COMMODITIES & THE 130+ YEAR BEAR MARKET

“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

Commodities have become an increasingly popular asset class in recent years as faith in fiat currencies has declined, economic growth has stagnated and traditional investments such as equities and bonds have become increasingly unreliable.  As demand for hard assets has increased Wall Street has been right there to satisfy this demand with various new products that are sold as “investments”, “hedges” or whatever can help these banks meet their ever increasing need to drive bottom line growth (and take money from greater fools).

Yesterday, Dylan Grice of Societe Generale published what I believe is an incredibly important piece of research showing that commodities are NOT investments.  In fact, when you buy a commodity for non-commercial purposes you are speculating.  Grice elaborated:

“The fluctuations of commodity prices have fascinated speculators for hundreds of years, but why should investors be interested? Commodities aren’t productive assets, so how can they create wealth over time? And why should they provide investors with a collectable risk-premium?  Commodity returns can be decomposed into the  “spot”  return and the  “roll” return. It’s not obvious to me that either are dependable sources of compoundable profit.”

He goes on to show that commodities have actually been terrible investments over the last 140 years  *(see more images below):

This makes sense as commodities have no cash flow and the purchase of such assets ultimately involves playing a zero sum game with the hope of one day selling to someone else at a higher price.  Seth Klarman, the founder of hedge fund Baupost and of value investing fame, recently described this phenomenon:

“Buying anything that is a collectible, has no cash flow, and is based only on a future sale to a greater fool, if you will—even if that purchaser is not a fool—is speculating. The “investment” might work—owing to a limited supply of Monets, for example—but a commodity doesn’t have the same characteristics as a security, characteristics that allow for analysis. Other than a recent sale or appreciation due to inflation, analyzing the current or future worth of a commodity is nearly impossible.
The line I draw in the sand is that if an asset has cash flow or the likelihood of cash flow in the near term and is not purely dependent on what a future buyer might pay, then it’s an investment. If an asset’s value is totally dependent on the amount a future buyer might pay, then its purchase is speculation. The hardest commodity-like asset to categorize is land, an asset that is valuable to a future buyer because it will deliver cash flow, not because it will be sold to a future speculator.”

Grice added that the purchase of commodities is actually the sale of human ingenuity.  You are essentially betting that humans won’t one day replace their oil based energy needs with some alternative energy.  Or you are betting that humans won’t find a way to more efficiently produce wheat:

“Why  should  commodities provide investors with a real risk premium? Shouldn’t  prices actually decline  in real terms over time? A bushel of wheat, a lump of  iron-ore or an ingot of silver today is identical to a bushel of wheat, lump of iron-ore or ingot of silver produced one thousand years ago. The only difference is that they’re generally cheaper to produce because over time, human innovation has  lowered the cost of production.  When you buy commodities, you’re selling human ingenuity.

Past performance is no guarantee of future results, obviously, but human ingenuity has a good track record of overcoming nature’s constraints so far. A commodity bull market is really just a bottleneck  and as a  species we’ve succeeded in bottleneck  removal. Historically, most bull markets have ended up where they started.

Why bet against human ingenuity by buying physical commodities when you can bet on it by investing in  the enterprises whose  task  is to remove the bottlenecks and lower commodity prices?”

Of course, there is a complexity in the equation here that Grice also tackles.  Commodities futures contracts have a built-in risk premium because you don’t transact in the spot price.  But Grice finds no evidence that this risk premium necessarily exists.  In fact, he finds that commodities markets tend to be in a consistent state of contango therefore creating a negative roll effect:

“If investors  had been  picking up  a  risk premium by systematically rolling futures indices their  total  return would be higher than the spot market return. So the ratio of the total return index to the spot index should steadily rise over time. In fact, the ratio has been zero for the last twenty years.”

“What the chart doesn’t show is that over the past 20 years the GSCI’s annualised total return has been 4.3% despite the spot return being 5.2%. In other words, the ‘roll yield’ has  been -0.9%. Since the year 2000 it has been even worse. The GSCI spot return has annualised an impressive 9.9%, but the total return has been only 3.9%. The “roll yield” has been -6%!”

Of course, this doesn’t mean you can’t make money in commodities.  As we’ve seen in recent years there are fantastic swings in commodity prices over time and savvy speculators can benefit from such swings.  For instance, CTA’s (trend followers) have had fantastic success trading commodities over the last 30 years according to the Barclay’s CTA Hedge Fund Index (the index doesn’t include survivorship bias, however):

The more important takeaway is to avoid believing that you are making an investment when you buy commodities.  Rather, you are making a specific speculative bet.  The fact that Wall Street has begun selling the idea of “investing” in commodities should play no role in your decision to buy a commodity.  In fact, I believe this is just one more case of Wall Street attempting to monetize the ignorance of the general public.  If you’re interested in generating sustainable income from commodities you are better off investing in the commodities related companies themselves.

There’s an interesting counterargument that can be made for a commodity such as gold, however.  Doesn’t its currency like characteristics make it unique?  Seth Klarman says no:

“Gold is unique because it has the age-old aspect of being viewed as a store of value. Nevertheless, it’s still a commodity and has no tangible value, and so I would say that gold is a speculation. But because of my fear about the potential debasing of paper money and about paper money not being a store of value, I want some exposure to gold.”

I would add that Grice’s comments regarding innovation are applicable here as well.  Ultimately, a bet on gold is a bet that we will revert back to some form of commodity based currency system which proves the modern fiat monetary system is flawed.  But as I have previously explained, I believe this is faulty thinking in the long-run.  In fact, the move from the gold standard was a form of financial innovation due to the fact that the gold standard imposed inherent restrictions on the modern complex and dynamic global economy.

What we are seeing in single currency Europe is in many ways equivalent to the flaws generated in a world which was once a single currency world (see here for more).  Obviously, that system is highly flawed. And it was these inherent flaws that ultimately led to the demise of the gold standard.  A move back to the gold standard would quite literally be like moving back into the stone age.

In the near-term, however, (remembering that all commodities are speculative bets) we can’t ignore the voracious demand for gold as a currency, the problems in Europe, the false belief that the Fed is “printing money” and the misguided belief that fiat currencies are not the wave of the future.  As I have repeatedly stated in recent years, it’s likely that gold prices continue to surge higher as investors seek a safehaven from a world of economic uncertainty, political strife and what is viewed as a failing fiat currency in Europe.  Ultimately, I still believe gold’s endgame in the current cycle is an irrational bubble, but that is a purely speculative short-term bet and not a long-term investment.

In conclusion, mathematician John Allen Paulos famously said:

“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.”

Investors are caught in a wave of euphoria in the commodity markets today.  And that’s not to say that it is wrong to own commodities or that their prices won’t be substantially higher in the coming years.  But just remember that the product your Wall Street broker so nicely wrapped up for you is NOT an investment.  It is a product that is guaranteed to line the pockets of bankers while you make nothing more than a speculative bet that a greater fool will one day buy from you at a higher price.

————————————————————————-

*Additional images provided below:

(Real Commodity Prices)

(Copper, aluminum & zinc prices)

(Real gold and silver prices)

(Real oil prices)

** A special thanks to Gregory White of Business Insider for help with this article

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Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • dhdell

    Awesome. Couldn’t have tied in Mr. Market himself to the fiat/commodity discussion any better.

    “The fact that Wall Street has begun selling the idea of “investing” in commodities should play no role in your decision to buy a commodity. In fact, I believe this is just one more case of Wall Street attempting to monetize the ignorance of the general public. ”

    Absolutely. Anytime Wall Street breaks out a brand new ETF or ETN, which increasingly have been related to things such as commodities and volatility, I run the other way. Considering JP Morgan’s rolling out of a new Copper ETF in 2011, I assume we should be prepared to short that shiny metal as well.

    The lack of cash flow- in fact the NEGATIVE cash flow produced by hoarding commodities in the form of storage (and other mgmt fees depending on the security)- is key here. This is why a “negative real interest rate,” or expectation of one, is so important to the performance of commodities- it’s the ONLY way to counter the negative cash flow associated with holding them.

    But back to Graham. It might interest some of you that the man was not just a “net-net” stick-in-mud investor- well he was- but he did distinguish between intelligent and no-so-bright speculation in Security Analysis:

    “Speculative operations are all concerned with changes in price. In some cases the emphasis is on price changes alone, and in other cases the emphasis is on changes in value which are expected to give rise to changes in price. I think that is a rather important classification of speculative operations…

    It seems to me that Wall Street analysts show an extraordinary combination of sophistication and naiveté in their attitude toward speculation. They recognize, and properly so, that speculation is an important part of their environment. We all know that if we follow the speculative crowd we are going to lose money in the long run. Yet, somehow or other, we find ourselves very often doing just that. It is extraordinary how frequently security analysts and the crowd are doing the same thing. In fact, I must say I can’t remember any case in which they weren’t. (Laughter.)

    It reminds me of the story you all know of the oil man who went to Heaven and asked St. Peter to let him in. St. Peter said, “Sorry, the oil men’s area here is all filled up, as you can see by looking through the gate.” The man said, “That’s too bad, but do you mind if I just say four words to them?” And St. Peter said, “Sure.” So the man shouts good and loud, “Oil discovered in hell!” Whereupon all the oil men begin trooping out of Heaven and making a beeline for the nether regions. Then St. Peter said, “That was an awfully good stunt. Now there’s plenty of room, come right in.” The oil man scratches his head and says, “I think I’ll go with the rest of the boys. There may be some truth in that rumor after all.” (Laughter.)

    I think that is the way we behave, very often, in the movements of the stock market. We know from experience that we are going to end up badly, but somehow “there may be some truth in the rumor,” so we go along with the boys.

    For some reason or other, all security analysts in Wall Street are supposed to have an opinion on the future of the market. Many of our best analytical brains are constantly engaged in the effort to forecast the movement of prices. I don’t want to fight our the battle over again here, as to whether their activity is sound or not. But I would like to make one observation on this subject.

    The trouble with market forecasting is not that it is done by unintelligent and unskillful people. Quite to the contrary, the trouble is that it is done by so many really expert people that their efforts constantly neutralize each other, and end up almost exactly in zero.

    The market already reflects, almost at every time, everything that the experts can reliably say about its future. Everything in addition which they say is therefore unreliable, and it tends to be right just about half the time. If people analyzing the market would engage in the proper kind of self-criticism, I am sure they would realize that they are chasing a will-o’-the-wisp.”

  • AO

    Very interesting. Thanks

  • goodfriend

    That’s typically why i like this blog: nice BROAD pictures.
    Anyway, trendfollwoers worked not so bad, why couldn’t we…speculate ?

  • dhdell

    BTW, sorry for the length above. Definitely NOT blog-comment appropriate!

  • dhdell

    It gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”
    – Warren Buffett

    “You could take all the gold that’s ever been mined, and it would fill a cube 67 feet in each direction. For what that’s worth at current gold prices, you could buy all — not some — all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?”
    -Warren Buffett

  • In Accounting

    Thanks for posting this, Grice and his buddy Albert Edwards are always worth a good read.

  • Mschn

    We were talking about this internally last week. Nice seeing the data go back so far. Thanks for this post.

  • InvestorX

    To all here,

    I would like to make an important point and even go against Graham and Klarman (whom I deeply respect and agree with them boadly):

    “Everything is a speculation!” (ok maybe one is less risky than the others, but it is still a speculation). The point was excellently made by Mish:

    http://globaleconomicanalysis.blogspot.com/2010/11/midas-crush-marketwatch-attempts-to.html

    ““Gold is always a speculation,” says James Grant.

    The legal dictionary defines speculate “to assume a business risk in hope of gain; to buy or sell in expectation of profiting from market fluctuations”

    By that definition, what isn’t speculation?

    Buying bonds is speculating that a company will be able to pay you back. Sometimes it works and sometimes it doesn’t as the collapse in GM shows. How many widows on fixed income counting on GM yields got wiped out?

    Little did GM bond investors realize they were foolishly betting (speculating) that GM would not go bankrupt. They lost.

    What about technology stocks, especially “bellwethers” like Cisco?
    Purchasing any stock is speculating whether or not the company can return value to shareholders.

    Cisco has not paid a dividend ever. Whether it starts to now is moot. Those buying dividend stocks are speculating the dividend will not be cut. In addition to GM, look what happened to the dividends of Citigroup, Bank of America, Wells Fargo, and the entire financial sector in the last few years.

    Buying those stocks was not speculation? And gold is? Please be serious.”

  • InvestorX

    Also: Graham makes the fine distinction b/w price and value increase, but the expected value increase is based on speculation that the firm will be able to deliver that value increase.

  • Shippy

    The term “speculate”, has a range of meanings. In its use to differentiate commodity “bets” from equity “investments”, the term speculation is used in a narrow context, that of mere “bets”. This thread’s purpose in its idea of “speculative bets” is to illustrate that a given price may increase and a bigger fool may provide you a profit.

    But the term “speculate” also has a much broader meaning, that of a thoughtful process involving consideration of various current and future business, economic and financial aspects of a given investment. It is in this context that TPC and its sources are differentiating securities investments from commodities.

    Last summer, a friend probed into my thinking in re commodities. His focus was on gold and silver, but he also ranged into other hard and soft commodities. I told him I was uncomfortable with the idea, but was unable to articulate precise reasons why, other than to say that commodities appeared to be too heavily weighted toward emotional effects (greed, fear, etc) rather than more tangible valuation considerations.

    My investment philosophy is built around the core idea of compounding income over a sustained period of years. Thus, I seek equities that have a demonstrated history of effectively compounding their earnings. My uncomfortability with commodities arises because, as this thread reveals, they have no element of compounding, and therefore fall outside my investment philosophy.

    Many thanks to Cullen for providing this thread. It vividly closed the loop of thinking for me.

    Nice job!

  • In Accounting

    I don’t want to derail the thread, but Reuters has just put out an excellent 13-page piece on the destruction of the middle class in America.

    http://www.reuters.com/article/idUSTRE6BF28720101216?pageNumber=1

    They do an excellent job of explaining the issue of wage arbitrage practiced by multinationals without resorting to protectionist or xenophobic arguments. I particularly liked this piece as it explains the problems we’re facing in a manner which most americans should be able to understand.

  • Max

    The weird thing is that this exotic ultra-risky “investment” is being embraced by people who wouldn’t touch a hedge fund with a 10 foot poll. The average hedge fund is much safer and more sound than commodity futures!

  • http://www.pragcap.com TPC

    Just look at the real returns. Futures markets are inherently zero sum. Equity markets are not (at least in the sense that they can create nominal wealth). I very much liked Grice’s line about selling human ingenuity. When you buy Cisco you are buying ingenuity. When you buy oil you are essentially betting against ingenuity.

  • Phil

    I tend to agree with investor x. Every investment is speculation about a better future and therefore positive return on money invested, be it through coupons, dividends, increase in asset prices, decrease in asset prices…
    The main difference would be perceived social usefulness : In other words wouldn’t speculation be just about creating additional money and investing something more than that (creating jobs, creating revolutionary products, whatever…)

  • walden

    But commodities are also used to PROMOTE human innovation. Rare earths, for example, are a small part of the building of fuel-efficient cars, but they provide essential and highly leveraged ways of investing in that development. Uranium is also a bet against fossil fuels.

    And commodities are one of the very best ways to hedge against inflation. TIPS are completely controlled by governmental definitions of inflation, while commodity prices are more (not completely, because of private manipulation) determined by market discovery.

    Finally, it seems to me to be methodologically wrong to separate commodities from equities so simplistically. A large part of the run-up of stocks in the first half of the 20th century depended on companies that produced or used commodities, such as U.S. Steel and Alcoa. Up until a couple of years ago, a great investment was home builders, but timber was a legitimate play there and many home builders owned their own forests as well. What kind of a company is Exxon Mobil? Is it a commodities play, a service play, a technological play? What, precisely, are you investing in? A large number of multi-nationals have diversified precisely to include commodity speculation as a hedge against other variables. Every airline hedges fuel, for example, and that speculation ends up affecting their bottom line.

    When I buy broad commodities indices together, I’m effectively betting on Chinese factory production and the companies that own them. Commodity investments may not produce dividends, but neither do many growth stocks. I’m betting that business will expand and demand more of my investment. And that may be a better way of investing in the developing world that investing in their stocks, information about which is still very dicey.

    So, while I understand how you can sort out speculation on (say) orange juice futures (“Trading Places”), and maybe even gold (which I do like very much), many commodities seem to me to be genuine investments in economic growth that eliminate the variations of individual stocks.

  • InvestorX

    My point is about the meaningless differentiation between speculation and investing – there is none.

    I am not saying anything about futures, commodities and expected returns. Zero sum or not, commodity futures and equities are speculations. Same is with cash – a speculation on lack of inflation, no default of your deposit bank etc.

  • InvestorX

    You can also read Mish’s post above till the end, cause I did not post it in full. Buying Cisco is theoretically a good idea, as long as its P/E is not 250. But even if it is a good investment at a good price, it remains a speculation.

  • http://www.pragcap.com TPC

    Sure, if you’re using these commodities for commercial usage they are likely great investments.

    Commodity prices, per SG, have historically deflated so how good is that inflation hedge in reality? It seems to me that buying the companies that produce these commodities are far greater hedges in the long-run…..200 years of falling average commodity prices should give a person pause before they decide that 25% of their portfolio should be invested in this asset class for the long-run….

  • http://www.pragcap.com TPC

    See, I disagree. I run a company. I think I’m a smart guy. I invest a huge amount of my money into my company. I am essentially investing in my ability to continue learning, improving, evolving, etc. I am investing in the idea that I will become more creative and expansive in my operations in the future. Is that speculating? I don’t think so. I know for a fact that I will be better and more well rounded in 20 years than I am now. My ideas will be better, broader, more intelligent, etc. I should ultimately output a more valuable product in 20 years than I do now. That’s not speculating. That’s just how the human body is designed to work. We grow, expand and evolve….

    If I were to take my company public one day would I suddenly be speculating? No. I’d still be investing in my company and its future potential growth. If you became a part owner you might meet me and feel as though my ideas and company are a good investment. Would you suddenly be speculating? I don’t think so. You might say, “man, that Cullen guy sure is stupid. His stock is going to $0.” Does that mean my investors are speculating? No. It just means they are stupid. :-) But ask Bill Gates’ investors in 1980 or Mark Zuckerberg’s investors in 2003….I think you get my point.

    When you buy a commodity on an exchange you are betting on a tangible good that may or may not be higher in price in the future. It doesn’t innovate. It doesn’t create. It doesn’t expand. It’s just a medium for people to innovate and create WITH. Whether that commodity is necessary in 100 years is entirely up to the ability of the innovators to more efficiently create an alternative….

    I am not sure if I got that point across or not….

  • Anonymous

    If Commodities are not a “good” investment then why to most of the central banks of the world subscribe to keeping a large amount of this useless metal on hand. I know…. they need paper weights for all that paper.

  • http://www.pragcap.com TPC

    The leading innovator of the world (the USA) has been reducing their gold supply for 75 years….China is accumulating gold. Go figure.

  • walden

    No argues from me on that TPC–I respect your wisdom far too much–but I will say also that the past 200 years has witnessed the rise of the West at the expense of the more populated East, and that is now reversing at a breathtaking pace. One of the reasons that farm land is suddenly such a hot buy is that there are far more people demanding, and able to demand, better food. And, to say that investing in oil is a bet against innovation when we are within +/- 5 years of peak oil and when China and India are suddenly producing and driving “dirty” cars at an exponential rate sounds a lot better and more moral than it is, I think. Commodity demand is a direct reflection of the great East-West shift in global power, and that can’t be captured on the charts above (which, by the way, show that equities outperform corporate bonds only since the Great Depression).

    Sure, the West will pull through this. But the challenges to the U.S. and Europe are unprecedented, because never before in one of these “this time it’s different” crises has there been another player, such as China, India, etc ready to compete for the lead in industry and technology and cheap, but quality labor. This may honestly be a tipping point in world history, and, if it is, charts of equities vs. securities vs. commodities over the past 50 years in a tiny part of the globe will mean very little about the future.

  • boatman

    commodities i only view as a trade…..gold just has a big window now.

    there’s my aquaintenance that kept his dead father’s smalltown bank stock as it was sold n resold..up to 2 mil worth..12 months ago he woke up and it was bk’d all he had was toilet paper……had bought GM too at 3$–GM wasn’t going anywhere i can still here him say.

    then my other buddy is working on lossing his 2nd .5 mill after the first one on tech-cisco esp. we see DOW 6000 again for all this sh*t is over….n it isn’t……

    buy n hold?…..pretty funny……its all speculation for the next 5-9 years.

    place your bets because thats what they are.

  • Jonnyblaze

    I actually very much disagree with the thought that commodities are speculative. In fact, I would argue that fundamentally commodities are one of the only things that have any true value. As such, I believe that OWNING commodities is one of the best ways to actually MAINTAIN real intrinsic value.

    I’m not saying that “investing” in commodities futures is a good idea. In fact, I wouldn’t recommend it for most people, and most people that do this are actually speculating, as you point out. But there’s a difference between USING something to speculate, and that thing actually BEING speculative by nature.

    Maybe it’s just semantics, but commodities have intrinsic value and are used to speculate. Stocks can be (and until very recently in history have been) used for non-speculative purposes in one context, but I believe that it is stocks and all financial securities that are by their very nature speculative.

    I do like the concept that buying commodities is essentially selling human ingenuity, but I would re-phrase that to selling human wealth creation. We can still be ingenious in other ways besides those which lead to financial gain…

  • http://www.pragcap.com TPC

    I think the important distinction is whether you’re using it for commercial use or for speculative use. There’s a big difference.

  • http://www.pragcap.com TPC

    I get your point Walden and I don’t necessarily disagree. I just think the main point is that if you believe in the commodity bull and the bigger trends you’re discussing (which I very much do) I think you’re better off buying the people (via their shares) who will maximize that profit via innovation as opposed to the commodity itself.

  • walden

    Boatman and Jonnyblaze say important things. And that brings up whether today with derivatives, HFT, and unprecedented gov’t intervention there can be any genuine equities investment in the way Benjamin Graham understood it. Graham would now barely recognize his most famous discipline, Warren Buffet.

  • http://www.pragcap.com TPC

    Buffett’s a curious case, huh? It makes me wonder if, in an attempt to diversify BRK, he hasn’t sucked the alpha out of its operation a bit too much?

  • Jonnyblaze

    Very true… btw thanks for the analysis above. I think it is excellent, but I just disagree with some of the conclusions drawn.

    I want to own commodities precisely as that hedge that the human ability to continue to manufacture wealth is at an inflection point in history. 200 years seems like a long time horizon, but let’s not forget that the commodities chart would probably bounce around that 100 level back into history as long as man has existed. Stock markets haven’t existed for as long, but I would have to imagine that if they did, there would have been relatively long Bull periods during the ancient Egyptian days (still can’t figure out those pyramids :) ), the Roman Empire, etc. and relatively long Bear periods during the Middle Ages, etc. Who knows, but there’s always the potential that we could be at one of these turning points — not saying we go back to the Stone Age or anything, but there have been other periods in history when “progress” and wealth creation seemed unstoppable, only to then, well, stop… World didn’t end and people still gotta eat!

  • blaw111

    I graduated from college in 1964. Gold prices that year were $35+/oz. In the early 2000s, most things cost roughly ten times what they did in 1964, and sure enough, gold did too. (Actually, it was a bit behind as the millennium changed, but because I’m a bit slow, I didn’t buy any until it was almost exactly 10 times $35.)

    Other great fools even slower than I didn’t begin to pile into gold until 2004. Since then, however, fool production has been astonishing, as measured both in gold and in Congress.

    Clearly the price for gold should be south of $400/oz. Therefore it seems a good time to consider selling. I’m looking for something that’s < 10X 1964 prices and has some potential. (I'm a speculator who's kind of risk adverse.)

    Speculators are fools, but I've slept pretty well in recent years (even having now admitted publicly that I'm a fool). The good news, for me at least, is that I read The Pragmatic Capitalist.

  • http://www.michaelcovel.com Michael Covel

    No one I know, and I know a few in the space who trade billions in commodity futures, view it as anything but speculation. You have a plan to buy and a plan to sell at all times. ‘Investors’ should have an exit plan too, but of course most don’t and when the Oct 08s happen — they throw their hands up.

    And for anyone who calls a speculator a fool … well … I will refrain.

  • Anonymous

    During the California Gold Rush during the 1800’s, wasn’t it the merchants who sold equipment to the miners the one’s who made money?

  • http://www.pragcap.com TPC

    The speculator is only a fool when he believes he’s not speculating.

  • blaw111

    Touche. (I thought I was hedging.) Fool^2

  • Roger Ingalls

    There a good point in there how the unions are dis-integrating, by accepting tiered wages (new hires make half of what existing employees make).

    Nice article, thanks. Kind of short on solutions…how many wrench turners are going to do well enough in calculus to get jobs that pay what their old job paid?

  • Bryan

    “I warn you that politicians of both parties will oppose the restoration of gold, although they may outwardly seemingly favor it, unless you are willing to surrender your children and your country to galloping inflation, war and slavery then this cause demands your support. for if human liberty is to survive in America, we must win the battle to restore honest money. There is no more important challenge facing us than this issue – the restoration of your freedom to secure gold in exchange for the fruits of your labors.”
    – Howard Buffett (Warren Buffett’s father)

    “But first let me clear away a bit of underbrush. I will not take time to review the history of paper money experiments. So far as I can discover, paper money systems have always wound up with collapse and economic chaos.”
    – Howard Buffett (Warren Buffett’s father)

    Seems like Warren forgot some of those father-son discussions.

  • LZ

    Good article, but from charts you present, I am not sure you can call any of them bear market. They are sideway market instead. Also I will not be surprised it breaks out this range in near future.

    Also it is such an irony if long commodity = short human ingenuity. Then what on the earth Benanake is doing? Are debasing currency, creating moral hazard and financial market ponzi scheme equal to short human ingenuity, too?

  • LZ

    And case can be made gold/silver break out 100+ year downtrend in 1971. We all know why and I don’t now it is bullish for human ingenuity or not.

  • Patrick

    Commodity trading has not changed since its birth on the docks of Venice, I believe it was, 800 years ago as a speculation and funding mechanism for ships to ply the spice and silk trade. If your “ship came in” you hit the mother lode.

  • William Merrick

    Wow, look at the stability before 1913… coincidence?

    “Money is the most marketable commodity” -Ludwig Von Mises

    No matter the efficacy of Austrian Theory, my statement is not to do with that; I digress.

    Instead, I am just pointing out that I agree, commodities are not investments, but they are also not necessarily speculations, either. I have speculated in commodities, and sold the palladium I bought 2 years ago just a few days ago. However, they can also be used as a long-run inflation hedge in the case someone wishes to hold something liquid other than fiat currency.

    “has no tangible value” Graham makes the age-old mistake of the “tangible” or “inherent” value argument- there is not such thing, because in order for something to have value, there must be a valuing actor. That makes value, as a concept, contingent on something other than the item being valued, which means it cannot be inherent.

    There are arguments against it being an investment, but it is not therefore always a speculation. If one is purchasing futures simply to try and gain the market, this is a speculation. If someone is purchasing physical commodities or commodity shares (warehouse receipts, essentially- whether in etfs, etc.), this could be just a value-storing strategy.

    By the same logic, if it is necessarily a speculation to buy and hold any commodity, it is a speculation to buy and hold any currency- because currency is a commodity.

  • K L Law

    Good stuff.
    By the same token in US Treasuries movement of late, we know Fed could well be the last “fool” cos no “greater fools” are found buying ‘em…..cos greater fools were already fooled when 10-year yields were trading below 2.5% yield to
    maturity………good stuff on Fed

  • prescient11

    I’m sorry, the whole “gold is useless” argument is so stupid that I tune it out the second that someone presents it.

    Gold IS money.

    Get over it all you deep thinkers. And as Mr. Buffet’s prescient father pointed out, all paper money systems collapse.

    But what he left out is ALL MONEY SYSTEMS collapse because of the greed and mismanagement of stupid politicians. I suppose it is the human condition.

    But I will state right here that I think that because nations are now nuclear, commodities are going to be repriced in a big way to the upside. And I have been saying that since copper was in the $2s. I will be out of the play in 2014, but not until then.

    I think this piece is clever, just completely incorrect. Everything is a speculation. TPC, you running a business is a speculation that you are not a moron and are providing something that others want, and will pay you for.

    EVERYTHING IS SPECULATION, THAT’S HOW THE WHOLE DAMN THING WORKS.

  • http://www.pragcap.com TPC

    I just think that’s nonsense. There is absolutely nothing about gold that makes it valuable. It is a pure human belief. If aliens landed on earth they would likely find me pretty interesting. They might find my ideas interesting. They might even find the things I am interested in to be interesting. But if you handed them a piece of gold they’d look at you baffled and see absolutely nothing of utility.

  • Bruce

    I love Grice normally, but I have to say this was about the stupidest piece of analysis I have from any analyst in quite some time.

    First, Commodities are mainly about two things: population growth and rising standard of living. So if you are betting on commodities, that is what you are betting on. Fortunately human ingenuity keeps grain and oil prices from going parabolic with the rise of marginal demand in Asia, but commodities are certainly not about betting against people. Quite the opposite.

    Second, if people are piling in just to keep their real wealth constant, why exactly is that bad? Should they keep the money in the bank and watch it’s purchasing power erode? Or in massively overvalued stocks?

    As an aside, I saw today that the average price of an acre of farmland in Iowa increased from something like 4300 to 5000 in one year. That is a huge move. No one except estates are selling farmland. No one.

  • prescient11

    You do realize how crazy you sound constantly invoking aliens.

    Let’s deal in reality and what has actually happened. Regardless of what some martian thinks, humans have valued gold highly since we started writing on walls.

    And I’m also interested to know what inherent value a piece of paper has.

  • walden

    True, too, about the Mona Lisa, a Babe Ruth rookie card, or a bag of diamonds. Society assigns them value. As David Goldman once wrote about the cost of a ticket on the last train out of Marseilles during the Nazi invasion: the ticket cost whatever you had.

    And try telling it to my wife that gold isn’t worth anything. Unfortunately, she can immediately tell the difference between 14 and 18 carat jewelery.

  • Jack

    I don’t really understand your position. You don’t think anyone could make money on commodities in a bear market? Or that if they did so it’s just because they’re lucky? Knowing where and when to get in and for how long maybe is not quite a science, but that’s not the point — it’s definitely not impossible…I think you might be underestimating the coming boom global growth that globalization is going to bring to a lot of the emerging markets.

  • http://www.pragcap.com TPC

    1) If that were true commodity prices would have shown real gains over the last 130 years as the population and standard of living has exploded to the upside. The evidence proves otherwise.

    2) The reason we invest is to outperform inflation. That’s the whole point. Just staying even does not achieve anything (unless you’re an underachiever).

    3) Land is different. It very much has a cash flow.

    Again, I am not knocking commodities. I am just saying that there are superior ways to invest in commodities than to buy a paper contract that you never plan on taking delivery of or using for commercial use.

  • http://www.pragcap.com TPC

    The point is that gold only has value to the extent that people believe it has value. Whereas if I buy stock in a company that helps invent drugs that help people live 20 years longer I am investing in something that doesn’t have perceived value but has real tangible value.

    This example might be better. Let’s say you know the earth is going to be hit by a meteor in 10 years. Would you rather invest in a project that helps build a space ship which ensures our species survives on some planet in outer space? Or would you rather hoard gold? And this is a scenario which could be very real one day….I don’t think anyone in their right mind would choose gold.

  • http://www.pragcap.com TPC

    I think you need to reread the piece. I am talking about investing. If you buy commodities because you believe a bear market is coming you are speculating on a specific short-term outcome. I am not saying it’s impossible. I am just making it clear that this is not investing and that over long time periods you’re unlikely to make money owning commodities outright.

  • prescient11

    Well, what I am saying is a little different. I’m comparing money to money here. Gold is money. Since the dawn of civilization. Rather than focus on stock, why does having a paper note act as money trump gold as money?

    It’s true, if a meteor was headed our way, I’d rather be in the spaceship or instant gratification business, but barring that event, I imagine gold is gonna do just fine.

    And if we’ve been in a 130 year bear market, that cycle is more than due to turn.

    Commodities are tremendous investments in human ingenuity and moving forward. This piece does not really make any sense other than just to show price trends.

  • http://www.pragcap.com TPC

    Well, see now you’re getting into the realm of using a commodity for tangible purposes. Of course gold has real useful and tangible uses. But the majority of gold that is owned today is either sitting in vaults or traded in electronic form. And those people are purely speculating on a belief that may or may not exist in 20 years.

  • http://www.pragcap.com TPC

    What is money? Does a stock certificate not represent money? Does a bond not represent money? Does ingenuity not represent money?

    Money is simply what we use to keep tabs on our commitments, obligations and needs. The beliefs and ideas that back these moneys are what give them value. Gold investors are betting that a belief will exist in 20 years. I don’t call that investing. I call it speculating. But I know for a fact that people will need energy in 20 years and if I can find a person who can more efficiently package energy and disperse it then I am onto something truly worth investing in.

  • http://blogfirstrider.blogspot.com/ first

    Do you have a chart of the dollar via commodities?

  • Flakmeister

    Here is the catch, the price of commodities has basically dropped while the energy per capita has risen. Now that is no longer rising, infact it is following, the price of commodities are rising. It is my belief they will continue to rise until me harness a energy source scalable by at least a factor 10.

    So yes, commodities have been in a 130 yr bear market while energy supplies were in a “bull market”. That has changed. Please do not argue otherwise unless you have a good working knowledge of thermodynamics and how we actual power this planet and our lifestyles.

  • Flakmeister

    Danm, how that typo/brain fart slip through… should have read.

    Here is the catch, the price of commodities has basically dropped while the energy per capita has risen. Now that is no longer rising, in fact it is falling. The prices dropped because of their production as fraction of our energy pie fell. Now that things are tightening the price of commodities are rising. It is my belief they will continue to rise until me harness a energy source scalable by at least a factor 10.

  • http://www.marketoracle.co.uk/UserInfo-Akhil_Khanna.html Akhil Khanna

    The commodities are going up due to the ETFs being launched by the Big Finance Companies. The rise in prices is pushing the actual user out of the market because the raw material prices are going up whereas the manufacturer is not able to recover them from his customers due to the high unemployment and shrinking demand.

    Moreover the prices on exchanges are now determined by speculators with deep pockets and the long, short positions on the exchange. Prices are no longer derived by the actual demand for consumption and the physical supply of a commodity. The speculators set the prices and the users have to pay the quoted price to buy the commodity. The pricing mechanism has been terminally flawed due to the speculation activity allowed on the electronic exchanges.

    http://www.marketoracle.co.uk/Article24581.html

  • Jack

    OK, that’s fine. But if you look at the statistics and see that there has been a general downward trend for the last 140 years, then you’re unlikely to get good yield on commodities in the future? To me it seems like you’re approaching speculation as if it’s an inherently bad thing, but informed (and yes, lucky too, I will concede) investors could conceivably make a good buck in the long run, especially if other investors want to play it safe by not placing any money early on the unheard of growth in demand that will sooner or later come from a lot of the emerging markets.

  • http://www.pragcap.com TPC

    I speculate every single day. My primary trading strategy (which I never discuss here) is highly specialized and highly speculative. But I believe I know something others don’t so my bets are made based on higher probabilities than I believe the other players are playing with….

    Speculation can be a worthwhile endeavor. But you need to recognize that it is indeed speculating. As I told Mike above, you’re only a fool if you believe you’re investing and not speculating….

  • JLM

    The article makes the term speculator into a dirty word with his reference to selling to a greater fool. Where as the sound thinker after great and careful analysis goes for an investment stream like a dividend from a big American bank. Who is the greater fool here? I will buy an ETF 2x on natural gas in either direction any day over a ‘sound investment’ and trade trade trade.

  • dhdell

    “buy n hold?…..pretty funny……its all speculation for the next 5-9 years.”

    Listen, buy-and-hold gets a bad rap- so do index funds. Sure, take a market peak and then say, “hey, that obviously doesn’t work.” Well, then I would take the opposite and look at the bottom of markets and say,”yeah, it does.”

    Proponents of BnH like Buffet are trying to give the average investor he best chance for success- invest in what you know and use, and given time, eveything will work out. However, Buffett has changed philosphies over time. He was, in no way, a BnH investor when he started out. He had absolutely NO issue selling something that was 80% price-to-value when he had an other opportunity to invest in something 50% price-to-value. Only when W.E.B. have billions to invest did he subscribe to BnH b/c when you have so much money to invest, billion-dollar opportunities are limited- his pond is quite small. But (sorry for the religious bent), but I see it like the Bible and other religious doctrines- if the avg. investor follows his circle-of-competance,margin of error & BnH rules, he odds of you getting ruined are small- risk is permanent loss of capial- nothing else.

    For the investor who actually can analyze businesses in terms of cash flow, competitiveness, etc., buy-and-hold means buy at a price less than intrisic value and then sell when price=>value or when the opportunity cost (of other investments) is greater than your current risk/reward.

  • dhdell

    ‘I think the important distinction is whether you’re using it for commercial use or for speculative use. There’s a big difference.”

    EXACTLY. Which is why the CFTC has speculative limits but also grants exemptions for those companies/financial institutions with economic use exemptions for hedging purposes.

  • dhdell

    “Buffett’s a curious case, huh? It makes me wonder if, in an attempt to diversify BRK, he hasn’t sucked the alpha out of its operation a bit too much?”

    the lack of alpha is due to size, nothing more. once Buffett dies :(, dividends will be intitiated (guaranteed), and the possibility of splitting the company into “baby-berks” will increase (much less likely due to the financial “lolapalooza” strength of BRK, i.e. the Burlington Northern purchase)

  • dhdell

    “The point is that gold only has value to the extent that people believe it has value. Whereas if I buy stock in a company that helps invent drugs that help people live 20 years longer I am investing in something that doesn’t have perceived value but has real tangible value.”

    I agree, as well as with your previous point that the currency argument is dead until your local grocery store is willing and able to accept gold ingots. However, one must accept the fact that ppl value gold (and to a lessor extent, silver) as valuable. While your grocery store may not accept your gold dust, someone surely will (at some point), but that brings as back to a barter system, or at least, a less fungible currency.

    “The point is that gold only has value to the extent that people believe it has value. Whereas if I buy stock in a company that helps invent drugs that help people live 20 years longer I am investing in something that doesn’t have perceived value but has real tangible value.”

    Right. Buffett’s point. Block of gold or all the land in the U.S., 10 exxons, and a trillion of (albeit decreasingly valuable) spending cash. However, percieved value (or under-value) is important in investing, whether it be shorting “Open table” or buying BP when everyone perceived risk of bankruptcy. However, on the whole, I agree with ypou- I would rather invest in something that is incorrectly thought to be trash than something ppl believed to be valuable, but in reality, is not.

    “I speculate every single day. My primary trading strategy (which I never discuss here) is highly specialized and highly speculative. But I believe I know something others don’t so my bets are made based on higher probabilities than I believe the other players are playing with….

    Speculation can be a worthwhile endeavor. But you need to recognize that it is indeed speculating. As I told Mike above, you’re only a fool if you believe you’re investing and not speculating…”

    The most important part of investing or speculating!!! Know which is which so you can limit your losses (whenspeculating),but double-down (when investing).

  • dhdell

    “The article makes the term speculator into a dirty word with his reference to selling to a greater fool.”\

    Like Cullen intimated, the GREATEST fool is he who thinks he is investing, when he is, in fact, speculating.

  • dhdell

    ” Of course gold has real useful and tangible uses. But the majority of gold that is owned today is either sitting in vaults or traded in electronic form.”

    The demand for Gold is incerasingly due to the onslaught of ETF and similar securities (NOT physical gold or silver, or coinage). Once you take that out of the equation, gold supply is MUCH greater than gold demand.

    What is the difference between physical and ETF-like demand? Well, physical is not liquid, which would make precious metals prices more “sticky.” So, the “demand” for Gold via ETFs are influencing price to a greater extent, when the true “demand” for such products (and the corresponding, underlying gold)is in MUCH weaker hands, given that they can buy (or sell) at the touch of a button. So, current demand is questionable, unless you buy the idea that the Chinese (super-savers) are just getting the ability to invest in Gold (which is wrong- they have been able to for almost a decade now,although maybe not in ETF form)

    THe intersting idea behind Gold, or more to the point, “GLD” etf, is the potential for bid holders, like Paulson & Co., to turn around and redeem their ETF shares in baskets of 200,000 for their equivalent in physical gold. If done at the right time, this could dramatically decrease the gold available in the market and push it parabolic.

    However, concerning central banks, they cannot sell via the open market, so private purchases of gold by central banks have no affect on market price, unless done stealth-ily in the market. if you look at recent central bank purchases, they have been done off-market via the ECB or another willing central bank seller. This isn’t to say that someone like China couldn’t, or wouldn’t, purchase gold in some way through the market, but any significant purchase CANNOT be done in this way. Moreover, for someone like China to increase its gold “exposure,” it does not need to do so with respect to its foreign reserves or similar holdings– they can and do buy companies and regional gold industries… as in Africa. They don’t need to put more Gold in their central bank “portfolio;” their “country” portfolio is defined and constituted quite differently.

  • CFS

    I think this is a great post. After reading all the comments I feel that one of the issues is that any purchase you make will typically have a part investment and a part speculation. The investment part would be associated with intrinsic value (NPV based on future cash-flows or in its absence cost of extraction/generation) and the speculative part based on a demand premium that is somehow independent of the NPV. Depending on the relationship between intrinsic value and market premium you can decide whether or not an asset is more of an investment or a speculative play. Do not get me wrong, both are guesses. But I would say that if you have a good valuation model, the market premium is a higher level of guessing than the cash-flow valuation guess.

    Commodity values are right now mostly speculative because there is a huge market premium that drives their value well beyond the cost of extraction/generation.

    The ultimate speculative asset are diamonds. Their generation cost is many times lower than their market value. But it is difficult to play with diamonds because the market is pretty much managed to keep the prices artificially high but relatively constant. So you know that their value is really decided by a cartel, and few people would gamble in that world.

    At the same time depending on the price you pay for an asset you may be investing or speculating. If you bought a house for a price that you could never recover by renting it, you were speculating. If you buy a company with PE 100 (read SUN in 1999) you are most probably speculating. Speculation grows as leveraging becomes cheaper.

    TPC is not condemning speculation, he’s just condemning the sale of highly speculative assets as if they were basically investments. I would say that applies today to both commodities and most stocks.

    Finally, an investment can turn sour, but it should do so with much lower probability than speculative plays. If not, your valuation model is wrong.

  • dhdell

    “But I would say that if you have a good valuation model, the market premium is a higher level of guessing than the cash-flow valuation guess.

    Finally, an investment can turn sour, but it should do so with much lower probability than speculative plays. If not, your valuation model is wrong.”

    So true. What you say is the absolutely the difference between speculation and investing. One can play a game of semantics between the two, but without a doubt, intrinsic value is definitely dependent upon BOTH qualitative speculation or judgement and the quantitative aspect of the equation. Every investment is about probabilities, whether it be in your economic forecasts, as well as how a company and/or other asset produces income, promises income, or mitigates cost, under such probabalistic scenarios.

    It’s like the argument between value and growth. Both are joined at the hip. But one should pay less for that which is not certain, i.e. growth. But value does not ignore growth. However, without tangible value, one must not overpay for growth.

    It like the cost of digging up gold. If it costs $750 an ounce, on average, to dig up gold for economic purposes- i.e. dental/medical uses or even for solar wafers, the market price above such costs/economic use is due to speculative assumptions, such as jewelery (b/c if the price gets so high, they will recycle), ETF investment, or physical stock and coinage. It is not that such assumptions, judgements, or speculation is wrong, but as you say, the more weighted to what has not (or rather, may not) happened, the more speculative the purchase.

    But the “greater fool” is much more about which is so improbable to happen. For example, when you take the current market for cloud computing (a terribly un-novel concept), teh total market for such services is something liek $5 billion/yr. Given a company’s mkt value of $20b., one would assume that the stock price incorporates not only the present value of a 400% growth of the market, but that the company is certain to enjoy 100% market share. It is not that such growth scenarios are implausible, but that one must refrain from paying too much for such growth, or else they will be relying too much on the “greater fool” or future realization of value paid today.

  • InvestorX

    Cullen,

    it is all semantics. Are you 100% SURE your company will be successful? Only because it is a low risk / high success deal or only because the outcome depends more on yourself (and not the vagaries of the market) it does not make it a sure thing. Then it is speculating. You can call it investment to soothe your neves and make youself more comfortable, but please be honest with yourself.

    I am all in for sensible investments (speculations). But there are few certain things:

    – based on insider information (now we see where e.g. SAC alpha comes from)
    – based on privatizing gains / socializing losses (banks)

    These are not specualtions, but are unethical / illegal (e.g. legal risk)

    It is one of the simplest things in markets: a good company that is more than fully priced in is a bad investment on average. Buying it is not only a speculation, but it is a bad risk/return speculation. You may be lucky with Apple, but what about BetaMax video standard or Juniper Networks? They were also smart and innovative.

    So I would agree with you on using “investment” for sensible speculations.

  • InvestorX

    Yes, but only if the price at which you buy is not too high (and driven up by a credit bubble).

  • InvestorX

    Choosing what to use for store of value is a speculation that this is a good store of value.

  • InvestorX

    Finally someone gets it!

  • InvestorX

    So Cullen, for you investing is a speculation that aims for something productive? But it is still a speculation. For me investing is about getting X return with Y volatility, no matter what instrument is used. I definetely prefer that productive investments should be the only way of speculation that there is, but unfortunately this is not how the world works. The ability to do productive invstments are distorted by:

    – corporate corruption (CEO comp in the stratosphere, dilutions, managing the company for the benfit of management, not shareholders etc.)
    – credit bubbles driving prices in the stratosphere
    – cartels
    – banking cartels
    – government intervention
    – wars
    – people prefering easy profits, as opposed to long-term productive investments (greed)
    – market sentiment swings, etc.

  • InvestorX

    Cullen, all your so called investments are made in a framework that is based on beliefs:

    – fiat currency is also based on belief (enforced by government true, but government can be overthrown, or can hyperinflate etc.)
    – bonds are also based on the belief that the issuer will be willing to repay
    – stocks are based on the belief that management will share value added with the shareholder and not waste, steal it etc.

  • InvestorX

    Agree 100% here.

  • Bruce

    TPC, this analysis is laughable. Oil wasn’t even used for anything until the 1900s, and for many decades it was so abundant relative to use it was basically free.

    This is a whole new ballgame now. The population has exploded, while arable land, oil reserves, and metals are at or close to peak.
    And The Fed/ Treasury provide unlimited easy money that fuels demand.

    I don’t see how you can NOT be invested in commodities.

  • Jonnyblaze

    Why is the belief that you’ll be able to sell to a “greater fool” any different than the belief that NPV is an appropriate way to “value” financial securities? Or even any different than the belief that the currency in which your “investments” are denominated will be worth anything or even exist down the road?… Sure, you can say that these assumptions are widely recognized and utilized, but then again so is the assumption that gold will go up. The only difference is time horizon — the gold goes up forever crowd generally has a shorter window, while the believers in various market conventions tend to have a longer life. In my mind, it’s all still speculation.

    The only real investment as I see it is either to either use one’s resources to increase one’s own knowledge/skills/ingenuity, or to increase one’s “social capital” by offering those resources to their fellow man. These are the things that have been around since time immemorial.

  • http://www.pragcap.com TPC

    Guys, do you even read the posts? I am not saying that you shouldn’t invest in commodities. I am merely showing that commodities futures and many of the products wall street is providing are likely not the best way to make money in commodities….

  • http://www.pragcap.com TPC

    Yes, there once was a day when investment resulted in productivity….That clearly, has been changing over the last 20 years. Now every retiree in America sits around speculating in an ETrade account….

  • http://www.NomadFund.com TMAR

    Well considering that all the companies you and they are valuing use commodities in some form or fashion, I would argue that this case study is USELESS. Ultimately all companies are made up of commodities in one form or fashion.

    I also agree with Bruce and some others, that we are in a new world here, and the past 130 years is not going to look like the next 130 years.

    TPC, I agree that most of these newly created products are not the route to go if you want to invest in commodities and I am glad someone is pointing that out, but most investors don’t understand how to do it on their own. The crowd that reads this blog is obviously slightly different and the do-it-yourself crowd.

  • Ilya

    I think people are arguing the wrong point. Speculation is buying/selling an asset in expectation of benefitiing from a price change (positive or negative). Investment is buying an asset for the cashflow (either explicit as in a bond or expected as in a stock) it provides. Assuming capital is productive (for people who do not agree with productive property of capital I refer to the classic work by Bastiat on capital and interest http://www.gutenberg.org/files/15962/15962-h/15962-h.htm) speculation is a zero sum game while investment is not. This is not to say that there are no bad investments and you cannot lose money investing. It is just to say that as long as people put their effort into productive work investment is not a zero sum game over a long term horizon. From this prospective hoarding commodity is not productive and is a speculative excersize. Not that you cannot profit from it.

  • Michael Covel

    Long only commodity ‘investing’ is moronic. For example, pick up the phone and call Goldline. Ask them when you will know it’s time to sell. When pressed — they will tell you that they will let you know — otherwise hold on as everything goes up!

    I think that is where Cullen is offering caution.

  • http://www.pragcap.com TPC

    Yes, the founders of Goldline will be wealthy long after the gold bubble bursts. After all, what currency do you think they transact in on a daily basis? These guys might be believers of gold, but they have hoards of cash sitting around. The irony of such a business is actually pretty sad.

  • dhdell

    “Why is the belief that you’ll be able to sell to a “greater fool” any different than the belief that NPV is an appropriate way to “value” financial securities? Or even any different than the belief that the currency in which your “investments” are denominated will be worth anything or even exist down the road?”

    You are not wrong, but I think your view of NPV may be biased. When valuing any asset with NPV, there are of course a wide range of possible values. A “point value” when analyzing investments is useless- proper valuation requires a probablistic range of qualitative and quantitative values. Given the uncertainty of such judgements, ppl like Buffett propose use of a margin-or-error to fend uncertainty of outcomes, performance, miscalculation, etc.

    Moreover, NPV is only one tool in the analyst’s toolbox. Not all assets are valued with one method; you use multiple scenarios for every tool, which should give you that range of potential value.

  • dhdell

    “I would argue that this case study is USELESS. Ultimately all companies are made up of commodities in one form or fashion.”

    The fact the companies use commodities in one form or another really doesn’t say much at all. Different companies have different input exposures, as well as the differing abilities to pass through such costs. It depends on the industry and more importantly, the individual company. So, companies may use commodities in one form or another, but just because of that does NOT mean they are all made the same, or that investing in them or commodities directly carry the same form of “speculation” that you are implying.

  • Jonnyblaze

    I think this line is key though: “as long as people put their effort into productive work investment is not a zero sum game over a long term horizon.”

    How productive has our work REALLY been in the recent history? The financialization of our economy and indeed our whole lives has really distorted this balance in my humble opinion. Doctors, engineers, scientists, heck all of us on this board fancy ourselves as day traders. So much capital has been mis-allocated over the past twenty years or so that I really believe there is no distinction anymore between investing and speculating.

    Furthermore, why should cash flow be the ultimate determinant? It’s only a false sense of comfort because we mistakenly make the assumption that our cash flow has intrinsic value. It doesn’t — it is only valuable insofar as it can be used to procure the things that do… You’re getting closer to investing if YOU yourself can take possession of the asset that you’re buying and do something productive with it. Recall that Investment in the Macroeconomic sense of the word has nothing to do with financial instruments — I think our predecessors in the field were onto something. :)

  • Jonnyblaze

    I’m completely on board with you on that one. That’s why I like the general tone of this post (get back to investing, not just speculating), even while I have some issues with the distinction. My point is simply that if people really want to INVEST, invest in themselves and the people around them.

    Your example further above was on point, but the fact of the matter is that I do believe the situation changes once you take your hypothetical company public. I’m sorry, but no one here can convince me there aren’t very real agency issues that crop up when ownership is divorced from operation/management. And the concept of diversification may be great from the perspective of the modern capitalist, but that’s only because the whole system is already set up to be speculative. Go back to your examples again — ask Bill Gates or Mark Zuckerberg if they wanted to diversify when they were building their businesses from the ground up. “Hell no” would probably be the answer — that kind of belief in an operation is lacking from probably 99.9999% of shareholders. Otherwise, they would go all in like the entrepreneurs themselves.

  • http://www.pragcap.com TPC

    My only point about being public is that it helped drive banks from the 3-6-3 model to the leveraged up high risk model. The need to make profits and compete with people like Goldman Sachs helped create this beast. While there are benefits to banks being public I wonder if it’s necessary if they were forced back to a 3-6-3 model….

  • http://blogfirstrider.blogspot.com/ first

    Result is: Gold up more than 500% in ten years.
    Stocks: Still down from ten years ago.

    We don’t need a 100 year trend to make money.

    The interesting question would be what will perform as well in the coming five or ten years.

  • http://www.pragcap.com TPC

    The Amex gold bugs index is up over twice as much as gold over the same period. You left 50 cents on the table for every dollar that you invested in actual gold.

  • http://blogfirstrider.blogspot.com/ first

    Ha Ha Ha…Its much worst than that TPC I sold long ago and did not take advantage of this long ride. I don’t understand Gold.To me it’s the pyramid of fear but I do realize that it’s been good to its owners.

  • Andrew P

    Buying oil (or even better, dividend paying oil stocks) is not betting against ingenuity. It is betting against ingenuity in a particular timeframe, which is something else entirely. I happen to think that eventually oil will be replaced as an energy source, but not for at least 3 decades, and I base this on my present day scientific understanding. There is a lot of money to be made in 2 or 3 decades.

    And yes, buying BP was a bet that their dividend would be maintained. I lost that one, but the dividend will probably come back once their accident costs are covered.

  • John C

    OK so Grice said that “You are essentially betting that humans won’t one day replace their oil based energy needs with some alternative energy” and he makes a good point. But lets take this to the next level. Lets say that world peace breaks out. Who needs Lockheed or L3 Comm or any defense stock for that matter? Maybe we find a miracle cure-all for cancer – now who needs Amgen? Maybe we find somethings that replaces routers, switches, or the entire internet for that matter – who needs Cisco? I could just keep going on but what’s the point. If we carry Grices viewpoint to the extreme everything is just one great big speculation. What a lot of you monetary guys tend to consistently overlook is that some commodities, like gold, have a very long history. For many, many centuries (not weeks or months) people have believed, for whatever reason, that certain precious metals are a store of value and when their own nations medium of exchange is in question, gold or silver is where you want to be. You can mock them or disagree with them if you wish but be aware that you are fighting thousands of years of ingrained belief. I’m not talking my book here either. I’m presently quite bearish on this whole commodity thing. I just don’t think the long term move is over yet but it appears to me that certain prejudices are involved in this whole discussion.