Long Commodities-Short Financials Trade Blows Up

All those who put on the long commodities-short financials trade have been decimated in the last month. Two of the commodity superbulls in Canada, Donald Coxe and Eric Sprott seem to have taken blows, although they are still deeply in the positive over the last few years. They are also sticking with their long-term bullish commodity calls.


Donald Coxe suggests that US central bank and Treasury intervention was to boost financials and hurt commodities:

According to Mr. Coxe, the Fed's ultimate goal was to trigger a rally in financial stocks, which would, in theory, help banks hammered by the credit crisis raise fresh capital and repair their balance sheets. To accomplish this, the decision to support Fannie and Freddie was deliberately announced on a Sunday, which had the effect of maximizing the reaction from thinly traded financial stocks on overseas markets.

Because many hedge funds were using massive leverage to short financials and go long on commodities, when North American markets opened and banks initially rallied, the funds were forced to cover their short positions.

At the same time, the U.S. dollar was rallying because the risk of holding Fannie and Freddie paper had diminished. The rising dollar, in turn, made commodities less attractive, giving funds that were already scrambling to cover their financial shorts another reason to dump oil, grains and other commodities.

I have to commend the high returns of these commodity-oriented funds but many of them are just too greedy. By that, what I mean is that I don't know why they put on a long commodities-short financials trade. If the argument is that this is a hedge, it's a very weak one. A US$ rally will crush this position--and this is what has happened (Mike Shedlock has a blog entry on the present outcome). It's nothing more than a "leveraged" bet, without actual leverage. You were simply boosting returns, as was the case early this year when financials fell and commodities rose.

Eric Sprott, who is perhaps the most successful commodity hedge fund manager in Canada, has also suffered poor returns of late:

The problem has been the stream of government-backed salvage plans for financial companies such as Fannie Mae and Bear Stearns Cos. Inc. These are keeping bank stocks artificially inflated and taking the wind out of a rally in commodities, he said – a complaint shared by other commodity bulls. Mr. Sprott expects that the U.S. government will rush to help should Lehman Brothers Holdings Inc. and Washington Mutual Inc. need aid.

“The Treasury and the Fed are breaking all the normal rules of engagement,” Mr. Sprott said.

Still, Mr. Sprott said the bailouts will eventually contribute to a renewed bull market in commodities because the U.S. government is having to print so much money to fund them. That will drive up inflation, push down the U.S. dollar and benefit gold.

Eric Sprott still remains bullish on commodities and gold. For what it's worth, his funds have made a lot of money for investors over the last few years. Even with the huge sell off, most commodity investors are still doing better than most others.

Hard to say if the commodities bull market has ended but one thing we can be sure of is the following. The run-up in commodities over the last year has mostly been due to momentum--some would say speculative--investing. All the fundamentals that were thought to have supported commodities seem to have dissapeared of late. Fundamentals alone will not explain how Potash (POT), a super-bubbly fertilizer company in Canada, could get chopped from $240 to $160 while earnings and sales are up.