Commodities! Huh! What are they good for? Absolutely something!

Cynics have long accused Dow Jones editors of trying to salt their benchmark industrial average with hoped-for winners.

It wasn't so long ago, for example, that Bethlehem Steel (BS:NYSE - news - commentary - research - analysis), now headed to the recycling furnaces of Chapter 11, was a Dow stock, as was Venator (Z:NYSE - news - commentary - research - analysis). Sometimes this alleged strategy backfires, as it did two years ago with the inclusion of Microsoft (MSFT:Nasdaq - news - commentary - research - analysis) and Intel (INTC:Nasdaq - news - commentary - research - analysis) near the end of the long tech boom.

Commodity exchanges must be forgiven the same impulses. The New York Board of Trade, pluckily doing business in Long Island City after the destruction of the World Trade Center, began trading a commodity index future based not on the Bridge/Commodity Research Bureau's unweighted CRB index, but rather on a Standard & Poor's commodities index (SPCI) that's weighted to reflect economic importance. Gold, interestingly, is excluded on the grounds that it isn't consumable.

Both the CRB and SPCI are geometrically weighted, while the Dow Jones-AIG and the Goldman Sachs commodity indices are arithmetically weighted. A geometric index is the Nth root of the product -- for example, the 17th root of 17 commodity prices multiplied together. An arithmetic average is the sum of the prices divided by the number of commodities. Those of you thinking about constructing a commodity index as a weekend project should note how different the weighting schemes of these indices are.

Weighing In Here are how the commodity indices weight their sectors

Source: Bloomberg

They're Bearish Until They're Not

No matter what you put in the index or how you weight the components, one answer is inescapable: Commodities are still in a very long-term bear market. How long, you ask? Go back to the Neolithic, buddy: Ever since the first accidental farmer planted some seeds, we've been figuring out how to produce goods more efficiently.

The Fed's aggressive-but-belated campaign of interest-rate cuts has put short-term interest rates -- now at 2.5% -- below consumer inflation, which is now at 2.6% on an annualized basis. This is significant in the world of commodities: Holders of an asset like gold may be able to realize a nominal gain simply by holding the tangible asset and letting inflation work its evil magic.

It may not happen now or even next year, but eventually we'll see commodity price inflation as a consequence of present monetary policies. If we look at the shape of the yield curve, here defined as the ratio of the forward rate between two and 10 years (the rate at which we can lock in borrowing today for a period starting in year three and extending to year 10) to the 10-year rate itself, we see how it leads commodity prices. The last cycle between peak monetary loosening and peak commodity prices took 42 months. If this cycle is repeated -- and there's nothing magic about 42 months -- we'll see a period of rising commodity prices between now and April 2005.

Follow the Curves Look for rising commodity prices, if history is any guide

Source: Bloomberg

Investing Implications

What's the point of being an emerging market if you can't emerge? Or, more precisely, who is going to be helped by a combination of rising inflation and rising commodity prices? The answer is the same globally. Debtors, including governments, are helped by inflation as they get to pay back their obligations in depreciated currency. Primary commodity producers, whether they're Saskatchewan wheat farmers, Brazilian coffee growers or Zambian copper miners, also benefit from the short-lived monetary illusion that they somehow have acquired an advantage in the terms of trade.

Forget about investing in any of these folks for the long term. The meek shall not inherit the earth, and neither will those in hock or those wedded to the land or to their mines. As I've noted so often, commodity consumers can add far more value than can commodity producers. But long-term verities need not get in the way of short-term opportunities to make a raid into the debtor/commodity-producer/emerging-market sectors.

The bear market in stocks has created a bull market in cash and government debt. Turn the yield chart over, and we're in irrational exuberance time for short-term rates. Unless events conspire to produce an economic collapse -- and the bet here is that we're going to bend, not break, economically barring something unforeseen -- risk is underpriced, and accelerating demands are going to convert recent monetary largesse into higher price levels.

For those of you who still subscribe to the quaint notion of buying low and selling high, it's time to start thinking about high-yield bonds, natural-resource stocks and emerging markets. These sectors are likely to be the leaders, such as they will be, over the next three years. Every now and then, commodities are good for something.