Over the weekend Barron's had an article on the boom in commodities markets and that it is probably about to suffer a correction. The article stated that most of the rise in the commodity markets are due to ETFs and Mutual Funds (MF) which are exempt from position limitations put in place by the CFTC (Commodity Futures Trading Commission). These limitations (for every long position there is a short position) are in place to protect the market from excessive speculation due to the limited size of the markets.
The ETF and MF money (every $9 out of $10) is not directly invested with the commodity exchanges, but with dealers that belonging to the International Swaps and Derivatives Association (ISDA). The dealers act as market makers for the commodity markets that the ETFs & MFs are investing in, by hedge the risk they have incurred back onto the commodity markets. What happens when all of the dumb money wants to sell their ETF or MF after the market drops 10-20%? There is too much leverage in the market to facilitate an orderly exit for all of these positions. Below is a chart providing a snap shot of the commodity markets and positions.
A Sucker's Bet
The Barron's article provides a nice little synopses of the issue:
'Here's the problem: The speculators' bullishness may be way overdone, in the process lifting prices far above fair value. If the speculators were to follow the commercial players -- the farmers, the food processors, the energy producers and others who trade daily in the physical commodities -- they'd be heading for the exits. For right now, the commercial players are betting on price declines more heavily than ever before...'
The ETFs & MF have taken almost 60% of the bullish (long) positions. Most commercial dealers have taken bearish (short) positions, betting against the continued rise in prices. These short positions are running almost 30% higher than the previous net-short record in March of 2004. The commercial dealers are the guys who have been in this business for a long time and have seen boom and bust cycles. It would make sense to watch what they are doing.
Everything I Know About Trading, I Learned From the Movies
How many times do you get to quote 'Trading Places' ?
Louis Winthorpe III: Think big, think positive, never show any sign of weakness. Always go for the throat. Buy low, sell high. Fear? That's the other guy's problem. Nothing you have ever experienced will prepare you for the absolute carnage you are about to witness. Super Bowl, World Series - they don't know what pressure is. In this building, it's either kill or be killed. You make no friends in the pits and you take no prisoners. One minute you're up half a million in soybeans and the next, boom, your kids don't go to college and they've repossessed your Bentley. Are you with me?
Billy Ray Valentine: Yeah, we got to kill the motherf... - we got to kill 'em!
Will It Last?
From Barron's, 'Index funds offer investors an easy, inexpensive way to gain exposure to a segment of the commodities markets or a broad-based basket of commodities. Result: The funds have drawn many private investors who have never ventured into futures, along with pension funds and other institutional players looking to diversify. But for all the virtues that the funds hold as a way of spreading bets across commodity markets, they take only long, or bullish, positions, avoiding short-selling. In other words, they trade on the naïve and potentially fatal assumption that commodities have the same tendency as stocks to rise over the long run.'
No and yes. In the short term think that the speculative money will run out at the first signs of trouble. The commodity market experienced a 5-10% drop in prices during the past two weeks, but has firmed up. Looking at the charts above, due to the drop in prices it looks like some of the speculative money has started to leave, or at least some have taken profits. Things that might cause the bubble to pop are:
- China / India - these countries have experienced a high rate of economic growth. Any slow down in this growth will affect commodity prices.
- Dollar - the dollar is at historic lows. Commodities are priced in dollars making it easier for other currencies to buy more of the commodities. If the dollar increases in value this discrepancy is negated.
- US - most consumers are spending on goods from China. If the US consumer starts to reduce their spending this will effect the demand for raw materials to make those goods.
- Lack of Buying - who is left to buy? Once there is a lack of buyers, the market will start to fall due to its own weight.
Long term commodities are a bullish bet. The earth's population is not getting any smaller and certain commodities are non-renewable. This sounds like a sweet spot for oil and natural gas companies. Also as more land is taken out of farm use due to urban/suburban development, whats left will become more valuable along with whatever it produces. Agribusiness sounds like a great thing to be involved in. In the words of Jim Rogers:
`If I told you how bullish I am about agriculture, you'd ask me to leave the room. Prices of agricultural commodities are going to explode. Inventories of food are the lowest they've been in over 40 years. The number of hectares devoted to wheat farming has been declining for over 30 years.'
Source:
'Commodities: Who's Behind the Boom?', by Gene Epstein, Barron's {$$$}
Rogers Says Sugar, Other Agricultural Commodities to `Explode', by Dave McCombs, Bloomberg News
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