May 28, 2010 5:05 AM

I’m writing to you from a plane somewhere over the Nullarbor in Western Australia. The original plan was to meander our way from Sydney to Adelaide, then north to Uluru (Ayers Rock) with stops along the way at points of interest. Then we were going to back track southwards and finally cut west through the emptiness of the Outback to my meetings in Perth. It seemed good on paper. My brother told me it made no sense. Every Australian laughed at my plan. Even the most hard core truckers thought I was insane. Finally, in Coober Pedy, I reconsidered. When the crazy people, hardened from living underground thought my plan was crazy, maybe it indeed was crazy. So, I’ve dropped off the car in Alice Springs and hopped on a flight to Perth, I’m thankful to be done driving for a while. 4,600 km in a week is enough. As I stare down at the ground from the plane, I realize why it’s called the Nullarbor. There are no trees—hence the name. There’s nothing. No civilization—as far as the eye can see.

The more time I spend in Australia, the more I like it. I also realize just how big it is. The drive from Coober Pedy to Uluru is seven hours. From Uluru to Alice Springs is another five hours. You shouldn’t drive both parts in a single day—we did. Fortunately, my girlfriend likes to drive while I get some reading done. She did a good job dodging sheep, cattle and kangaroos at 140 km/hr until she damn near totaled a camel. Let’s just say that neither of us anticipated camels—until they darted across the road. Some follow-up research implies that while native to Asia, Australia now has the only wild camel herd in the world. Go figure. They were imported for their stamina on the arid mail routes and a few escaped to rapidly populate the Outback. I wish someone had warned us before we set off into the bush. Camels are bigger than our rental car.

Twelve hours in a car gives you plenty of time to think. I wonder about the volatility. This has become a market where thousands of prop desks and hedge funds all trade various products with the similar strategies and copious leverage. These strategies are almost always trend following in nature. They buy when something is going up, sell when it’s going down and keep very tight stops. If it goes against them by more than a few percent they all exit the trade. It’s a giant herd of computer programs. This used to only impact the equity markets. Now, no markets are immune. In the past two weeks, the Aussie dollar traded in a 15% range. Palladium dropped 25% in a six day period. Copper routinely moves around 3% a day, so does crude oil. How is a business supposed to cope?

Roller Coaster

Can you handle the volatility?

When I started trading over a decade ago, a 2% currency move took weeks to play out. Now it happens faster than you can brew coffee. This volatility may help hedge funds, but it slowly grinds away the productive economy. A businessman fights hard for every basis point of margin. He tries to undercut competitors by mere pennies to gain business. In a world of roughly constant prices, if you work to cut costs, you will win the business. What about now? You might be the low cost provider, but if your competitor locked in his copper yesterday, he can undercut you by 3%. If you locked in your Aussie dollars last week, you cannot compete with him. How do you run a business like this? Does a small businessman need a whole prop desk working full time to lock in his costs? Is this why most large businesses are increasingly looking like hedge funds with widget subsidiaries? I can name dozens of large companies that have made the majority of their profits over the past few years from currency gains. At some point, it makes you wonder why they even bother with their supposed ‘core businesses.’

Traders have been active in markets since markets were created. However, in the past, traders mainly served to provide liquidity. The floor trader stood there to take the other side of orders and make a spread on the bid and ask differential. Prop desks at large banks served to match up even larger transactions and take a small piece of the spread for themselves. These processes served to dampen volatility. They matched buyers and sellers at roughly the going price in the market.

There have always been players actively speculating on the direction of various markets. These individuals serve a clear purpose. They slowly push a market towards equilibrium. This is all beneficial. However, until a decade or two ago, these speculators were a tiny piece of daily volume and an even smaller piece of the open interest. They helped the process—they weren’t the process. Now, there are thousands of hedge funds involved in these markets. Every large bank feels compelled to participate in the melee. These speculators now are the market—not the actual buyers and sellers of the various products. This creates anarchy. When it’s going up, everyone piles in to get a piece of the action. When it goes the other direction, everyone runs for an exit. The businessman is left to guess about the direction of various markets that are vital to his business. Skill and luck in locking in inputs is more important than intelligently running your business.


In the past, unless there was a crisis, most markets barely moved. When they made moves, those moves took weeks to play out. It gave people time to adjust their contracts and pricing. Now it is all so sudden. A computer program decides it’s time to move, and everyone jumps in on the action. Volatility is never good for a business. This sort of volatility is maddening.

There is clearly a problem here. You do not want the financial economy to overtake the real productive economy. Nor do you want the financial world to act as a tax on the productive economy by grinding bits of profit off it on these moves. I am all for free markets. I do not think we need a solution to this process. Rather, I think that as investors, we need to be aware of it. You can no longer just watch an industry’s margins and spot the low cost player. Often, the low cost producer is not actually the low cost player—he just got lucky at locking in his inputs. This is usually not a sustainable advantage. Sometimes, one firm is repeatedly better at locking in their costs. Should you attribute value to that? If they get it wrong one year, and they lock things in disadvantageously, how do you value that? These are all questions that we need to be aware of. Volatility creates winners and losers. How do you judge that process by just looking at the income statement? Should all businesses just become hedge funds? If you have a net margin of 5% and your inputs swing around that much each week, do you have any choice? As investors, analyzing a business just got even more difficult.

Categories: General
Positions Mentioned: none
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