Hot Money Switches into Commodities

[Michael Evans]

Last week I wrote about gold prices reaching $600/oz, and said I couldn't think of any good reason why they would go that high. By that I meant inflation was under control, interest rates were fairly stable, and the dollar continues to hold its value.

Perhaps, however, that synopsis was a bit misleading, because there is a very good reason why gold prices -- and other commodity prices -- have been skyrocketing. The hot money that once propelled the stock market to unsustainable highs in 2000 and then propelled the real estate market to sky-high prices in 2005 has now switched into commodities. At least for a while.

Naturally, when that happens, you would expect to see stock prices and housing prices fall. That's not exactly what has happened; the stock market as measured by the S&P 500 recently made five-year highs, although it has backed off in the past couple of days. And housing prices are still rising on a natoinal average basis even though they are off 5% to 10% in the formerly "hot" regions.

However, that's only Phase 1, which can basically be described as new money flowing into commodities, but old money staying in stocks and real estate. As the returns on commodities continue to outpace those other two markets, we are probably going to see some of the money pulled out -- admittedly easier to do with stocks than housing -- and switched to commodities. That would cause a more sustained decline in stock prices.

A recent graph in the Wall Street Journal showed monthly gold prices peaking at about $550 an oz in Jan 1980. Wait a minute, I said, I remember them a lot higher than that. So I got out my old charts, and sure enough, they actually peaked at $873/oz. A few days later they were down to $600/oz and a few days after that, to $450/oz. That's almost a 50% loss if you're asleep at the wheel -- and that's if you are in cash, as opposed to options or futures.

As I said earlier, I don't know how much longer commodity madness will continue. In the past, I have severely underestimated the stupidity of investors to buy near the top. But while this is happening, the flow of hot money out of stocks and into commodities will depress the stock market as long as it lasts. And when commodities finally do crash and burn? Those same investors will have to sell more stocks to pay off their loans. So while I realize the stock market has shown some modest strength so far this year, I think it will give back all those gains and then some before it turns around again.