The efficient markets hypothesis has long beguiled the investment industry. But it’s not so much a hypothesis as a moving target — a target increasingly within range.
EMH has been articulated in three forms: strong, semi-strong and weak. To state these forms pungently, in the strong form everyone knows what everyone else knows, so there’s no advantage. In the semi-strong form, some people know more than others, but most don’t, and besides, the trading costs are prohibitive. And in the weak form, no one really knows; markets take random post-prandial walks after breakfast at the opening bell and between lunch and the afternoon bell.
At the centre of this is the asymmetry of information. Does it exist? Yes. There are Nobel Prizes to validate it – but not prove it. Uncertainty lies at the heart of the human sciences. But the notion of asymmetry leads to another interesting notion: asymptote. Economic theory models reality, often in truncated fashion. But it spots trends, trends that might never be close to the vanishing point, but approach it every year.
Case in point: commodities as as portfolio diversifier. Commodities were thought to be uncorrelated assets that nevertheless produced similar returns to the S&P 500 over the long term. But no more, say Ke Tang, at Remin University of China and Wei Xiong at Princeton University.
“Prior to the early 2000s, despite the liquid futures contracts traded on many commodities, commodities behaved very differently from typical financial assets. Commodities had little price co-movement with stocks, and commodities in different sectors had little price co-movement with each other. These aspects of commodity prices were in sharp contrast to the price dynamics of financial assets, which are typically exposed to market-wide shocks and shocks to other assets, through various channels related to risk appetite and the trading of diversified investors…”
Commodities, like hedge funds, were discovered – or rather “rediscovered” – after the tech bust, when relative returns took a back seat to the notion of “absolute returns.”
“The tide changed in the early 2000s, when the collapse of the equity market in 2000 and the widely publicized discovery of a small negative correlation between commodity returns and stock returns led to a belief that commodity futures could be used to reduce portfolio risk. This belief allowed Goldman Sachs and other financial institutions to successfully promote commodity futures as a new asset class for prudent investors. As a result, various instruments based on commodity indices have attracted billions of dollars of investment from institutional investors and wealthy individuals.”
While hard assets have different attributes from stocks and bonds, nevertheless as Tang and Xiong note, these attributes become remarkably fungible once removed from the specialized realm of commodity traders.
“Commodities are real assets in that their values are intrinsically connected to physical productions and consumer demands of commodities. This aspect makes them different from typical financial assets, such as stocks and bonds, whose values derive from their future cash flows. On the other hand, the need of commodity producers and consumers to share commodity price risk with a larger set of economic agents also motivates integration of commodities markets with the broad financial markets. The increasing presence of index investors in commodities markets precipitated a fundamental process of financialization amongst the commodities markets, through which commodity prices now become exposed to shocks to financial markets and to other commodities. In this paper, we systematically analyze this financialization process and the resulting spillover effects of the recent financial crisis on commodity price volatility.”
To paraphrase: as assets are financialized, they are subject to the same shocks as other financial instruments, and in a crisis, all correlations go to one.