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Commodities Bubble Bursting? Not By a Long Shot: Pros

Thursday, 5 May 2011 | 2:19 PM ET

The recent commodities pullback suggests to some the bursting of a bubble, but many investment pros think it's just a temporary pullback.

Cash and gold
Lilli Day | Photodisc | Getty Images
Cash and gold

A perpetually weak dollar and strength in global demand should underpin commodities' strength, while investors looking for diversification in their portfolios also will continue to need commodities as correlations break down, they pros say.

"They should still be a part of any longer-term allocation," said Kevin Mahn, chief investment officer at Hennion & Walsh in Parsippany, N.J. "For investors building a diversified investment strategy, they should be looking at them regardless of what's happen in the markets the past couple weeks."

What has been happening is a massive commodities slidesignaled by a huge-run up in silver prices. The white metal soared 81 percent in a three-month period before reaching a closing high on April 29. Since then, it has tumbled nearly 25 percent as exchanges have upped margins—or the money required to buy a contract on speculation.

The rest of the commodities sector has fallen simultaneously due to several factors, including worries about global growth and a rise in oil stocks.

On Thursday, signs of competitive currency devaluation between the US and Europe sent the greenback surging against the euro, which pushed the price of dollar-denominated commoditiessharply lower.

Nevertheless, the longer-term case for commodities remained mostly intact.

Traders cited the margin requirements as one of three factors contributing to silver's decline—the others being a $50 price perhaps unsupported by fundamentals and dissipating worries over inflation.

"All three of these are somewhat off-base," Mahn said.

Not only will silver demand continue but it also will be buttressed by a strong trade for copper and aluminum as global construction demand grows, he added. Mahn also believes grainswill rise, evidenced by food demand that has boosted global prices to their second highest on record, according to a United Nations report.

"We have to be concerned with the rising expectationsand clearly...the rising risks of inflation," J.J. Burns, head of J.J. Burns and Co. in Melville, N.Y., said in a CNBC interview. "It's happening in raw materials, which we're seeing every day now."

Burns believes another factor working in the favor of commodities is that they will be an attractive alternative to stocks after the Federal Reserve ends its liquidity program in June.

The Fed's move to buy various debt from financial institutions has given the stock market a huge boost that could run out when the central bank concludes its $600 billion Treasury-buying program next month.

"Let's see when the morphine client has that pain killer taken out and see how much pain comes back into the market," Burns said.

There are other factors to consider as well.

Four hikes in margin requirements in as many days have been cited for the precipitous drop in silver prices. But over a longer time frame, experienced traders say the opposite may prove true.

After the selling period abates, the rise in margins effectively will have cleared out the smaller players, leaving the trade the domain of deep pockets who could step in and drive prices still higher. Indeed, traders doubted whether enacting a similar margin squeeze in oil would help drive down prices as well.

"Actually we could see a parabolic move back to the upside," Lincoln Ellis, managing director of the Linn Group's Asset Management group, told CNBC. "With nobody else to sell to you could see a move right back up."

Gold & Silver Bubbles Bursting?
Insight on where commodities are heading, with CNBC's Brian Sullivan. Lincoln Ellis, Linn Group, and Matt Shapiro, MWS Capital, offer insight on the fate of gold and silver. Are the bubbles popping, and what should investors do?

Finally, there is the issue of correlation and how it has broken down among various asset classes.

Through much of the Fed's intervention in the markets, most investments moved in the same direction at the same time. But as expectations change and investors have tried to get ahead of the Fed's future plans, commodities, metals in particular, have broken away and again can serve as an effective portfolio hedge.

"Gold and silver still exhibit the most important characteristics that investors prize—low correlation to financial assets like stocks," Nicholas Colas, chief market strategist at ConvergEx, wrote in a note to clients Thursday. He said the pattern has been "less than 20% correlation in both cases for last month, and persistently low measurements in 2011. Even with the well-publicized increase in Exchange Traded Fund ownership of these assets, they still do not move in lock step with stocks."

To be sure, in the short-term commodities are likely to remain volatile.

Ellis said he wouldn't start adding silver positions until it dips below $30 an ounce, a forecast echoed by Philip Klapwijk, strategist at metals consultancy GFMS, who told Reuters that once the current price unwind finishes, silver should have no trouble returning to its former levels.

Investors probably will want to be wary until them—not haphazardly selling but also not rushing to increase positions either.

"For our clients, I have the highest relative percentage to alternative asset classes than I've had in recent memory," said Hennion & Walsh's Mahn. "What that said I probably don't have any more than 5 percent to any one of those commodity groups. It's higher than it's been, but not overweight by any means."

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