Impact of Commodity ETFs on Prices: An Update

Includes: DBA, DBC, GLD, IAU, SLV
by: Mike Steinhardt

I’ve been asked to follow up on an article I wrote on March 10, 2008 about commodity prices and the effect that I felt(feel) commodity ETFs have on the underlying commodity.

Please read the whole thing by clicking here. Here is the second half with some key points highlighted:

In my opinion, the real cause of this problem is easy to identify. It is a combination of monetary and fiscal policy of the United States Government coupled with investment demand, much of which is a result of those failed policies. The reality is the main thing that has dramatically changed since August is the credit crisis and now, the stock market declines.

Commodities is the last main asset class that is not declining so it gets a massive increase in demand for hard assets. Capital leaving fixed income and the stock market have to go somewhere. As long as the Fed and the Treasury devalue the dollar, it will continue. As long as bond markets are in disarray and stocks slide, it will continue. This asset allocation demand is a very powerful force. Just remember it works in both directions. When it reverses, I expect that 33% declines will be common.

We’ve had commodity prices rise before, but when that happened in the past, most commodity ETFs did not exist. Increasingly since 2005, retail investors and their advisors now have a convenient choice to park capital and in my opinion, the existence of the commodity ETFs traded in the US and on the LSE are having a significant impact on prices. Just look at the assets in the Gold ETFs - they have increased approximately 100% from about $10 billion of the yellow metal last year to almost $20 billion now.

Some commentators expect the final thumping in financial markets will come from a decline in the commodities (the last hope for capital appreciation and preservation).  If margin calls and forced deleveraging require that commodities are sold to generate capital, I agree that could be a catalyst for their demise.

If any or all of the following happens, I would be looking to exit commodities: the economy stabilizes, the credit crisis abates, the stock market bottoms and the dollar appreciates. Until then, I think the commodity ETFs will feed on themselves and head higher.

I like Commodity ETFs as an investing and hedging option, but they are contributing to the inflation that Bernanke is ignoring (maybe because he is largely responsible for causing it.)  I am watching for divergences in underlying price growth and the asset values in the ETFs to figure out when the run is ending. When investors decide to pull money out of commodities to reallocate to stocks and bonds, these commodity ETFs will get whacked.

Retail investors who came late to the commodity party have gotten hurt (if they held on). In that post I mentioned my expectation that “33% declines will be common.”  That was a general observation based upon some technical work that I do, and after reviewing what has happened from the peaks to the current pullbacks, I am going to stick to those numbers.  However, each commodity has its own supply and demand factors as well as correlations to macro economic factors, such as failed US monetary and fiscal policies as well as their own asset allocation issues.  I don’t do firm price targets, so I’ll just have to wait until the market tells me they are reversing direction.

As for my theory about watching for fund flows into the specific commodity ETFs to see when the bullish run was getting tired and ready to rollover…. if you check the daily dollar trading volume for a couple year history (pick GLD, SLV, DBC or other examples to test) you will see two periods of a few days each where there was a surge in daily trading volume.  One was mid-March and the other was mid-July.  Obviously, both of those involved interventions by the Treasury and Federal Reserve and corresponding moves in the US dollar. 

As a result, I am comfortable with the actual results of my original theory, although there were many other coincident factors that question the standalone value of this analysis.  Regardless, you can pull up the HEDGEfolios profile of any of these Commodity ETFs and see how my signals correspond to those dates and the surges in dollar trading volume.  Here is one example (click here for the SLV).

Okay…so now what?  Note that this past week, I gave UP signals to the gold ETFs (IAU and GLD) and on August 25th, I gave USO an UP signal.  Obviously, that was not good timing so far with all three being down significantly.  I’ll adjust if I need to, but so far I am getting less negative on commodities.  Other than the three I just mentioned, I have DOWN signals on all the other commodity ETFs I cover.

I’ll be watching the fund flow info to see if it plays out again but mostly, I am getting less bullish on the US dollar and consequently, less bearish on commodities.