Do Fundamentals Matter Anymore? May 2006

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1 1 Do Fundamentals Matter Anymore? May 2006 Forecasting metal prices used to involve assessing basic supply and demand fundamentals. To a large extent, this is still true, but the spectacular price rallies of the past year begs the question of just how relevant fundamentals have become given the enormous amount of fund money flooding the markets. This brief will look at where metal prices have historically been as measured by a key fundamental ratio, and where prices are today based on this same measure. It will also examine the scope and size of fund money that is currently in the system. The stock to consumption ratio is a widely used fundamental measure used to forecast metal prices, and basically tells us how many weeks of global weekly inventory there is given the current rate of consumption. We note from our graph below, for example, that in copper s case, the current stock ratio (in red) is about 2 weeks. This is very similar to levels in reached 1997, 1988, and Copper Price vs. Stocks/Consumption Ratio Yet, if we plot this ratio against monthly average prices, as we do in the following chart, we see just how much higher copper prices are this time around compared to previous cycles. The circled area in red shows the cluster of monthly average prices in the past year when the stock ratio was at weeks. We note that prices in this decade were in the $3,000-$6,700 range, with the spike to $6,700, of course, occurring just this month. Now look at where average prices were in the 1970 s, 1980 s and 1990's when the stock ratio was at similar levels -- prices never breached the $3,500 in any of the periods under question*. * The recent price spikes are not as high when adjusted for inflation. However, making such inflation adjustments is in itself debatable given that the cost of producing most metals has fallen over the years.

2 2 Copper Stock Ratio vs. Prices Our stock ratio for aluminum (chart, next page) shows the same thing, namely, that price spikes were much higher over the past two years than they were during other periods when the stock ratio was low. We note that the current stock ratio is around 6 weeks, with prices averaging $2750 so far this month. The only other time when prices responded with a similar spike was in the 1980's when a low ratio took prices briefly to just below $3,000 on a monthly average basis. On the other hand, when the ratio was similarly low in the 1970 s, prices barely got to the $2000 level.

3 3 Aluminum Stocks Ratio vs. Prices In the case of zinc, we see in the chart below that there has been a similar push higher lately, with the market now looking at 5-6 weeks of global inventories on hand. In fact, price spikes this year are almost double levels reached in the 1980's when the stock ratio was at a similarly low level.

4 4 The charts above suggest that funds are responsible for the recent exaggerated price swings in these metals, as fundamentals alone at least by this one key measure do not fully explain the explosive moves higher. The types of funds at work in our markets are both the active kind, (commodity trading advisors and hedge funds), as well as the passive kind (index funds). Data we have compiled shows just how quickly all three groups have grown in terms of money under management. Index funds have $80 billion under management, (chart 1) and primarily seek commodity exposure through various fixed baskets in order to negatively correlate (and reduce) existing risk on existing bond and stock portfolios. The second group -- the CTA s -- have $130 billion under management (chart 2), while global hedge funds have an estimated $1,000 billion under management. (Depending on their charters, some of the funds in the global hedge fund group are also allowed to trade commodities). Index Funds (in billions) (Chart 1) Source: Man Financial Estimates

5 5 CTA Funds (chart 2) Global Hedge Funds (chart 3) Source for Charts: Man Financial One of the symptoms of growing fund involvement in the markets is that fund volume has outpaced that associated with trade origins. We note from the graph on the next page that LME fund volume (in red) has exploded of late, while volume by commercial origins has receded mainly due to the fact that holding short positions in raging bull markets consumes an enormous amount of cash flow and becomes a difficult endeavor to sustain.

6 6 Source for Data: Man Financial What is striking when looking at the role of funds, is just how much more money potentially exists that could still enter the commodity markets. The chart below captures this point. Here, we show total investable funds in the world a whopping $150 trillion. Of this amount, roughly half is held by banks, a little more than a quarter is in bonds, and a little less than a quarter is in stocks. However, look at the category of alternative investments where macro funds, CTA s, and index funds reside. This group currently comprises a mere 0.2% of total investment funds, suggesting that there is still much more room to grow. Global Investments, $150 trillion alternative investments: significant growth prospects Bonds Macro Funds Bank Assets Equities alternate invstmnt <0.2% CTAs Index Funds Source for Charts: Man Financial

7 7 Conclusions: We predict that commodity markets will continue to attract even more fund money, especially given the current investment mindset where commodities are very much in vogue. So are fundamentals still relevant, or shall we all attempt to start tracking fund flows instead? Our view is that over the long run, fundamentals are relevant, but because their impact period is so long, funds will dominate short-term trading and direction. We also find that funds usually reinforce the price direction set by the prevailing fundamentals, but do a poor job fighting the underlying trend as previous, largely contrarian, commodity debacles have illustrated. Commodity analysts, among others, will therefore have to come to terms with funds as an ongoing and growing presence in the markets. Short-term indicators, like technical patterns, volume, open interest, and commitment of trader reports, (classifying the types of investors have open positions), will all have to be utilized more frequently to get a better sense of what funds are doing. Commercial hedgers have to counter the increased intraday volatility by making more use of options. They also have to move away from fixed-price hedging and towards premium hedging in order to avoid being caught in raging bull (or bear) markets whose intensity is frequently whipped up by fund activity. The exchanges themselves have to make information available more quickly so investors get a better sense of fund flows. As an example, the frequency of commitment of trader reports could be increased to a daily basis as opposed to the current weekly snapshot. After all, measuring how long or short funds are these days is perhaps just as important as knowing about the next mine strike. -- Written by Edward Meir and Fred Demler -- emeir@manfinancial.com, fdemler@manfinancial.com This report is issued by Man Financial Limited, which is authorized and regulated by the Financial Services Authority and is a member of the London Stock Exchange. Man Financial Limited is a member of the Man Group. References to "MFL" in this report shall mean Man Financial Limited unless otherwise stated. The report was prepared and distributed by MFL for information purposes only. The report contains information and opinions, which may be used as the basis for trading undertaken by MFL and its officers, employees and associated companies. The report should not be construed as solicitation nor as offering advice for the purposes of the purchase or sale of any security, investment, or derivative. The information and opinions contained in the Report were considered by MFL to be valid when published. The report also contains information provided to MFL by third parties. The source of such information will usually be disclosed in the report. Whilst MFL has taken all reasonable steps to ensure this information is correct, Man Financial Limited does not offer any warranty as to the accuracy or completeness of such information. Any person placing reliance on the report to undertake trading does so entirely at their own risk and Man Financial Limited does not accept any liability as a result. Securities and derivatives markets may be subject to rapid and unexpected price movements and past performance is not necessarily a guide to future performance. Moreover, products referred to here are highly leveraged, and thus increases the risk of being involved in adverse market movements.man Financial Limited. Sugar Quay, Lower Thames Street, London, EC3R 6DU. To be removed from future Man Financial updates, including rate offers, simply reply to this and enter, "REMOVE FROM LIST" on the subject line. Removal may also be requested with a written request to R. Leesley at Man Financial, 440 S LaSalle St, Ste 2000, Chicago, IL (include a copy of this ). CUSTOMERS PLEASE NOTE: When unsubscribing, unless you specifically request not to, you will CONTINUE to receive your statements electronically if you already do so.