Commodity bubble confirmed?

18May06

We apologize for that bit of hyperbole. While we have been chronicling the case for a commodity bubble, one can confirm a bubble only in hindsight. Now, John Spence at Marketwatch.com reports that Morgan Stanley (MS) chief economist Stephen Roach is now firmly in the commodity bubble camp.

"Like clockwork, liquidity-driven investors have migrated from asset to asset, desperately in search of yield," he said. "The world is now in the midst of another bubble — this one in commodities."

The economist said the jumps in prices of materials the past few months are reminiscent of charts of dot-com stocks in late 1999 and 2000.

"That speaks to an important aspect of any speculative bubble — price excesses that spread into the far reaches of an asset class."

Spence earlier made the case that investor ardor for commodity mutual funds is reminiscent of previous fund manias. Commodity funds may simply be the latest manifestation of a (sadly) typical case.

"Anyone with a pulse knows that energy stocks, commodities and international companies have done well," said Don Cassidy, senior research analyst at Lipper Inc. "Whether it's overdone depends on where the global economy is headed," he said, adding a slowdown could hit demand for commodities from key developing economies such as India and China.

Fund investors' tendency to chase returns and their terrible collective record at timing markets are well documented — for example some analysts use mutual-fund flows as a contrarian indicator.

Russell Investment Group portfolio strategist Stephen Wood in a recent study for financial advisers says investors' self-inflicted woes are compounded by habitually underestimating market volatility in the near term.

This ardor has also transferred itself to the alternative energy arena as well. Scott Patterson in the Wall Street Journal reports on the gold rush (pun intended) to create investment vehicles that are "..designed to help investors cash in on an impending boom in alternative energy, spurred by soaring oil prices and the threat that crude could stay expensive for years."

With all booms there is a fundamental case for investors' interest in alternative energy companies. The move up in oil prices has made all manner of technologies now more feasible then ever. The question is whether that has already been priced into the shares of the existing companies.

An analogy might help. The Internet bubble peaked some time in 1999 (or 2000). The vast majority of Americans have only recently begun to enjoy the fruits of these efforts, due in large part to the widespread adoption of broadband. Undoubtedly alternative energy will also provide us with some breakthroughs that make energy cheaper and cleaner. However it will take time (and patience) for investors to really profit from this potential.

Investors need to not only be correct in their fundamental assessment of a trend, but they also need to get the timing correct. The commodity and alternative energy booms have already generated tremendous returns for those early investors. Now that these trends have been well-recognized, future profits will in all likelihood become more difficult to capture.

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