Read any story about the commodities boom in a business publication today and it’s likely to remind you of a car ride with your three-year-old -- the question "Why?" is posed incessantly. In response to that question, pundits have offered these explanations for skyrocketing prices for commodities ranging from oil to soybeans:

• surging demand from emerging economies
  
• an influx of new investment, as investors seek a hedge against a declining stock market
  
• plain old investment speculation, fueled by the abundance of mutual funds and exchange-traded funds tied to commodities indexes
  
• a weak dollar
  
• a decreasing commodity supply due to any number of factors
  
• all of the above

Whatever the cause -- incidentally we think it’s all of the above -- this commodities boom, in our view, has led to a bubble in the prices of commodity stocks that’s poised to burst. The stock prices of some companies that extract oil, sell fertilizer, and produce steel, for example, are escalating to exceedingly high levels, causing our proprietary quantitative model to sound alarms the likes of which we haven’t heard since the dot-com bubble of 1999-2000.

Commodity prices soar

Driven by robust global economic growth, which increased demand for energy, food, and industrial materials over the past five years, certain commodities have risen in price at meteoric rates: copper, 408%; coal, 263%; scrap steel, 375%; and phosphate, 1,187%.

In response, commodity stocks in aggregate have been soaring, some recording triple-digit gains over the past five years. For instance, some mining stocks have produced returns of more than 700%. Some oil-production stocks have gained as much as 280%. And some agricultural-chemical and seed stocks have returned more than 1,150%. But what shoots into the stratosphere must eventually fall back down to earth.

Using our quantitative model, we’ve identified nine key momentum factors that we believe are especially telling indicators of a bubble in the energy and materials/processing sectors that may be ready to pop, of rising stocks that may be ready to fall from the stratosphere – hard. Of those nine factors, three are showing especially compelling signs of trouble ahead. The three factors involve measurements of the extreme rates of change in the 50-day moving average (the movement of a stock price over the past 50 days), the frequency of Wall Street analysts’ upward revisions in earnings estimates, and soaring valuations.

When the returns of stocks that rank highly on these and other factors are more than two points of standard deviation from the average returns of all stocks in their sectors -- as is the case now -- we believe those sectors are extremely vulnerable to a significant correction. Specifically, our model is pointing to a burst in these energy and materials/processing stocks in the near future: coal, agricultural-chemicals, steel, precious-metals, contract-drilling, and oil/gas production stocks.

Investors and hundreds of billions of dollars have been attracted to the commodity bubble. A recent Lehman Brothers report estimated that assets in commodity index funds, such as those that track the Goldman Sachs Commodity Index, have more than tripled, from about $70 billion in 2006 to $235 billion by April 2008. "Of this $165 billion increase, about $90 billion is accounted for by financial inflows to these indices," Lehman noted, "with the remaining $75 billion increase stemming from price appreciation of the original underlying investment."

Ominously, even investors who are aware that a bubble is forming tend to stay in as long as possible, motivated by the desire to maximize returns and by the "greater fool" theory – the belief that if you own an over-valued stock that’s highly prized, someone will buy it from you later at a higher price. And there seems to be no shortage these days of swarms of investors flittering around to buy richly priced, highly coveted commodities stocks.

Although some analysts have suggested that commodity stocks aren’t in a bubble, that sky-high commodity prices are legitimately based on a supply/demand imbalance, we beg to differ. We think the market’s exuberance towards commodities has turned irrational. As Barron’s noted about the recent behavior of various commodities investors: "If the speculators were to follow the commercial players – the farmers, the food processors, the energy producers, and others who trade daily in the physical commodities – they’d be heading for the exits. For right now, the commercial players are betting on price declines more heavily than ever before." We agree, and it’s likely to take a toll on the prices of more than a few commodity stocks at some point.

In the sage words of Walter Bagehot, former editor of The Economist magazine, "The rocks only show when the tide has gone out." Our quantitative model is indicating that the commodity-stock tide may be waning and the rocks may be starting to surface.

It may be time to get out of the water.

The views expressed represent the opinions of Turner Investment Partners as of the date indicated and may change. They are not intended as a forecast, a guarantee of future results, investment recommendations, or an offer to buy or sell any securities. Opinions about individual securities mentioned may change, and there can be no guarantee that Turner will select and hold any particular security for its client portfolios. Earnings growth may not result in an increase in share price. Past performance is no guarantee of future results.

Turner Investment Partners, founded in 1990 and based in Berwyn, Pennsylvania, is an investment firm that manages more than $25 billion in stocks in separately managed accounts and mutual funds for institutions and individuals, as of March 31, 2008.