Commodities: Burst Bubble or Buying Opportunity?

By Julian Murdoch

The big question facing commodity investors is obvious: Is the recent run-up in commodities prices a speculative bubble or is it a natural expression of supply and demand?

It is the same question we've been asking for more than a year. To a large extent, nothing else matters.

We decided to take a fresh ... and perhaps a definitive ... look at the issue.

First, a definition of the term "bubble." The most elegant one I've seen was from "The New Palgrave Dictionary of Economics" (with thanks to Justin Lahart): a bubble "refers to asset prices that exceed an asset's fundamental value because current owners believe they can resell the asset at an even higher price." It seems almost axiomatic; a market buoyed by belief. It's a kind of capitalist religious fervor.

Yes, We Are

Given the recent pullback in commodity prices, you could easily argue that commodity prices were and perhaps still are overvalued, a position many analysts take. The numbers can support their arguments. Oil is down 30% off its July high. Gold is down 14% (after clawing its way back from being down 24% last week). Aluminum has lost around 22%. Such numbers lead to article with titles like "The commodities bubble has burst," the premise being that it's all over, and we're just waiting for overweight operatics.

No, We're Not

If you get past the Chicken Littles and look at some of the underlying fundamentals, however, you find that for many commodities, supply is tight and demand is growing.

Famed commodities guru Jim Rogers is still bullish on commodities, if his latest remarks in India are any indication. (Do keep in mind that he was hired to talk at the opening of a commodity equity fund.) Back at the end of August, he wrote an article titled "Why commodity prices are not done rising yet," in which he lays out a simplified version of his super-cycle theory. The main points of his theory remain intact: no new oil fields, continued Asian demand. He touches on the fact that there has only been one new lead mine opened in the past 25 years.

Another analyst, Dan Amoss, comments that the recent correction has been in part fueled directly by failures in the financial sector, with big commodity fund managers like Ospraie Management forced to sell out positions to raise capital: 

The commodity sector wipeout of the last two months has obliterated any froth or excess. And now, prices may overshoot to the downside. One thing is clear; fear and forced selling are driving the commodity markets right now...not underlying fundamentals. 

Amoss also notes that low commodity prices may result in reduced production of certain commodities if/when the price of the commodity drops below the cost of production. No company is going to continue mining if they are losing money to do so. In other words, the pullback is itself a driver of supply - or the lack thereof.

Maybe

Fence sitters should find fellowship in the slightly scary comments by CFTC Commissioner Michael V. Dunn on September 5: 

Based upon our staff's surveillance and research, we can tell a pretty good story about why market fundamentals have been, at least partly, behind the price increases in agricultural and energy markets. But, it is undeniable that there have been large flows of new investment into our markets.

The real question here is scale. Each one of these investments might be relatively small, but what happens when the trickle becomes a flood? Essentially, the argument goes, instead of pricing just supply and demand factors, commodity markets have begun to price commodities' value as an asset class as well, creating a price distortion or possibly even a bubble.

So what is the answer? The answer is ... we are not quite sure. Considering our current knowledge, I doubt it is possible to come up with a definitive answer one way or another at this time - markets and market behavior are simply too complex and our understanding is still evolving. [Emphasis mine.] 

Scary, but let's face it, pretty damned honest.

What Do The Data Say?

With all these differing viewpoints - all from very smart people - who should we believe?

Rather than playing pick-your-pundit, let's look at some data.

During a recent interview with HAI, one of our favorite commodity analysts - Jeff Saut of Raymond James - suggested we perform a simple comparison. Saut said that we should plot the value of the Commodities Research Bureau index (CRB) against the S&P 500 over a long time horizon.

So let's do that.

First, here's a look at each index's long-term performance.

The CRB spot index shows that commodity prices have risen over time through cycles of growth and contraction. The most recent growth, however, has been far above the norm. On the whole, the CRB has risen 358% since 1950.

Of course, we don't trade commodities in a vacuum. Let's take a look at the long view of the S&P 500.

Now that's a nice curve - especially if you called the top of each peak. (Full disclosure - I didn't.) One thing to notice is the scale on the charts: The S&P 500 growth is much more dramatic than that of the CRB spot index. It's also more concentrated, with the vast bulk of the growth occurring from the 1980s onward.

So what happens if you divide the value of the S&P 500 by the value of the CRB Index over this same historical time period?

Here's the chart:

Step back for a minute and think through what this chart means.

The chart basically depicts the value of commodities compared to the value of stocks; how much stock you can buy with X amount of commodities. As you can see, in the mid-1970s, commodities were expensive relative to stocks - or the stock market was cheap, depending on your point of view. But as the S&P 500 rose, it far outdistanced any gains in commodities.

The long-term average for this ratio is 1.54. Currently, despite the run-up in commodity prices, we are far below the long-term average. In other words, we're still WAY at the bottom of the relative valuation of "stuff" vs. "stocks."

The theory goes that if we were truly in a bubble, the price of commodities would be higher relative to the price of stocks - aka, the ratio on this chart would be higher. We obviously don't see that right now, though the upturn at the end of the chart could be the beginning of a trend.

Eight years ago, the CRB/S&P 500 ratio hit a historical low of just 0.15. We've recovered a bit since then. But we aren't back to "normal" by a long shot.

Here's a chart of the most recent eight-year period, which shows the recovery of the CRB/S&P 500 ratio in recent times.

Caveats And Explanations

I love these kinds of basic charts, because they force you into interpretation. There are several things going on here. The most obvious is the shift in the economy and the composition of the S&P 500 since the 1950s. We have, as a nation, moved from a post-war era focused very much on stuff, on defense and on industry, to an economy based far more on information and services. So the fortunes of enterprise simply disconnected from the copper and corn and steel that drove the middle years of the last century. Commodities may be less important to the economy than they were in the past (although the size of the reduction in this ratio is staggering).

There is also the matter of investability. One of the many reasons for the prolonged bull market in equities has been the rise of an investor class - but those investments have gone almost exclusively into equity and fixed-income positions. Commodities have only been available for general investors for a short period of time - some would argue really just in the last decade. More access means more money going in - and out - of commodities; hence the catch-up.

Final Thought

Here's the thing about bubbles - to truly be able to call a market event a bubble, you have to be able to look back at it and see the pop - the crash. Until then, any downturn is just a "correction," and any upturn just a bull market.

While an imperfect analysis, this CRB/S&P ratio implies we're still coming off the bottom of the seesaw on commodity prices. That could mean the commodity prices will rise; alternatively, we could be in for a mass decimation of U.S. equity values. As much as I love commodities, that sure ain't something I'm wishing for.

Comments

[Help!:]

Dear Julian Murdoch,

Please help me understand something (I think this is something that some of your other readers might be interested in as well). The issue is the huge variance in trading values between open end mutual funds and closed end ETF’s.

The open end mutual funds essentially trade once per day at the closing net asset value (NAV) of the fund. The closed end ETF’s trade all during the trading day, often at large discounts to their NAV. In this extremely volatile market, why would an investor want to be forced (by utilizing open end mutual funds) to wait until the end of the trade day to get in or out of a security?

In addition, why would an investor want to pay par value (NAV) on an open end mutual fund rather than purchase something with a built-in gain (a closed end ETF at a significant discount)?

For example, the world stock open end mutual fund Capital World Growth & Income Fund (symbol CWGIX) from American Funds trades once a day at its NAV (0% discount) and yields about 2.80%. Conversely, the world stock closed end ETF BlackRock Global Equity Income Fund (symbol BFD) trades during the day at around $11.22 (a 20% discount to its NAV) and yields around 17.00%.

Would you recommend that I buy CWGIX or BFD? Please explain this phenomenon. I do not understand. Thank you.

Sincerely,
Mark J. Mohr

2008 Sep 22 01:11 PM

[Help!:]

Please explain.

2008 Sep 22 01:39 PM

[mangolfer:]

Everybody keeps pointing at "fundamentals".... Have the fundamentals changed since Katrina? Oil took off and has never come back since Katrina.... Another point, how can anybody know where "peak oil" is? Everything already discovered in the ground is estimated. Not to mention all the undiscovered oil that keeps showing up. Not to mention all the new technology for removing oil from the ground. I don't see it going up near term with out something illegal causing it to rise.

2008 Sep 22 09:41 PM

[Mark Anthony:]

Dear Julian:

You started by giving the correct definition of a bubble:

a bubble "refers to asset prices that exceed an asset's fundamental value because current owners believe they can resell the asset at an even higher price."

But you failed to continue to pursue that topic and further ask the question "what are the current fundamental values of commodities". So you failed to reach any conclusion. Only when you can answer that question correctly, do you know whether current commodity prices are too high or too low.

Please read this discussion because it gives the precise answer to the question of fundamental values of commodities:

seekingalpha.com/artic...

I believe that far from being a bubble, many commodities are actually far below their rightful fundamental values at current prices.

2008 Sep 22 11:56 PM

[Emerald:]

It may take two years, but the larger emerging markets of India, China and Brazil contiue to grow. Some have commodities (Brazil), the others have limited supply. Commodities are still a good investment if your time horizon is al least five years.

2008 Sep 23 01:09 PM