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This ‘Cycle’ Certainly Hasn’t Been Super

Five years into the biggest money-printing exercise of all time, and commodities are (incredibly) approaching the status of being universally loathed. On Friday, gold provided a great illustration of one reason I always say that investors should have a position in diversified commodity indices. A Goldman Sachs report released a couple of days ago (with gold 20% off the highs) suggested that prices may have further to fall; more important to Friday’s rout, though, was the increase in the European assessment of how much more money Cyprus will have to raise for itself (€6bln, or about 35-40% of annual Cypriot GDP) to complete the bailout, and the speculation that Cypriot gold reserves will have to be sold.

Add to this the fact that Friday’s economic data was weak with ex-Auto Retail Sales -0.4% and the Michigan Confidence figure showing a surprising drop. Clearly, investors believe this to be a death knell for inflation (as opposed to the “death bell” – I’m not sure what that is – that Citigroup says has been sounded for the commodity supercycle).

But all of the data, and the European sovereign crisis, apparently does support rapidly rising home prices and equities at disturbing multiples of 10-year earnings!

Considering that commodities have been around far longer than equities, bonds, or even money itself, it is incredible how little understanding there is about them.

One misunderstanding, and key to understanding the current situation, is not peculiar to commodities. It is simply the common confusion of nominal and real quantities. In a nutshell, the change in any good’s nominal price over time consists of two things: a real price change, and a change in the price that recognizes that the value of the currency unit measuring stick has changed – that is, inflation. We’re familiar with this construction in the form of the Fisher equation, which tells us that nominal yields represent the combination of a real return that is the cost of money plus a premium (or, less frequently, a discount) for the expected change in the price level over the holding period. But that construction applies to all price changes.

So if the price of your ham sandwich rises 3% this year, is there a bull market in ham sandwiches? Well, in all likelihood not – it’s just that the overall price level is rising by roughly that amount. What about if the price of the ham sandwich rises by only 1%, because ham is becoming cheaper? Then we would say that there was a 2% decline in the real price of the ham sandwich, plus 3% inflation.

Now, if prices instead rose 15%, the ham sandwich in this latter scenario would not still be only rising in price by 1%. It would likely rise by 13% or so: the 15% inflation, minus the 2% decline in the real price of a ham sandwich. Even if a ham sandwich glut was forcing a 10% decline in real prices, the nominal price of a ham sandwich would still be rising in that case.

So, when groups trumpet the “end of the commodity cycle,” they seem to be confused. It is possible that they are saying that real commodity prices should decline over time, but I wonder whether their clients would be awed by that prediction since it has been the norm for hundreds of years. Moreover, if they were referring to real prices, then if CPI goes up 10% and commodity prices go up 5%, they will be right – but clients might not see it the same way.

But I don’t think that’s what they are saying. If it is, then those groups are also a bit late to the party – commodity indices, which include additional sources of return, have underperformed inflation by 28% since 2004 and are down about half from the 2008 highs. Frankly, in the chart below (Source: Bloomberg), which shows the DJ-UBS commodity index divided by the NSA CPI, I don’t see anything which looks like an up-leg of a supercycle, except perhaps the doubling from 2003-2008. Is a 100% gain over five years a “supercycle”?


Now, in the SP-GSCI, which has a much greater weight in energy, it looks plausibly like a “supercycle,” as prices tripled in real terms off the lows in 1999 (see Chart, source Bloomberg), and admittedly the chart looks a little feeble at the moment. But that difference is, as I just suggested, mostly due to energy. And if you think the energy supercycle has ended…just short energy, don’t paint all commodities with the ugly brush!


And, by the way, it seems like a pretty wimpy supercycle if the peak in real terms doesn’t even approach the earlier peak.

In nominal terms, all of these charts look different, with the downswings being dampened and the upswings accentuated, because of inflation. But that’s certainly not the right way to look at commodities (or any asset) over time. We don’t care about the nominal return. We care about the real return. And viewed through a real return lens, commodities are much closer to being really cheap than to being really rich!

Obviously, I disagree with all of these groups when it comes to commodities generally. About gold I have no firmly-held opinion about its valuation at the moment, but commodities generally we see as cheap – in fact, we expect triple the real returns from investing in commodities indices over the next ten years compared to equity investing. This is a function of both the very rich absolute valuations of equities and the very cheap absolute valuations of commodities indices.

Moreover, if inflation does in fact accelerate – something which has nothing to do with the weak Michigan or Retail Sales numbers – then commodities will also have terrific nominal returns while equities might well have negative nominal returns.

  1. Eric
    April 14, 2013 at 9:34 pm

    Thank God someone spotted that idiotic “death bell” malapropism!

  2. HP Bunker
    April 14, 2013 at 10:00 pm

    The disconnect between commodities and equities is strange, but I think the explanation is simple: equities have been rising, so investors (“speculators” might be a better word) expect them to continue on an upward price trajectory, and vice versa for commodities. People may believe the disclaimer “past performance does not predict future results” on an intellectual level, but when faced with rising or falling charts, they are helpless to resist!

    In the past few weeks, several “equity strategists” (almost an oxymoron, from what I’ve seen) whose predictions for the S & P have been proven to be too conservative this year have capitulated and raised their year-end price targets, often dramatically, and in every case not because of better than expected fundamentals but rather because the market response to bad news has thus far been to rally in spite of it. In other words, “the market will be immune to deteriorating fundamentals in the future because it has been so in the past”. Just like “technical analysis”, this sort of dynamic holds for precisely as long as investors generally believe it will hold. Of course, it works as well for, say, tulip bulbs or beanie babies as it does for stocks.

    Anyway, all you need for commodities to rally is for them to rally, see? Once they start going up, then all the Cramer types will take notice and point out how it’s only natural that commodities should rise in the face of worldwide QE, and investors “shouldn’t fight the Fed”, etc. Once the move upward in commodities starts, expect Goldman to shortly pronounce it expected, overdue, and inevitable!

    • April 15, 2013 at 7:27 am

      Not today, though! The response of gold to a 20% decline from the highs is an immediate 8% further fall (and more for silver)! Exactly as predicted by your model! 🙂

  3. Eric
    April 15, 2013 at 2:38 pm

    ugh. tried to hedge my commodities, miners, drillers etc against “risk off” with some equity shorts. i mean, its working, of course. but not as well as hoped! surely this counts as blood in the streets for all of our (here at e-piphany) beloved assets. (I know you “told me so” about the miners, but still…) At least I own the same physical assets i did last week and have a little bit more cash.

  1. March 12, 2014 at 4:08 pm

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