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Commodities Beat-Down Continues
The recent commodities sell-off has been breathtaking. This is especially true since the most-recent downturn occurred from a level where the expected future returns from commodity index investment were reasonably good – and, as a spread above expected equity or bond returns, probably around the best levels ever.
But investors have a strong tendency to use the current level, rather than some esoteric measure of value, as the level from which expected market moves are evaluated. What I mean by that is this: in theory, if some event happens in the capital markets, the reaction in the market should depend on whether that event has already been “discounted” in the current price. That is, if we are all expecting Microsoft to raise its dividend, then the price of Microsoft should reflect that change already, and when it subsequently actually happens it should have no effect on price. Indeed, if the market has overestimated the change in fundamental value, then the price of Microsoft should retrace somewhat when the news is actually announced. From that, we get the old saw that one should “buy the rumor, sell the news.”
The fact that this isn’t really what happens is not exactly news. In the early 1980s, Bob Shiller demonstrated that the volatility in the equity marketplace was much greater than the changes in the real underlying values should support.
In practice, investors don’t behave rationally. The same event can be discounted over, and over, and over again. Each investor, it seems, hears news and assumes the current price does not incorporate that news, no matter what has happened previously to the price. Based on my own unscientific observation, I think this is more true now that there are more retail investors, and news outlets that benefit from making everything sound like new information. If my supposition is true, one implication is that markets can deviate further and further from fundamental values. In other words, we get more bubbles and inverse bubbles than we would otherwise.
As a great current example, we might consider commodities. The slowdown in China’s economic activity is discounted anew almost every day, as more information comes out from that country that its economic engine is (at least) sputtering. One would think that China was the only consumer of industrial metals and energy, and that its consumption is going to zero, based on the behavior of these markets. And with every tick higher in the dollar, every commodity seems offered. It’s risk-off, then risk-off again, then risk-off again, ad infinitum.
Now, there is no doubt that commodities in 2008 were overvalued, and arguably in 2011 they were also expensive. But the four-year beat-down of commodities – pretty much the only asset class that has declined in value over that time period – is breathtaking in its depth and, as it turns out, its breadth. I was curious about whether the recent break of major commodities indices to new lows – below the lows of 2008, when it felt like the world was ending (see chart above, source Bloomberg) – was broader, in that it seemed like every commodity was participating. So I put together a chart that shows the proportion of commodities (considering only the 27 major traded commodities that are in the Bloomberg Commodity Index) that were above their 200-day moving averages. The chart is below (Source: Enduring Investments).
It isn’t quite as bad as I had thought. The recent slide has taken the proportion back to 18% (meaning 82% are below their 200-day moving averages), but commodity prices have been sliding for so long that the 200-day averages are now generally declining pretty smartly. Notice in general the post-2011 average, compared to the pre-2008 average. Even without seeing the price chart, you can tell the 2011-2015 bear market from the 2002-2008 bull market!
One other observation about commodities, to be fair. The chart I showed, above, of the Bloomberg Commodity Index, incorporates carry in commodities. That is, it adds the futures roll, and collateral return, to the movement in spot commodities. Over the last few years, the collateral return hasn’t been very good and the roll return has actually been substantially negative, so that the return of spot commodities has in fact been better than the return to commodity indices. The chart below (source: Bloomberg) shows the Bloomberg Spot Commodity Index; you can see that we are still above the 2008 lows.
Being “above the 2008 lows” doesn’t strike me as a strong performance. Stocks are also above the 2008-09 lows, by 200% or so. LQD, the investment-grade bond ETF, is about 45% higher. HYG, the high-yield ETF, is 41% higher. Heck, M2 money supply is around 50% higher than it was in early 2009.
And yet, every time we hear more news about China, investors behave as if it is new information, and sell commodities off some more. As I said above, these moves can last longer these days than they did in the past – but this is unsustainable. With commodities, an added complexity is that investors don’t know how to evaluate expected return (since there are no cash flows), and so it is hard for them to compare “value” to other asset classes. But the value is there.
Proper Seasonal Gold Chart
In an excellent (and free!) daily email I receive, the Daily Shot, I ran across a chart that touched off my quant BS alert.
This chart is from here, and is obviously a few years out-of-date, but that isn’t the problem. The problem is that the chart suggests that gold prices rise 5.5% every year. If you buy gold in January, at an index value of 100, and hold it through the flat part of January-June, then you reap the 5% rally in the second half of the year.
No wonder people love gold! You can get a 10% annual return simply by buying in July and selling in December!
The problem is that this is not the way you should do a seasonal chart. It has not be detrended. We detrend data because that way, we can express the expected return for any given day as (the normal expected return) plus (the seasonal component). This is valuable because, as analysts, we might have a general forecast for gold but we will want to adjust that forecast to a holding period return based on a seasonal pattern. This is very important, for example, with TIPS yields and breakevens, because inflation itself is highly seasonal.
Now, the seasonal chart done correctly still suggests that the best time to own gold is in the second half of the year, but it no longer suggests that owning gold is an automatic winner. (It is a separate argument whether we can reject the null hypothesis of zero seasonality altogether, but that’s not my point here).
If I was doing this chart, I would also include only full calendar years, so if I move the start date back to January 1, 1982 and the end date to December 31, 2014 here is what I get:
Frankly, I would also use real prices rather than nominal prices, since it is much easier to make a statement about the expected real return to gold (roughly zero over time, although it may be more or less than that based on current valuation metrics) than it is to make a statement about the expected nominal return to gold, since the latter includes an embedded assumption about the inflation rate, which I would prefer to strip out. And I would also include data from the 1970s.
Summary of my Post-CPI Tweets
Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments.
- Core CPI +0.18%, y/y rises to 1.77%. Pretty much as-expected on the headline figures.
- Was some market concern about a possible higher print following PPI, but there isn’t much correlation.
- Note that the next two months of CPI will ‘drop off’ an 0.10% and an 0.05%, so we should get to 2% on core inflation by mid-September.
- Of course the Fed’s target is ~2.25% on core CPI (since they tgt core PCE) so Fed can argue it’s still below tgt. Uptrend may concern.
- Housing inflation on the other hand going to the moon
- This is great chart and it’s the reason core never had a chance of entering deflation territory. & will go up. (retweeted Matthew B)
- Housing #CPI overall just hit 2% y/y. Primary rents 3.53%. OER, which is 24% of the whole CPI, rose to 2.95% from 2.79%. Wow!
- …our model for OER is at 3.1%, and the actual number HAD been lagging. I love it when a plan comes together.
- So housing drove core services to +2.5% y/y, core goods -0.4%.
- So if housing busted higher, what was the services offset? Medical care, 2.51% y/y vs 2.84% last month.
- WSJ argued earlier this month that is expected because under Ocare people are actually spending their own money.
- Within medical care, drugs went to 3.44% vs 4.05%, pro svcs went 1.83% from 1.58%, and hospital & related to 3.48% from 4.51%. So maybe?
- Yes, core PCE & core CPI are going to be rising. But core PCE won’t be anywhere close to the Fed’s tgt by Sep.
- Here is core and median CPI (the latter not out yet today) and core PCE.
- core commodities are about where they should (eventually) be, given rally in TW$. A bit ahead of schedule though.
- This chart means either that home prices are overextended or incomes need to catch up, or both.
- Here is our OER model that is based on incomes. Not a tight fit but gets direction right.
- I wondered about this when I paid $180/night for room in S. Dak. Hotel infl driven in part by fracking boom?
- probably would fit better if I used a regional lodging index rather than national, I suspect.
The summary of today’s CPI release is that the underlying pressures remain the same, and the trends remain the same. The really interesting dynamic going forward isn’t in CPI (although at some point when core goods starts to rise again, that will be quite interested), but in how the Fed reacts to the CPI. When they meet in September, core CPI will be around 2%, a bit shy of where the Fed’s target is. But the uptrend will be clearly apparent, and core and median CPI will likely be closer to 2.5% than 2% by the end of the year.
So the interesting dynamic is this: even though inflation is below the Fed’s target, and growth isn’t great shakes, and there are risks to the global economic system in Europe and in China…will the Fed tighten in September anyway? If they do, then it will be surprising if only because the FOMC passed on many opportunities over the last five years which would have been much more accommodating (no pun intended) to a normalization of rates. Sure, if they now recognize that they should have tightened three years ago it shouldn’t color their decision today – the best time to plant a tree may have been thirty years ago, but the best time that we can actually choose from is today – but the Fed hasn’t usually been so limber in its reasoning. Especially with a very dovish makeup of the Committee, I would be surprised to see them hike rates unless inflation has surpassed their target and growth is pretty strong with global risks receding.
However, the strength of my view on that has been slipping recently. Although I think most of the Fed’s talk on this point is mere bluster, we do have to pay attention when Fed speakers – and especially the Chairman – say the same things multiple times. While Yellen has expressed only an expectation that the Fed will raise rates later this year (and we have no idea how conditional that expectation is on stronger growth, on Chinese growth, on European volatility etc, she has said this multiple times and at some point I have to conclude she means it. I still think that the odds of getting rates even up to 1% in a single series of moves is slim, but I admit the more-consistent Fed chatter is worth listening to.
Greece: We Get It
“When in the Course of human events it becomes necessary for one people to dissolve the political bands which have connected them with another and to assume among the powers of the earth, the separate and equal station to which the Laws of Nature and of Nature’s God entitle them, a decent respect to the opinions of mankind requires that they should declare the causes which impel them to the separation.
“We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness. — That to secure these rights, Governments are instituted among Men, deriving their just powers from the consent of the governed, — That whenever any Form of Government becomes destructive of these ends, it is the Right of the People to alter or to abolish it, and to institute new Government, laying its foundation on such principles and organizing its powers in such form, as to them shall seem most likely to effect their Safety and Happiness.”
Greece has voted ‘no.’ It should not surprise us that this has happened. The only surprise is that it took this long for “one people to dissolve the political bands which have connected them with another.”
