Be wary of pushers of the commodities bubble.

Zynx

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Thu Mar-20-08 10:09 AM
Original message

Be wary of pushers of the commodities bubble.

Specifically, this relates to the various commodities bulls on this board. I won't name names, but we all know who they are and they will undoubtedly flame me.

For the past five years, there has been an epic rally in commodities. To a large extent there has been economic basis, just like most bubbles, including the ill-fated housing bubble. In housing, there was unusually short supply combined with slightly elevated demand. In the early years of the housing bubble, the gains were reasonable, but as time went on, speculators and momentum players played their hand. The gains became more and more rapid. Financial planners and newsletter writers explained how housing was the best way to make money for even average investors. Just before the peak, the frenzy was the greatest. When housing burst, many didn't realize just how steep and protracted the declines would be since the arguments for the increases seemed so well founded in economics. This is best seen by how many investors attempted to catch the falling dagger of the stocks of the luxury home builders which had a number of recovery rallies within the context of a broader decline.

With commodities, there has been an economic basis for the rise. Economic growth worldwide has been above average over the past five years. Industrial growth in China and India in particular has put considerable strain on the supplies of iron, copper, cement, and all manner of other commodities, including oil. However, in the past year and a half, the gains in commodity prices across the board have taken on an exponential nature.

These are charts of various different measures of commodities, some of which weight energy more, some metals more, some agriculture more. They all paint one picture: an increasing rate of appreciation across the board. This applies particularly to gold and oil. In the case of gold, and commodities in general, the decline of the dollar has caused movement in its direction as have concerns about inflation and financial market instability, which also play into dollar weakness. Oil has been buoyed by the weak dollar and supply disruptions. However, there is another factor at work here that is also very important and that is the involvement of the unregulated hedge fund industry. http://www.nytimes.com/2008/03/20/business/20commodity.html?em&ex=1206158400&en=8a43b9c2f504045f&ei=5087%0A

As commodity markets are relatively small in size, far smaller than equity or credit markets, large infusions of investor money have an unusually large impact on prices. For example, a couple years ago I remember hearing that buying all the Zinc contracts in the world would only take $3 billion. By comparison, the market capitalization of Microsoft is nearly $300 billion. A couple hundred million dollars cannot manipulate the price of Microsoft, but it certainly can manipulate the price of a single commodity. The hedge funds have pumped tens of billions into the commodities markets chasing these gains and they are doing so at an ever increasing rate. Financial advisers and investment firms, the same ones who pushed individual investors into real estate leverage schemes in 2003-2006, are now pushing people into commodities and have done so heavily over the past year.

Make no mistake, this is a classic bubble. Better than normal fundamentals have been stretched to their extreme. In the 1990s leading up to 2000, better than normal earnings growth led to stocks with valuations in the stratosphere. In the mid 2000s, better than normal supply and demand characteristics in real estate led prices to increase at 3x their normal rate. Now, commodities, on the basis of foreign growth and a weak dollar, have taken on exponential gains annualized at up to 60%. Anything that can increase that rapidly can fall just as quickly. Commodities are historically very volatile, perhaps the most volatile of asset classes. 4-5% moves on a daily basis in commodities are more common than similar moves in stocks or bonds. This even applies to the fabled "safe haven" of gold. It is true gold is a hedge against inflation and turmoil, but only to a point. In the early 1980s, gold got bid up to $800 an ounce and 15 years later it was around $250. In the same time absolutely every asset class obliterated it. Stocks, bonds, real estate all outperformed and generally normally do. The speculative frenzy, particularly in the last year that has taken gold from $650 an ounce to over $1000 is a bubble like any other. The same applies across the board and it is driven by the same big Wall Street money as all the others. Commodities do not represent some fairer, more democratic market than other financial assets. It is precisely the same if not even more extreme.

In the past three days, gold has fallen approximately $120 an ounce from its peak. Other commodities have corrected on the order of 10% or more. This was not to be unexpected. Once again, they are by no means stable markets. Many commodity players operate with extremely large amounts of leverage compared to their equity. Trading houses, under pressure from the general financial market turmoil, are reining in the commodities players as well. Furthermore, slumping US and other developed nation industrial demand will continue into the near future, putting fundamental pressure on the commodities markets just the same as any other recession that has ever happened. Less consumption means less production, which inevitably means less consumption of commodities. The recession of 1981-1982, which was preceded by a similar commodity boom, killed commodities in an incredible fashion. The recession of 1990 also brought down commodities prices. The recession of 2001 brought metals prices in particular considerably lower. This one will be no different and this is compounded by the unwinding of the hedge funds and momentum investors that contributed to the exponential surge in prices.

In short, these are not safe havens. The gold bugs are not your friends. Commodities bulls are playing into the hands of yet another Wall Street fad. If you truly want your money to be safe, the safest place is in FDIC insured bank accounts. Spread it around if you have more than $100,000 just to be safe. The odds of your bank failing are and will remain relatively small. Certainly smaller than the odds of a major wipe out in any financial asset. Short term Treasury bills are also safe, but your bank is pretty damn safe. The government has considerable means to prevent a loss of deposits. Besides, major bank failures would undoubtedly be coincident with such a major economic correction that commodities would be clobbered anyway. Please, do not chase one bubble to escape another. People did that from stocks to housing and paid dearly for it in the end when if they had just stayed in stocks, assuming they owned a broad index fund, they would have been fine, even if the returns have been anemic in the short term following the biggest stock market bubble in history from which we are still staggering.

I cannot predict if this is the end of the commodities bubble or not. I was a year early on housing and three months early on stocks in early 2000. However, I can say with absolute certainty that by examining history and economic fundamentals that the commodities bubble exists and it will burst. If you are interested in preserving wealth, stay away. You can look longingly at your gains just as stock investors did in 2000 or real estate speculators did in 2006. They always called those that warned of a bubble jealous of their massive multi-100% gains. However, most got greedy and lost all of those gains. Don't fall for the same trap.

Thank you.