Irrational exuberance, expounded by Nobel Laureate Robert Shiller, is unfounded market optimism which is devoid of a fundamental foundation of asset valuation.

Instead, it rests on the psychological biases and disposition effect of investors. It creates undue short-lived economic optimism and severely impacts the market and the economy.

The commodity market is not immune to irrational exuberance, as inflated commodity prices compelled the government to suspend more than half-a-dozen active futures contracts in December 2021 for a year.

However, the plausible reasons for this suspension have not been explored yet.

Arguably, commodity exchanges across the world function on the Efficient Market Hypothesis, popularised by economists Fama and French, which enables every participant to make informed decisions with all the publicly available data and information.

Such information is assimilated, which could be daily updates or weekly/monthly data estimates issued by various states, central government authorities, international newswires, and other sources.

An efficient market, where the price is a signal, ensures the most optimal allocation of scarce resources that helps technical analysts predict a fair value of the asset — financial or commodities.

However, technical analysis on prices may not give a transparent explanation for the suspension of futures.

Instead, we need to look at a fundamental analysis for dissecting the proximate causes of invoking or revoking the suspension of futures trading in commodities.

Fundamental analysis

Consider the case of cotton.

While it has gained considerable traction in trade, the clamour for suspending the cotton futures contract calls for revisiting its fundamentals that can complement the technical analysis and justify the decision on suspending its futures or continuing its trading.

Pressure groups are lobbying for its suspension at the cost of farmers who have been primary beneficiaries of higher cotton prices for several years.

To build a perspective based on cotton fundamentals that impact the spot and futures is important.

First, domestic and international supply concerns are due to unseasonal rainfall and its adverse impact on the harvest.

The USDA expects the lowest harvest for the US as growers in the country’s drought-hit south-west abandoned vast tracts of cropped areas in 2021-22. The Cotton Association of India (CAI) estimated the cotton crop for 2021-22, beginning from October 1, 2021, at 315.32 lakh bales, down by 37.68 lakh bales or 10.67 per cent compared to 353 lakh bales of 170 kg each as on April 30, 2022.

Cotton output outlook 

Market participants expect the cotton production for 2021-22 to be about 300 lakh bales.

Unseasonal rains raised quality concerns besides the poor harvest, which has propped up the demand for quality cotton.

Farmers are also reportedly holding on to good quality cotton in anticipation of better prices.

Second, the supply is also adversely affected by the lower opening stock which fell sharply to 75 lakh bales for 2021-22 against 125 lakh bales for 2020-21 following export demand.

Third, per the Committee on Cotton Production and Consumption (COCPC), in November, cotton sowing acreage (provisional) for 2021-22 was down 7.2 per cent to 120.69 lakh hectares compared to 130.07 lakh hectares in the previous year.

Fourth, arrivals from October-April of the current crop year were down 15.38 per cent.

However, prices started cooling in November 2021, as arrivals in market yards or APMCs improved. Figure 1 records the arrivals at APMCs of cotton in bales (lakh) and the percentage change in arrivals between July 2022 and October 2020.

Fifth, polyester yarn prices, a by-product of crude oil and a close substitute for cotton, have increased with the rise in crude prices — the absence of a cheaper alternative to cotton supported global cotton prices.

Policy implications

Pricing of commodities should reflect the fundamentals of commodities. So, first, setting up a nationwide price pooling agency is necessary which should have an arm’s length relationship with the exchanges or associated agencies.

It should not have any vested interest in the setting of prices.

Second, commodities that are traded should have good representation across production and consumption centres, be standardised in grade and specifications.

The price pooling mechanism should capture such differences in pricing to enable a fair valuation.

Third, for reliable price discovery and broad-based price dissemination, the electronic spot and futures market should co-exist underlying robust market microstructure.

The Product Advisory Committee of the exchange and the market regulator need to work out the modalities for such a microstructure.

Otherwise, market participants would rig the market, create commodity bubbles, and compel the government to suspend active contracts on account of irrational exuberance.

Dey is Chairman of CFAM, IIM Lucknow. Views expressed are personal