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Are ETFs Predicting a Commodities Crash?

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Commodities have gone from being an afterthought for all but the most sophisticated of investors to a favorite of coffee-machine conversation. In response to all the speculative fervor over commodities, exchange-traded funds have popped up faster than McMansions did during the housing boom.

Yet although commodity ETFs don't look like those pictures of decaying unsold homes in the middle of the California desert, they are showing some signs that they're at least ready to take a break in the long bull market for the asset class -- and at worst, behavior in the ETF market could prove to be a predictor of a long-awaited reversal for commodity prices.

A matter of supply and demand
One of the appeals of commodity investing is that commodities are simple to value. You don't have to go through long, detailed analyses of intrinsic value or try to guess how much a company will earn 10 years from now. Rather, at its most basic level, the best measure of a commodity's value is simply what market participants are willing to buy and sell it for.

For a long time, ascertaining commodity values took knowledge of an arcane corner of the financial markets: the futures exchanges. Although many discount brokers now give customers access to futures markets even with traditional brokerage accounts, it used to take a separate relationship with a specialized futures broker to gain access to the commodities markets.

Now, though, measuring demand for a particular commodity has never been simpler. With ETFs, you can see exactly how many shares investors own on any given day. And by looking at historical data, you can see how money flows in and out of particular commodities over time -- and potentially draw money-making inferences from your observations.

Getting out
Lately, the mood among commodity ETF investors has been anything but calm. When you look at share data for popular ETFs, you can see the competing forces that have buffeted the sector in recent months.

Perhaps most obviously, precious metals have seen many investors exit as prices stopped moving straight up. In mid-April, the SPDR S&P Gold ETF (NYSE: GLD  ) owned almost 39.6 million ounces of gold. But during the May sell-off, that figure fell to around 38.3 million ounces before bouncing back in the ensuing months. More dramatically, the iShares Silver Trust (NYSE: SLV  ) went from holding almost 11,400 tons of silver in late April to just 9,500 tons recently, after silver's plunge.

Interestingly, that trend isn't as clear when you look at leveraged precious metals funds. For instance, with ProShares UltraShort Silver (NYSE: ZSL  ) , shares outstanding have ballooned from just 5 million in March to more than 35 million now. But demand for shares of ProShares Ultra Silver (NYSE: AGQ  ) has also risen, albeit less significantly.

However, the outflow phenomenon goes beyond precious metals as well. After a big ramp-up in interest in February, the United States Natural Gas Fund (NYSE: UNG  ) has seen big reductions in outstanding units during March, April, and May. The related United States Gasoline Fund (NYSE: UGA  ) , which had big inflows during the early months of the year as gas prices soared, reported net withdrawals in May. Even the all-purpose iShares GSCI Commodity-Indexed Trust (NYSE: GSG  ) has seen big net redemptions in May after large inflows in February.

Keep your balance
The important thing investors have to remember about commodities is that their prices tend to move in cycles. When they're in favor, commodities can see their prices move upward sharply. But they can plummet just as quickly when the tide shifts. A crash in commodity prices may not be inevitable, but many investors are clearly content with the profits they've already made in the asset class over recent years and are adjusting their portfolios accordingly. You should consider doing the same thing.

There's more to the world of ETFs than just commodities. Take a look at three ETFs we've discovered at The Motley Fool that we think are pretty promising. Sign up here for our free special report to learn more.

Fool contributor Dan Caplinger usually steers clear of hot commodities. He owns shares of the iShares Silver Trust. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy isn't just a fad.

Read/Post Comments (1) | Recommend This Article (6)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 26, 2011, at 1:44 PM, LawrenceCheok wrote:

    The analysis is based only on market behaviour and sentiments, which does not reflect the fundamentals of the underlying commodities.

    As we know by now, silver/gold have been moving upwards since this article. Gold hits new high, today at $1613. That is prove of the fundamental flaw in this analysis.

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