How to Spot a Bubble in Commodity Prices

Trying to spot a bubble in commodity prices requires you to have experience, patience and a clear picture of your objective. Given that commodity prices are often driven by persistent trends in the general economy, most notably inflation, their prices tend to follow long-term trends. This phenomenon can lead to bubbles in the prices of these assets that are prone to fast and significant reversals. If your goal is to spot a bubble for the sake of avoiding the reversal, this can be accomplished by following some basic rules. If, however, your goal is to profit from the bursting bubble, your timing must be far more precise, and making it so is very difficult.

The Trading Patterns of Commodities

Commodities tend to follow long-term trends because their prices are so often driven by economic factors that are stable. Inflation is often the biggest contributor to upward trends in the prices of commodities. This is because it is believed that raw materials, particularly those that do not decay, like gold, are the best stores of value. As inflation sets in, an ounce of gold should maintain the ability to buy the same amount of food, even though more dollars are required. Given that central banks, like the Federal Reserve, consciously try to regulate these factors, they tend to be more predictable. You should understand that the expectation of inflation is as important as actual inflation because it can drive people to buy commodities in preparation of the coming price increases.

Economic Cycles Lead to Bubbles

The reality or fear of inflation cannot last forever, and ultimately, the economy will shift, bursting any bubble that has been created. Many commodities traders follow the observable trends, so price levels can become even more exaggerated, particularly near a reversal point. When inflation subsides, these inflated price levels have a tendency to reverse, with the largest moves coming immediately. If you own commodities at this point, you can lose a lot of money very quickly. The over-inflated prices normalize, and prices fall back to equilibrium. This is what happened to oil prices after they reached $150 per barrel. Prices reversed sharply and continued to fall until oil was trading near $40 per barrel. If you had owned a significant position in oil, you would have lost significantly.

Understand Your Goal

Bubbles are a function of time and circumstance. The longer the bubble has to inflate, the more pronounced the reversal is likely to be. Common signs of bubbles include regular price appreciation without any catalyst and higher prices in spite of overbought conditions. If your goal is to avoid the crash, closing your position when these signs exist can protect your capital. If, however, you wish to time the crash, this is very hard. The economy is capable of allowing out-of-balance conditions to persist for months. Many speculators thought $120 would be the top of the oil bubble and lost significantly as it inflated to $150. Calling a top is often impossible, even if you are a professional. Being aware of this reality is a great first step to making intelligent decisions.