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The End of the End-of-the-World Trade

by: James Cullen September 05, 2008 | about stocks: DBC / GSG / XLF    
James Cullen

James Cullen

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I'm stealing this phrase from Toro, but the "End of the World Trade" is essentially long any and all combinations of commodities, and short any and all combinations of financials and consumer discretionary (the latter sector constitutes the most heavily shorted stocks as a percentage of float by far – despite what the SEC might make you believe). It has been one of the dominant momentum trades of the last year, and its reversal in the last six weeks has had serious consequences because of how far the trade had been pressed.

Yesterday saw the announcement of the closing of Ospraie Management's flagship commodity fund, once the world's largest, after the fund lost 26% of its value in August alone. It's been noted that the extreme volatility in numerous markets has taken even experienced and well-regarded fund managers by surprise, and this seems to be no exception. On the other hand, I tend to agree with David Merkel's assertion that sharp moves tend to mean-revert, whereas slower grinding price movements tend to persist. So, which is it? Consider:

At some point, commodities accelerated from a slow melt-up to a sharp gallop. And, because the self-evident difficulties of earning consistent market-beating returns in commodities, this is almost a Macroeconomics 101 lesson in supply and demand… unless...

Unless the Peak Oil/Scarce Everything crowd is right, and there simply isn't the supply to be brought on line at a cost anywhere near existing prices. How correct could they be? I won't begin to speculate, as that is an entirely different subject that I'm probably not fully qualified to write about. The best I can offer is that a weakening global economy is going to decrease demand for commodity inputs, and the amount of hot money in those assets could create even more in the way of volatility. Looking several years out, there will be demand for these commodities, and prices will rise. What role, then (if any) should commodities play in a portfolio?

As part of the process of analyzing the existing portfolio for the Boston College Investment Club, one thing I'm trying to be more aware of is the risk management side of things – it's much more important to not lose money, after all, but that tends to get overlooked. The argument is out there that an allocation to commodities can reduce risk, since they are an asset class unto themselves uncorrelated with equities. This has proven to be true only to an extent, because it really depends on the other allocations and hedging actions that are being taken. If you're short (or underweight for those seeking relative performance) financials, long commodities – specifically oil – has been a highly correlated trade, so it hasn't really added much in terms of diversification benefits.

The BCIC portfolio owns several financials – Goldman Sachs (GS), JPMorgan (JPM), Bank of America (BAC) - and plenty of companies with related financial exposures, like Interactive Brokers (IBKR), General Electric (GE), and Harley Davidson (HOG). Because the first set tend to be the best-of-breed names, hedging in a non-direct way (i.e. through a long commodities position) seems unreasonable, in that such a correlation could break down because the existing relationship is due more to technical trading than business fundamentals… not to mention that the point of owning the best businesses is to allow for greater returns with less risk over a long time period.

Commodities have certainly offered great returns over the majority of this decade in an otherwise tough equity market, and became very popular because of this. I'd also argue that the reduced visibility of commodities allowed financial firms to charge more in the way of fees, and thus accelerated the democratization of commodities, but the net result is that commodities have become overcrowded, at least at present.

It's tough to find values on the equity side of commodity-producing companies, and thus in terms of opening up the BCIC portfolio to alternate investment methods, I'm going to be pushing much more for short selling (either directly or via put options) because I think that offers a more direct and effective way to hedge long equity exposures at the retail investor level. And, as a final sidenote, I will also be pushing for a larger allocation to some high-quality financial firms with easily understandable businesses. They do exist, and the distressed market surrounding their shares offers value.

Stock position: None.

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This article has 10 comments:

  •  
    Sep 05 10:07 AM
    That oil chart is telling me the price is going to test $100 at some point. If it can't hold there, $90 is the next stop.

    If it can't hold $90, look out below!
    Reply
  •  
    Sep 05 10:08 AM
    I am humored by the fact that investors say the bull market in commodities is coming to an end. Yes it has and will continue to be a bumpy ride because of the enormous leverage and the extreme volatiltiy. I am not suggesting to get out of stocks all together and replace it with commodities but investors that have the stomach should have some exposure to commodities (5-20%) depending on risk tolerance and investment goals. From January 1, 2008 the Dow is down 16%, S&P down 17%, Crude up 12%, Gold down 6%, Soybeans are even, Live cattle up 10%, Sugar up 17% just to look at a few of the commodities. So help me understand again how the bubble has burst please????The late comers have got slammed but commodity investors with a larger than 1 quarter time horizon keep the faith. If you want to know specific plays we are making check out or commodity newsletter. www.mbwealth.com/repor...
    Reply
  •  
    Sep 05 10:18 AM
    I used to be that commodities were understood to be the ultimate business cyclical sector - when economy was strong commodities were up very strongly, and vice versa. And clearly this is still the case - the bullish case for commodities was always based on the 12% growth in China and India. So the negative correlation of commodities to stocks is a bogus notion - except in case of serious geopolitical instability where you'd expect gold and oil to shoot up.
    So, to believe that as the end-of-the-world is approaching and be buying commodities is sheer stupidity - because by definition end-of-the-world really means a serious recession in china.
    Reply
  •  
    Sep 05 11:18 AM
    I couldn't call that the end of the world trade- if the world ended,there wouldn't be any demand for anything. A more proper name would be 'the rest of the world is finally catching up' trade. I agree with kotika that commodities area a signal of the business cycle, while I haven't looked at the charts or statistics, I would assume that commodities and stock prices would be positively correlated to some degree and not really provide much diversification benefit. I pity the poor fool pension funds that bought into this crap that they should load up on commodities for their portfolios,this asset class does not provide safety of income which is their charge.Any pension fund manager who bought into the commodity trade should be fired, then sued.
    Reply
  •  
    Sep 05 12:17 PM
    The "democratization&... of the commodities trade that the author talks about was enabled by the expansion of electronic trading, low commissions, and low minimum investments into the commodities area. For the first time ever, an average guy watching Jim Cramer on TV in his bedroom could put his name on a contract to buy or sell a million barrels of oil, or tons of coal, or whatever, and then sell that contract later in the day from the comfort of his own home. In that way it was part 2 of the technology stock bubble. It allowed the dumb money and the fast money to enter the market and momentum-trade prices up until they eventually crashed. Supply and demand didn't matter any more for commodity investments than it did for tech stocks.

    With taxes on LT capital gains and dividends at just 15% and every other option unattractive because of low interest rates and slow growth, who could blame the funds for trying their hand at the gamble?

    These same circumstances will survive the bubble bursting, so the question is, will the bubble reinflate or will another investment class come along to captivate the day traders?
    Reply
  •  
    Sep 05 01:27 PM
    If you'd re-post those charts on a linear scale instead of logarithmic, I suspect your readers might see a whole different world.
    Reply
  •  
    Sep 05 04:22 PM
    Just the Facts - good point, might need to make a follow up post showing that.
    Reply
  •  
    Sep 06 12:19 PM
    can a society really thrive(or survive) by shuffling useless paper around?how long?i you dont make a good useful end product are you useless?
    Reply
  •  
    Sep 06 02:46 PM
    Any Porfolio Manager that put money into commodities VS Financial Debt should be praised. If the rumours of a Frannie bailout come to pass, pity the Portfolio managers of thousands of banks holding billions of dollars of Preferreds of these GSEs.

    B of A will NOT guarantee Countrywide's Debt, Bear Sterns, is Washington Mutual next? Pension Fund managers don't have a clue as to the value of their "Prudent" past investments. With commodities, what you see is what you get and at least they get to rise again rather than disappear forever.

    Reply
  •  
    Sep 06 04:43 PM
    whats real whats not?that is the question.millions rely on others for the retirement funds.is this good?do you trust some selfserving person with your retirement income?
    Reply
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