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The 'Truth' Hurts

February 28, 2007

Dear Fellow Options Trader,

I believe an ancient Chinese philosopher once said, "Man can never do but one thing." In other words, when you introduce one solution into an equation, it produces consequences. And all too frequently, those consequences have unanticipated costs.

As an example, economist/philosopher Adam Smith maintained in his classic "Wealth of Nations" text that each individual, seeking only his own gain, "is led by an invisible hand to promote an end which was no part of his intention" -- with that end being the public interest. "It is not from the benevolence of the butcher, the brewer or the baker that we expect our dinner," he wrote, "but from regard to their own interest."

Most would agree, or maybe even argue, that this is an example of reasonable or positive unintended consequences.

SOME INCONVENIENT TRUTHS

However, history is full of unintended consequences that don't work out so well, and one from our recent past and present is ethanol. Al Gore's "An Inconvenient Truth" just won the Academy Award for best documentary, partly because of the warning it sounds about global warming.

The press reacts to stories about global warming; causing the public to react, which in turn causes our politicians to react. The politicians, Republicans and Democrats, decide that ethanol is one of the solutions, so billions of dollars fly toward ethanol faster than you can say "pork"!

But what's the unintended consequence, Doc? Where's the harm to the common woman or man?

I'm glad you asked.

Consider for a moment that corn futures have more than doubled in the past year. We're not talking about consumer demand for soft drinks (made with corn syrup) or corn on the cob. Oh no, we're talking about corn as the basic ingredient in ethanol!

Our government, pushed by examples like Brazil and fueled by the media and movies like "An Inconvenient Truth," is helping to create demand for ethanol, which may eventually command up to 50% of the U.S. corn crop.

Without getting into how this impacts what we pay for what we eat -- from the sugars we get from corn syrup, to corn flakes, to the livestock that must be corn-fed -- I want you to consider the impact on our land that planting and harvesting more corn (to meet growing demand) will have.

Corn, like all crops, has to be irrigated, plowed by tractors and nurtured with insecticides and nitrogen fertilizers. Then it has to be transported to an ethanol plant, where natural gas or electricity (or both) helps break it down from starch to sugar. The ethanol is distilled out and you're left with a mash that can be fed to cattle -- but the mash only lasts for a few days before it rots. So, more energy is needed to dry the mash and transform it into a longer-shelf-life food.

And in case you thought I was done with my ethanol-bashing, consider this.

Corn crops are not nearly as effective as grasslands and or forests at absorbing the carbon dioxide gas that "An Inconvenient Truth" conveniently leaves out. Sure, Brazil can produce enough ethanol to help it become energy-independent, but if that independence comes at the expense of razing the Amazon rain forest, isn't that a very dangerous unintended consequence?

THIS WEEK'S EXAMPLE OF UNINTENDED CONSEQUENCE

To say the Chinese stock market is volatile is like saying Ohio State merely got nipped in the BCS Championship game! Daily swings of 3% to 5% are the norm, not the exception. Part of the reason is the tremendous potential that is China, and part of the reason is that the potential profits one can make in that region are anything but a secret.

In China, billions of dollars are chasing stocks that are about as liquid as someone living in a $4 million home with an interest-only loan upon which he or she has just filed for bankruptcy. In other words, not very liquid!

But the billions just keep trying to get in, and last year they drove the Shanghai Composite Index to a 130% gain. Something had to give, and that something turned out to be the People's Bank of China, which raised cash reserves for the fifth time in eight months to stem the speculative buying.

Stemming speculative buying may have been its intention, but its action prompted one of those unintended consequences that I've been speaking of. The vaporization of liquidity forced the selling of shares in Shanghai, and that selling accelerated throughout its trading day. When the smoke cleared, the Chinese markets had fallen 9%, their biggest decline in a decade.

That's the problem with an area or a sector getting too hot -- it ignites a buying spree and creates a fire hazard! Once the embers from yesterday's meltdown cool off, we'll no doubt see that the speculators were smoked out, just as the People's Bank of China wanted. But was the domino effect on the global markets, albeit unpredicted, worth the risk?


Jon "Doctor J" Najarian
Editor
ChangeWave Options Trader