Commodity Bubbles and Valuation: Imperfect Together

by: James Picerno


Commodities may or may not be in a bubble, which leaves strategic-minded investors grasping (and gasping) for context.

The media is flush these days with the "B" word, including Tuesday's Wall Street Journal, which advises: High Oil Prices Spur Thoughts About Bubbles, But This Might Be Misguided. Meanwhile, earlier this month, via Bloomberg News, Lehman Brothers energy analyst Edward Morse wrote in a report that commodities were, in fact, in a bubble and that it would burst by the end of the year.

Many others preach the opposite, arguing that the run-up in commodities prices are a reflection of supply and demand trends rather than a speculative frenzy. Whether it's true or not, the idea that speculators have gone wild is catching on and some in Congress are considering new laws aimed at curtailing commodity trading by institutional investors.

So, what's a prudent investor to do? There are no easy answers, although we can start with the facts. Fact number one: pricing commodities is inherently speculative. That's independent of whether commodities are in a bubble or not. In contrast, stocks, bonds and real estate (save for raw land) enjoy the attribute of generating measurable cash flows, which can be analyzed in the cause of putting a valuation on said assets. Commodities, by contrast, generate no income directly. Instead, one can only sell a barrel of oil or an ounce of gold to produce cash flow. The problem is that it's forever unclear how much cash the commodity will generate until the day of the transaction arrives.

Yes, that's true for stocks, bonds and income-producing real estate as well. But the difference is that informed investors recognize that a bond's current yield, a property's income stream and a stock's dividends (or earnings) lend themselves to any number of analytics to effectively reverse engineer the "fair value" of the security or property by putting a present value on the future income. True, in the short term such analysis must be taken with a grain of salt, but over the long haul estimating the present value of prospective dividends, coupon payments, earnings and rent historically go a long way in dispensing intelligence on the matter of valuation.

Alas, commodities generate no income and so estimating fair value is unavoidably speculative. That by itself doesn't make commodities a "bad" investment, but it does remind that commodities stand alone from stocks, bonds and real estate. In fact, it's that difference (of which valuation is but one part) that makes commodities attractive in the first place.

That leads us to fact number two: because commodities can't be valued as an income-producing investment, it's unclear how to estimate the relative size of commodities vs. stocks, bonds and real estate for asset allocation purposes.

Calculating the market capitalization of stocks and bonds, and the equivalent of real estate, is fairly straightforward. That allows for informed guesses as to the passive asset allocation among those asset classes. Commodities, on the other hand, are a tricky bunch.

Commodities have no market capitalization, at least in terms of futures contracts. Long and short positions in futures always offset one another and so the market cap is always zero. That leads to a variety of tortured alternatives to figuring out the market cap equivalent of commodities so as to figure out how big the marketplace is relative to stocks, bonds and real estate. One approach is estimating global commodities total production. Another is looking at liquidity factors, open interest and other measurable variables tied to futures. Each comes with its own limitations and challenges.

For what it's worth, your editor uses what's known as total dollar value traded. This is basically the dollar value of futures contracts that change hands over a specified time frame. We'll leave it to another post to detail why. Suffice to say, it's one of many methodologies and it comes with its own peculiar share of pros and cons.

Where does that leave us? As you might expect, a passive global markets allocation gives a high weight to commodities these days, thanks to the rise in prices, which in turn has boosted the total dollar value traded of futures contracts. Mr. Market puts a much higher value on commodities in 2008, and by more than a few measures.

If you accepted the total dollar value traded numbers as is, commodities would have been valued at just under the total global market capitalization of equities at the end of last year, which implies a passive allocation of 50/50 between stocks and commodities. Clearly, that's far too aggressive for most investors, although so far the heavy weight in commodities has proven itself worthy.

Nobody knows if an aggressive weight to commodities will continue to generate high returns in a broadly diversified portfolio of the major asset classes. However, this much is clear: a zero percent weighting is almost certainly extreme, and so too is a 50% weight relative to stocks. Somewhere in between is reasonable. Exactly where depends on the investor, i.e., her risk tolerance, investment goals, expectations, etc.

In short, a quantitative analysis only brings you so far in strategic portfolio design. At some point, there's nothing left to say other than: You're on your own. Caveat emptor!

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