A Day of Reckoning
What goes up must eventually come down...and commodity prices weren't an exception. Although some are reluctant to refer to the 2007/2008 rally as a bubble, I am not. In finance, a bubble is defined as a scenario in which market prices rise and become overvalued by any measure of valuation, and in my opinion this seems to fit the bill.
- At first it is easy to confuse a bull market with trading genius, but it can't last.
A market bubble is a rally that is artificially and temporarily driven by a mob mentality of market participants. In reality, it is difficult to quantify and analyze the true driving force behind prices as they are moving, but what happens next can provide insight. I believe that what ultimately categorizes a market move as a bubble is the manner at which prices adjust to more realistic levels. The sharp price decline that succeeded the 2007/2008 commodity rally suggests that the market was grossly overvalued and this conforms to the characteristics of a bubble.
During the commodity "bubble," the benchmark index for commodity prices, the Reuters-Jefferies CRB Index, nearly doubled in value. Commonly referred to simply as the CRB, it is designed to provide a representation of a diversified holding of long-only futures.
The CRB reached its peak of nearly 475 on July 3, 2008. From there the commodity bull came crashing down in a magnificent fashion. In December 2008, the Reuters-Jefferies CRB Index had fallen more than 50% from its peak and was valued near 200. This was the lowest level in 6½ years and became the perfect example of the tendency for market prices to go down faster than they go up regardless of the slope of the incline, as shown in Figure I.2.
Figure I.2 The irrational exuberance in commodities can best be depicted by the rally and subsequent plunge in the CRB Index.
As prices deflated to what were debatably more rational levels, traders were faced with difficult decisions in terms of speculation. Historical price envelopes had been intensely magnified; thus, in a post-bubble world, speculation in the commodity markets potentially became more lucrative, but the risks were exaggerated as well.