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“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” – Benjamin Graham
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We invest client funds across six core asset classes: domestic investment grade bonds, inflation protected bonds (bonds whose coupon and/or principal payment is adjusted upwards when inflation increases), domestic stocks, foreign developed market stocks, emerging market stocks, and real estate (primarily through REITs). One “asset class” we don’t own is commodities. Why? Because investing in commodities is anything but investing. It’s speculation.
So what exactly is the definition of investing? Well, the Ben Graham quote is a good place to start. But the best way I found to determine whether you are speculating or investing comes from a paper written by Ben Inker of GMO. He says investors should ask themselves at least two questions about potential investments: (1) “Where do the returns from the investment come from and who funds them?” and (2) “Why would the funder of those returns be willing to offer a return above that of cash in the long run?”
For brevity’s sake I will just discuss the first question. To simplify things, imagine you are retired and all financial markets shutdown permanently tomorrow and you will be left owning whatever is in your portfolio — forever.
Would you want to own bonds? Sure, every six months (typically) you would receive an interest payment from whoever issued the bonds and at the end of the term you would receive back your principal. So far so good.
Would you want to own stocks? Sure, a share of stocks represents a fractional ownership of a business and as an owner of the business you are entitled to your portion of the cash the business generates. Company executives and the board manage the business on your behalf and sometimes they pay out most of the cash in dividends or sometimes they reinvest some or all of it back into the business to generate even more cash in the future. In our example, if the financial markets really did shutdown there would be a lot of people clamoring to receive their cash solely as dividends! But in any case you, the investor, have a claim on a stream of cash flow just like bonds.
What about real estate? Sure. In our portfolio we have exposure to real estate through stock in special types of companies referred to as Real Estate Investment Trusts (REITs). REITs typically own income producing properties such as office buildings, apartments, or malls and they pay out 90% of their earnings as dividends. So you would be comfortable owning them and receiving the cash flow.
Now what about commodities such as oil, wheat, pork bellies, or copper? They don’t generate a cash flow. As a retiree (as opposed to, say, a farmer, manufacturer, or food processor) you don’t have any use for the commodities. Your only choice is to sell them to someone who actually needs them. But remember in our example the financial markets are shut down, so you are stuck with your several barrels of oil, copper ingots, and slowly spoiling wheat and pork bellies. Commodities are useless if you don’t need the actual item. Their value comes only when you sell them to someone else at an ever higher price. That is not an investment. It’s a speculation. Of course, people have made money speculating, but that’s not what we do.
In addition, as we would expect, because commodities don’t have any characteristics that make them an investment, their returns have essentially gone nowhere over the last 140 years as the chart below shows.
“Rubber Duckie, you’re the one, You make bath time lots of fun, Rubber Duckie, I’m awfully fond of you.” – Ernie, Sesame Street
Bubbles always need a good story–a story that gets people excited, that sounds good enough to convince most people they have to participate, and a story that’s usually rooted in facts. The strange thing is that these stories are often true. It’s just the price of participating or the investment chosen that is wrong. For instance, take the tech bubble. The story was that the internet and computers were going to revolutionize business and society. That story was largely true. Almost everyone uses a computer today both at home and at work. Business and individuals are more productive. Communication is faster and easier. Except the bubble took things just a little bit too far, and investors paid through the nose to buy tech companies. Microsoft, Applied Materials, Cisco, JDS Uniphase, Dell, etc., would all have been average or above average investments if investors paid a reasonable amount. Instead, they bid them up to 25, 50, 100 or more times earnings.
So it’s important to realize that when I talk about the commodity bubble, I don’t disagree with the story. The world economy really is growing and the demand for natural resources is increasing; the population is growing and eating more food and higher quality food at that; we really do have to look for oil (and other commodities) in harder to reach places. It’s the price of the commodities and the nature of them as investments (rather than as speculation) that I disagree with.
“People generally worry only about what happens one or two steps ahead and anticipate being able to get out before a collapse… In countless situations people prepare exclusively for near-term outcomes and don’t look very far ahead. They myopically discount the future at an absurdly steep rate.” – John Allen Paulos
The other thing with bubbles is that they all last long enough to make anyone who predicted them look like a fool. It’s likely the commodity bubble will continue for quite some time, and I am prepared to look like a fool for many years. I’d rather look foolish and save clients the heartache and financial loss of another bubble than to go along with the crowd no matter how large that crowd or how many famous converts it has.
History of the Commodity Markets and the New Index Fund Era
Commodity markets were and are intended as a place for producers and/or users of commodities to enter into contracts for the delivery or sale of commodities at guaranteed prices. The markets helped reduce volatility in commodity prices and allowed producers and consumers to lock in prices and better manage budgets and production. Participants in commodity markets can be divided into two categories: hedgers and speculators.
Hedgers are defined as those that produce or intend to consume the commodity and are using financial instruments to lock in a set price. They may be producers, such as farmers, mining companies, and oil and gas exploration companies. They may also be consumers of the commodity, usually processors or manufacturers, such as apparel companies hedging the price of cotton, a tire manufacturer hedging the price of rubber, or a utility company hedging the price of natural gas or coal.
There are two categories of speculators. First, are those that speculate by hoarding the physical commodity itself. An example of this would be a speculator chartering tankers and filling them with oil and then mooring them offshore with the hopes of selling the oil at a higher price later. The second type is someone who buys a future contract (or sells) on one of the commodity exchanges and hopes to resell that same contract at a later date or when it expires at a higher (lower) price. In both cases, the individual does not intend to purchase the commodity for consumption. When examining speculative activity it’s important to look at both types of speculators: physical speculators and those using the financial markets to speculate.
Prior to 2000, commodity markets were strictly regulated. In 2000, the Commodity Futures Modernization Act was passed, which among other things did away with position limits in commodities markets. While commodity index funds have existed since 1991, it wasn’t until recently that they became popular and could handle large inflows of funds. In 2003, several academics published research showing that commodities did not show strong correlations with other asset classes like stocks, bonds, or real estate. Wall Street, never having met a fee generating idea it didn’t like, seized on this research and began creating and selling commodity index funds to retail and institutional investors. Over the better part of the next decade $350B flowed into newly created commodity funds.
The chart below shows the total assets that are linked to the S&P Goldman Sachs Commodity Index.
(Source: bettermarkets.com data)
Commodity index funds track other indexes, such as the Dow Jones-UBS Commodity Index, but the S&P GSCI remains the most popular.
To understand the effect this $350B inflow of speculative money has had on the commodity markets, let’s first look at the participants of the markets pre-CFMA 2000 and post-CFMA 2000 (the index fund era).
Participants in Commodity Markets Today
Historically, most commodity markets operated with hedgers making up 70-90% of the market and speculators making up the remainder. Some level of participation by speculators is necessary to maintain a healthy market, and commodity markets functioned well pre-2000 with speculators making up 10-30% of the market. Now, however, the level of speculators has risen dramatically.
The chart below shows the cotton market in 1996, 2008, and 2010. In 1996, speculators made up 20-30% of the market and hedgers made up the rest. In 2010, speculators account for almost half of the market.
(Source: bettermarkets.com data)
The oil market shows an even more pronounced change in the types of activity. From 1995 to 1999 speculators made up only about 10% of the market. Fast forward to 2006-2010 and speculators now dominate the market, making up almost 70% of the market!
(Source: bettermarkets.com data)
Some markets also have data available on the number of speculators that are actually index funds (think the commodity ETFs and mutual funds that are springing up). Again, we see that speculators made up the minority of the market (about 35%) from 1995-1999. Then from 2006-2010 they made up the majority of the wheat market. We can also see that the increase in speculators is almost solely due to commodity index funds.
(Source: bettermarkets.com data)
Oil and the Effects of Speculation
We can also see the effects of speculation in the price of commodities themselves. The prices for many commodities spiked around 2003-2004. The chart below shows the price of oil in 1960 dollars (adjusted for inflation). As you can see, prior to 2000-2003 all spikes in oil prices were the result of events that affected the oil supply, including the two 1970s oil embargoes and the 1991 Gulf War. Then something strange happened. With the Commodity Futures Modernization Act of 2000 and the advent and popularization of commodity index funds, oil prices went through the roof.
(Source: bettermarkets.com data)
There could be other reasons; after all, correlation does not imply causation. So lets look at the actual use of commodities.
Is the Global Demand Story True?
Earlier I said that I don’t necessarily disagree with the “commodities story” I just disagree that they are attractive investments especially at current prices. The graph below shows world industrial production (a good proxy for commodity demand) versus commodity prices.
Source: Thompson Reuters
As you can see, world industrial production is growing and perhaps even growing faster than it has in the past. But commodity price increases have far outstripped production. Again, the meteoric rise in commodity prices coincides with the 2003-2004 rise of commodity index funds and the $350B influx of investor assets that are now in the commodity markets.
What is likely to happen? Commodity prices will likely continue to rise, driven mostly by speculation. Some sources report that on average pension plans and endowments have a target allocation of approximately 5-6% to commodities, but currently only have a 2-3% allocation. That means there is still much more money to be poured into the commodity markets. The attractiveness of the commodity story and willingness of Wall Street to sell any product regardless of its merits as an investment probably means retail investors will continue to increase their commodity exposure as well.
Investments in commodity markets depend on being able to sell your commodities (or contracts) to other investors at ever higher prices as they generate no cash flows by themselves. The tech bubble and the real estate bubble were built on the same principal of forever rising prices justifying the investment. Just as those ended in tears so will this bubble. The only question is when. I have a feeling this bubble will last long enough to make this article look foolish for several years to come.