Financial Times June 10 th 2010
http://www.ft.com/intl/cms/s/0/d2c42e22-7427-11df-87f5-00144feabdc0,s01=1.html#axzz1WV4KM3Sy
Di-worsification is what you do when you invest in mediocre assets for a mediocre reason – for example, because a statistical model has told you they reduce risk. Thanks to the boom in commodities over the past decade, they have become a favoured choice for di-worsifying institutions everywhere. The profusion of ETFs, funds, indices, and brokerage coverage has made them unprecedentedly easy to access for individuals too. However the long-term performance of commodities is pathetic, and there is little reason to believe that “this time is different.”
In Saul Bellow’s 1956 novel “Seize The Day” the hero is led to financial ruin by a dubious investment advisor who encourages him to take oversized positions in the Chicago commodities market. Bellow’s timing was excellent. The CRB index peaked out in 1956 and did not make a new high until 1972., when another intense bull market got underway. The great 1970s boom peaked out in 1980, and this time new highs were not seen for twenty five years.
The pattern of short booms followed by long slow declines is characteristic of commodities markets. The result is a miserably poor return on investment over the long haul. If Bellow’s hero, Tommy Wilhelm, had held a position in the CRB Index from 1956 until today, he would have lost 75% of his capital in real terms. The idea that commodities are a good inflation hedge is absurd.
The noughties commodities boom began in 2001. If the 2008 peak is not breached, then the bull market will have been somewhat shorter and weaker than the 1970s blow-off – 7 years versus 9 years, and a trough-to-peak gain of 150% versus 250%. However in the 1970s consumer price inflation was high. This time inflation has been subdued, meaning that in real terms the trough-to-peak rise in prices was roughly the same. If the commodity markets follow the same pattern as last time, we can expect to see a multi-decade bear market in which prices make a series of new all-time lows in real terms.
The bulls would say that market conditions have changed out of all recognition; that supply limitations are finally being reached, that new discoveries are in ever more remote and inaccessible locations; also that China’s insatiable demand for raw materials constitutes a new demand factor. But all these explanations were equally valid ten years ago when prices were much lower. The currently very high premium of selling prices to extraction costs – as revealed in the super-normal profit margins of the extractors – is the best possible incentive for exploration, also for substitution and conservation.
In reality the new drivers are not so new as they appear at first sight. Industrialization did not start with China – the post-war reconstruction of Europe and Japan were also “unprecedented” in their time, and technologies such as deep-sea drilling and deep mining were revolutionary when they first appeared. Historically there has always been a substantial time-lag between rising prices and new supply – which is why commodity bull markets are so intense and the bear markets so long-lasting.
Commodities haven’t even done their job as risk reducers. During the credit crisis the commodities indices mimicked the gyrations of other risky assets, with the correlation to stock markets of individual commodities such as copper and oil rising to new highs. Unsurprisingly, given the inflows of hot money, commodities have become just another aspect of the global “risk on / risk off” trade.
Why have commodities been such a bad investment for so long? The simple answer is that commodities generate no income – as opposed to, for example, equities, which generate the bulk of their long-term return from the reinvestment of dividends Worse, commodity investors have recently
had to endure a negative roll as several of the more popular markets have been forced into contango. The result has been a significant underperformance of ETFs in particular versus the spot markets they are supposed to be tracking.
The complicated answer is that commodities don’t deserve to generate any return. As the name suggests, they are undifferentiated lumps of naturally occurring materials. Value needs to be added to them by the application of knowledge; it is investment in that process of application
that earns the return. Over the long haul the price of the commodities themselves revert to the cost of production.
As societies become more sophisticated, , knowledge generates ever greater returns. By contrast societies in which commodities are highly valued are by definition primitive. That is why the price of copper peaked out in ancient Egyptian times, when a few kilograms could buy you a slave girl. Its purchasing power has been in decline ever since. Essentially copper has been in a bear market for three thousand years.. Consider that before you di-worsify.