From the April 01, 2011 issue of Futures Magazine • Subscribe!

Commodities and the law of gravity

All asset classes throughout history, especially commodities, abide by the "Law of Gravity." The Law states that any market that defies gravity with escalating rising prices for too long and goes too high is destined to fall back down under its own weight. Gravity always will win out in the end by bringing a particular asset market back down to normalcy, no matter how bullish the fundamentals appear to be at the time. There are certain "DNA" markers that every asset class has shown over the years that have been very predictive in ascertaining when such gravitational forces likely will get the upper hand and bring asset prices back down to earth and to reality.

One of the best barometers to gauge this gravitational inflection point is to look at the 10-year average return in overall commodities on a historical basis. The greater the 10-year average return, the more overvalued commodities have become; the lower the 10-year average return, the more undervalued overall commodities have become. This is not rocket science or differential equations, but simply the recognition of the principle of "reversion back to the mean" of historical returns. Nothing goes up or down forever. Remember, a major top will be placed in any asset market when the current perceived fundamentals are at maximum bullish levels and very few at the time can conceive of fundamentals ever becoming bearish.

You never will be able to sell a market at the top if you wait for the perceived fundamentals to turn bearish. You must sell when everyone is convinced that the bullish case is the only view and that any bearish view is to be considered a relic of someone out of touch with the "new normal." As we all know, the term "this time is different" is what sucks everyone in to abandon sound long-term historical valuation metrics. A companion to that are claims of a "new paradigm." We heard those claims regarding equity market P/E ratios up until 2000, and more recently regarding housing before the credit collapse. It is never different. The only thing that is different in every one of these cycles is the individuals who will lose their entire fortunes as a result.

Looking over a 200-year analysis of overall commodities using this 10-year average return metric gives you a perspective where commodities currently are positioned in the historical valuation range. The previous peak based on the 10-year average came at the end of the bull commodity run of the 1970s and the most recent trough corresponds with the low in 1990.

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