Secrets Of Success: Prepare to spot a bursting bubble

Have you noticed something familiar in the air recently? I have. What I am hearing is the sound of investment professionals girding their loins for a showdown about the case for investing in commodities and mining stocks. The argument is an exact replica of the one that characterised the later stages of the internet bubble. It will, I suspect, end much the same way, with a spectacular but short-lived vindication of the bullish camp and an equally spectacular but more protracted and painful aftermath.

This is the kind of debate that makes investment markets such fun to observe and so hard to get right. Nobody can doubt that the mining sector, and commodities in general, are on a fantastic roll. The price of oil has risen sixfold in seven years, copper has quadrupled in four, and silver and sugar have both tripled in three years. Orange juice has doubled in two. We are living through what is the biggest commodity rally of the past half-century.

Amid all this excitement, it is easy to forget, as the US fund manager Bill Miller pointed out this week, that it is only seven years since The Economist had a famous front-page cover saying that the world was drowning in oil and predicting that the world could be heading for a price of $5 a barrel. As often happens, that more or less marked the bottom of the oil price slump. The price today is more than $70 a barrel. And you can find normally sensible people predicting that it will go to $100 a barrel or more before the current bull market phase has run its course.

At the same time, as Jim Rogers pointed out in his percipient book Hot Commodities two years ago, it is not that long ago that most of the world's biggest investment banks suspended their coverage of mining and resource stocks on the ground of lack of interest. Now hardly a day passes without the arrival of some new bulky research tome from a broker and investment banker justifying the argument that this bull market could go on for years. Commodities are indeed hot, so much so that, having been the pariahs of the investment world for half a generation, they are being pitched to pension funds and institutions by consultants as a perfect new asset class for their portfolios. This is usually a reliable contrarian indicator that the best has already been seen.

What is really driving the new demand for commodities is the strong price performance of the past five years. As always happens, momentum creates its own demand, nowhere better typified than in the market for silver, where it is frustrated investment demand, not physical demand, that is mostly now driving up the price. This will in time - if it has not already happened - create another of the classic bubbles of financial market history. A rise in interest rates, a big move in the dollar, a cyclical downturn in the Asian economies could wreak havoc when the music finally stops, not least because many market participants are highly geared.

The first and most telling sign of a genuine bubble is that plausible-sounding rationalisations and extrapolations start to take the place of serious or consistent analysis. Most people are now familiar with the main outlines of the bull case for commodities, principally soaring demand in China and India - as these two countries belatedly race towards industrialisation - and shortages and capacity constraints on the supply side. There is no doubt that these are the factors that explain the start of the current bull market, as spotted by the likes of Jim Rogers and Warren Buffett five years ago.

But just as you could justify almost any price for an internet stock if you assumed that their business metrics would go on growing indefinitely, so too there is almost no limit to what price you can plausibly justify the current price on a mining stock if you assume that today's high prices will continue growing indefinitely. A brilliant piece of research by James Montier, the behavioural strategist from Dresdner Kleinwort Wasserstein, recently dissected some of the absurdly ambitious earnings forecasts that mining analysts are building into their valuation models.

His analysis shows that mining-sector analysts are forecasting 20 per cent growth in earning in the next 12 months, 31 per cent in the following two years and a mere 21 per cent over five years. This is despite the well-documented fact that analysts of all kinds routinely overestimate future earnings growth. But even if you accept the analysts' exaggerated forecasts of permanently higher mining stock earnings, and assume a heroic dividend-payout ratio of 50 per cent (which is twice the current ratio), the best you can do is get a figure somewhere close to current market valuations.

Bill Miller takes a different approach, but his conclusion is the same. Only by assuming that supply and demand will never come back into balance can you possibly justify where commodity prices are today, let alone argue that they are worth buying now on value or investment grounds.

Copper's average cost of production, observes Miller, is 90 cents per pound and the marginal cost about $1.30 per pound. The current price is around $3.25 per pound. "It is not," says Miller, "a question of if copper prices are going down, it is a question of when." Supply blockages can put off the day of reckoning, but not avoid it. (His, Montier's and other comments can all be found on my website at www.independent-investor.com).

But, of course, this brings us back precisely to what is driving this market, which is no longer fundamental supply and demand, but speculative buying fuelled by the usual cheerleaders on Wall Street and in the City (investment bankers well to the fore). Those who are rushing into mining stocks now are betting on the price continuing to rise above and beyond fundamental value, a phenomenon better known as the Greater Fool Theory.

What we know from previous bubble episodes is that this process of self-reinforcing momentum can go on longer and further than rational investors ever expect, which is why I for one am not going to say that we have yet seen the top of the current market, though the recent price action in gold and other commodities, as my technical analyst friend Brian Marber observes, looks very similar to what you expect to see at market peaks.

jd@intelligent-investor.co.uk

Independent Partners; request a free guide on NISAs from Hargreaves Lansdown

PROMOTED VIDEO
Finacial products from our partners
Property search
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

ES Rentals

    iJobs Job Widget
    iJobs Money & Business

    Ashdown Group: Marketing Services Manager - (communications, testing, DM)

    £32000 - £35000 per annum + benefits: Ashdown Group: Marketing Services Manage...

    Guru Careers: Finance Account Manager

    £Neg. (DOE) + Excellent Benefits: Guru Careers: A Finance Account Manager with...

    Ashdown Group: Java Developer - Hertfordshire - £47,000 + bonus + benefits

    £40000 - £470000 per annum + bonus: Ashdown Group: Java Developer / J2EE Devel...

    Ashdown Group: Direct Marketing Manager - B2C, Financial Services - Slough

    £45000 - £55000 per annum + Benefits: Ashdown Group: An exciting opportunity h...

    Day In a Page

    Jeb Bush vs Hillary Clinton: The power dynamics of the two first families

    Jeb Bush vs Hillary Clinton

    Karen Tumulty explores the power dynamics of the two first families
    Stockholm is rivalling Silicon Valley with a hotbed of technology start-ups

    Stockholm is rivalling Silicon Valley

    The Swedish capital is home to two of the most popular video games in the world, as well as thousands of technology start-ups worth hundreds of millions of pounds – and it's all happened since 2009
    Did Japanese workers really get their symbols mixed up and display Santa on a crucifix?

    Crucified Santa: Urban myth refuses to die

    The story goes that Japanese store workers created a life-size effigy of a smiling "Father Kurisumasu" attached to a facsimile of Our Lord's final instrument of torture
    Jennifer Saunders and Kate Moss join David Walliams on set for TV adaptation of The Boy in the Dress

    The Boy in the Dress: On set with the stars

    Walliams' story about a boy who goes to school in a dress will be shown this Christmas
    La Famille Bélier is being touted as this year's Amelie - so why are many in the deaf community outraged by it?

    Deaf community outraged by La Famille Bélier

    The new film tells the story of a deaf-mute farming family and is being touted as this year's Amelie
    10 best high-end laptops

    10 best high-end laptops

    From lightweight and zippy devices to gaming beasts, we test the latest in top-spec portable computers
    Michael Carberry: ‘After such a tough time, I’m not sure I will stay in the game’

    Michael Carberry: ‘After such a tough time, I’m not sure I will stay in the game’

    The batsman has grown disillusioned after England’s Ashes debacle and allegations linking him to the Pietersen affair
    Susie Wolff: A driving force in battle for equality behind the wheel

    Susie Wolff: A driving force in battle for equality behind the wheel

    The Williams driver has had plenty of doubters, but hopes she will be judged by her ability in the cockpit
    Adam Gemili interview: 'No abs Adam' plans to muscle in on Usain Bolt's turf

    'No abs Adam' plans to muscle in on Usain Bolt's turf

    After a year touched by tragedy, Adam Gemili wants to become the sixth Briton to run a sub-10sec 100m
    Calls for a military mental health 'quality mark'

    Homeless Veterans campaign

    Expert calls for military mental health 'quality mark'
    Racton Man: Analysis shows famous skeleton was a 6ft Bronze Age superman

    Meet Racton Man

    Analysis shows famous skeleton was a 6ft Bronze Age superman
    Garden Bridge: St Paul’s adds to £175m project’s troubled waters

    Garden Bridge

    St Paul’s adds to £175m project’s troubled waters
    Stuff your own Christmas mouse ornament: An evening class in taxidermy with a festive feel

    Stuff your own Christmas mouse ornament

    An evening class in taxidermy with a festive feel
    Joint Enterprise: The legal doctrine which critics say has caused hundreds of miscarriages of justice

    Joint Enterprise

    The legal doctrine which critics say has caused hundreds of miscarriages of justice
    Freud and Eros: Love, Lust and Longing at the Freud Museum: Objects of Desire

    Freud and Eros

    Love, Lust and Longing at the Freud Museum