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

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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Comments

  1. 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

  2. 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.

    • 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….

  3. 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.

    • “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.

  4. “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.

  5. “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).

  6. ” 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.

  7. 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.

  8. “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.

    • 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.

  9. 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.

    • 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….

  10. 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.

  11. 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.

    • 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. :)

      • 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.

        • 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….

  12. 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.

    • 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.

  13. “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.

  14. “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.

  15. 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.

    • 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.

  16. 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.

  17. 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.