such as beliefs and doubts into reasonable mathematical parameters with risks and returns. With his tool he was able to confirm some of Shiller's ideas about behavioral finance. Specifically, he was able to test that volatility comes from how much risk appetite traders are feeling. The mob can misprice assets either when it's feeling too cautious or when it's overconfident and greedy.

That certainly jibes with our observations of the U.S. dollar and the commodity markets in the past several years. Any study of irrational behavior and the resulting market inefficiencies would be mathematically unpalatable (and therefore incomplete) if economists didn't have a way to empirically test such theories, so for the future of where this debate goes -- are markets rational? Irrational? Both? -- look for more statistics treatments such as Hansen's.

News media has tried to turn this 2013 Nobel Prize into an either-or proposition, calling Fama's and Shiller's ideas "contradictions," "opposites," or a "clash." Admittedly, the two men's discourse over the past decades has shown two theories butting heads. But the Nobel committee itself didn't see it that way. It said, "The laureates have laid the foundation for the current understanding of asset prices. It relies in part on fluctuations in risk and risk attitudes, and in part on behavioral biases and market frictions."

Markets seems to have both lucid moments and berserk moments, and it takes both these models to explain the whole thing. That feels correct to me. Generally, commodity prices are no more predictable by pattern analysis than the proverbial monkey throwing a dart at a chart. But when commodity markets do get wild and irrational, it's been proven that more is going on than just a "random walk." Our challenge as market participants is to figure out when the market is in a rational mood, when it's not, and then use the inefficiencies themselves to our advantage.

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Elaine Kub is the author of Mastering the Grain Markets and can be reached at elaine@masteringthegrainmarkets.com.

The risk of loss in trading futures and options on futures can be substantial. Each investor must carefully consider whether this type of investment is appropriate for them.

Fama Eugene F, 1965, "Random Walks in Stock-Market Prices," Selected Papers No. 16, 1965 Management Conference of the Graduate School of Business of the University of Chicago.

Shiller, Robert J, 2000, "Irrational Exuberance," Princeton University Press.

Reeve Trevor A, and Robert J. Vigfusson, 2011, "Evaluating the Forecasting Performance of Commodity Futures Prices," International Finance Discussion Paper No. 1025, Board of Governors of the Federal Reserve System.

(SK/CZ)

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