-- John Kemp is a Reuters market analyst. The views expressed are his own --
By John Kemp
LONDON (Reuters) - Inexperienced “noise” traders who follow the herd, over-react to data, and lack the financial strength and understanding to stay the course during corrections have been blamed for rising volatility in commodities.
Recent crashes in silver, crude and gasoline that seem to lack any grounding in fundamental supply and demand factors have all been blamed on naive investors who lack the financial strength to hold a position through a drawdown and stampeded for the exit at the first sign of trouble.
Perhaps the best example was the 8 percent slide in U.S. gasoline futures on May 11 after the Energy Information Administration announced gasoline stockpiles had risen 1.3 million barrels.
The stock build was enough to trigger a trading halt and caused a sharp dive in prices for crude and diesel. Yet the rise amounted to just 0.6 percent of gasoline in storage. It came after stocks had fallen more than 36.5 million barrels (15.2 percent) in a string of 11 consecutive weekly draws, pushing them down to the lowest seasonal level since 2006.
Was that a rational response to signs of a trend reversal, or an irrational over-reaction to a single data point that failed to see the bigger picture?
Supporters of the efficient markets approach tend to divide market participants into (1) professional insiders (who make rational decisions based on a deep understanding of fundamentals); and (2) noise traders (outsiders with little understanding who misinterpret data, over-react to news, are overly influenced by others and prone to herding).
In this view, smart money insiders make profits at the expense of dumb money outsiders.
Dividing the market into smart money and noise traders has been popular following the crashes (no one was making this point when prices were going up). Glencore chief Ivan Glasenberg described the events of the last few sessions as “froth”. Others spoke about retail money and “tourists” being flushed out.
There is a certain plausibility to this characterisation. Clearly market participants cover a wide spectrum of knowledge, focus and ability -- from long-serving professionals whose livelihood depends on intimate knowledge of a single market to day traders who watch multiple assets and try to pick trends from the tape.
But this elegant theoretical model conceals more than it reveals. It is next-to-useless for analysts and traders.
If selling by noise traders threatens to push prices below the level consistent with fundamentals (perhaps because they misinterpret the significance of a rise in gasoline stocks), the theory insists insiders have an incentive to take the other side to make a (more or less guaranteed) expected profit.
The efficient markets theory ensures prices always reflect fundamental supply, demand and inventories; any deviations away from fundamental equilibrium will be very short term.
The big problem is the assumption that professional traders have access to unlimited liquidity, can take positions of any size and suffer any drawdown to offset irrational behaviour by the noise crowd. But liquidity is not unlimited. Even large hedge funds with long lock-ins struggle to carry losing positions for long.
In a world of limited liquidity, noise traders and herding can carry prices far from fundamentals for a considerable period. It may be rational for even the savviest professional trader to jump on the trend even if they do not consider it to be “fundamentally justified” (whatever that means in practice). When it comes to bonus time, it is better to be right for the wrong reasons, than wrong for the right ones.
In a limited-liquidity world, trends and market behaviour become “new” fundamentals alongside supply, demand and stocks. There is not much left of efficient markets, and the division between rational traders and noise traders becomes specious.
The other problem is distinguishing between noise traders and rational ones. It rather depends on where one is standing.
In the hit television comedy “Yes, Minister”, Private Secretary Bernard Woolley gave Minister Jim Hacker a tutorial on perspective: “That’s one of those irregular verbs, isn’t it? I give confidential security briefings. You leak. He has been charged under section 2a of the Official Secrets Act”.
For a fundamental analyst or trader, confident of their position, noise traders are someone else who has the opposite view, and therefore must be “wrong”.
Most denunciations about inexperienced tourists and noise traders have come from the bullish side of the market in the wake of the crashes. There were few complaints when prices were rising. Presumably noise traders were then providing momentum and useful liquidity.
Reports from the U.S. Commodity Futures Trading Commission (CFTC) show a record speculative net long position in WTI-linked futures and options prior to the first crash on May 5 amounting to 500 million barrels of oil.
Press reports last week of large mark-to-market losses at a number of commodity focused and macro hedge funds running into hundreds of millions of dollars revealed just how large some positions in oil and other commodities were. In aggregate they account for a large share of the total speculative length.
The total valuation of the speculative net long position in WTI prior to the crash was $55 billion. For small-scale noise traders, there would need to be tens of thousands, even hundreds of thousands, of them to account for a significant share of the market, even with leverage.
There is no evidence for this. If the froth is identified with the “other-reporting” and “non-reporting” categories of the CFTC data, then it accounted for just 21 percent and 6.5 percent of all speculative positions - and those are just the on-exchange positions and take no account for OTC.
These positions are negligible when compared with the positions run by the large hedge funds, let alone the huge long positions invested by pension funds through bilateral total return swaps with investment banks.
George Soros is one of the most successful hedge fund managers of all time. Last year, he described the gold market as “the ultimate bubble” but that did not stop his hedge fund going long to ride the trend. He has famously articulated the theory of “reflexivity” in which price movements can themselves alter the fundamentals of the market, at least for a time.
Soros’s hedge fund is known to have had long positions in gold. His fund, like others with a similar approach, may have had positions in other commodities. Is Soros a naive noise trader or a rational fundamental one?
What about computer-driven trading programmes? They trade in enough volume and speed they could have pushed prices below fundamental levels in recent days and contributed to record volumes. But if they influenced prices in the sell-off, did they also push prices unsustainably high beforehand chasing momentum? Is this froth or a new fundamental?
The distinction between noise traders and rational professionals is unsustainable and adds nothing useful. It certainly does not explain volatility in recent sessions. It might work in niche markets like silver but does not come close in the bigger markets like oil and gasoline.
Price crashes are often blamed on noise traders and weak longs. Recall economist Irving Fisher’s comment about “shaking out the lunatic fringe” after the 1929 Wall Street Crash. But evidence suggests it is more often the big institutions behind sudden market tremors (portfolio insurers in 1987, LTCM in 1998, quant funds in August 2007, subprime desks in 2008, the equity flash crash of May 2010).
For every naive investor trying to flip a subprime home, there are usually insiders who get it wrong on a more significant scale. Rather than blame the tourists and the froth, a better explanation for recent flash crashes begins with the positioning of the big players.
Editing by Keiron Henderson