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“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” – Benjamin Graham
We invest client funds across six core asset classes: domestic investment grade bonds, inflation protected bonds (bonds whose coupon and/or principal payment is adjusted upwards when inflation increases), domestic stocks, foreign developed market stocks, emerging market stocks, and real estate (primarily through REITs). One “asset class” we don’t own is commodities. Why? Because investing in commodities is anything but investing. It’s speculation.
So what exactly is the definition of investing? Well, the Ben Graham quote is a good place to start. But the best way I found to determine whether you are speculating or investing comes from a paper written by Ben Inker of GMO. He says investors should ask themselves at least two questions about potential investments: (1) “Where do the returns from the investment come from and who funds them?” and (2) “Why would the funder of those returns be willing to offer a return above that of cash in the long run?”
For brevity’s sake I will just discuss the first question. To simplify things, imagine you are retired and all financial markets shutdown permanently tomorrow and you will be left owning whatever is in your portfolio — forever.
Would you want to own bonds? Sure, every six months (typically) you would receive an interest payment from whoever issued the bonds and at the end of the term you would receive back your principal. So far so good.
Would you want to own stocks? Sure, a share of stocks represents a fractional ownership of a business and as an owner of the business you are entitled to your portion of the cash the business generates. Company executives and the board manage the business on your behalf and sometimes they pay out most of the cash in dividends or sometimes they reinvest some or all of it back into the business to generate even more cash in the future. In our example, if the financial markets really did shutdown there would be a lot of people clamoring to receive their cash solely as dividends! But in any case you, the investor, have a claim on a stream of cash flow just like bonds.
What about real estate? Sure. In our portfolio we have exposure to real estate through stock in special types of companies referred to as Real Estate Investment Trusts (REITs). REITs typically own income producing properties such as office buildings, apartments, or malls and they pay out 90% of their earnings as dividends. So you would be comfortable owning them and receiving the cash flow.
Now what about commodities such as oil, wheat, pork bellies, or copper? They don’t generate a cash flow. As a retiree (as opposed to, say, a farmer, manufacturer, or food processor) you don’t have any use for the commodities. Your only choice is to sell them to someone who actually needs them. But remember in our example the financial markets are shut down, so you are stuck with your several barrels of oil, copper ingots, and slowly spoiling wheat and pork bellies. Commodities are useless if you don’t need the actual item. Their value comes only when you sell them to someone else at an ever higher price. That is not an investment. It’s a speculation. Of course, people have made money speculating, but that’s not what we do.
In addition, as we would expect, because commodities don’t have any characteristics that make them an investment, their returns have essentially gone nowhere over the last 140 years as the chart below shows.
“Rubber Duckie, you’re the one, You make bath time lots of fun, Rubber Duckie, I’m awfully fond of you.” – Ernie, Sesame Street
Bubbles always need a good story–a story that gets people excited, that sounds good enough to convince most people they have to participate, and a story that’s usually rooted in facts. The strange thing is that these stories are often true. It’s just the price of participating or the investment chosen that is wrong. For instance, take the tech bubble. The story was that the internet and computers were going to revolutionize business and society. That story was largely true. Almost everyone uses a computer today both at home and at work. Business and individuals are more productive. Communication is faster and easier. Except the bubble took things just a little bit too far, and investors paid through the nose to buy tech companies. Microsoft, Applied Materials, Cisco, JDS Uniphase, Dell, etc., would all have been average or above average investments if investors paid a reasonable amount. Instead, they bid them up to 25, 50, 100 or more times earnings.
So it’s important to realize that when I talk about the commodity bubble, I don’t disagree with the story. The world economy really is growing and the demand for natural resources is increasing; the population is growing and eating more food and higher quality food at that; we really do have to look for oil (and other commodities) in harder to reach places. It’s the price of the commodities and the nature of them as investments (rather than as speculation) that I disagree with.
“People generally worry only about what happens one or two steps ahead and anticipate being able to get out before a collapse… In countless situations people prepare exclusively for near-term outcomes and don’t look very far ahead. They myopically discount the future at an absurdly steep rate.” – John Allen Paulos
The other thing with bubbles is that they all last long enough to make anyone who predicted them look like a fool. It’s likely the commodity bubble will continue for quite some time, and I am prepared to look like a fool for many years. I’d rather look foolish and save clients the heartache and financial loss of another bubble than to go along with the crowd no matter how large that crowd or how many famous converts it has.
History of the Commodity Markets and the New Index Fund Era
Commodity markets were and are intended as a place for producers and/or users of commodities to enter into contracts for the delivery or sale of commodities at guaranteed prices. The markets helped reduce volatility in commodity prices and allowed producers and consumers to lock in prices and better manage budgets and production. Participants in commodity markets can be divided into two categories: hedgers and speculators.
Hedgers are defined as those that produce or intend to consume the commodity and are using financial instruments to lock in a set price. They may be producers, such as farmers, mining companies, and oil and gas exploration companies. They may also be consumers of the commodity, usually processors or manufacturers, such as apparel companies hedging the price of cotton, a tire manufacturer hedging the price of rubber, or a utility company hedging the price of natural gas or coal.
There are two categories of speculators. First, are those that speculate by hoarding the physical commodity itself. An example of this would be a speculator