Why Mainstream Investors Should be Watching Bitcoin and Lumber

There has been a lot of media attention on the wild swings in bitcoin (BTC) yesterday, with a massive drop being followed by an equally sharp, steep recovery. That volatility is being dismissed by the usual suspects as being just in the nature of cryptocurrencies. Those that have been saying since bitcoin was trading in the hundreds of dollars that it was going to collapse are ignoring the fact that they have been wrong for years, and are shouting, “I told you it was risky and was going to collapse!”

On the other hand, those who have been a part of the currency’s spectacular run up see it as business as usual and that the bounce-back after a big drop is just more evidence that BTC/USD is going to at least 100k, and probably a lot higher.

If extreme volatility was limited to bitcoin, none of it would matter to regular investors who hold stocks and bonds, and whose idea of an “alternative” investment is a REIT. However, it wasn’t. And what is going on there and in other, relatively obscure markets, tells a story that even the most conservative investor should be heeding.

Lumber (LBS) futures, for example, did something remarkable yesterday. Trading in the benchmark “random length” contract for July delivery was halted twice on the Chicago Mercantile Exchange (CME), once for a limit down move, then for a limit up. For those like me with a trader’s mindset, that is an interesting little tidbit, but the significance of yesterday’s trading in lumber doesn’t end there. The recent moves in that market are indicative of what is going on elsewhere, and what happens in lumber from here may well give an early indication of what we can expect in the stock market in coming weeks.

A “limit up” or “limit down” move is when a contract drops or rises far enough and quickly enough in one session to trigger a circuit breaker, a pause in trading enforced by the exchange to calm things during these extreme moves. That happens occasionally in all markets, but for it to happen twice in one day in opposite directions, is rare.

The problem with that kind of volatility when it comes in a commodity futures market is that traders aren’t the only ones involved. Commodity futures existed originally to give those involved in the production and use of a commodity to hedge against future price moves, and to smooth out the inevitable fluctuations so as to make long-term business decisions easier. That “legitimate” use of futures, however, has been crowded out in lumber over the last few months as speculation has resulted in a chart that looks like this year to date:

When you get a chart like that in a relatively small commodity market such as lumber without some major distortion of supply, it usually indicates that the supply and demand conditions and expectations that are the fundamental drivers of pricing are no longer driving things. If they were, supply would have increased as prices rose and there would have been no bounce back after last month’s massive drop in housing starts that indicates a big drop in demand was reported. Instead, even as demand dropped and supply began to catch up, speculators continued to drive the price up.

Don’t get me wrong: I have nothing against traders. I have been one most of my working life. But when their activity moves from the peripheral to the central, it rarely ends well, because markets exist for reasons other than speculation. As I said, commodities markets offer hedging opportunities for producers and users of a product, forex markets enable free trade between nations and corporations, and the stock market’s real function is to raise capital for businesses.

Sometimes, those reasons get lost, and we get into a situation that Oscar Wide once described as knowing "the price of everything, but the value of nothing." That seems to be where we are now in a lot of markets, including stocks, but eventually, a correction back to fundamentals always comes. What matters to investors is whether it happens gradually, or in a major, bubble-bursting kind of crash.

That is why, even if you aren’t involved with crypto or commodities, you should be keeping an eye on markets like bitcoin and lumber. If we shift back to a market that is driven purely by fundamental conditions, there will be a painful period of adjustment, and the first signs of that will come in the markets where the dominance of speculators is most pronounced. Yesterday saw some signs of extreme turbulence in those markets, so what happens over the next few days will be critical to all investors.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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