Commodities bubble brews?

— -- Potash POT isn't what you would call a glamour stock: It makes fertilizer. Nevertheless, the stock has soared 203% the past 12 months.

The world isn't running short of potash. At current consumption rates, there's enough to last 300 years, according to the International Fertilizer Industry Association. But there does seem to be limitless optimism about future fertilizer use — as well as the upward spiral in the cost of potash itself, up 150% over the past 12 months.

It's not just potash. Across the board, commodities prices are soaring. On Wednesday, light sweet crude oil closed at $133.17 a barrel, more than double the price 12 months ago. Overnight it topped $135.

Commodities are the first growth industry of the 21st century. The prices of energy, basic metals and foodstuffs have soared, and so, some say, has speculation. This year alone, cocoa is up 40%, copper has soared 24%, and corn has risen 33%. And the price charts for some commodities are beginning to look suspiciously like the Nasdaq fever line in 1999, just before the tech-laden stock index crashed in March 2000. And, as the economy continues to work through the more recent crash in home prices, the question inevitably arises: Is there a commodities bubble brewing?

Possibly, say many experts.

"Certainly, we're seeing a lot more interest (in commodities) across the board," says Barry Cronin, chief investment officer at Taylor Investment Advisors, a Greenwich, Conn., money management firm. "There's no mistaking that there's a significant amount of speculative money in the market." But is it a bubble? "That's the $100,000 question," Cronin says.

Price bubbles involve irrational behavior by investors drawn to the prospect of quick profits. But such manias aren't entirely measurable. There's no magic indicator that flashes bright red when a reasonable investment trend suddenly becomes unreasonable. Instead, you have to look at several different ways to measure bubble behavior. By those measures, the bubble in commodities is forming, but it's not at full froth.

Nevertheless, new signs of commodities mania keep bubbling up. The basic sign is a near-vertical rise in prices, says Ben Inker, director of asset allocation for the GMO funds. "If you look at the way oil has been moving lately, it's almost inconceivable that there is information about the future supply and demand of oil that's driving this," Inker says. "It cannot be the case that, relative to three weeks ago, we have information that would make the price of oil go up that significantly." The price of a barrel of light, sweet crude oil has soared 17.4% the past three weeks.

And Wall Street, for one, thinks that the market for commodities is hotter than the market for stocks.

Responding to price run-ups, the mutual fund industry has in the past 12 months rolled out dozens of commodity-related exchange traded funds, with tickers such as MOO— a fund that specializes in agricultural stocks. Others include a coal fund, KOL, and a raw materials fund, RAW. The funds typically invest in commodities futures contracts and have attracted billions in new investments the past 12 months.

Top financial exchanges

The world's largest financial exchange company as measured by market capitalization is no longer NYSE Euronext NYX, which deals in stock trading. It's the CME Group CME, formed from the merger of the Chicago Mercantile Exchange and the Chicago Board of Trade. The CME now has a market capitalization of $25 billion, vs. $19 billion for NYSE Euronext. CME averaged 10.2 million futures contracts a day in April, up 30% from a year ago.

Assets in managed futures programs, limited partnerships for the wealthy that invest in futures, total $218 billion and are up 6.3% this year, according to BarclayHedge, a Fairfield, Iowa, company that tracks hedge funds. True, $218 billion is minuscule in comparison with stock funds, and not all managed futures programs are in commodities. But assets in managed futures pools are up 474% from 2000, when they had just $38 billion. And interest in commodities is "at a level I've never seen before," says Sol Waksman, president of BarclayHedge.

Pension funds and other big, institutional investment pools are starting to pour money into commodities, too. Calpers, the California public pension fund, announced in March that it's devoting $1 billion to commodity investments, up from $450 million in past years. It's part of a long-term, inflation-linked strategy, spokesman Clark McKinley said.

Unlike the wealthy investors who choose actively managed commodity pools, pension funds and other public entities tend to prefer passive, indexed investments. Index funds have no manager and simply follow a commodity index, such as the Standard & Poor's GSCI Commodity Index GSG— the index that most of Calpers' commodity investments follow. The index soared 18.7% this year through April.

Individual investors, too, are choosing commodity index funds. PowerShares DB Agriculture ETF DBA has seen $22.5 billion in new money flow through its doors the past 12 months. Investors poured $1.2 billion into its more diversified twin, the PowerShares DB Commodity Index ETF DBC.

Until commodity ETFs came along, average investors were largely excluded from the commodities markets. "It's not just for the ultrahigh-net-worth investor anymore," says Robert Maroney, principal at Connecticut Investments, an investment advisory service.

In fact, the mutual fund industry has rolled out 52 new exchange traded funds that invest in diversified commodities, energy or precious metals in the past 12 months, according to industry tracker Morningstar.

That's rarely a good sign: Fund companies are notorious for rolling out many sector funds at the top of a bubble. By the time fund companies identify a trend, put together a fund and get approval from the Securities and Exchange Commission to sell shares, the trend is often on its last legs. For example, the fund industry rolled out dozens of new Internet and technology funds in 1999 — just before the tech bubble collapsed.

Every bubble starts with a rational investment thesis and, in this case, it's the roaring economies of India and China, whose voracious appetites for steel, copper and oil have been pushing up the prices of raw materials. Improved diet and nutrition in emerging markets, as well as U.S. mandates for biofuel use, have driven up the cost of food. And India and China seem to be in the throes of a wage-price inflation cycle. China's inflation rate rose to 8.5% the past 12 months ended April, vs. 3.9% in the USA for the same period. India's inflation rate rose to a 3½-year high of 7.6%. Wages in both countries have skyrocketed. As a result, the prices of Chinese imports — long an important method of controlling price inflation here — have started to rise sharply.

Normally, whipping inflation is a job for a nation's central bankers. They push up interest rates to slow down the economy and cool off demand, shutting down inflation. But most central banks are doing the exact opposite.

China and many of the oil-rich Persian Gulf states, for example, have been buying dollars — and to do that, they have been creating money. "The Saudis and the Chinese have flooded their economies with their own money," says Paul Kasriel, chief economist for investment bank Northern Trust.

And U.S. central bank policy, at the moment, is aimed at avoiding recession, not taming inflation, says David Wyss, chief economist for Standard & Poor's. The Federal Reserve has pushed its key short-term fed funds rate down seven times since September, to 2%, its lowest level since 2004.

The question, then, is whether the rush of money into the commodities markets has helped push prices higher than they would be otherwise.

Lucjan Orlowski, professor of economics at the John F. Welch College of Business at Sacred Heart University in Fairfield, Conn., thinks so. "Without a doubt, that's propelling prices," he says. For example, Orlowski estimates that, given current supply and demand, a barrel of oil should cost about $70 a barrel.

But others, including the Commodity Futures Trading Commission, the government agency that regulates the futures markets, argue that many commodities that have no futures trading whatsoever — such as durum wheat and hay — have risen sharply, too. So speculators in the futures markets may not be responsible for all the gains in commodities.

The answer to the bubble question, at least for now, may be somewhere in the middle. Craig Caudle, a principal at Liberty Funds Group in Dallas, says only crude oil has reached its inflation-adjusted high. So he doesn't think that wild-eyed speculation has set in yet.

But he does see the impact that big money flows are having on the commodities markets. Normally, financial advisers recommend commodities because they aren't closely correlated with stocks and bonds. And, in fact, many commodity prices move independently of each other: Wheat doesn't necessarily rise when oil does, for example. Putting 5% of a portfolio's assets into commodities tends to reduce the portfolio's overall volatility.

Because many institutional investors are pushing money into commodity indexes, however, many commodities are starting to move much more in lock step, Caudle says.

The cure

If inflation is the root cause of a potential commodities bubble, the cure is fairly simple. Central banks have to raise interest rates to slow economic growth. Already, the futures markets are predicting a quarter-point increase in the fed funds rate by the end of the year as the Fed turns its attention from warding off recession to fighting inflation.

Unfortunately, the Fed can't do it alone. "The Fed can't control what's happening outside the U.S.," says Wyss. As long as the global inflation cycle remains intact, prices could continue to rise. And as long as prices rise, money will continue to pour into commodities, pushing prices yet higher.

Should world central banks act in concert to end the commodities bubble — if indeed it is a bubble — the end may not be pretty. In the commodities markets, you can make as much money by betting on falling prices as you can by betting on rising prices. All commodities traders really want is a clear trend: They don't care whether it's up or down.

Investors got a taste of the volatility of the commodities markets in March, when gold soared to a record $1,011.25, then swooned to a low of $871 in April, a 14% plunge. Should a world economic slowdown turn commodities prices down, they could fall faster and harder than many investors expect.

And, because the cure for inflation is a slower economy and higher interest rates, there's always the danger of global recession. Still, says Orlowski, the cure is better than inflation. Higher prices mean real suffering for the world's poor, who are struggling to cope. "The futures bubble means a transfer of real income from the poor to the rich," Orlowski says.

If unchecked, he says, "It will have very profound political consequences across the globe."