Secrets Of Success: The bubble has deflated, not burst

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The Independent Online

For those who have tried to persuade investors that commodities are where widows and orphans can safely stray (which has been one of the investment sales stories of the past 12 months), the behaviour of the commodities markets this year has surely been a disappointment.

Commodities have so far borne much of the fallout from the global risk attack among investors in the middle of the year, and - unlike stock markets, which have bounced back strongly - they have not properly recovered since.

If nothing else, this at least supports the argument that the two asset classes have a low correlation, which is one of the planks on which the case for commodities is now made.

As he contemplates a year in which his record of beating the S&P 500 index looks like being broken after 15 years of outperformance, Bill Miller of Legg Mason can at least look back on his warning about the overhyping of commodities in the spring with some satisfaction.

One other thing I have learnt all over again this year is that when it comes to commodities, as with currencies, looking at charts can add valuable perspective to more fundamental analysis. I have to give credit to Brian Marber, once the doyen of City technical analysts (now semi-retired), for helping me keep my feet on the ground all year about prospects for oil, gold and other commodity prices.

As early as February, Brian was telling me, via some characteristically trenchant notes about the latest market movements, that oil and gold were both looking vulnerable to a significant change in direction. This was at the time when brokers and others were talking the price of gold up to $900 an ounce and oil to $100 a barrel. As we know, it hasn't quite worked out that way.

This week, gold has fallen back to around the $550 an ounce mark, while oil has dropped below $60 a barrel, its lowest level this year, having touched more than $76 a barrel at one point. Given that commodities generally produce no income, this year's experience has demonstrated that they will periodically produce much more volatile price behaviour than most other types of asset.

Needless to say, talking about commodities as a general asset class is not always that helpful. The CRB index, for example (probably still the most widely quoted index of commodity prices), has a high weighting in energy, whereas other indices give greater weight to different types of commodity. When oil prices take a sharp move, therefore, as they have done in the past month or so, it will tend to produce a similarly sharp movement in the most quoted commodity index, even though the picture is less clear-cut when you look at the individual index components.

In general, agricultural commodities have mostly lagged energy and industrial commodities since the bull market began five years or so ago, but they have recently done relatively better, as the charts show. The supply and demand pressures, led by rapid Chinese growth, that have propelled oil and metals prices higher over the past few years are not so marked in the agricultural markets.

In his latest monthly commentary, Robin Griffiths of Rathbones, another technical analyst I've followed for years, makes the point also that commodities, as measured by the CRB index, having trounced equities handsomely during the latter stages of the bear market, have only just kept pace with the stock market in the past three years.

While they have done very well, doubling in the last five years, commodities as a class have not yet participated in the kind of unsustainable bubble that is evident in the US housing and private equity markets, for example.

In the short term, commodity prices seem to be reflecting the same influences that have been driving down bond prices again since the summer; namely, expectations that the monetary squeeze being applied by central banks, coupled with technically overbought markets, is leading towards a slowing of economic growth and possibly a mild recession. (As always with economic prognostications, it is sensible to avoid taking predictions of this kind too literally, as events almost invariably confound consensus projections about the timing of such trends.)

The most interesting question for those interested in commodities is whether the events of the past six months invalidate the general argument for commodities as a buy for the long term, put forward by the likes of Jim Rogers and others.

It seems to me that this year's setbacks are in no way inconsistent with that thesis, which is predicated on the fact that capacity constraints in mining, oil production and so on cannot be removed overnight, but will take several years (and lots of capital investment) to eliminate.

What we saw at the start of the year were clear signs of speculative excess in a number of commodity markets, and with oil and gold having fallen by around 20 per cent from their peaks, much of this has now usefully been unwound.

Most of my technical analyst friends, who by definition are more accustomed to the cyclical behaviour of commodity prices than first-time investors, seem to think so too. You would be unwise to expect commodity prices just to go on falling indefinitely - no markets ever do that - and it is more likely that once the economic runes become clearer, they will start to rise again, in due course resuming the secular upward trend.

But just because a bunch of consultants with advice to sell have declared that commodities are now an alternative asset class, it does not mean that the price behaviour of commodities will start to change. As long-duration assets, they are inherently more volatile than other types of investment and no amount of legitimisation will change that fact.

In the meantime, in the stock market, note the strength of large cap stocks; the long-awaited rotation away from small and midcap shares might finally be under way.

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