Commodities' Downward Trend: Beginning of the End, or Merely a Speed Bump?

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Includes: GLD, SLV, USO
by: Abnormal Returns

Earlier this year we wrote extensively on the topic of commodity investment and the potential for a commodity bubble. Our trepidation was driven by the impression that investors were confusing a bull market in oil, metals and other commodities with the longer-term case for an investment in commodity futures. It seems that these chickens (not in most commodity indexes) are coming home to roost.

The Economist highlights how the fall in oil prices is raising questions in the minds of many about their long-only commodity investments. In addition to the drag of negative future rolls are having on returns, the broader case for commodities is thinner today.

Moreover, one of the main reasons for investing in commodities, diversification, is weakening. In the past, prices for oil and gold, for example, tended to move in the opposite direction from shares, allowing investors to hedge against stockmarket slumps. But in recent months, points out Simon Hayley, of Capital Economics, a research firm, shares and commodities have begun moving in tandem. If investors’ commitment to commodities begins to waver, prices could tumble further, whatever the details of supply and demand.

Shefali Anand in the Wall Street Journal (sub. req.)checks in on commodity-focused mutual funds and finds inflows despite the sharp pullback in prices. Apparently investors are still comfortable with the longer-term case for commodity investments. Although another leg down in prices could scare even the diehards.

Randall W. Forsyth at Barrons.com wonders if the wave of newly introduced commodity-related ETFs, ETNs and mutual funds were not a sign that the commodity boom had gone too far, too fast.

Clearly, the proliferation of instruments offering exposure to commodities to investors who can’t or don’t want to trade futures or options is the latest example of Wall Street’s willingness to market the latest hot concept to the public. And, as usual, the hoi polloi usually jumps on the tail end of the bandwagon.

Chuck Jaffe at Marketwatch.com takes to task the United States Oil Fund (NYSEARCA:USO) exchange traded fund as his “stupid investment of the week.” USO is one of many commodity-related ETFs that launched in the last year. Jaffe’s main complaint is that many investors may have purchased the fund without having a firm grasp on what it can actually accomplish.

“The USO sure makes people think they know what they’re getting, which is an instrument that lets you play on the price of crude oil,” says Jim Lowell, editor of the Forbes ETF Advisor newsletter. “That is where most investors stop thinking about it and start investing in it. … That’s not quite how it works, and if you can’t understand what you’re investing in, good luck if you actually buy it.”

One additional thing to contemplate in regards to a correction in the commodities bull market - currencies. Certain currencies, the Australian & Canadian dollars, are perceived by many to be commodity-related. Weaker commodities could mean a weaker Aussie and Loonie. Tavia Grant in the Globe & Mail notes some research calling for just that.

These factors indicate the loonie’s allure may be diminishing. The report’s conclusion: “If major commodity markets remain soft, let alone weaken further, the loonie is poised to finally retreat.”

Another implication of a commodity turn-down could also be commodity exchange mergers and acquisitions activity. It will be interesting to see if the ICE-NYBOT merger deal is the last gasp for the commodity cycle.

We have no idea whether this commodity correction is the beginning of the end, or merely a speed bump in a longer-term commodity bull market. In either case, it is important to remember that investors or all stripes should have a firm grip on the fundamental nature of an asset class before investing. Especially in the case of commodities where the underlying instruments and markets are different than the standard stock and bond markets.

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