The next bubble

Since 2000 it seems our economy has lurched from bubble to bubble. First there was the technology stock bubble of the early decade. For two days in March 2000 the NASDAQ index closed above 5,000, and then the bubble deflated spectacularly; by the end of the year it had shed over half of its value, and it trades today (2,271.48) roughly where it closed out the year 2000. Next there was the housing bubble, the fallout from which we have been dealing with for the past nine months. This latterly bursted bubble has imperiled the health of the country's largest financial institutions, forcing them to access foreign capital to avoid fire sales of their own assets. It has also threatened the health of our corporate debt markets, not to mention putting thousands out of their homes thanks to foreclosure. In terms of wealth destruction this latest bubble has wiped out an unprecedented amount of money. Citigroup (C) alone has had lost nearly $150 billion of market capitalization in the last year.

What explains the formation -- and bursting -- of these bubbles? There are key things specific to each (for example, the role of securitization in the residential mortgages), but to my layman's mind I think the most important factor is the mere existence of huge pools of investable money. In this these bubbles can be considered as the American financial system being a victim of its own success. The success lies in having created these pools of money that can be invested, as well as the mechanism for efficient trading on a mass scale, but it seems the system is increasingly plagued with these bubbles because, at the end of the day, as money multiplies on an historical basis, good investing ideas don't, so huge amounts of money -- aided by computer models that aren't very much different from one another -- flow into the same investments. This explanation isn't meant to supply a unified-field theory of financial bubbles, but I do think the paucity of sound investment ideas relative to the amount of investable money greatly increases the chances of bubble formation. Obviously, policy choices (such as interest-rate movements and financial regulation) play a major role as well.

If this is more or less true, what does it tell us about what might be the next bubble? Over the past few years there has been an enormous influx of money thrown down on natural resources and raw materials, and I for one am becoming suspicious of the recent spike in that area. It looks an awful lot like a bubble in its final stages of irruption.

The latest example is captured in this weekend's Wall Street Journal, which reports that market speculation has spiked the price of green coffee beans by 22% since the beginning of the year on the futures exchanges. But coffee is just the tip of the iceberg. Last May, after thinking about the possible impact of ramped up ethanol production on corn prices, I decided to play around with a few exchange-traded funds that tracked corn prices. I bought into ETF Securities' CORN fund (traded on the London Stock Exchange) at $2.07 per share; by July its net asset value had dropped to $1.77 per share, and I began to get unnerved. I got the sneaking suspicion that I was trading in an area about which I knew next to nothing and was about to get soaked, so I abandoned the investment. As of Friday, the ETFS CORN fund's NAV was $2.62, a nice 23% gain since my initial investment in May (had I only the courage to see it through) and 34% since its low point in July.

This spike in value has been seen repeatedly across most commodities -- oil, tin, copper, coal, and the list goes on. The velocity of inflation in these areas has been aided by a steadily declining dollar, as much of the trade in commodities is dollar denominated; in addition, demand from China has been longer and stronger than many economists anticipated, so global world demand for commodities continues to outstrip supply in some cases. A weak dollar and continued supply/demand imbalance are some main drivers of the bubble we are seeing in commodities, but in late January Forbes magazine identified another possible culprit. In an article titled "The Petrodollar Bubble Pump" Charles Biderman, CEO of TrimTabs (an investment research company), explains:

Why did the prices of oil and other commodities rise so much? The reason is simple -- hedge funds funded indirectly by commodity producers pumped huge amounts of cash into commodities.

We do not disagree that oil demand has been rising and oil supply is relatively constrained. But an oil industry expert we have known for years argues that if top oil industry insiders believed oil prices would exceed $60 per barrel for at least several years, tremendous amounts of new supply would come online not only from greatly enhanced drilling but from nontraditional sources such as oil shale and tar sands.

We believe oil prices of $100 per barrel are due solely to inflows into hedge funds that use some of their new money to buy commodities. Funds of hedge funds typically allocate a portion of their new money to commodities. Where do hedge funds get a good deal of their new money? We think much of it comes from commodity producers. In other words, commodity producers were using some of the additional cash generated from higher commodity prices to invest in commodities, which in turn drove commodity prices higher still.

If this is on target, what does it mean? Biderman says:

The reverse of Goldilocks is a growing, growling bear. Global growth in demand for commodities seems to be decelerating, which means inflows into equities and commodities will be lower, which in turn means equity and commodity prices will decrease. As commodity prices drop, less money will be available for investment by commodity producers, which will reduce asset prices further.

As the WSJ story this weekend on coffee suggests, we may be further away from a deceleration in commodity prices than Mr. Biderman thinks (though, granted, coffee is a special case in some regards), but before you blithely pour your money into commodities, you might think twice about how long this bubble has until it, too, begins to deflate.

In real terms, when you look out into the universe of commodity stocks, there are a few that look set for a fall. Take, for instance,

Freeport-McMoRan Copper & Gold Inc. (FCX). It is up over 82% over the last 52 weeks. Market demand is high, but perhaps not so high as to justify the stock-price increase we've seen from FCX. More than likely, what we're seeing with FCX is the effect of base and precious metals being used as financial instruments by speculators more so than market movements of supply and demand. In this Mr. Biderman's words of caution should be taken seriously. If you've ridden the FCX wave over the past year, now might be a good time to take your profits and look for something else.

Barrick Gold Corporation (ABX) is another high flier that might be due for a fall. It is trading over 73% higher than one year ago. ABX earnings have surprised the Street to the tune of nearly 30% the last few quarters, but most folks have been revising future earnings lower. It might be a good time to take profits if you've had a position over the past year. Canada's Goldcorp Inc. (GG) is another one to watch -- it is up nearly 60% over the past year. Across the gold-mining industry, price-to-earnings figures are high, and in my opinion are probably unsustainable.

Elsewhere, BHP Billiton (BHP), which is up 77% since March 2007, and Arch Coal (ACI), up 63%, seem similarly due to decline from their 52-week highs.

At this juncture it would take real stones for you to short these stocks, but when they do drop, the thud will be loud and clear. Take your profits while there are profits to take. I'll track these five stocks from tomorrow's opening bell and update you next quarter concerning what shorting them would have done for your portfolio.