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.Reuse content