Gold, silver, oil bull markets now look frayed

Updated: Apr 30 2006, 05:30am hrs
Investments in gold, silver and other commodities should be causing a queasy feeling by now. After a boom that took the prices of many raw materials to the highest levels in 25 years, the commodities market seems to be entering its final, manic phase.

Gut-wrenching price movements. Claims of paradigm shifts. A flood of overinvestment. It is all spookily similar to the dot-com bubble in early 2000. The question is when the crash will come --and what the consequences will be for the global economy.

Current high prices are unsustainable, Simon Hayley, an economist at Capital Economics Ltd in London, said this month in an analysis of commodity prices. Bulls like to note that prices are still generally below their historical highs in real terms. But this ignores the fact that there has been a long-term downtrend in real commodity prices.

Last week, silver climbed to a two-decade high, before it plunged 17% in two days, the biggest drop since March 1983.

On Monday, silver was back on the rack again, recording a decline of more than 8%. At least nobody can complain that the metal is boring.

Gold, which has been reaching quarter-century highs, was infected with the nervousness of its less-precious cousin. It dropped 2% as silver slumped.

Gold then had its biggest weekly gain in four years, and traded at its highest level since the days when Ronald Reagan was the new US president and we all thought personal computers were just a fad.

Copper, oil

Elsewhere, froth was still bubbling around other commodities.

Copper prices have reached record levels. And so has aluminum. Oil, as anyone who has filled up the tank of the car recently has noticed, has also been climbing to new highs (for signs of nervousness in that market, look at the Saudi Arabian stock market -- down from 20,000 to 12,000 in only eight weeks).

Jim Rogers, a former fund manager for George Soros, has carved out a niche as the biggest bull of the commodities rally. This month, Rogers predicted gold would reach $1,000.

Well, maybe it will. When a bull market is raging, it is hard to say where it will stop. Pause to think about it, however, and there are reasons why this one is overdone.

A global economy requires commodities to make all the stuff it needs. Yet the strongest growth will always be in industries such as technology and finance. You dont need silver to create a podcast. Nor do you need copper to start a hedge fund.

China and India are creating surging demand for commodities. Yet in time those economies will rebalance from exports to internal consumption. And as they grow, they will become more service-orientated, just as mature nations have done. Their demand for commodities will slow.

Investment spike

Lastly, the huge increase in prices is creating a big spike in investment. The stock market is flooded with new mining companies and the new supply coming onto the market will start to put downward pressure on prices again.

Inflated prices encourage overinvestment. Just recall the technology bubble seven years ago. Too much money was poured into websites and telecommunications systems. Thats why you can now get a great deal on your phone calls. Youll soon be getting great deals on aluminum.

The pattern is always the same. Too much investment will lead to too much capacity. In the medium-term, that will make prices as artificially low as they are now high.

Of course, you could argue that the extreme volatility had so far only been seen in the silver market. Silver isnt a terribly important commodity, either for investors or for manufacturers. And yet, when you get toward the end of a boom, it is often in the peripheral markets that you see the first warning signs of trouble.

Silver as harbinger

In the Internet crash, for example, some of the smaller web companies found it impossible to raise cash at the start of 2000. By the end of the year, it was impossible for any of them to find investors.

In the same way, whats happening in the silver market today may well happen in other commodity markets within a few months.

In its final leg, any bull market becomes increasingly unpredictable. The outcome is familiar. The market ends up overshooting on the way down, just as it has on the way up. For the commodities bull market, that point cant be far away now.