Are Commodities Overpriced?

In my article ‘How to Invest in Commodities‘, I highlight the different routes to commodity exposure for retail investors. The dominant method, commodity Exchange Traded Funds (ETFs) have seen record inflows during the first part of 2011. Although it is impossible to identify what proportions represent individual investors, it is clear from ‘buzz’ on investing forums around the globe that many retail investors are taking up a bite of the apple, after having seen eye-watering gains in 2010.

The heavy retail inflows have been exacerbated by the low interest rates available on deposits as interest rates remain near or at all-time lows in the USA and UK. Spectators on the sidelines have grown increasingly nervous at the levels of ‘dumb money’ being investing into commodities, and interpret it as a sign that commodities are becoming overpriced. This is also known as the fear that commodities are a ‘bubble market’.

Why Do Some Experts Believe Commodities Are Overpriced?

The reasons for this signal are simple. As the ‘Common Sense Investor’ explains in ‘Understanding the Role of Bubbles in an economy‘, bubbles occur when investors “try to chase the prices of assets instead of making purchases based on the intrinsic value of the assets.” When an investors decides which deposit account to invest in, they will compare interest rates, availability of funds and the quality of the bank. This informed decision making creates an effective market place that punishes overvalued assets (or services) and corrects prices. If you apply this principle to the commodities markets, you will see that investors are behaving in a different method. Is the average retail investor looking at economic conditions, estimating the intrinsic value of gold, and placing a buy order if the market price is below this? Apparently not. What you see are investors putting money into gold funds simply because they regret ‘missing out’ on the previous year gains, and fall into the fallacy of assuming that this price behaviour will continue in the future. Irrational purchases that ignore intrinsic values help fuel a bubble, and it is usually the retail investors who loose the most in the subsequent correction.

Have Commodities Been Overpriced Before?

Commodity bubbles are not a new phenomenon, and they have been observed in the past. To take gold as an example, see the price chart below:

Commodities Were Overpriced in 1980

As you can clearly see, gold entered a bubble around the year 1980, which was swiftly followed by a crushing market crash, from which the nominal price of gold only recovered 25 years later in 2005. Adjusted for inflation, the real price of gold has even now still not returned to the lofty heights of 1980. In todays money, the gold price in 1980 was $2,200 per Ounce. In other words, victims of the last crash who bought their gold near the market highs have never recovered the purchasing power of that investment even after 30 years.

What are the Characteristics of Overpriced Commodities?

Large Retail Investor Participation

Back in 1980 when gold was seriously overpriced, retail participation was limited by the lack of gold funds available for investment to the general public. However in other bubbles such as the ‘Dot Com Bubble’ in 2000, retail participation, AKA ‘dumb money’ is high as individuals feel reassured by strong historical performance and are influenced by the positive media headlines of ‘record smashing performance’. Back in reality, these individuals have already missed out on the gains. The popularity of gold ETFs supports the arguement that retail  participation has reached high levels.

Cries of ‘New Paradigms’

It would be untrue to imagine that investors in a bubble have no idea that asset prices are high. Rather, investors appreciate that prices are high, pointing to a ‘change in fundementals’ or ‘paradigm’ that justifies a new, higher price level. In some respects, changes in investment paradigms do appear to exist. For example, if we look back at the gold price graph above, you will see that post-bubble, gold prices found a substantially higher price floor at $300, which is a completely different to the sub-$50 prices at the start of the 1970s. This change however is not as large as it first appears, given that US Dollar inflation hit a 10 year high of 10% in 1980, and therefore much of the gold price inflation was due to the devaluation of the US dollar.

The Extrapolation of Short Term Trends

Valuations during bubbles tend to include the expectation that current trends will continue indefinitely into the future. This runs against the law of averages, which proposes that all prices tend to revert to the mean in the long term.

In Conclusion Are Commodities Overpriced?

I must leave you to make your own judgement on whether commodity prices are overpriced. Bullish investors insist that the rise of emerging market economies will tip the supply & demand scale enough to create a permanently higher market price for commodities from this point onwards. Taking lessons from history, I’m inclined to agree, but I believe the forecasted effect on price is overplayed.

Critics suggest that much of the recent demand for gold has actually been from physical gold ETFs and other investment tools funded by institutions and arm chair investors. Indeed, the SPDR Gold Shares fund is the worlds biggest holder for gold except for 5 central banks. When its investors decide that gold has had its run, what do you think the sale of that amount of gold will do to the share price?

Also consider that many governments are still hurting from the financial crisis, and are running large budget deficits and national debt. What would happen if government decide to sell off the gold reserves, as the UK government did between 1999 and 2002.

I personally believe that precious metals (the favourite of speculators) are vastly overpriced, and will experience a painful correction. This doesn’t mean that I believe gold will crash in 2011. Given that I recognise this as a bubble, I expect for the price to continue to rise for the foreseeable future until a trigger causes investors to loose their confidence in their toxic holdings. I won’t pretend to be able to time this future event, and that’s why I have no position in commodities at all. For my specific views on the pricing of gold, see ‘Is Gold Overpriced?‘.

Simon OatesAre Commodities Overpriced?