The metals analysts at Man Financial Group just released a report titled “Do Fundamentals Matter Anymore?” Do they sound frustrated? No more frustrated than the many portfolio managers who are lagging the indices because they have not jumped onto the commodities bandwagon. To many, the spike in commodities prices is most reminiscent of the tech stock boom that collapsed in 2001.

Just as the sudden falloff in tech stocks had far-reaching ramifications, so too could a downdraft in commodities prices prove painful for numerous financial institutions – including a large number of hedge funds and investment banks that are knee-deep in copper, aluminum, and zinc.

A commodities analyst for Man Financial, Ed Meir, takes a look at copper prices (among others) in the report mentioned above. He focuses on the stocksto-consumption ratio, a widely used statistic that measures inventories against demand. The data supports the view that the copper market is tight, with a current stock ratio of two weeks, about the same level reached in 1997,1988,and 1974.Yet though prices spiked higher in those earlier periods, the rise this time around is, literally, off the charts.

The price of copper is today at $7,120 per metric ton; in analogous past periods, the price never traded higher than $3,500 per metric ton. What is most striking is that the supply-demand balance for copper has actually weakened this year. According to analysts at TD Bank Financial Group, the global copper market reached equilibrium last year after two years of supply deficits, which drove prices higher. Demand for copper dropped about 2% in 2005 while production rose 3%; markets are expected to remain slightly in surplus into next year. The analysts at TD are forecasting that copper prices in December will be off 18% year-over-year.

Similarly, the International Copper Study Group recently released an updated forecast for the balance of this year and next. They project demand rising 4.1% this year and an additional 5.3% next year. Production is expected to climb 6.8% this year and 3.6% next year, leading to surpluses in both years.

Why then are prices up 68% this year?

Mr. Meir has followed commodities markets for 20 years. He says, “I’ve never seen anything like it.” His explanation: The push is coming from speculators, in the guise of index funds, CTA funds, and hedge funds. He points out that index funds now have $80 billion to invest, almost double the 2004 figure. CTAs, or commodity trading advisers, have an additional $130 billion under management, and global hedge funds have $1 trillion under management. All three categories invest some portion of their funds in commodities in one way or another, and they are growing like topsy.

Mr. Meir can trace the activity by the funds on the London Metals Exchange, compared to trading by industry participants, and demonstrates that by the end of last year, the funds were responsible for more than half of the activity. This is triple their participation compared to the 2000 level.

While one is tempted to read potential disaster in Mr. Meir’s statistics, his view is that there is a great deal more money that can come into the commodities markets. He points out that global investable funds total $150 trillion. All alternative investment vehicles, including the three categories mentioned, amount to a tiny fraction of the entire pot. He surmises that with the excellent performance being recorded in the area, more funds will want to join in the fun.

His view? In the long run, fundamentals will out, but for now, incoming fund flows will continue to buoy the markets. He argues that “funds usually reinforce the price direction set by the prevailing fundamentals, but do a poor job fighting the underlying trend.” Consequently, he estimates that copper prices in 2007 will average $8,000, compared to $6,475 this year.

Our view? Watch out. What Mr. Meir’s work really shows is that good trading results have attracted billions of dollars being invested today without much regard to value or economic underpinnings. This doesn’t work out well in equities markets, and it won’t work out well in commodities, either.

One group that he has not included in his calculations is the proprietary trading desks of the large investment banks. Goldman Sachs, for instance, has become a big player in the commodities arena, as has Morgan Stanley. In Goldman’s first quarter (ended February) FICC trading (fixed income, currency, and commodities) both for the firm’s account and for clients totaled $3.74 billion, 50% higher than the year earlier quarter and 36% of total firm revenues. While we imagine that fixed income products account for the biggest slice of revenues, management cites commodities as one of the principal areas of expansion.

For the fiscal year ended November 2005, trading and principal investments – which include private equity holdings – generated 75% of pre-tax earnings and 66% of revenues.

If we assume that margins held constant in the first quarter and made the further assumption that FICC trading generates margins at least comparable to those earned on equities trading and principal investments, we could make the case that FICC accounted for almost 40% of earnings in the first quarter. Again, the commodities desk is probably not the no.1 contributor, but it is a safe guess that it is a large portion.

So we can be pretty sure that the nimble folks at Goldman and elsewhere on the Street are going to be quick off the mark if it looks like the commodities game is winding down. Fund managers may decide to ride out a sluggish quarter, but the investment banks will not want to jeopardize earnings. When China recently announced that it was raising interest rates to slow the rate of that country’s growth, commodities markets came temporarily unglued. As cooler heads assessed the likely modest impact of interest rates moving from 5.58% to 5.85%, the bulls returned and prices for gold and other products shot up again. It could have been a tipping point.

Mr. Meir says commodities markets at the end of the day follow industrial production. The unusual thing about the current cycle is that many countries around the world are growing at the same time. Nonetheless, the fundamentals do not appear to support current price levels, much less further gains. If the traders smell a downturn, you most definitely want to run for cover.

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