The Fate of Leveraged Hedge Funds

I believe that the recent turmoil in the global financial markets is only a preview of what might happen if and when the credit and real estate market bubbles burst. As was the case with the rest of the world, Canada’s stock markets tumbled more than anyone would have liked to see. The only sector that got out of the rubble relatively unscathed was that of commodities.

Why? Simply, there is nothing lurking in the depths of fundamentals that could bring commodities down just yet. What I mean is that the demand for raw materials and for fossil fuel is still there and still growing. The demand outpacing the support also means that prices are likely to hold. The economics in the commodity sector are strong, enabling it to insulate itself from non-economic threats, such as the scary levels of risk and speculation in the credit and real estate markets.

However, time is not on anyone’s side, including the commodities. At the moment, whatever is going on in the credit and real estate markets resembles a small, relatively contained fire. But if and when this contained fire spreads across the economic landscape, the delicate balance between supply and demand might be disturbed in the very, very long run.

We have already seen the impact of this fire in the equity markets. For the time being, the commodity markets are holding up. Confidence is the key word here. The only problem is that at the epicenter of this confidence are hedge funds or, in other words, speculators. An even bigger problem is the fact that those same hedge funds were also at the very epicenter of investing in low- cost subprime debt. So currently, the most scared of traders are also the most confident ones? Isn’t that a paradox for the books!

I suppose it is understandable why hedge funds turned to commodities. But, with their track record, I really don’t like to see them piling into commodities. According to the U.S. Commodity Futures Trading Commission, long futures in oil, gold, and copper have hit record highs. I’d hate to see what will happen when hedge funds start unwinding those longs to offset whatever they may have lost in the credit market.

Unfortunately, this is what hedge funds do. They speculate, and if losses are incurred, hedge funds cover them with whatever might be working for them at a moment. Hedge funds have loads of money, they are not long-term investors, and that is what may have been screwing things up for the rest of us as of late.

As many of our resource investors may have already noticed, the prices of gold and copper have corrected somewhat. To make matters worse, a number of analysts expect prices of these commodities to continue sliding. This prediction is based on the fact that current prices have already built in about one-third of hedge funds’ speculation. But if the credit and real estate markets in the U.S. continue get pounded, more leveraged hedge funds will have to start selling their longs in the commodity markets. And you know what happens when there are more sellers than buyers — prices fall!