Why You Should Step Away From The Commodities Table

Includes: GAZ, PTM, USO
by: Paulo Santos

You might think you're on a roll, that you've got a hot hand going. But there are times when the signs become too obvious. In a long gone epoch, that would be the shoeshine boy giving stock tips to JP Morgan. Later, maybe it was the cab driver letting you in on the Webvan opportunity.

Today, we've gone up several notches in the ladder of sophistication. Still, very few investors/traders would question that if you see the public visibly willing to pay $1 for $0.50, something is wrong and the edge of the world might not be so far (illustration by A.Siegel).

Sure enough, the Commitment of Traders report shows long positions being taken and kept on many different commodities, namely crude (NYSEARCA:USO). But that doesn't tell us the demand is uninformed. It could well be a bunch of prescient traders are fully aware of the monetary shenanigans that now emanate from every central bank in the world.

So what kind of signs am I talking about, that tell us beyond a shadow of a doubt the uninformed public is buying commodities heavily, and that as such care must be taken not to do the same?

The signs come from a very specific circumstance. In normal times, most ETFs and ETNs follow the value of their underlying quite closely, because of the process where units of these funds can be created and redeemed by authorized (large) investors. But, once in a while, that process gets disrupted. Legal limits are hit, position limits are hit, and it becomes impossible to create new units. In those times, if demand for the fund is strong enough, it can happen that the fund decouples from its underlying value.

Now, no informed trader would buy such funds once they become overvalued compared to what they represent. It would simply make no sense, and the informed trader would always look for alternatives that are priced rationally and fairly. But an uninformed trader might not even know that the value has gone haywire. He'd just think "I want commodity exposure" and buy.

So if you see a fund trading in volume at a large premium to its underlying, you know something is wrong. And if you see several, you witness a trend. And we have such trend today, with funds like the iPath Dow Jones UBS Natural Gas (NYSEARCA:GAZ) and UBS E-TRACS Long Platinum TR ETN (NYSEARCA:PTM) departing from reality and showing us that the uninformed public really is buying commodities left and right.


Caveat Emptor! The signs are now as clear as they'll ever be that uninformed traders are buying into commodities hand over fist. The last time I saw a movement where irrationality was so obvious, with European ADRs back in May 2006, the S&P500 (NYSEARCA:SPY) took a quick dive within weeks (in that case, several ADRs reached their issuance limits, and also started trading at considerable premiums to the same stocks trading in Europe).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.