UNINTENDED CONSEQUENCES
One of the earliest things drilled into my head as I started my Wall Street career in 1982 was that commodities are cyclical.
A person starting his/her career in the same place a quarter of a century later would likely be taught something a bit different. They'd be told that commodities are in a secular bull market growth trend, thanks to near-perennial demand from the developing world lead by China and India.
But the other thing I learned a bit earlier in kindergarten, was that trees don't grow to the skies.
And that's why it's good to see the cover story in Barron's this weekend, titled "Commodities: Who's behind the boom?" It's the one near-mainstream piece in recent months that does a very good behind-the-scenes job in explaining the drivers of the current commodities boom, and how it may end one of these days:
"CHINA, AS EVERYONE KNOWS, IS A BIG FORCE IN THE extraordinary boom in commodities. Its voracious appetite for everything from corn and wheat to copper and oil has helped push up U.S. commodities prices by some 50% over the past 12 months.
But China is by no means the whole story. Speculators -- including small investors -- are also playing a huge role.
Thanks to the proliferation of mutual funds and exchange-traded funds tied to commodities indexes, speculative buying has gone way beyond anything the domestic commodities markets have ever seen.
By one estimate, index funds right now account for 40% of all bullish bets on commodities. The speculative juices are even more plentiful -- nearly 60% of bullish positions -- if you count the bets placed by traditional commodity "pools..."
"Indeed, the great commodities bubble started springing its first leaks two weeks ago: Oil, gold and other major commodities posted their steepest weekly drop in half a century. Though prices have since firmed, they could eventually drop 30% as speculators retreat. The only real question is when."
The entire piece is worth reading, perhaps even a couple of times. It explains particularly well, the regulatory quirks that provided the exceptions for the commodities mutual funds and index funds, to side-step the position limits on commodities speculation posed by the regulatory authorities in 1936. And it provides some eye-opening statistics on how much these funds that can mostly make only bullish calls, are driving the prices up.
First, here's the scope of what we're talking about:
"...the index funds hold about $211 billion worth of bets on the buy side in U.S. markets.
Applying a similar method, but with slightly different assumptions for indexes tracked, Bianco Research analyst Greg Blaha puts that figure at $194 billion. Either figure is enough to turn the index funds into the behemoths of the commodity pits, where total bullish positions now stand at $568 billion."
Next, their influence to date:
"...the index funds have effectively bought 36.6% of the domestic 2007 crop, and that if you add the commodity pools, the figure climbs to 59.1%. In wheat, the figures are even higher -- 62.3% for the index funds alone, and the figure jumps to a whopping 83.6% if you add the pools. Betting against them as never before are the commercials, who deal in the physical commodity (SEE CHART ABOVE).
The CFTC provides these figures on index trading for only 10 commodities. Why are such major commodities as crude oil, gold, and copper excluded? The agency's rationale, which even certain insiders question, is that it would be hard to get reliable information on these other commodities from the swaps dealers."
The one small nit I'd pick with the article is that it doesn't include an additional booster to some commodities prices in recent months. I'm referring of course to the highly politicized government policies that have provided a subsidy driven-boost to corn-based ethanol prices, as part and parcel of the "greening" of America.
But that nit aside, the Barron's piece is a terrific primer on the current forces driving the commodities Bull market.
And these trends don't just influence the financial markets.
This bull run in turn has contributed meaningfully to boosting grain-based food prices world-wide, causing economic pain to millions of folks in the developing world. This New York Times piece is a must-read on this sad and politically unsettling development.
It's a question of when, not if, these forces driving the "secular" bull market in commodities, abate.
And when we do, we're likely to have a different view of inflation than we do now. And we'll again re-learn a lesson in Bubble economics.
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