Are Commodities The Next Investment Bubble?

I have heard it said that in a bubble, the price of the hot item affects the economy more than the economy affects the price of the hot item. While this was true during the past two bubbles (internet/technology stocks of the late 1990’s and early 2000 and housing) does this hold up with the current sector shift into commodities? Could we be witnessing the formation of the next bubble?

Before we get ahead of ourselves, it is a good idea to determine what classifies a “bubble.” A bubble can be loosely defined as when excess resources, capital and financing are being poured into a specific hot investment as compared to other capital investments. There are differing types of bubbles, but James Montier did a good job of categorizing them:

1. Greater fool theory – higher prices are willing to be paid as long as there is someone else to buy it from them – speculative
2. Fundamental analysis – investors err by extrapolating that past returns will continue indefinitely into the future
3. Fads – investors succumb to pressure to conform to the majority’s view (social and psychological factors)
4. Informational – prices deviate from the fundamentals because investors assume they have hidden information that supports higher prices

Additionally, if you take a look at both of the most recent bubbles mentioned above, you can see a consistent pattern emerging from their formation to the eventual bursting:

– Bubbles usually start because of rotational investment shifts; investors seeking “the next big thing” move money into these investments in an attempt to improve returns

– Hype and over-promotion become rampant

– The word “new” is usually always bandied about by the pundits and used by investors to rationalize why this time is different than the past

– Institutional investors are usually leading the charge into the hot investment

– Individual investor follows the institutional money

– The non-investor feels they are being left out and follows the herd, believing they must not miss out

– Speculation follows – leverage and margin are used in excess

– Bubbles seem to be always tied to loose credit policies or easy money

– Bubbles tend to initially fund unsound business, and promote over-investment

– Bubbles invariably start slowly and gradually build over a period of years

– At the peak of a bubble misrepresentation and fraud flourish

– After the peak, prices fall precipitously and then partly recover

– After the recovery there is usually another protracted period when prices stay stagnant or drift lower

– Bubbles are often followed by economic recessions

The inevitable bursting of a bubble can be very painful and has the tendency to redistribute wealth, as the early adopters who cash out take the money from the late arrivers. Sadly, the late investors then usually get saddled with an investment rapidly declining in value that frequently becomes illiquid, and as such they lose out even more. However, even with the associated pain bubbles are good for a free economy. Daniel Gross points out in his book, “Pop,” that bubbles leave behind a new commercial and consumer infrastructure. “The stuff built during infrastructure bubbles – housing and telegraph wire, fiber-optic cable and railroads – don’t get ploughed under when its owners go bankrupt,” he reasons. “It gets reused – and quickly – by entrepreneurs with new business plans, lower cost bases, and better capital structures.

So where does this leave us with our original questions?

As an investment advisor I am in a unique position to be able to see the trends of a bubble develop. I see when institutional money begins its shift into other markets. I see the promotional machine begin and when it ramps up to a furious pace in an attempt to lure investors’ money. I see when clients begin to take abnormal interest in their portfolios and start calling to make sure they have some exposure to the current “hot” investment. Finally, my clients let me know it’s time to take some profits off the table because the phone rings continuously requesting a change in their portfolio to heavily skew it away from a successful, less risk, diversified strategy to one of putting the majority of their eggs in one basket. While the timing may not be spot on, every time we have had bubbles my clients turn out to follow that consistent pattern mentioned above, which is a great forecaster of things to come. So when clients started calling and asking about their exposure to commodities, it raised a red flag for me.

Without question, commodities could be the next technology or housing bubble. Many of the patterns seen in past bubbles are present today. Based upon my clients’ activity level I would put us mid-stream into the bubble. From a fundamental standpoint as well it seems only mid-stream because some of the imbalance in commodity prices is due to the current imbalance in supply and demand and is therefore justified. Upward price adjustments can also partially be contributed to the weakening US dollar (e.g. oil’s mercurial rise – the largest component of a commodity index – which is pegged to the US dollar). With the dollar continuing to fall, some of the price increase is exacerbated. The rest is due to world economic expansion and, my cause for concern, speculation. Because the majority of the rise is not speculative, at this time it is a little different than previous bubbles and therefore makes it harder to gauge. Of course, the greater the speculation, the closer we approach a true bubble.

When it comes to bubbles recognition is only half the challenge. The other half is what to do and when to do it with regards to your investments. It is recommended that investors manage their risk exposure by never investing more than 5-10% of their assets into any one sector. This approach always limits potential losses so if a bubble does occur, while you may have some minor pain (a 10% loss) you have not been wiped out. Another prudent practice is to regularly review your asset allocation and rebalance your portfolio to insure that any investments that have become out-of-balance are readjusted (i.e. partially sold off) to within the risk tolerance you have set for your portfolio. The advantage of this is that during bubbles, those investments will rise, and regular rebalancing will bring this investment back to an acceptable risk level, thereby reducing exposure and locking in some profits. While this may not maximize gains it unmistakably minimizes losses, which are a major concern if the potential for a bubble exists.

As the hype surrounding commodities continues to build, the chances are increasing that we are moving closer to a true bubble, which is terrible news considering we have yet to recover from the previous one. The effects of another bubble so soon after the last could be devastating to the US economy. However, the good news is that it’s not too late to turn it around. Even with the excess capital flow into commodities continuing unabated, I feel we are still months, if not a few years, away from this situation turning into a full-fledged bubble. This gives the forces that could slow it down or reverse the trend a chance to take hold. In the meantime, be aware that the signs are there, because you don’t want to end up as one of the late arriver’s.

Source by Chuck Gibson