January 23, 2015

The World's Worst Investment . . . Is Looking Pretty Good Right Now

In the first decade of this century, when commodity prices were strong, there were many promoters of the idea that passive investment in commodity funds, tracking the futures prices, ought to be a key portion of any investment portfolio. Anyone who acted on that idea, however, has fared badly in the years since 2008. As far as asset classes go, funds that hold commodity futures contracts have been just about the world’s worst investment since the summer of 2008. 

There are lots of reasons why, in normal circumstances, such investments are inferior to stocks, bonds, real estate, or precious metals, but these are not normal circumstances. The precipitous collapse in the price of oil, far below the cost of production for “new oil,” makes these funds an intriguing proposition these days. To make the case for them, we shall take a look not only at the history of commodity prices as such, but also at the relationship to other asset classes as well. On the theory that what goes way, way down, must come up, we will rest our case.

First, here’s a survey of the overall carnage. The index below is the Goldman Sachs Commodity Index Fund (GSG). Because it is  heavily weighted toward energy, it has had more extreme price movements than other commodity indexes, but all the commodity indexes rose and fell along similar lines over the past two decades. 

Now let's look at a couple of ratio charts, The first chart shows the ratio between commodities and bonds, in this example the ratio between GSG and long term US Treasury bonds. 

If you started out in 1999 thinking that an investment in commodities would put the kids through college, that looked like a really good idea over the next nine years. Then it became a very bad idea and you realized you needed a second job at McDonald's to swing it. From early 1999 to mid 2008, commodities were very good and bonds were very bad. Then the relationship reversed in the years thereafter. 

The same story may be told for the ratio of stocks and commodities, though this is even more lopsided in the denouement. The following chart shows the ratio between GSG and SPY (an exchanged traded fund showing the total return, including dividends, of the S and P 500). 

Here's another that looks at the ratio between GSG and the Vanguard Total Return Bond Fund, making the picture even worse than the earlier ratio chart comparing GSG with US Treasury prices. 

The general collapse in commodity prices is especially striking in light of expectations prevailing only a short while ago. In 2011, the investment guru Jeremy Grantham produced a chart showing the movement of commodity prices over 110 years, beginning in 1900. Grantham titled the essay in which the chart appeared "The Great Paradigm Shift." Its argument was that "this time is different"--that is, that the general movement downward in commodity prices that had occurred over the preceding century had been reversed by a series of shortages so severe that the trajectory of prices was almost certainly upwards. 

As Grantham explained, the GMO Commodity Index equally weights 33 different commodities, so it is measuring different things from the GSG index. Summarizing its significance, he argued: "The prices of all important commodities except oil declined for 100 years until 2002, by an average of 70%. From 2002 until now, this entire decline was erased by a bigger price surge than occurred during World War II. Statistically, most commodities are now so far away from their former downward trend that it makes it very probable that the old trend has changed – that there is in fact a Paradigm Shift – perhaps the most important economic event since the Industrial Revolution." 

This chart was produced shortly before the huge break in the commodities market in the summer of 2011. Grantham emphasized that his argument was about the medium to long term. In the short term, he acknowledged, a bust was possible, after which would come the mother of all buying opportunities. Grantham's is a proprietary index and I have not seen an updated version, but the following chart of the Greenhaven commodity index (GCC) is probably a reasonable proxy for the GMO Index. It gives a much heavier weighting to agricultural commodities as compared with the GSG, which helps explain the big rise from late 2008 to 2011. Given its relative under-weighting of energy, it hasn't fallen as far as the GSG, but it's still packing a lot of hurt in the last few years. 

The conclusion I draw from these various charts is that investing in commodity funds has indeed been an extremely bad idea since the great blowoff of 2008. Since mid-2011, everything has gone down, with oil leading the pack of late. Investment firms have pronounced the end of "The Great Commodity Supercycle." Huge investments were made in oil, cooper, iron ore, gold, silver, corn, and soybeans. And they have just about all come a-cropper. 

As we said at the outset, however, what goes way, way down must come up at some point. The firms which made these investments may have lagging share prices for some years; by the same token, however, the prices of the underlying commodities are likely to recover before the share prices do, and with greater relative vigor. (It was observed recently by an oil expert that the share prices of the major oil companies reflect a long term oil price of $75-85. The price at this writing is $46). Another objection is that the funds tracking energy commodities will probably lag a simple price index, because the futures markets are in contango. True enough, but these deficiencies of commodity funds did not prevent the out-performance that occurred between 2000 and 2008. Whereas there are reasonable arguments that both stocks and bonds are in a bubble, the same cannot be said about commodities. They are definitely in bust mode, oil most of all. (James Paulsen has a recent piece in Barron's summarizing the data on the pricey character of US stocks. 10 year US treasury bonds, by the same token, have a yield of 1.90%.). Most convincing of all is that the marginal cost of "new oil" is within shouting distance of $100 a barrel. Unless the world faces another Great Depression or, better yet, The Apocalypse, the price has got to recover. 

One more point. One of the things that the promoters of investment in commodity funds always emphasized was that commodities have not been especially correlated with stocks and bonds. They therefore help balance out a portfolio and make it less susceptible to wild swings. As the following chart shows, however, that is not always true. Stocks continued to go up during the commodity bust of 1998, but beginning in 2001 there was a fairly tight correlation for the next ten years. That has now broken apart. While the 1998-99 precedent does command some respect (and while stock prices rose after the oil price collapse in the mid-1980s), the chart also suggests the existence of a Great Divergence. Both commodities and bonds are forecasting a recession, whereas the stock market sees only sunny vistas ahead. Something has got to give.  

All in all, I think it a decent bet that our miserable companion in this journey through commodity history, the GSG, will outperform either stocks or bonds over the next three years. It might outperform both. The former possibility (outperforming one or the other) is of a sufficiently high order of probability as to justify some inclusion in an investment portfolio (anywhere, say, from 5 to 10%). If economic activity is as poor as the markets in both bonds and commodities are saying, stocks would have great difficulty maintaining their current valuation. Since oil has borne the brunt of the recent decline, the oil fund USL(holding futures contracts over 12 months)  looks like a more eligible instrument than GSG for playing a rebound in commodity prices. [I am much more confident about USL than GSG, as explained below, but its trading history only goes back to late 2007 and thus can't be shown on the long term charts used above.]

There are certain perils in this strategy. You would be trying to catch a falling knife; there's an old saying (especially among momentum investors as opposed to the value mavens) that you shouldn't try to do that. Secondly, the process may take several quarters to play out, so cost averaging into the position would definitely be the prudent course even for impulsive types. Third, as a general rule, most commodity mutual funds have high expenses, front end loads, and returns that fall well short of a pure price index; they are, as a rule, poor instruments that are more valuable to their administrators than their clientele. I guess that leaves us all dressed up and nowhere to go--that is, convinced of the overall merit of the analysis favoring commodities, especially oil, but rather perplexed over how to implement it.

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Update 1/25/15: By way of further caution, here's a chart provided by Jeffrey Gundlach in his recent investor presentation, notes of which are available at Business Insider. "The white line is the commodity index, the yellow line is the commodity index you can actually invest in. Investable commodities have been losers for years. Gundlach says you lost 800 basis points per annum over the last 10 years investing in commodities."

As Gundlach's chart suggests, the really big hit that occurred in this regard was from the summer of 2008 to the summer of 2011. Since that time the two indexes have tracked pretty closely. This is shown in a ratio chart of USO with WTIC (that is, the etf holding near month futures contracts) and the price of oil. Interestingly, both USO and USL have outperformed $WTIC since the summer of 2013. As the ratio chart of USO:USL shows in the bottom frame, USO has been the consistent underperformer of USL (holding 12 month contracts), especially of late. Weirdly, USO is traded far more frequently than USL (a recent figure shows 40 million contracts for USO, only about 100,000 for USL), and this despite USL's clear superiority based on the historical record and the fact that, logically, USL is the far better instrument when the oil market is in contango, as now. (See this very useful primer at Seeking Alpha)

Another note of caution comes from Steve Briese, a commodity market specialist who has been bearish on oil prices the last year and has been cited in several pieces in Barron's. In a January 10, 2015 followup at Barron's, Briese argues that oil could fall as low as $20 a barrel. He puts emphasis on the very large long positions that commodity funds still hold in oil futures, and draws an analogy with the crash of oil prices that occurred in 2008-09. "From the peak in July of last year, the funds have liquidated about 25% of their long positions. But their positions are so large that, even if they liquidate another 25%, they would hold a significantly greater number of contracts than they did in the bear market of ’08."

Briese's thesis raises an important question about the impact of "financialization" on the commodity markets, a subject I delved into a few years back. Briese's forecast of $20 a barrel oil seems absurdly low to me, but the general argument that these commodity funds matter for the movement of prices is undoubtedly sound. (If it were to fall to that level in a general liquidation, it would indubitably constitute the mother of all buying opportunities. Given the danger of a further fall in prices, I guess right now we're at the stepmother of all buying opportunities.)

One final series of charts suggests that, if you were to play this dangerous game, USL looks to be the most eligible instrument. It is a series of ratio charts comparing the price of USL with other commodity indexes. USL is much less exposed to the contango issue than USO or GSG, and these ratio charts suggest support levels right about here relative to just about every other commodity index.

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