Serious Money: The end of the commodity bubble?

The new millennium brought an end not only to the long bull market in stocks that began in 1982, but also to the protracted bear market in commodities.

Years of under-investment in the infrastructure of several commodities combined with the emergence of China and India as major buyers meant that prices could only go up.

Investors' hunt for additional yield in a low-return world added fuel to the fire. Not surprisingly, indices of commodity prices have more than doubled since 2001.

However, the almost uninterrupted price rise has hit a bump in the road and several commodities from oil to plastics have endured significant setbacks.

Should investors buy on weakness or call time on the current bull market in order to avoid a more serious hangover?

The economic climate combined with supply constraints has been hugely supportive of the longest and most extensive bull market in commodities since the 1970s.

Global economic growth has averaged almost 5 per cent per annum over the past three years, driven primarily by the American consumer and a Chinese investment boom. However, the housing market that has underpinned consumer spending in the US is in freefall.

Homebuilders have more than half a million unsold new homes on their books while surveys of sales prospects have not been as pessimistic since the trough of the 1991 recession.

Whether the poor housing market alone is enough to bring an end to almost 60 consecutive quarters of growth in consumer spending is unclear given the welcome relief currently provided to households via lower energy prices and long-term interest rates. Nevertheless, growth will slow.

Chinese demand has been by far the most important factor in the physical market for commodities. China's share of the total growth in global consumption of industrial materials over the past four years has been staggering - its share has been almost one-third for oil, more than one-half for aluminium, copper and steel, and almost 90 per cent for nickel and steel.

However, the authorities are determined to slow investment spending and monetary policy has been tightened. Furthermore, a number of administrative edicts have been issued in a concerted effort to slow investment in a number of commodity-intensive sectors. The implications for global demand are obvious.

The demand for commodities has been exacerbated by the return of investors.

There has been a flood of papers in recent years that highlight the diversification benefits of commodities as an asset class - low correlations with other asset classes means that return per unit of risk can be improved.

Some have recommended that pension funds should allocate as much as 15 per cent of their total assets.

Investors have been happy to oblige somewhat in an effort to reverse some of the damage caused by excessive exposure to stocks in the late 1990s.

Some of the converted include the large endowment funds of Harvard and Yale. Simultaneously, investment banks are hiring commodity traders en masse.

Retail investors have also entered the fray and assets under management by commodity trading advisors amount to more than $70 billion, up threefold in three years.

The return of the investor combined with strong global demand in the physical market has led to significant distortions in prices. To appreciate these distortions, it is necessary to understand the dynamics of commodity investment.

Investors typically gain exposure to commodities through the futures market as direct physical investment is not practical while a portfolio of commodity-related stocks provides significantly less diversification benefits.

Thus, to gain broad exposure to commodities an investor will buy a basket of futures contracts, which are continually rolled into new contracts to avoid expiries. The total return earned is determined by the spot yield - the price performance of the underlying commodities, the roll-over yield - the rolling of contracts into cheaper or more expensive contracts, and the collateral yield - the interest rate earned on the assets underlying the futures contracts.

Historically, the roll-over yield has been the most important component of returns. Indeed, a diversified basket of commodities has generated a negative spot of almost 2 per cent in the long run.

Typically, futures prices are below spot prices and converge towards the latter over a contract's life. The increase in price accrues to the investor as the exposure is rolled into a cheaper contract.

However, strong demand from end-users and investors has caused futures prices to exceed cash prices. Consequently, despite impressive price performance so far this year, current roll-yields have caused returns to turn negative. Furthermore, investors' hunt for higher returns has contributed to a reduction in diversification benefits as correlations with other asset classes have increased.

Commodities have been on a roll in recent years but many of the factors underpinning the bull run are at risk. US household spending is set to slow as too is Chinese investment. Furthermore, supply constraints are set to ease as new capacity comes on-stream.

This is a potent cocktail for declining prices. Throw in negative roll-yields and reduced diversification benefits and only one conclusion is clear. Investors should reconsider their position on commodities.

Charlie Fell is an independent consultant and lectures in finance and investment at UCD and the Institute of Bankers in Ireland.