Wisdom of Investment Crowds: Signals to Watch for a Commodity Bust

I nearly had a knock down drag out with my wife over dinner on Monday night. No the topic was not her handbag or shoe spending habits, which she usually holds in check quite nicely by her frugal nature, although the occasional "accident" does happen. Rather, the topic that created the virtual slugfest between us was on what signals to watch for in the commodity markets that might clue a buyer about a decline and whether or not volume levels in short ETFs and ETNs are good indicators of folks betting against the broader commodity indices (and specific ones such as aluminum, in certain cases). As background, many commodity markets have risen materially in the past six months, despite the fact that industrial demand has been sluggish throughout much of the world. Still, despite the economic situation, at this point in time, in the vast majority of ETFs and ETNs, the dominant dollar volume (>95%) is nearly all in long funds, representing the view of speculators and others that commodity markets will continue to climb.

In contrast, I have anecdotally observed that the long/short balance in non-commodity ETFs (e.g., S&P indices, both leveraged and un-leveraged) is at least slightly more balanced. Now, this is not a scientific analysis and investors buy commodity ETFs for a number of reasons that would not indicate a direct bet against the markets (e.g., potentially offsetting long physical positions through a hedge) but it is telling that short interest, at least in short funds, is low. However, it is possible, depending on your brokerage house, to go short a long ETF or ETN, but these types of transactions are more difficult and less likely (and there's no way to track volume, as far as I can tell). So this leaves us with one at least somewhat empirical observation -- the wisdom of the crowds is still betting on an appreciation of the commodity markets.

Now, crowds can be wrong -- very wrong. But as a firm believer in the concept of prediction markets, I believe that when there's such a skewed balance to one side, it's telling. But what will be more telling is when trading volume and interest in short commodity ETFs and ETNs rises. Then we'll known that, perhaps, the commodity bubble will potentially be closer to bursting until real demand catches up with earlier speculative investment interest. As a final side note, I caught up with a friend in the financial services business yesterday who told me that as of the past few weeks, all the major brokerage houses are now making investors write a letter to their broker/dealers stating that it is their idea to invest in leveraged ETFs and ETNs rather than their investment advisor's. Clearly, if there is a bubble, the investment houses don't want to take legal responsibility for this type of gambling.

Just don't tell my wife this because I fully plan to go short in some of the commodity markets which, in my view, have no business being where they are based on anything but speculation. However, I won't be playing the leveraged short (or long) ETF and ETN commodity game. After all, I want to stay married.

- Jason Busch