All that Glitters is not Gold!

When I see a front-page article about a very risky asset class appear on the front page of the nation’s mainstream newspapers, I think to myself, “this can not be good.” So it is with commodities, the asset class where I cut my teeth as a young trader over twenty years ago.

It’s not surprising that this would happen. Investors are frustrated on two fronts: many stocks are mired at low levels as a result of the US housing recession and credit crunch and interest rates are dropping like a stone because of Fed actions and fear, making the renewal of CDs and purchase of safe US government bonds seem like a sucker bet. What’s an impatient, performance-driven investor to do? Look for what HAS done well, in other words, many find themselves in the terrible circle of buying past performers. Over the past year or so, the stand-out asset class has been commodities.

Oddly enough, many started to see hard assets as “safe” – a perverse interpretation of how these markets work. According to the New York Times’ Diana Henriques, “The booming commodities market has become increasingly attractive to investors, with hard assets like oil and gold perhaps offering a safe hedge against inflation, as well as the double-digit gains that have fast been disappearing from the markets for stocks, bonds and real estate.” (NYT: 3/20/2008)

While commodities have been seen as a hedge against inflation, it is not clear whether the type of inflation we are experiencing now—the demand push, rather than the choking off of supply, will continue. In fact, historically, commodities have weakened when the globe slows, and given that the US accounts for a good chunk of the globe, many have expected that inflation will ebb as the US economy cools down.

It appears that the recent run-up in commodities has been catalyzed by four factors: a sagging US dollar; falling US interest rates; increased demand from the emerging markets; and speculative mania. Of the four, speculation, not a fundamental economic underpinning, has been the driving force of the last 5-10% run-up in these markets, as investors tried to flee poor returns and high risks in other parts of the capital markets and chased return. When those same investors took the trade off, the result is a plunge in price like we saw on Wednesday and Thursday.

Most importantly, to hear anyone apply the word “safe” to commodities is crazy: commodities are among the most volatile asset classes and while they can certainly move up quickly, they can plunge just as fast. Commodity neophytes learned that lesson last week: the most active April contract in gold fell approximately 12% from Monday to Thursday. This is not to say that commodities are dead. In fact, I believe that we are in the midst of a long-term bull market. But it is always important to understand how even in bull markets, assets can get overheated before resuming their upward ascent.