MATERIAL WORLD

No sooner have investors rediscovered the lure of commodities than their own enthusiasm threatens to ruin the rationale. Prices of raw materials are seeing widespread gains as talk of a “super cycle” is in the air. Copper, lead, soybeans, wheat, cotton, coffee, cocoa and feeder cattle have all registered double-digit percentage gains in the past year. Some of these gains can be traced back to the rise in oil prices. The planned substitution of ethanol for gasoline encouraged corn planting, which took acreage away from crops like soybeans and led to a surge in prices. Higher livestock prices can, in turn, be explained by higher grain costs.

But the broad strength of commodity prices may also reflect the appeal of the sector as an “alternative asset”, along with hedge funds and private equity. Ever since the dotcom bubble burst, investors have been keen to diversify away from shares and government bonds. That has led to the launch of a whole series of exchange-traded funds based on commodities, which have made the asset class accessible for a much wider range of investors. The recent credit crunch may have given commodities a further lift. Speculative money that had been flowing into high-yield bonds and structured credit is now looking for a new home. Some commodities, particularly gold, are also seen as a hedge against a declining dollar.

Such a bet could still lose money, of course, if the world slipped into a non-inflationary recession. But investors seem to feel that the global economy can overcome the problems in the American housing market. Individual commodity prices are still highly volatile thanks to speculative demand. A sharp rise tends to attract “momentum” investors, who push prices up even further until end users start looking for alternatives. At that point momentum buyers retreat.

Just like everybody else, commodities speculators are looking for a meaningful relationship between the prices of different commodities. When a market is transformed from specialist niche to retail phenomenon – as is the case with commodities – many new investors rely on rules of thumb. The simplest involve price ratios, of which the best known centers on gold and oil. A common refrain of gold bugs is that an ounce of gold now buys less than eight barrels of oil, against a long-run average of just under 16. On that basis, gold is cheap and ought to rise as it reverts back to its “mean”.

Since 1982, the gold-oil price ratio has risen as high as 33 and has fallen as low as seven. Several qualitative factors link the direction of oil and gold prices, such as a tendency on the part of investors to hoard both at times of crisis or rising inflation. But making judgments on the future through a backward-looking ratio of market-set prices is nonsensical. The current ratio is no reliable guide as to whether gold will rise or oil will fall. Looked at another way, the gold-oil link is very weak. Comparing daily price movements of the two over the long term yields a correlation factor of less than 0.1. The correlation of, say, gold and silver prices is much higher. But even then, the volatile ratio between the two offers no guide.

That said, the frequency with which such ratios are cited as investment tools helps in one way. Alongside the sharp rise in correlation between the daily price movements of most commodities recently, it highlights the swelling amount of cash entering the market without a fundamental basis. When pension-fund investors buy an index, all the components are bought indiscriminately, regardless of their true value. It is a classic paradox. What works for the individual cannot work for the group. Yogi Berra, the baseball player, grasped the problem when he said: “Nobody goes there any more; it’s too crowded”.