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. Today 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 lower-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.

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