When Gold is Google
By Eric J. Fry
Commodities are rallying...and because they are rallying,
investors are buying them...and because investors are
buying them, commodities are rallying. You get the idea.
Commodities are red-hot...and everyone knows it. Even so,
almost no one knows exactly what to do about it. Should we
be buying $65 crude oil or selling it? Should we be buying
$570 gold, or selling it? Should we by buying 19-cent sugar
or selling it? Or if we are stock investors, should we be
buying ExxonMobil and Archer Daniels Midland and Phelps
Dodge, or selling them? The answers are not self-evident,
especially because many large institutional investors have
decided to throw money at the commodity markets.
"Billions of dollars of long-only index-fund money is
pouring into these markets," explains Richard Morrow,
founder of Bullfrog Capital Management. "And that's
throwing the traditional fundamental influences all out of
whack. These markets are just too small to handle an influx
of money this large."
"How small is small?" I ask.
"If you added up the entire value of the 2005/06 corn,
wheat, soybean, cotton and rice crops they would total
roughly 60 billion dollars. In other words, the entire
U.S. Agricultural row crop sector is 1/200 the size of the
S&P500. So this new liquidity that's pouring into 'our
markets' cannot be efficiently absorbed."
"Sounds like you've got two sets of 'fundamentals'
influencing the commodity markets,' I suggest. "You've got
real-world demand for the commodities themselves; and
you've got index-fund demand."
"Right," Richard agrees, "and the interaction between these
two different sets of fundamentals have created extreme
price inefficiencies."
"Give me some examples," I ask.
"We're going to have the biggest US and world soybean crop
ever, with the largest carryout ever. And beans are $6.00.
They just shouldn't be up here. With record U.S. and world
soy carryout [Editor's note: "carryout" refers to the end-
of-season stockpile] and big U.S. soy acreage coming, I'm
looking for an opportunity on the short side of the soy
market. Cotton is another interesting one. The funds are
record-long into one of the largest US carryouts ever! The
U.S. crop is materially larger than a month ago and the
U.S. domestic consumption is falling like a stone from
already low levels. Furthermore, cotton exports are running
below pace to meet the USDA estimate. So it is very
possible that the U.S. will end up with a cotton carryout
over 8.0 mil bales. This would be the largest carryout in
history and is more indicative of sub 45-cent July cotton
rather than 58-cent cotton."
"He who has the money makes the rules, I guess."
"Yep," Richard agrees, "We're no longer in a world market
for commodities, or even a U.S. market; we're in an index-
fund market. The markets that I trade are being swamped by
long only index money. Cotton, corn, wheat and cattle all
have record open interest due to the tidal wave of index
fund flows. These markets are simply too small to handle
these huge inflows on a weekly basis.
"If it is any comfort to you," I reply, "index-fund money
seems to be sloshing around in all the commodity markets."
"Oh yeah, I know," says Richard. "I think you've got about
$20 of index-fund premium in the crude oil market right
now. Crude should be trading about 5.8x natural gas on a
BTU basis. But the current ratio is 7.3 to 1, or 26% over
valued. And I think natural gas is way overvalued. Natural
gas inventories are going to all-time highs. How anyone can
be bullish $9 natural gas is beyond me."
"What about gold?"
"Same story," Richard relates. "The inflows into gold and
silver are simply huge. We have no idea how high these
markets are going. Our feeling is that gold is the 'new
Google.' Investors want to own it at any price...I can tell
you this; if the money-flow into these markets stops,
there's going to be some great opportunities on the short
side."
"Yeah, that's true," I agree, "but you might need to wait a
while for that to happen. The fundamental short-sellers are
almost always too early."
"Maybe so," says Richard, "but I don't want to get carried
away with all that. I'm still finding opportunities to
trade...It's just that the game has changed."
"Thanks Richard...and good luck."