Hard Assets Investing: An Interview With Brad Zigler

As managing editor of HardAssetsInvestor.com, Brad Zigler spends his days immersed in commodities: researching the markets, interviewing key opinion leaders and analyzing late-breaking news. His daily column, posted on the site as "Brad's Desktop," has become a must-read for many in the commodities market.

As a special thank you for completing our survey, we're pleased to provide this exclusive interview with Brad covering some of the biggest and most hotly debated topics in the commodities space.

HardAssetsInvestor.com [HAI]: Do you believe in the commodities supercycle?

Brad Zigler (Zigler): I'm not sure I subscribe to the Elliott Wave conception of a supercycle, but I definitely believe that we are in an inflationary cycle which favors commodities.

I say this after witnessing two decades of managed disinflation in the U.S. economy. I think we are seeing a cyclical pendulum swing, and a rebirth of inflation, and that is supporting the strong move in commodities.

HAI: Let me ask that a different way: Are we closer to the beginning or the end of the bull market in commodities?

Zigler: I can't tell you exactly where we are in that bull market, but I don't think we're at the end of the cycle. If you subscribe to the Jim Rogers notion, we could be in this bull cycle for another six years. I don't necessarily agree with that, but Jim makes a convincing argument.

I don't think we've seen the end of inflation, which is playing a big role in the recent commodities move. So don't count commodities out. That said, I do believe that there is bound to be significant volatility along the way.

HAI: You "don't think we've seen the end of inflation," but the most recent CPI [Consumer Price Index] numbers showed relatively tame inflation growth. How does that match up?

Zigler: I think the CPI numbers understate most readers' lived experience of inflation.

A more telling measure of inflation would probably be its monetary precursor: money supply growth. Here the government is playing a sleight-of-hand trick. Back in 2006, the Federal Reserve discontinued publication of M3 money supply statistics, the broadest measure of money. The growth in M3 is looked at as a bellwether of inflationary pressure. If you subscribe to the notion that inflation is more dollars chasing fewer goods, this makes sense.

The discontinuation of M3 means that the broadest measure of money supply growth is now M2, which cuts out a large and substantial portion of money supply, namely large time deposits, institutional money market funds, short-term repurchase agreements and other large liquid assets.

M2 grew 5.9% in calendar year 2007. M3 money supply growth is still being tracked by a private organization. The M3 growth rate they estimate is 15.1%, a much scarier number. It seems to me that the Fed is trying to hide a statistic under the excuse that M3 was too expensive to publish, when in fact they are tracking virtually all the components and reporting it separately anyway. It's a hoodwink.

HAI: Do inflationary pressures impact just oil and gold, or do they impact commodities as a whole?

Zigler: The impact is felt across the board. Oil and metals prices have a certain degree of speculative froth right now, which is directly related to the inflationary pressure.

HAI: What influence is institutional money having on the commodities space?

Zigler: It's creating some froth in the market. Some observers have said there may be as much as 15%-25% speculative premium in the price of oil right now.

Of course, it's hard to stand in front of that freight train as it rolls over you while you're screaming, "the market is wrong!" Sometimes, it's best not to get in the way of the market. As they say, "the trend is your friend."

But you can't ignore it either. Absolute reliance on continued higher prices without expecting some volatility-especially from the weaker hands in the market-is dangerous.

HAI: Is gold still a good "safety asset," or has it become a trader's tool?

Zigler: There's still a lot of speculative fever in gold, as evidenced by the price action in recent weeks. I tend to think of gold as a tool used during crises. People think of it as an inflation hedge, but really, it hasn't been that recently. If anything has been an inflation hedge, it's been the price of oil.

HAI: Should all investors own commodities in their portfolios? If so, how much is enough?

Zigler: [That's partially a question of] personal risk tolerance. Studies done by Ibbotson have indicated that if you had a moderate-to-conservative asset allocation plan and your risk tolerance was modest, the optimal level of commodity exposure should probably be no more than 20%. For some people, it might be closer to 10%.

HAI: But if investors really put 20% of their portfolio into commodities, or even 10%, wouldn't that just increase the speculative frenzy?

Zigler: If it were a universal allocation, maybe. But as we know, investors often resist the advice of experts. There are going to be some people who will overexpose themselves, and then there will be some people who can't be persuaded that commodities have any place in a portfolio, so they're going to stay away from the allocation altogether.

Consider what David Swenson of Yale does. As manager of the Yale Endowment, he pushed the endowment's real asset allocation to record levels. In fact, commodities were the highest sector allocation the endowment had in 2006. But if you look at his latest book, his basic advice to investors was, "Don't do what I do, because you can't do it as efficiently as I can; you don't have the tools, the resources or the scale."

In his book for retail investors, he recommended zero exposure to commodities for that reason. That is going to ring true with a lot of investors, who will continue to look at commodities as being a speculative vehicle only, and not part of their investment portfolio.

HAI: How does that jibe with what Rick Ferri says?

Zigler: Rick Ferri is saying the returns generated by commodities in the long run equal inflation. Therefore, there is no real return to be had. What Rick asks is, "Why should I give up space in my asset allocation for that when I have space for assets that have real, proven relative returns?"

HAI: What do you think?

Zigler: I see Rick's point. If you're looking at incorporating a new asset, you have to ask from which bucket you are taking the capital, and you have to look at the price of that. If I'm going to take assets out of my equity allocation, what's the expected return I'm giving up, and what's the expected return I should count on?

Ferri's problem is that he doesn't have enough confidence that commodities can provide a consistent real return, due to the strong cyclicality of returns. After all, commodities spent more than two decades in the shadow of paper assets recently.

On the other side of that is Larry Swedroe's point of view, where even if average returns aren't as great with commodities as with equities, the lack of correlations with other assets provides a diversification effect. According to Larry, a commodities allocation is more about insurance than anything else. It's a hedge against catastrophe.

HAI: And your opinion?

Zigler: Well, you're speaking to an old commodities rat. I'm a little biased.

Comments

[mslasky]

This isn't a commodity "super cycle". It's a Malthusian fact. Human population is at an all time high, and going higher, with several billion people newly engaged in enthiastic capitalist consumption. Unless I forsee a population decline, I'm heavily overweighted commodites - permenantly.

[User 174447]

Coming from a so-called expert, what do you think is the best ratio for the commodities market against other stock market options for a beginner like me?
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[eric hart]

This seems to be a balanced article. I have read Swenson's book and the Ibbotson study and they are well researched, lucid documents.

One problem--I don't agree with Swenson about one little item. As a small investor (non-institutional) an individual can participate although not replicate what Swenson does in the real asset space.

It is through ETF's that the average retail investor has unprecedented access.

Sure, you cant replicate the complicated trades of the big traders, but so what?

If there is a major commodity bull market destined to last 5-10 more years--which seems very likely--it makes sense to buy and hold commodity ETFs (CUT, SLV, DBA for example) until money supply growth and inflation moderate.

Silver, for example likely has significant upside from here, as does natural gas--two undervalued commodities right now.

After 25 years of falling inflation and interest rates, it appears likely we are headed to a stagflationary environment. Such an environment favors commodities.

It is wise to allocate a portion of your overall portfolio to some commodity base, as bonds and stocks trade sideways.

[ManagingEditor]

Thanks for the feedback.

With respect to the cyclicality of commodity prices, mlasky, let's not forget the statistical tendency towards mean reversion. Yes, populations are growing, but growth RATES can vary significantly. Look at UN Population Division projections for China, as an example, to see an arc leading to stabilization, then decline. Couple that with infrastructure improvements -- woefully ignored during the past two decades of disinflation -- that increase supply and you have the ingredients for price mitigation. Prices may stabilize at higher levels, but GROWTH in prices is like to moderate, meaning those investors who jump on the commodities bandwagon later see less upside potential realized.

As for the "beginner's" allotment to commodities, User, five percent of total assets in a broad-based commodity index-based investments, such as exchange-traded products GSP, GSG, DBC and RJI, are comfortable starting points for most financial advisors and their clients. Shading the allotment upward is a matter of taste and familiarity with portfolio theory.

You're right, Eric, about Swensen's aversion of a commodities allocation in his model. I'm inclined to think he did so because he advocated the use of Vanguard index (or index-like) mutual funds as exemplars of his strategy. Vanguard's low cost (expense ratio wise) and accessibility through dollar cost averaging (systematic investment of fixed dollar amounts over time), together with its ownership structure, were answers to the protestations he leveled against most other mutual funds in "Unconventional Success." You can find a working example of the Swensen portfolio in my Registered Rep. article, "Illiquidity Is Beautiful For Some," registeredrep.com/inve...). There were simply no Vanguard commodity index mutual funds extant when Swensen wrote his manuscript.
Of course, a well-diversified portfolio of ETFs/ETNs -- including an allocation to commodities, as outlined above -- can be used in lieu of mutual funds, but the dollar-cost averaging issue must be addressed for those still in the portfolio-building stage. An account with Zecco.com, though, can be used by retail investors to get commission-free ETF/ETN trades, facilitating the process.

[mslasky]

RE: Managing editor. Good points, but, the history, that reversion to the mean depends on, is no longer present, therefore, it's power to predict the future is invalid, in my view. Prior generations used a very small portion of earth's resources - this is no longer the case. Agriculture in particular; there's no way to manufacture more land, and arable land is diminishing, by virtue of erosion, climate change, increased climate variability (climate is reverting to the mean, the last 100 years being utterly unique), land used for dwellings, increased worldwide meat consumption, etc. I conclude agricultural prices are going up "indefinitely&quo... Non metallic minerals less so, since the supply is the entirety of the earth's crust! Statistical arguments, while valuable, are very tricky - they depend on assumptions and contexts. Are you certain your assumptions and contexts are still valid for a world of close to 7 billion people, all clamoring for 'stuff'?

[mslasky]

Addendum: I forget to address your point about diminishing rates of growth. In the face of a constant large population base, and a diminishing supply (think metals), price pressures are more moderate than they would have been, but an implacable up-trend remains intact.

[ManagingEditor]

Taking the absolute route to complex matters such as commodity pricing is, I think, dangerous. The tendency to mean reversion didn't evaporate overnight.

Technological improvements, too, have to be factored in.

Don't get me wrong: I'm not saying that there isn't scarcity. Some of what we see, however, isn't population-related.

From a trading and investment standpoint, there are very few straight lines.

[mslasky]

I agree that short term commodity pricing is complex, and unpredictable; but also, that malthusian pressures give a strong upward bias for the indefinite future. I agree that a portion of commodity pricing has nothing whatever to do with population pressure. But, technological improvements cannot change the fact that the present population outstrips earth's sustainable agricultural productivity, and other resources. Technological exploitation of the deeper crust, the ocean basins, or the asteroid belt, will inevitably be accompanied with much higher prices, and still the population grows. Mean reversion is mere mathematics. Without a comparable context and history, of which I propose there are none, there is no mean to revert to. When, previously in history, has the earth had this population base? When in history has technology permitted the level of use of metals and land? I say never. Thus, reversion to the mean is the wrong tool to be used to evaluate future commodity prices. I again agree with your observation about investing and straight lines - especially over short time frames. In longer time frames, short of a population implosion, I can't see any way for commodities to decline in value, especially in comparison to other types of equities. I agree that absolutes are dangerous. The conventional advice to put 5 or 10% in commodities, is way too cautious. Decisions based on commodity price performance for the last 200 years, will not, I fear, serve us well going forward.

[bearfund]

Even if we suppose that Ferri is right and the long-run real return on commodities is zero, that's still a good deal better than the return on Treasuries, which is deeply negative. The real yield on TIPS has been hovering near zero and recently fell below even that, while commodities soared. The obvious read there is that the market doesn't think much of the CPI, but at a deeper level it suggests that there are good reasons to take risks in commodities when the circumstances favour it. One needn't have timed the market well at all to have done better with commodities than with equities or bonds. The real question people should be asking is what signals herald the beginning of a commodities-up, paper-down phase in the economic cycle, and what signals herald its end? Within that phase, one is more likely than not to win with commodities even with randomly selected entry and exit points, and more likely than not to lose with anything else.

While the infinite-term fundamentals for food and oil are extremely bullish, I'm not silly enough to think we won't eventually see another Paul Volcker step in and restore some measure of faith in fiat money. When that happens, most investors will put commodities back on the shelf and forget about them, until the cycle turns once again.