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Possible rule changes for Indexed funds ? OUCH!!

From: Stan
This is primarily directed to Jim, but I'm interested in anything anyone here has to say about the subject. David Roche I believe has already weighed in on this.

I do not know if everyone has seen it yet, but there was another article in the print edition of Barrons this weekend about the current level of commodity prices -- to make a long story short, the discussion centers on the possibility of a serious decline in commodity prices. A cut & paste of a portion of the article that I found online is reproduced below for reference.

Setting the fundamental debate aside, one issue raised by Barrons is that index funds and commodity pools now represent a significant portion of the longs in many of these markets, with the commercials correspondingly short. Examples cited of fund/pool control are 59.1% of the 2007 US soybean crop and 83.6% of the wheat. We've talked here a few times about the lopsideness of the grain markets, but we've never really examined it in detail.

Barrons hypothesizes that if the CFTC were motivated for some reason to remove the exemption on position limits for index funds, those groups would have to liquidate their substantial long side positions in order to comply with the rule change. 50% declines could result.

One can make reasonable inference that the Fed trying to move in on the CFTC's turf here is a clear indication that politically motivated rule changes may be in the offing to suit the Fed's agenda. There is no shortage of people who have labelled current commodity price levels as a speculative bubble not founded on true supply/demand fundamentals, and they are wetting their pants wanting to intervene in the name of combating inflationary pressures -- why would anyone expect them to play fair in the current situation?

Longer term I'm sure everyone agrees that food prices especially are going to go where they belong in the end, but in the near term, poor saps like us on this list could get burned rather badly "Bunker Hunt style" by things like unforeseen rule changes.

So my humble question of you is this: Do you think this rule change stuff is all just a lot of big talk to try to dampen the market, or do you think there is a genuine risk in the current setup? I can't think of anyone on Earth more plugged into what's really going on here

From Barrons --

To get a further idea of the impact of these speculative bets, Barron's asked Briese to measure them against production in the underlying markets. He calculates that in soybeans, the index funds have effectively bought 36.6% of the domestic 2007 crop, and that if you add the commodity pools, the figure climbs to 59.1%. In wheat, the figures are even higher -- 62.3% for the index funds alone, and the figure jumps to a whopping 83.6% if you add the pools. Betting against them as never before are the commercials, who deal in the physical commodity.

The CFTC provides these figures on index trading for only 10 commodities. Why are such major commodities as crude oil, gold, and copper excluded? The agency's rationale, which even certain insiders question, is that it would be hard to get reliable information on these other commodities from the swaps dealers.

WHAT MIGHT FINALLY TRIGGER THE bursting of the commodities bubble?

One possible trigger was cited in a Barron's interview with Carl Weinberg of High Frequency Economics, published last week. Weinberg anticipated a break "some time this year" in industrial commodities, including crude oil, copper and natural gas once there is news of "even the slightest slowdown in the Chinese economy," the country whose insatiable demand, together with that of India, has been a rallying cry of the bullish speculators. When industrial commodities prove vulnerable, speculative money could start fleeing agricultural commodities, also.

Société Générale analyst Albert Edwards goes much further. Based on his view that the "Commodity bubble is nonsense on stilts," Edwards holds the "very strong conviction that before the end of this year, commodity prices...will be unraveling." He believes the triggering events will be the "unfolding U.S. consumer recession" and likelihood of "negative CPI [consumer price index] inflation rates."

A sudden turnaround in the dollar could be another trigger, notes Briese. By making dollar-denominated commodities ever cheaper in terms of other currencies, the collapsing dollar has been a legitimate bullish factor. "But the buck won't go down forever," Briese argues. "The same cycles that coincided with the dollar's major bottom in 1992 are due to make a low later this year. A rebounding dollar would pinch demand for dollar-denominated commodities."

Alternatively, to borrow a quip from the late humorist Art Buchwald -- who once explained that his candidate lost the election owing to "not enough votes" -- the bubble could burst from not enough buying. Brokerage houses have been advising their clients to allocate part of their portfolios to commodities, compared with allocations of zero several years ago. Even a shift of five percentage points would have been more than enough to account for the dollars that have fueled the "nonsense on stilts."

But what if the U.S. economy proves more resilient than currently thought, doesn't fall into recession, and instead starts growing again? The resulting rally in the stock market could send the allocation share back to zero and the bubble could burst, not with a bang, but with a whimper.

The CFTC could also prick the bubble by enforcing its own rules. If the agency were to rescind the exemption on position limits given to the index funds (say, on a phased basis, so that the funds could make an orderly retreat), prices would probably fall back to reflect their true supply-demand fundamentals.

Briese's analysis of commercial hedger positions leads him to believe that commodities in general were fully valued in terms of the fundamentals as of early September 2007. Based on the 24-commodity S&P Goldman Sachs Commodity Index, that would mean about a 30% collapse from present levels. But, he adds, "Given the tendency for prices to overshoot, commodity values could be cut in half before they stabilize."

Maybe it's time to start listening to the smart money.

(end of article transcript)

-- link to Barrons article from the week before for background -- http://www.cattlenetwork.com/content.asp?contentid=207504