Commodities may or may not be in a bubble, which leaves strategic-minded investors grasping (and gasping) for context.
The media is flush these days with the "B" word, including today's Wall Street Journal, which advises: High Oil Prices Spur Thoughts About Bubbles, But This Might Be Misguided Meanwhile, earlier this month, Lehman Brothers energy analyst Edward Morse wrote in a report that commodities were, in fact, in a bubble and that it would burst by the end of the year, via Bloomberg News.
Many others preach the opposite, arguing that the run-up in commodities prices are a reflection of supply and demand trends rather than a speculative frenzy. True or not, the idea that speculators have gone wild is catching on and some in Congress are considering new laws aimed at curtailing commodity trading by institutional investors.
So, what's a prudent investor to do? There are no easy answers, although we can start with the facts. Fact number one: pricing commodities is inherently speculative. That's independent of whether commodities are in a bubble or not. In contrast, stocks, bonds and real estate (save for raw land) enjoy the attribute of generating measurable cash flows, which can be analyzed in the cause of putting a valuation on said assets. Commodities, by contrast, generate no income directly. Instead, one can only sell a barrel of oil or an ounce of gold to produce cash flow. The problem is that it's forever unclear how much cash the commodity will generate until the day of the transaction arrives.
Yes, that's true for stocks, bonds and income-producing real estate as well. But the difference is that informed investors recognize that a bond's current yield, a property's income stream and a stock's dividends (or earnings) lend themselves to any number of analytics to effectively reverse engineer the "fair value" of the security or property by putting a present value on the future income. True, in the short term such analysis must be taken with a grain of salt, but over the long haul estimating the present value of prospective dividends, coupon payments, earnings and rent historically go a long way in dispensing intelligence on the matter of valuation.
Alas, commodities generate no income and so estimating fair value is unavoidably speculative. That by itself doesn't make commodities a "bad" investment, but it does remind that commodities stand alone from stocks, bonds and real estate. In fact, it's that difference (of which valuation is but one part) that makes commodities attractive in the first place.
That leads us to fact number two: because commodities can't be valued as an income-producing investment, it's unclear how to estimate the relative size of commodities vs. stocks, bonds and real estate for asset allocation purposes.
Calculating the market capitalization of stocks and bonds, and the equivalent of real estate, is fairly straightforward.
