Catching Market Waves

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The recent plunge in commodities prices has investors wondering whether a major bubble has burst. But was there really ever a bubble? It is true that since their lows between 1998 and 2001, commodities and especially industrial commodities have been on a tear. Between 1998 and early 2006, crude oil rose from $11 per barrel to over $70, copper from 60 cents per pound to over $4, nickel from $5,000 per tonne to over $20,000, while gold went from $255 an ounce to over $700. But before deciding that the commodities bull market is over, investors should consider the following: commodity-price cycles—also called Kondratieff Waves, named after an influential early 20th century Russian economist—play out over decades. From peak to peak or trough to trough they last 45 to 60 years, and within that span there are also up and down cycles lasting 22 to 30 years. The last up cycle peaked in 1974; the last downward wave lasted for more than 20 years. While it's true that commodity prices have soared since 2001, the rise may have only just begun. That's because real commodity prices (adjusted for inflation) were, in the 1999-2001 period, at the lowest level in 200 years. Today, commodities (with the exception of copper) still sell in real terms for about one-third their 1970s peak.

It's no secret why prices are rising. The rapid industrialization of China (and increasingly India) has shifted the demand curve, leading to permanently higher equilibrium prices. China, which absorbed 12% of global copper production in 2000, now takes in close to 22%. Yet per capita consumption of raw material and energy in China and India is still low. The average U.S. citizen consumes 27 barrels of oil annually, Japanese and South Koreans 17 barrels. But annual per capita consumption in China and India is 1.7 and 0.8 barrels, respectively. That demand is only going to grow over the long term.

Commodities have also been boosted by the ultra-expansionary monetary policies pursued by the U.S. and Japan. Since 2002 excess liquidity has driven up prices for all kinds of assets, including real estate, stocks, art and collectibles, leading to a huge amount of leveraged speculation. However, most recently, global liquidity, while still expanding, is doing so at decelerating rates; that has led to a sell-off in equities and commodities. I would expect this correction to last another few months—until central banks around the world embark once again on monetary expansion. In this correction phase it would not be surprising for commodity prices to decline from their recent peak by 30% to 50%. Copper prices would seem to be particularly vulnerable.

We've seen this happen before. During the last great commodity bull market, gold declined from $195 an ounce to $103 between December 1974 and August 1976—and then rose by 800% to reach a peak in 1980. Similarly, in the great equities bull market between 1982 and 2000, the Dow lost 40% from August to October 1987, before a sevenfold rise. Long-term bull markets are characterized by intermediate sharp corrections, and I have little doubt that the commodities bull market will, following the current correction, reassert itself, although price leadership may change from industrial commodities to precious metals and grains.

One lesson from history is worth bearing in mind. Rising commodity prices have historically led to an increase in international tensions, as countries become concerned about reliable supplies of raw materials. If those tensions lead to war, commodity prices can go ballistic. All major modern industrial-commodity price peaks were reached during wartime—whether it be the Napoleonic Wars, the U.S. Civil War, World War I, or the Vietnam War. So celebrate rising commodity prices if you must; but remember where they sometimes lead.