Why you should prepare for the next bubble

A professional investor tells MoneyWeek where he'd put his money now. This week: Stuart Fowler, senior fund manager at Axa Investment Managers

I've got a hunch that we are going to see a bubble in the resources sectors in the UK stockmarket at some stage in 2006. Some may believe that the strong performance of the mining sector over the last eight years has already caused a bubble but it's my contention that we have yet to see the high valuations and manic buying of commodity shares that would mark a true bubble. Commodities are not my area of expertise, but what I read tells me that the physical markets (as opposed to the shares of commodity companies) may well be entering a bubble era already. My assertion is that this has yet to fully feed through to share prices.

My hunch is based on two lines of evidence. The first is that the dynamics of the relevant parts of the stockmarket are reminiscent of the early stages of the technology, media and telecoms (TMT) boom of 1999. At that time the phrases new economy' and old economy' were coined and almost every stock could be allocated to one group or the other. On the days one segment went up or down, the other group went the other way. It's been getting a bit like that in 2006, particularly in the gyrating moves in the market after the sell-off that started on Friday 12 May 2006. It's almost getting to the point where the only way to beat the market is to be overweight in the appropriate area day by day a frustrating situation for bottom-up, fundamental stock-pickers. Will we soon be talking about super-cycle stocks and normal-cycle stocks? If my hunch is right, then we will be, and the fortunes of every fund manager for the rest of 2006 will be determined by their weightings in the relevant portions of the market.

The second reason for suspecting that a bubble is on the way relates to fundamentals. It's hard to get a bubble without some realistic justification. (The driver of the TMT bubble the idea that the internet would change the world has proved to be pretty accurate, if not uniformly profitable). And there really are good reasons for strength in commodities. There is a tight supply and demand situation, extra supply cannot be brought on quickly, inventories are low, and there are new investors such as hedge and pension funds putting money into the underlying markets. If sentiment recovers, it's not impossible that we'll see an oil price over $100 and copper and other metal prices reaching new highs. With many commodity shares trading on single digit p/e ratios, earnings forecasts being revised up on a regular basis, and further takeover activity inevitable given strong corporate cash flows, a bubble looks increasingly likely.

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One of the ways I will be testing my hunch is to watch the valuations of normal-cycle' stocks. One of the features of the TMT boom was that old economy' stocks just got cheaper and cheaper at one point BAT Industries yielded over 12%. Normal-cycle' stocks aren't inappropriately priced right now, but should we see a real divergence in performance between the two portions of the market, and that means there will be some outstanding value opportunities. Given what I learned in the TMT boom, however, I wouldn't be looking to take advantage of those opportunities quickly. In 1999 I basically got my funds positioned correctly at the early stages of the boom, but started taking profits and switching into old economy names far too early. The stocks I had sold rose again by many multiples, so I stopped switching probably just at the point when I should have started. What I will do this time if there is a bubble is to seek to run a long super-cycle' position all the way up, then panic hard and fast once the inevitable roll-over begins.