Not Yet Enough Focus on Commodities For a True Bubble To Have Formed

We recently wrote that an investor’s starting point for exposure to commodities should be their relative weight compared to all possible investments.

For example, if commodities are 5% of the investable universe, the average investor has to be at 5%. If all investors shifted to 10% it would simply bid the price up artificially.

On the other hand, it is reasonable to assert that investors have had too little exposure to commodities historically, and that the weight may still be too low to reflect the fact that the investing world has to play catch-up.

Morgan Stanley’s Stephen Roach sees the trend as having reached bubble proportions:

Virtually every major institutional investor I visit around the world — from pension funds and insurance companies to mutual fund complexes and hedge funds — has a large and growing commodity department. The same is true of foreign exchange reserve managers and corporate treasury departments of multinational corporations. One major Wall Street firm is now run by a former commodity executive, and another has turned over management of its global bond division to the architect of its thriving commodity business.

Of course, the same could have been said in the mid-1980’s regarding equity departments, when they still had a long run ahead of them. As you know, we are not shy about drawing comparisons between today’s commodity markets and the mid-1980’s equity market. Roach, too, has picked up on this.

A recent Ibbotson Associates study recommends that commodity weightings in a multi-asset balanced portfolio could be increased, under conservative return and risk-appetite assumptions, to a high of nearly 30%. That would be more than three times current weightings and greater than seven times the estimated $2 trillion value of current annual commodity production (see T.M. Idzorek, “Strategic Asset Allocation and Commodities,” March 2006, available on ibottson.com). The Ibbotson analysis praises commodities for their consistent outperformance and negative correlations with other major asset classes — going so far as to praise commodities for actually providing the protection of “portfolio insurance.” It concludes by stressing “…there is little risk that commodities will dramatically underperform the other asset classes on a risk-adjusted basis over any reasonably long time period.” Laboring under the constant pressure of the asset-liability mismatch, yield-starved investors can hardly afford to ignore this enthusiastic advice. As a result, with multi-asset portfolios likely to have ever-greater representation from commodities, the financial-market dimensions of the commodity trade are likely to become increasingly important.

It was in the early- to mid-1980’s that the “equities always outperform in the long run” thesis began to take hold. As with other super-cycles, there is a kind of first wave that earns investor awareness before everyone jumps on and begins talking about and investing in the fad du jour. Is the commodity cycle played out? We don’t know, but we’ll bet you heard lots of cocktail party chatter about Internet stocks in 1999 and investment homes in 2004. When is the last time you chatted up someone’s pork belly portfolio? But Roach isn’t buying that argument.

For my money, there is far too much talk about the globalization-led commodity super-cycle. It gives the false impression of a one-way market, where every dip is buying opportunity. Yet commodities as a financial asset are as bubble-prone as any other investment. As is always the case in every bubble I have lived through, denial is deepest when asset values go to excess.

Admittedly the circles Stephen Roach hangs out in are different from ours. Perhaps the pork belly portfolio is the topic du jour at his cocktail parties. (Now that we think about it, perhaps we’re grateful we hang out in different circles!) But our bet is that this is still perhaps the third inning of the stock/commodity reversal game. As soon as there is a Jim Cramer of commodity investing, we’ll consider contrary opinions. In the meantime, we think investors are still too focused on stocks and not enough on commodities. As Steve Saville puts it:

In any case, regardless of what happens over the next several months, it’s important for investors to understand that the long-term bull markets in metals and the stocks of metal producers did not end earlier this year. Long-term bull markets don’t end when the major stocks in the bull-market sector have valuations that are less than half the broad market’s average valuation; they end after valuations in the bull-market sector reach huge premiums.

Disclosure: Author owns shares of Streettracks Gold ETF (GLD) and United States Oil Fund (USO).

Comment on this article

Comments

[Asif Suria:]

William, I did read Stephen Roach's statement a couple of days ago and while he might be right about "froth" in the commodities market, I believe that he might be a little early in calling an end to the commodity bull market.

However I do not buy the argument <i>"valuations in the bull-market sector reach huge premiums"<i>. While this may be true of certain sectors (the internet and alternative energy sectors come to mind), it is not universally true. When steel stocks usually reach the peak of their cycle, their valuations appear very low and they tend to sport single digit P/Es. The same could be said of the housing sector.

When I made a negative call on the housing sector last September and then did a follow up blog post in May 2006 titled Housing Sector In Pain, some homebuilders had single digit P/Es and most of them had a P/E below the average P/E of the S&amp;P 500.

2006 Sep 26 07:52 PM

[William Trent_:]

Asif,

A point well made, and one that I think applies particularly well toward certain commodities that have ready sources of new supply (agricultural commodities, for example.) Such commodities would tend to follow more of a cyclical pattern such as that you describe for homebuilders and steel, both of which are classic cyclicals.

The distinction between those and gold/oil would be that gold and oil are hard to find, increasingly hard to get at once found, and require significant time between the discovery of a shortage and the availability of new supply or substitutes. In this case, it can be seen more along the lines of Internet stocks, where the first few were in high demand, but then once the fever caught on so many new Internet companies were launched that the stocks weren't worth the paper they were printed on.

The same will happen (again) for oil and metals. It will just take longer than is implied by the recent correction.

2006 Sep 26 08:47 PM

[WC Whiner:]

</em></i>&... tags.

'Net stocks might be more easily replaced than gold or oil; all it takes is more VCs and some IPOs. That said, both gold and oil can be substituted, too -- the former if not with diamons or platinum then with less gold (who needs an ounce of gold? they want an x% exposure), the latter with any other energy source.

While I have a lot of sympathy for your basic arguments, I just don't see where you make the case that distinguishes 2006 from 1981.

FD: I am underweight the energy complex and sold my last gold miner some months back

2006 Sep 26 11:52 PM

[William Trent_:]

WC,

The obvious reason, which I am sure you have considered in your own analysis, is that in 1981 inflation was very high and beginning a long-term downtrend (at the end of which it reached acceptable levels.) The current <i>level</i&g... of inflation is much lower today, so there is much less room for disinflation to benefit financial assets.

The next logical argument is that the <i>direction<... of inflation is uncertain today. However, it seems to me that either higher inflation or outright deflation would favor real assets over financial assets.

So to me the argument against commodities today is that inflation will stay in a sweet spot, declining somewhat from current levels but not entering deflation territory. Given my sense of the risks, I don't see that I am receiving an adequate risk premium for financial assets and thus prefer the real ones.

Given that you clearly feel otherwise, would you be up for making the case that distinguishes 2006 from 1974?

2006 Sep 27 10:12 AM

[Asif Suria:]

Interesting thoughts William. Does the new oil discovery in the Gulf of Mexico along with increasing crude oil reserves not dampen your enthusiasm for oil?

2006 Sep 27 02:49 PM

[William Trent_:]

Given that it will be years before those are productive, no. It is a matter of worldwide demand growing roughly 5% per year (maybe slowing to 3% if the economy slows down) while supply is flattish. The main adjustor to demand is price, which ultimately encourages people to by compact flourescent lights and hybrid vehicles but in the short run these have very minor impacts. As with most other commodities, it all comes down to supply.

Over the next several years the drills will be put in place to access all the new oil discoveries, and a nuclear plant or two will be built, and solar and wind will be installed and more competitively priced, and hybrids and flourescents will be somewhat more widespread, and (what will seem like very suddenly) the world will once again have more oil than it knows what to do with. If you can tell me what part of that equation is happening over the next 12 months I will become bearish on oil. If you can't...

2006 Sep 27 06:47 PM