One of the aggravating factors in the credit crisis was the proliferation of financial products being traded between banks and hedge funds that had no underlying economic rationale. Unfortunately, after a short period of restraint in the aftermath of the crisis, this manifestation of "casino capitalism" is making a comeback. Individual investors need to be aware of this trend and the spillover effects on asset prices -- particularly in commodity markets.

Welcome to the casino!
In casino capitalism, speculative interests are not content to take on risks that result from the financing of trade and industry. Instead, they create risks from whole cloth. For example, when John Paulson made the "greatest trade ever" by betting against subprime mortgages, he wasn't bearing a risk that arose naturally in the housing finance market.

Instead, he engaged Goldman Sachs (NYSE: GS) to manufacture a specific bet for him ex nihilo. Goldman then went out and found a counterparty for the trade, which ended up having speculators on both sides (unfortunately for the investors that took the other side, they didn't have the sense to realize they were speculating).

Don't hate the player. Hate the game.
I don't begrudge John Paulson his winnings. His mandate is to preserve and grow the wealth of his investors, and he has succeeded beyond all expectations. As George Soros once said: "My defense is that I operate within the rules. If there is a breakdown in the rules, that is not the fault of the lawful participant but the fault of those who set the rules." All the same, one shouldn't confuse the social and economic utility of a casino and that of an insurance company.

How we know there's been a resurgence of a casino mentality:

  • Do you remember "naked" credit default swaps -- buying insurance on bonds that you don't own just to speculate on the perception of a firm's creditworthiness (a pure casino bet)? Banks including Goldman, Barclays (NYSE: BCS) and Deutsche Bank (NYSE: DB) are doing one better by trading credit default swaps on General Motors (NYSE: GM) debt, despite the fact that the company has virtually no debt on its balance sheet as a result of its restructuring.

Oil aboard!
The signs are also prevalent in commodity markets:

  • According to the Commodity Futures Trading Commission's weekly Commitments of Traders report, during the seven days ended Feb. 22, speculators including hedge funds and commodity trading advisors increased their bullish positions by 30%. The aggregate net long position of 240,000 futures and options is the largest total since June 2006.

I see no reason why oil couldn't revisit the all-time high it set in 2008 (which doesn't mean it will). Individual investors may be tempted to try to capture a piece of oil's positive momentum through the United States Oil Fund (NYSE: USO) or the iPath S&P GSCI Crude Oil TR ETN (NYSE: OIL), but I would strongly discourage them from participating in this mug's game. Forecasting price action is extremely tricky, and the structure of these derivatives-based products contains some quirks.

  • ICE Futures, the largest U.S. soft commodity exchange, is considering limiting speculation in cotton futures by requiring that traders with long or short positions in excess of 30,000 bales of cotton demonstrate their underlying economic rationale. That's a highly unusual move, but it's a response to a highly unusual market. Cotton was the best-performing commodity in the S&P GSCI Commodity index last year, and price strength has continued into 2011 -- the benchmark futures has risen a vertiginous 154% over a 12-month period to Feb. 2.

    That sort of increase inevitably attracts hedge funds and other speculators. Nothing wrong with that in principle; in practice, however, regulators and market participants are concerned that these flows are overwhelming fundamental demand and could disrupt the market, hurting those who treat cotton as more than just a financial asset.

Fundamental, then speculative
Are there sound fundamental reasons behind the increases in commodity prices? Assuredly. Growing demand from emerging markets, political unrest, and adverse weather events: All these phenomena are real. However, the price impact of speculative money can't be ignored. As Warren Buffett observed at the 2006 Berkshire Hathaway annual meeting:

In metals and oil there's been a terrific [price] move. ... As the old saying goes, "What the wise man does in the beginning, fools do in the end." With any asset class that has a big move, first the fundamentals attract speculation, then the speculation becomes dominant.

In several commodity markets -- I'd mention oil, cotton, and gold -- we may be at or dangerously near that point today.

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