ANATOMY OF A BUBBLE
But This Time is Different...
 
Here we go again...only this time, its commodities.  These days, both retail and institutional investors are allocating part of their portfolio to commodities. Historically commodities have not been considered investments, but recently that has changed. After all, oil has more than doubled over the past year, while wheat has skyrocketed 90%, soybeans 80%, and even copper has risen 20% year-to-date. More generally, the Dow Jones - AIG Commodity Index had an average annual return of 1.7% from 1/1/91 to 1/1/01. For the period from January '01 to January '07 this accelerated to 6.9% annually, and the annualized return from January '07 to June '08 was a whopping 25%.  The 'experts' usually point to dramatically increased demand from China and other emerging economies to explain the recent price explosions, but it is hard to believe that the supply demand balance has shifted enough to move prices by 25% in 18 months, especially since virtually all commodities are participating in this surge.
 
Investors buy commodity funds and ETFs, or even play the futures market directly to participate in these dramatic returns. Assets invested in commodity index funds have surged from $13 billion to $260 billion over the past five years and California Public Retirement Systems (CALPERS) now holds over $1 billion in commodity related investments.  When naysayers throw out terms like "speculation" and "bubbles," and point to prior appreciation in different asset classes as examples of what can happen when the booms burst, investors often scoff at the implication, continue to buy, and say "this time is different."  However, this is rarely if ever true.
 
Same Old Story
 
Was it different in the late-80's and early 90's when easy credit resulted in a real estate bubble in Japan and even contributed to the Nikkei climbing to just below 40,000?  Japan was considered the future great economic superpower to rival the US and any naysayers were told "this time is different."  Needless to say, the bubble burst, the "Asian Economic Miracle" was transformed into "The Lost Decade," the index hit a low of 7,600 in April 2003, and Tokyo residential real estate lost as much as 80% of its value.
 
Was it different in the mid- to late-90's when investors gobbled up dot.com companies without viable business models as they started springing up all across the country.  Naysayers were told "this time is different" and were laughed at by their "forward-thinking" friends. Needless to say, the bubble burst after the Nasdaq peaked above 5,000 in early 2000 (it now trades about 2,200), the country fell into recession, and Greenspan took this opportunity to ignite the housing bubble. 
 
Was it different between 1997 and 2006 when the domestic residential real estate market reaped significant valuation increases and folks with lousy credit, no money, and tenuous job situations were able to take out mortgage loans? Residential real estate (as measured by the Case Shiller Index) appreciated 3.7% per year between '91 and '01, but 11.6% annually from January '01 to January '07. Naysayers were told "this time is different" because finite available land implies that supply cannot keep up with the growing demand. Since then prices have declined about 13.6%, which is a minor correction after nearly doubling over the preceding six years for no other reason than that credit was cheap and easy.
 
Hate to "Burst Your Bubble"
 
Generally speaking, bubbles occur as asset prices escalate far beyond their intrinsic value without much basis to economic or market realities.  The initial price movements are usually driven by real changes to the supply demand balance, but they can get amplified as more investors watch the initial price appreciation and jump on the bandwagon in order to participate. 
 
Some Commonalities