Commodities: High Volatility, Dumb Money....and A Rebalancing Bonus

I noted last week the large daily moves in commodities as an example of "irrational markets:. The WSJ reports on that volatility

Prices of everything from gold to copper and cotton leapt to new highs, only to be slapped down just as quickly. Trading volume in many commodities roared to records, including for silver, cotton and corn. Since the beginning of October, the Dow Jones-UBS Commodity Index's 30-day realized volatility has doubled to 25%, the highest since September 2009.

For commodities, the overarching reason for the volatility is the outsize reaction to new signs that China has stepped up its moves to tighten credit and contain inflation. But the huge amount of money flooding into commodities markets appears to be helping exaggerate those moves.

The reason for those movies "hot money" no doubt some of it "dumb money" that bought in late in the rally and liquidating at a loss on the selloff, while others get whipsawed buying high selling low in the volatile markets. Even if the actual buying comes from money managers it can reflect retail flows into commodity funds.

With that money has come a new breed of investors more focused on trading in and out of commodities to profit from price moves rather than the standard producers and consumers relying on the market to manage their risks.

Since August, money managers, such as hedge funds, have raised their bullish bets on oil, copper, soybeans and many other markets. These funds' total net-long positions all peaked in the week ended Nov. 9, before being cut in the past week, according to the Commodity Futures Trading Commission.

All this suggests volatility will at least be around, if not increase, in the short term, even if many people believe commodities overall have a lot further to rally.

"When you have this large [speculative] exposure built up, you do run a risk," said Tim Evans, a commodity analyst at Citi Futures Perspective, a commodity-research arm of Citigroup. Because "you've used up your potential to draw in more new money—that's the time when you are vulnerable to a reversal."

in other words "dumb money" coming in late and getting burned on the short term market reversal.

Investors "are getting more and more nervous as we get close to year end," said Andy Smith, senior commodity strategist at Bache Commodities. They are "not sure whether they should take the money off the table and run for the year or stay in the game."

 In contrast to the the nervous short term investor in commodities trying to market time, ook at the above from the perspective of the long term investor. That long term investor  has an allocation to commodities and a policy of rebalancing to target, The volatility of a  sharp rally followed by a reversal in the midst of a long term uptrend is just what he wants. He can sell off part of his position at a product to get back to his target allocation and buy more on the dips when he becomes underweighted. If the long term trend is positive he adds a "rebalancing premium" to his gains on the commodity position,