Jump Off the Commodities Bandwagon

03/31/2008 12:00 am EST

Focus: MARKETS

James Stack

President, Stack Financial Management

James Stack, president of Stack Financial Management and InvesTech Research, says there’s too much bullishness about commodities, and investors should be cautious.

Let’s call this “my problem”—because I get nervous when any bandwagon that I’m on starts to get overcrowded.

More than three years ago (by December 2004, when oil was still near $40 a barrel), we dramatically increased our portfolio allocation in energy stocks from 7% up to 17%—over twice the energy stock weighting in the Standard & Poor’s 500 index [then]. We had no crystal ball that oil prices were headed to $100 a barrel. We simply had historical precedent on our side.

And that’s my problem with staying on the bullish commodity bandwagon today: I know that a great deal of this run-up has been fueled by the synchronous global expansion following the 2000-2001 recession.

Today, the emotional arguments are very compelling. “Oil is a limited resource, and they aren’t making any more of it!” “Gold can only move higher, as long as the dollar continues to fall.” “Growth in China, Asia, and India has changed the long-term outlook for commodities.”

The US dollar has tumbled 35.7% since its previous high in 2002, and over 11% since early last year. However, if the latest research news from ECRI (Economic Cycle Research Institute) proves correct, then we feel the tumbling dollar may soon hit bottom: if Europe drops into a recession, that will ultimately lead to rate cuts and a narrowing of the US–Euro interest rate spread. That is when the dollar could start to surprise everyone to the up side.

Bottom line: the arguments for rising oil prices, $1,000 gold, and commodity shortages seem perfectly logical. But that’s always the case. And it is when things appear “too perfect” that it becomes easy to expect the recent past to continue ad infinitum. Both commodity prices and the dollar are cyclical. And it is when a cycle has run to an apparent extreme—like today—that it becomes most important to adhere to prudent portfolio allocation practices.

The historical lesson remains that all commodity prices are cyclical. They go through up cycles and down cycles. And it gets dangerous whenever one starts to say, “but this time is different!” The fact that long-term futures contracts are now pricing oil at $97+ all the way out through 2015 means the bullish bandwagon couldn’t be more overcrowded.

We don’t know when it will start, or what fundamental news will trigger it, but we expect both crude oil and gold prices to peak in the not-too-distant future. And when they do, the resulting correction will likely be swift—and even more sudden Our advice, if you have not done so already: reduce holdings in oil, gold, and commodity-related stocks to core positions that you intend to hold for the next five or ten years, regardless of a sizable correction.

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