Most of the money made in the market over the last several years has been pure unadulterated manipulation. In this market valuations matter little. Instead, speculation in very large dollar amounts results in something that is far from efficient.
For those that ride the wave of these speculative frenzies, huge profits can be had. A great example of this can be seen in the huge boom in commodity prices. Hedge funds with billions of dollars under management pushed up prices of everything related to basic materials, oil and agriculture products.
It was a huge bet on the global economy and inflation. Ultimately, the trade became some sort of sick capitalistic self-fulfilling prophecy. The higher these goods traded in value, the more inflation was likely to become a problem.
Long after these trades started to perform, any individual investor could have rode the coattails to prosperity. You didn’t have to time it perfectly. All you had to do was identify the market with the most speculation and go from there.
The best part about this new dynamic in the market is that the trade works in both directions. In other words, when the trend ends, selling ensues. In some cases the selling can actually be more acute due to the leverage involved in the original trade.
That has certainly been the case with commodities. Prices have fallen fast and furiously. The lower values precipitated margin calls that resulted in additional selling. Mind you, this is not selling due to fundamental reasons, but more due to the nature of speculation and the unwinding thereof.
In the case of oil, we saw a huge run-up in prices until the peak of nearly $150 per barrel. Stocks associated with crude enjoyed significant gains in value. Take a company like Devon Energy (DVN). (See also: "Avoid Devon Energy Like the Plague.")
Over the last five years, DVN energy moved from just over $20 per share to a high of $127 in early July. The move was directly correlated to the increase in oil prices. Interestingly, despite the rapid rise in stock value, DVN’s valuation was still relatively reasonable.
Huge gains in revenue and profits resulted in a stock that still traded for low fundamental multiples of earnings and sales. Such a state drew in value managers that were misguided in thinking that high prices would grew into perpetuity.
What these folks failed to realize is that…
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…high prices were nothing more than a mirage. As soon as demand destruction began to take hold in mid-July, the speculators bailed like rats jumping from a sinking ship.
These players knew full well that the absence of the huge dollar amounts committed to the long side could create a vacuum that would suck the life out of the trade. Once the unabated inflation play ended, it was time to pull out.
They did pull out, but only after oil dropped to $100 per barrel. Shares of DVN followed suit and lost nearly half their value. The credit crisis only added momentum to the drive lower.
The move to the downside has been mostly unabated until the OPEC decided enough was enough. An emergency meeting of the group that controls 40% of world oil supplies stopped the bleeding.
Do you see the pattern here? The big boys drive the price higher and the absence of their huge pool of capital pushes the price lower. That move is only halted when a bigger boy in the form of OPEC joins the fray.
To fight the decline in oil prices there is speculation that the cartel will cut production by up to 3 million barrels per day. That is a huge number and not to be treated lightly.
I have suggested previously that OPEC would struggle with its effort to stem the tide. A slumping economy would trump any move to reduce supply. Inevitably producers will cheat even if they announce a cut.
What I failed to consider was the power of the hedge funds. In concert with an obliging OPEC the stage was set for a key reversal in prices irrespective of the economy. Remember, prices in the market have little to do with fundamentals.
What we have now are the ingredients for a mini-rally in crude. OPEC is hot on the trail for $100 oil. With their friends the hedge funds they very well may get it.
This is your chance to ride the wave back up to that level.
This article was written by Jamie Dlugosch, contributor to InvestorPlace.com. For more actionable insight like this, go to: www.InvestorPlace.com and check out:
