Commodities: The Next Bubble?

One of the oddities of the financial markets is their nature to be excessively volatile. This enables assets to move from being mindlessly over valued to confusingly cheap, sometimes in very short time spans and with little new information. But is there a way to profit from this inefficiency?

Fighting the trend is not advisable, although it is sometimes unavoidable. An alternative approach is to just sit out the insanely unpredictable movements and watch others battle it out. Take Warren Buffett during the dotcom bubble. While the markets raged on (and he underperformed every benchmark out there), he never allowed the greedy thoughts of 100% returns in less than a year to obscure his judgment. At the same time, he was constantly criticized as wall street analysts spoke of a new economy and old valuation techniques that no longer produced correct valuations. Even if you recognized a bubble, shorting the market was dangerous. While a 100p/e ratio was common for a company with negative earnings, the possibility of a 200p/e ratio wasn't off the table. By the time the burst came, you could have been broke if you had mis-timed your shorts. Analysts added to the confusion. At the height of the bubble, BUY recommendations outnumbered SELLs by 100:1.

On To Commodities

While its hard to argue against the long term outlook for commodities, the market in my opinion has definitely got ahead of itself in terms of pricing - but shorting it could be very dangerous. Today I read an article entitled The Death of Gold which really got me thinking. As the author points out, the public being overly optimistic is generally a good sign of a bubble and particularly in the case of silver, all you hear is BUY BUY BUY likes its a sure bet. The same could be said for oil, wheat, etc.

Interestingly, I have compiled a chart of the Total NAV of SLV, A silver ETF that has become very popular lately. This shows the magnitude of the publics interest in the precious metal.

Barron's argued a few weeks ago that ETFs are significantly contributing to the commodity bubble. These investment vehicles have given the average retail investor a chance to participate in a commodities rally, thus sealing its own fate - a rally has occurred while short term economic fundamentals have been weakening. Given the solid long term fundamentals and the weak short term economic fundamentals, there is no reason why these markets should be so immensely inverted. For example, oil deliverable in June 2008 is going for $115.35, while delivery in June 2011 is going for $105.84.

Wall Street

As interest in commodities climbs, so does Wall Streets' coverage and favorable recommendations to their retail clients. A company that I have the utmost respect for (as well as being a shareholder), is Goldman Sachs, a company who is very bullish on commodities. After the big sell-off a few weeks ago, Goldman commented that the dip was a buying opportunity and that those who buy and hold will do well in the long run. This sort of sentiment from such a successful firm adds to the lure for retail investors and can distort the reality. While Goldman may be over-weight commodities, they are not 'all-in' by any means. Although I am unsure of the actual numbers, this view could affect their portfolio by altering their asset allocation to 7% commodities from 5%*. Compare this to some retail investors who have over 50% of their portfolio in commodities and commodity related stocks.

Also don't forget Wall Street's role in the dot-com bubble, the housing bubble, the 1987 crash, (do I need to go on?). Sometimes the experts lose touch with reality or even cause the debacles themselves..

Perpetual Commodity Bulls

Then there are the perpetual bulls such as the gold bugs. As their market of choice rallies, so their voices get louder and people take more notice. Yet all too often, these are the people that get hit hardest when the bubble bursts. Like those that bet that housing prices could only go up, the perpetual bulls will ultimately feel the wrath of a bubble bursting harder than those who are able to take profits at the risk of missing out on further upside.

While finishing up this article I happened to come across Jon Nadler's piece that is published almost daily on Kitco.com. If you want an unbiased perspective of the gold market, it's one of the best out there. In it he said:

Denis Gartman editor of the daily Gartman Letter, is "abandoning ship" on his positive gold outlook after three years, on expectations that efforts to contain food prices will curb demand for the metal as a hedge against inflation. Jon Nadler

*Example. Not actual statistic.

Disclosure: None (Recently sold off SLV holdings)

Comments

[Rhett:]

Sold SLV? Big mistake.

2008 Apr 22 09:37 AM

[boardroom_j...:]

Another meandering article that does not address the title question! Please, tell me how to profit by not participating! I wish there was a way to just ban writers that submit this crap so I don't waste my time on this fool again.

2008 Apr 22 12:25 PM

[Adam Katz:]

Rhett, to clarify I sold my SLV when silver was at $20.50. SLV was at $198 and considering I got in at around $130 I was very happy with my return. I will still be looking to get back in for the long term, just short term I believe that the market got ahead of itself.

jimmy, no need to attack me. I am new to contributing articles and any constructive criticism will be well received. As per the title, the SA editors preferred it to my title which addressed the current over valuation in the commodity markets ("Commodities Bubble?"). As I said the long term fundamentals are undeniably good, and I will be looking to re-enter later this year depending on how the macro picture plays out and the effect it has on the broad commodities market.

Adam Katz

2008 Apr 22 01:19 PM

[g miller:]

Actually, Adam, I thought your article was pretty good. I reduced, but did not eliminate my own precious metals holdings, because it appeared that a pullback was occuring. Why did you not delve more into the cause and whether or not it involved "cartel" or government manipulation? Based on de facto inflation and currency risk, it seems as though gold and silver should be higher.

2008 Apr 23 01:01 AM

[Adam Katz:]

With most consumable commodities there is a general concern for a long term shortage. Other commodities aside however, gold in and of itself has a few characteristics which I believe will never allow it to trade at its 'full' potential. It will always "seem as though gold and silver should be higher". I hope to put an article together this week on that very topic so check back.

Another note on the inflation and currency risk, I think that too much emphasis is put on the nominal USD price of gold and only using U.S fundamentals when discussing gold price. Take a look at these charts I posted on my site a few weeks ago: www.plusev.ca/gold-usd.../

Gold has strengthened against every major currency over the past year, its move has gone far beyond that of USD weakness. In Canada our strong currency has actually led us to very low inflation numbers. Check out my other SA article on Canadian interest rates for a more in depth discussion. Globally, countries are taking note of inflation, raising rates in some economies. China and India, the two largest gold consumers are both raising rates which is gold negative, even Britain is refraining from rate cuts to combat inflation (and boy do they need them). The only country not showing restraint is the U.S, where the nominal price of commodities is their real price. However, even in their case, interest rate futures have been showing an easing of expectations, from a 50bps cut next month, now down to over a 15% probability that rates will be held constant.

2008 Apr 23 09:51 AM

[fanning:]

One way to play the short term trading is to buy HGD.TO for bear of gold and silver price.

2008 Apr 24 11:04 AM

[silver-bullet:]

Hold physical gold or silver, because the US$ will soon collapse:
www.youtube.com/watch?...

2008 Apr 26 06:32 PM