Are commodities today's bubble?

Commodity prices have been advancing upwards since late 2001/early 2002. The CRB index has more than doubled since then. By historic standards both the absolute price levels and, at times, the rate of increase in the prices of certain commodities has been extreme. The big question is whether commodities are the latest bubble? The alternative is that rising commodity prices are a reflection of demand growing at a rate which supply is unable to match.

Unfortunately, there is no clear answer to either question. The principle pro-bubble and anti-bubble arguments are summarised below. As a small investor with no better ability to foresee the future than anyone else, I have no idea which view point is correct. It is also possible that some commodities are in a bubble while others are not - meaning that the selection of individual commodities rather than a basket of commodities is the preferred approach to investing in this sector.

Pro-bubble arguments

(i) prices have reached historically high levels (records in some cases) and the rate of increase is unsustainable;

(ii) investment money makes up a sizable proportion of the demand for commodities (in part fueled by the increasingly easy methods of investing in commodities) and that demand will not continue (and is likely to reverse) once prices pull back;

(iii) the US economy is in recession and this will result in reduced demand for commodities, not only in the US but also in other countries due to the impact that an economic slowdown in the US will have on its trading partners.

Anti-bubble argument's

(i) inflation is back. Commodities (particularly those with supply side constraints on increased production) offer a good hedge against inflation. In effect, investors should still be buying commodities;

(ii) prices may be high in nominal terms but in inflation adjusted or real terms are still well below previous peaks;

(iii) demand from emerging economies is genuine end user demand and growth in that demand will continue despite any slowdown in the US. In effect there is at least some degree of decoupling;

(iv) supply side constraints limit the ability to increase supply to match demand (at least in the short term) and, further, supplies are subject to disruption from a variety of causes. Falling inventories in at least some commodities can be pointed to.

While I do not have an answer to the big picture question, I have allocated a small proportion of my assets to commodities. In part, I have done this because I believe that demand exceeds supply in at least some commodities and in part because I believe that there is at least some degree of decoupling from the US economy. The other reason for investing in commodities is diversification. While diversification alone does not justify holding a particular asset class, so far my limited forays into the world of commodities have been financially rewarding.

Going forward, I intend to maintain at least some exposure to commodities either through a commodity fund or by selecting individual commodities. For the latter, there are two approaches which can be adopted. The first is to join the momentum investors and buy commodities which are trending upwards. The second approach is to buy commodities where the demand from end users exceeds supply and where inventories are limited.