Archive for March, 2010

Suspension of demand/supply law for base metals

Sunday, March 7th, 2010

According to the economic law of supply and demand, if there is more and more supply for a given commodity, the prices should decrease if everything else remains equal. Conversely, if the supply decreases, prices should rise.

Normally this is the case for commodities like base metals. The level of stock for a given metal in the London Metal Exchange (LME) should give a good indication of the quantity supplied. So, we invite our readers to take a look at the supply/demand situation for lead, nickel, zinc, copper and aluminium. In particular look at the 5-year charts for the trend starting in January 2009. What do you see?

When? you look at the charts, you will notice something very strange. Since January 2009, the prices of these base metals rose as the supply grew as well. What is going on? Had the economic law of supply and demand being suspended as well?

Good question.

Remember what we wrote in Does rising house prices imply a housing shortage??

The belief that prices will always go up forever and ever can create its own artificial demand. The insidious thing with this belief is that it is a self-fulfilling prophecy- belief leads to increased ?demand,? which in turn leads to higher prices, which reinforced the belief, which in turn leads to increased ?demand? and so on and so forth. When this happens, higher prices lead to even higher ?demand.? Such artificial demand can act as a sink-hole for whatever quantity of supply until money runs out in the financial system (which is not possible under today?s a fiat credit system).

Indeed, this is our interpretation of what happened to base metals as well. The expectation of rising prices acts as a sink-hole for whatever quantity of supply. The most common word used to sum up this phenomenon is “speculation.” Another word that is also often used is “investment demand.”


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When you look at the big picture, there is a big growth in “speculation” and “investment demand” over the past 10 years. From real estate, stocks, bonds, commodities, foreign exchange and even art-work (see Epic, unprecedented inflation). Today, with advances in financial engineering and information technology, it is possible to speculate in the global commodities market in the comforts of your home with the click of a mouse.

What is the root cause of this? As we wrote in Why oil cannot function as currency reserves?,

… when governments undermine the store-of-value function of money (something that can only be done in a fiat monetary system), investors will flock to useful, vital and scarce commodities to store their wealth. This in turn will result in those scarce commodities becoming scarcer. The food riots around the world in 2008 were an example of how this can happen (see Who is to blame for surging food and oil prices?).

For the fundamental economic law of supply and demand to work, prices have to convey accurate market information. Prices are expressed in terms of monetary units. That means the monetary unit is the yardstick which is used to measure the relative value of things. What if the integrity of this yardstick is being compromised? As we wrote in our book, How to buy and invest in physical gold and silver bullion,

Let?s suppose you want to compare the length of two boxes. You may use a ruler to measure their lengths and from the results of your measurement, conclude which one of them is longer. A ruler can do such a job because its length is reasonably consistent for the foreseeable future.

Now, imagine that ruler is as elastic as a rubber band. Do you think it is still a useful tool to measure the length of the boxes? An elastic ruler is useless because you can always make up the measurement of the boxes to whatever you please just by stretching the ruler such that the edge of the box is aligned to any intended measurement markings in the ruler.

Now, let?s take a look at oil prices. Since oil is priced in US dollars and if the supply of money and credit (in US dollars) can be expanded and contracted by monetary inflation and deflation, how useful do you think it is as a calibration for measuring the value of oil relative to other things?

The rise of “speculation” and “investment demand” is a sign of a funny monetary system.

Yet another real estate spruiking by mainstream news media

Thursday, March 4th, 2010

Today, as we look up the Sydney Morning Herald (SMH), we saw yet another blatant attempt at real estate spruiking. The offending article reported,

It’s a figure to break the hearts of first home buyers: Sydney’s median house price is inching towards $600,000 – almost double what it was a decade ago.

The subliminal message to prospective home buyers is clear: buy property now before it is too late.

The article reported that ‘wherever’ you look, the supply of housing is low and prices are going up. Then it picked a few locations here and there and sought the opinions of real estate agents (of all people) as examples to ‘prove’ that point.

Really? Is it really ‘wherever?’

If you read the comments below that article, one person wrote,

I just did a quick search on the Internet for properties available in Upper North shore Sydney and found over 200 in about 5 seconds. How this counts as a shortage I’m unsure… If there is a shortage wouldn’t it be hard to find a place?

Indeed, this is journalism on the cheap. Get a median (while conveniently leaving out the details and context), spin a story by taking the biased opinions of a few real estate agents located in a few places and then hope that readers will fall for the story through a mental pitfall called lazy induction.

We have one comment about the median. For those who are initiated, the median is obtained by lining up all the sale prices in ascending order and then pick the one right in the middle.

There are two facts about first home buyers:

  1. They tend to go for the lower end of the market.
  2. Since the first home-owner grant was phased out in 2010, first home-buyer activity declined significantly.

These two facts implies that sales are skewed towards the higher end of the market. That means the median figure will move upwards by definition. Conveniently, this basic analysis is omitted from the SMH article.

It’s bad enough to read cheap journalism. It’s worse to read cheap and biased journalism. We wouldn’t be surprised if the real estate industry is one of their biggest advertisers.

Thinking tool: going beyond causes & effects with systems thinking

Wednesday, March 3rd, 2010

Recently, we were reading a property investment newsletter. As expected, it listed reasons why despite house price inflation over the decades, housing is still ‘affordable.’ One of the reasons is this: Decades ago, families lived on single income. Today, families are living on double income, which means their purchasing power had increased over the decades. Hence, with increased purchasing power, house price increases. Basically, the increase in the number of dual-income households is (one of) the cause and house price inflation is the effect.

At first glance, this cause and effect seems logical isn’t it? Is this argument the truth? We don’t know, but we know that if one buy into that argument, then that’s another justification for house price inflation, which depending in one’s bias, is good enough.

What if we reverse the cause and effects? That is, house price inflation is the cause and the increase in the number of dual-income households is the effect? Another way of saying that is that as houses become more and more unaffordable, more and more families are forced to depend on dual income to service the mortgage debt. Certainly, this is the situation of young families nowadays.

Now, the point of this article is not to argue which is the cause and which is the effect. Both of them are unprovable interpretations. Since they are unprovable, each of them panders to our beliefs and bias. The main point of this article is this: always be alert to reverse the and cause and effects and see if the logic still holds. If so, you may be on to something more subtle and complex.

In this example, the property investment newsletter’s interpretation is probably an oversimplified narrative. Human nature is such that everyone has an unbreakable habit of simplifying and reducing the complexities in life into easy to understand story. As we wrote before in Mental pitfall: Narrative Fallacy,

Narrative Fallacy is a natural human weakness because by default, our minds seek to form theories, jump into conclusion, seek judgements and explain what we see. It takes a conscious act will to do otherwise.

The reality could be more complex than just a simple cause and effect. It is possible that over the years, rising house price (among other factors) led to the effect of more dual income families (among other effects), which in turn led to even more rising house price, which in turn lead to more dual income families and so on and so forth. In other words, the cause leads to effect, which feed-back into causes, which in turn feed into more effects i.e. a positive feedback loop.

If you can think along this line, congratulations! You’re now utilising systems thinking. Systems thinking is a very important skill that can gives you the edge not only in investing, but also in other aspects of life. We will be covering more of systems thinking in the days to come. Meanwhile, if you are interested to learn more on your own, we recommend this introductory book: The Art of Systems Thinking. This is a fascinating subject and we can only bring it to life through practical examples in the field of investing and economics.

Lastly, our friend, Professor Steve Keen utilises systems thinking in his modelling, which is something that neo-classical economists are lacking.