Lucky Generals, Index Funds and Inflation
In the mid‑1980s, I was working as a futures broker when an important client from New York visited our London office. We went to lunch, and he returned to the trading room with me for a chat about the markets. A few minutes into the conversation, he leaned over and asked me to buy 200 lots – 10,000 tonnes – of sugar on the London market.
I called the floor, executed the order, and reported the fill. We kept chatting. A little later, he told me to sell the 200 lots. I did as instructed and calculated that he had just made close to $100,000. Curious, I asked what had prompted him to buy.
“I was looking at the price screen behind you,” he replied. “The price was slowly rising and hit a resistance level where heavy selling came in. It failed a couple of times, then pushed through. I assumed the sellers would need to buy back, and that their buying would drive the market higher in the short term.”
I turned around to look at the screen. It was showing London rubber, not London sugar. He had bought the wrong commodity. I briefly thought about telling him, but instead muttered something about Napoleon preferring lucky generals over clever ones. He didn’t react.
Half a lifetime later, I found myself back in London visiting a client. We went for lunch, then returned to his office for coffee at the trading desk. The team gathered around as we discussed sugar. I don’t recall the exact “big number,” but the market was trading quietly just above the 65-point level on low volume. It nudged 65 a couple of times and then bounced.
“It’s going to break 65,” I said, almost to myself. “And when it does, it will drop at least 45 points.” My remark sparked a bull‑bear debate around the desk. While they argued, the price tested 65 again, broke through, and promptly fell 45 points.
One of the team turned to me: “I understand why you thought 65 would break, but how did you know it would fall 45 points?”
“I really have no idea,” I replied.
I was reminded of those two episodes when I wrote last week about Jesse Livermore. He reportedly told his son:
“Every stock is like a human being: it has a personality, a distinctive personality: aggressive, reserved, hyper, high‑strung, volatile, direct, logical, predictable, unpredictable. I often studied stocks like I would study people; after a while, their reactions to certain circumstances become more predictable.”
I added, “The same is true of commodities. Each has its own character. Once you trade in a market long enough, you begin to anticipate how it is likely to react under stress, at key levels, or to specific macro shocks.”
This got me thinking this week about index funds. After all, they don’t care about a commodity’s personality. They just throw them all in a basket.
I first wrote about them in my book, The Sugar Casino, published in 2016. (Here is an updated version of what I wrote.)
A commodity index fund is similar to an equity index fund; the money within the fund is invested in futures contracts that are based on, or linked to, a commodity price index. The value of these indices fluctuates depending on their underlying commodities, and this value can be traded on an exchange in a manner similar to stock index futures. The price index may represent the entire commodity asset class or a specific segment, such as energy or agriculture.
The S&P GSCI (formerly the Goldman Sachs Commodity Index) is perhaps the best-known and most widely followed index. It was created by Goldman Sachs in 1991 and sold to Standard & Poor’s in 2007. The S&P GSCI comprises 24 commodities from all major sectors, including energy products, industrial metals, agricultural goods, livestock products, and precious metals.
The Bloomberg Commodity Index (BCOM) is likely the second most widely followed commodity price index. The index was launched in 1998 as the Dow Jones‑AIG Commodity Index (DJ‑AIGCI) and renamed the Dow Jones‑UBS Commodity Index (DJ‑UBSCI) in 2009, when UBS acquired the index from AIG. It was rebranded under its current name in July 2014. BCOM currently comprises 25 commodity futures across seven sectors. No single commodity can constitute less than 2% or more than 15% of the index, and no sector can account for more than 33% of the index (based on the annual weightings of its components).
The CRB Index was first created by the Commodity Research Bureau, Inc. in 1957, and initially included 28 commodities: 26 traded on futures markets and 2 on cash markets. Its components and formula have been periodically revised. The best-known modern version, long branded as the Thomson Reuters/Jefferies CRB Index and now linked to Refinitiv and CoreCommodity, comprises 19 commodities.
Index funds were significant players back in 2016, and I contacted Dave Whitcomb to ask if they still are. “Very much so,” he told me. “I call them ‘whales’.”
Dave sent me two charts from a class he taught recently at Geneva University. The first shows an agricultural basket that includes corn, wheat, KC wheat, soybeans, soybean oil, soybean meal, live cattle, feeder cattle, lean hogs, cocoa, sugar, coffee, and cotton.
The second zooms in on sugar as a single market.
He told me that “Index funds tend to increase their positions in agricultural futures when forward‑looking inflation expectations rise. These funds use agricultural futures as a store of value and an inflation hedge, so it makes sense they would add exposure when they expect inflation to rise.”
“It’s striking to see the relationship play out in real time,” he added.
However, I wondered how effective these funds were in using indices to hedge against inflation. In his must-read book, Commodities as an Asset Class, Ivo Sarjanovic found that the correlation between inflation and commodity prices has been low over the long term (1960–2021), although there have been specific episodes where the correlation rises. Capturing those episodes requires an active strategy, not a passive one.
When I interviewed him for my blog in 2023, Ivo told me, “If you trade in commodities, you must understand the specifics and dynamics of each market. Commodity trading offers many opportunities, both on the long and the short side. And you need to be aware that not all commodity families behave similarly. So, choosing the right product or sector is crucial.”
I contacted Ivo last week to ask if we were in a period of high correlation and if a weakening dollar was bullish for commodities.
“Different commodities respond differently to the same macro stimulus,” he told me. “A weaker dollar generally supports commodities, but some benefit more than others, while some do not benefit at all. Different currencies influence each flow: the rouble for wheat, the yuan and real for soybeans, the Thai baht for sugar, among others. Understanding how the dollar interacts with each of these currencies is crucial to predicting how each commodity will trade.”
Effective or not, index funds continue to be major players in our markets. In a chapter he contributed to the second edition of my book, Commodity Conversations, Dave wrote, “Whether you’re a professional trader, risk manager, or market analyst, the ability to interpret and anticipate macroeconomic developments has become as fundamental as understanding traditional supply and demand dynamics.”
As a trader, you must do both: understand the personality of your market and avoid (or surf with) passing whales. A bit of luck also helps.
Next week: Swimming with the Sharks.
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