Tom Szabo

Commodities: Brief Correction or Bursting Bubble?

There are quite a few small "commodity stocks" where the project economics are now underwater. If commodity prices slide far enough, the same thing could happen to some of the majors. Over time, the price of a given commodity (absent a monopoly like diamonds) will be slightly higher than the marginal cost of production. This is a reality that most current (sophisticated) investors recognize by awarding P/E ratios that are subpar to the market as a whole. If we do have confirmed peak production in a particular commodity, the paradigm may very well change but this is not something we will be able to confirm until several years of declining production in spite of higher prices. I agree that if and when the mom and pops buy up this sector, there could be other new paradigms to explain the overvaluations. Investing on that basis, however, is an application of the greater fools theory and not the way any billionaire got to be that way. Instead, if you have enough patience to wait for the type of absolute proof that is required to borrow every last penny you can to buy commodity stocks, you might be rewarded in the years ahead. And I don't think it will be too late if you just chill out now and wait for it. Remember the new paradigm: several years of rising commodity prices in spite of declining annual production. If it happens, that would be true alpha.

Commodities: On the Downhill Slope?

Some studies suggest an allocation of 1/3rd to stocks, 1/3rd to bonds and 1/3rd to gold will actually increase overall portfolio performance while reducing volatility. This is over the long term, which is what most investors who are looking to invest for retirement would care about. I know gold isn't the same as commodities but the point is that you need more than a mere 5% to make much of a difference in any allocation strategy.

The Bear Reaches Out for Commodities

Dux, I refer to the global business cycle, which is very real and has not been vanquished. Think-About-It, the standard of living for the average Chinese cannot equal or pass our current level due to a number of preventive factors. A clumsy way of summarizing these would be to say China simply has too many people, but I'll try to add in some nuance. (1) China's one child policy has created incredible demographic headwinds that will become very fierce in the years ahead. Basically, the population is aging at such a rapid rate that the majority of consumer income will be spent supporting the hundreds of millions of elderly. You think the $50 trillion social security liability facing the U.S. is a big deal? China's problem is an order of magnitude larger, and not only is it off-balance sheet but it isn't even acknowledged. (2) The Chinese economic miracle has failed to reckon with the environmental, social, health, safety, social and other costs attendant to industrialization. These all have to be factored into standard of living, and when you do that, the Chinese are actually further behind then raw per capita income or GDP figures would suggest. (3) Absent weird science, there will never be enough energy or beef (just 2 examples) produced on Earth to satisfy Chinese consumption were it to equal the current level enjoyed in the U.S. (4) Chinese growth has been accompanied by gross misallocations of capital. A large portion of the nation's wealth has been squandered on "investments" with zero merit. We too overbuilt in New York, California and Miami, but that excess will eventually be absorbed by domestic dreamers, immigrants, or foreign bargain hunters. But how many people are going to buy that empty, crumbling office building or shopping center in a Beijing or Shanghai suburb? I'd say it's about par with Detroit. And as nuts as the building craze got in the U.S. over the past few years, we weren't doing a lot of building in Detroit. This will haunt the domestic Chinese economy for decades. (5) Political change in China will be required at some point for advancement past a certain "achievement plateau" that looms in the not-to-distant future. The struggle for control of the government will likely create major upheavals that will periodically stall economic progress. The Chinese have set up a system with zero flexibility. That's okay if you're a Communist, but dangerous when you are a Capitalist.

The Bear Reaches Out for Commodities

Everyone in China, India and other emerging economies will never have the current standard of living as the U.S, etc. The numbers simply make it impossible. Perhaps OECD living standards will decline and meet the emerging economy standards in the middle sometime in the distant future. No matter, the commodity cycle will continue to exist and it isn't based on "profit-taking, bargain-shopping, and silly panic" but rather on the very real business cycle that impacts supply and demand. Simply put, we may have entered that part of the commodity cycle where supply balances or exceeds demand. This is a temporary condition, a small cycle within a larger cycle if you will.

That larger cycle is what's really important and often gets missed. Probably because it is so large, spanning centuries as it does. I'm not talking about Elliott Waves, Kondriateff theory or anything like that. Rather, what I'm talking about is a mega-shift in the entire global system where commodity prices are in the midst of reversing their centuries long decline (driven by technological improvements that increased yield, access and efficiency) and starting a climb that may last centuries as well. If not centuries, at least until nanotechnology or some science we haven't event dreamed of will allow humankind to cheaply manipulate matter at the elemental level and thus create unlimited supplies of just about any material.

Commodities: On the Downhill Slope?

I don't understand why moderate amounts, or only 5%, should be allocated to the commodity theme if you think they continue to be in a secular bull market. Just because they are volatile and can drop 50%? What about financials, home builders, high-tech, retail? What about a strategy of increasing exposure during a pullback and then reducing it during periods when commodities are soaring? What else is currently in a confirmed bull market? If allocating only 5% to commodities, that means 95% is being allocated potentially to sectors in a bear market! Yes, it's very possible there is still some ways to go until commodities reach a bottom--I for one wouldn't be surprised by oil trading under $100--but one could utilize put options to protect against the worst case scenario while still maintaining a reasonable exposure to the sector. But don't bother with a constant 5%, it ain't worth the effort unless you are talking about gold buried in your back yard.