May 27, 2008
COMMODITY BUBBLES & VALUATION: IMPERFECT TOGETHER
Commodities may or may not be in a bubble, which leaves strategic-minded investors grasping (and gasping) for context.
The media is flush these days with the "B" word, including today's Wall Street Journal, which advises: High Oil Prices Spur Thoughts About Bubbles, But This Might Be Misguided Meanwhile, earlier this month, Lehman Brothers energy analyst Edward Morse wrote in a report that commodities were, in fact, in a bubble and that it would burst by the end of the year, via Bloomberg News.
Many others preach the opposite, arguing that the run-up in commodities prices are a reflection of supply and demand trends rather than a speculative frenzy. True or not, the idea that speculators have gone wild is catching on and some in Congress are considering new laws aimed at curtailing commodity trading by institutional investors.
So, what's a prudent investor to do? There are no easy answers, although we can start with the facts. Fact number one: pricing commodities is inherently speculative. That's independent of whether commodities are in a bubble or not. In contrast, stocks, bonds and real estate (save for raw land) enjoy the attribute of generating measurable cash flows, which can be analyzed in the cause of putting a valuation on said assets. Commodities, by contrast, generate no income directly. Instead, one can only sell a barrel of oil or an ounce of gold to produce cash flow. The problem is that it's forever unclear how much cash the commodity will generate until the day of the transaction arrives.
Yes, that's true for stocks, bonds and income-producing real estate as well. But the difference is that informed investors recognize that a bond's current yield, a property's income stream and a stock's dividends (or earnings) lend themselves to any number of analytics to effectively reverse engineer the "fair value" of the security or property by putting a present value on the future income. True, in the short term such analysis must be taken with a grain of salt, but over the long haul estimating the present value of prospective dividends, coupon payments, earnings and rent historically go a long way in dispensing intelligence on the matter of valuation.
Alas, commodities generate no income and so estimating fair value is unavoidably speculative. That by itself doesn't make commodities a "bad" investment, but it does remind that commodities stand alone from stocks, bonds and real estate. In fact, it's that difference (of which valuation is but one part) that makes commodities attractive in the first place.
That leads us to fact number two: because commodities can't be valued as an income-producing investment, it's unclear how to estimate the relative size of commodities vs. stocks, bonds and real estate for asset allocation purposes.
Calculating the market capitalization of stocks and bonds, and the equivalent of real estate, is fairly straightforward. That allows for informed guesses as to the passive asset allocation among those asset classes. Commodities, on the other hand, are a tricky bunch.
Commodities have no market capitalization, at least in terms of futures contracts. Long and short positions in futures always offset one another and so the market cap is always zero. That leads to a variety of tortured alternatives to figuring out the market cap equivalent of commodities so as to figure out how big the marketplace is relative to stocks, bonds and real estate. One approach is estimating global commodities total production. Another is looking at liquidity factors, open interest and other measurable variables tied to futures. Each comes with its own limitations and challenges.
For what it's worth, your editor uses what's known as total dollar value traded. This is basically the dollar value of futures contracts that change hands over a specified time frame. We'll leave it to another post to detail why. Suffice to say, it's one of many methodologies and it comes with its own peculiar share of pros and cons.
Where does that leave us? As you might expect, a passive global markets allocation gives a high weight to commodities these days, thanks to the rise in prices, which in turn has boosted the total dollar value traded of futures contracts. Mr. Market puts a much higher value on commodities in 2008, and by more than a few measures.
If you accepted the total dollar value traded numbers as is, commodities would have been valued at just under the total global market capitalization of equities at the end of last year, which implies a passive allocation of 50/50 between stocks and commodities. Clearly, that's far too aggressive for most investors, although so far the heavy weight in commodities has proven itself worthy.
Nobody knows if an aggressive weight to commodities will continue to generate high returns in a broadly diversified portfolio of the major asset classes. But this much is clear: a zero percent weighting is almost certainly extreme, and so too is a 50% weight relative to stocks. Somewhere in between is reasonable. Exactly where depends on the investor, i.e., her risk tolerance, investment goals, expectations, etc.
In short, a quantitative analysis only brings you so far in strategic portfolio design. At some point, there's nothing left to say other than: You're on your own. Caveat emptor!
Posted by jp at May 27, 2008 9:44 AM
I recognize that earnings and sales for any particular stock may be--and have been--fudged in some cases. On the other hand, earnings for stocks generally are certainly more reliable. I'm less inclined to question the earnings for the S&P 500 than for Acme Plumbing Inc.
Meanwhile, dividends paid can't be denied, for either individual stocks or markets overall. Certainly we can agree on that, which leads to the opportunity of valuing equities (and bonds via their coupon payments) on a fundamental basis, which is to say the cash flows paid to investors. Commodities, by contrast, don't pay dividends or coupons, which makes them "speculative" in the sense that the only way to value commodities is to guess what someone else will pay for them in the future. That doesn't mean commodities should ignored. In fact, I'm a big believer in the idea of always owning commodities as part of a strategic allocation. In that context, commodities don't really look speculative so much as valuable as a diversification tool.
Posted by: JP at June 2, 2008 10:04 AM
I'm not sure that investing in commodities is any more "inherently speculative" than investing in stocks. The absence of accounting reports showing earnings, sales, etc., is really irrelevant because the reports are not particularly accurate and are usually fudged to make a stock more valuable than it is.
Commodity investing, OTOH, is a true micro-economic decision. Does the price of a commodity accurately reflect the balance between supply and demand? Depending on your assessment of the state of supply and demand you can buy or sell the commodity?
Distortions in the price of a commodity are no different than in a stock. For example, by any normal stock valuation measure, GOOG is way overpriced. Yet investors continue to push it higher (even after its fall from $700 grace last year) believing that the future will bring greater earnings, profitability, even maybe dividends. This is "speculation."
The same is true right now for oil and food.
Posted by: Lilguy at May 31, 2008 11:12 AM
Given your want to quantify the size of the commodity markets through the notional value of future contracts traded, aren't you missing the bigger picture? Have you attempted to quantify the notional size of commodity swaps and like instruments currently on or off the books? Given the surprising melt down in the mortgage arena, the commodity market may not be too far behind once attempted unwinding occurs.
Posted by: Ed Gjertsen II at May 28, 2008 12:33 PM
Well written report.
I would like to add that there are a finite amount of future commodity contracts that can be purchased. If the amount of dollars chasing a limited amount of contracts increases, then the result will be an increased cost for the contract, regardless of the real value of the underlying commodity. The amount of dollars invested in commodities by Hedge Funds and Institutions over the last several years has increased substantially. In fact, it is now hard to borrow oil ETF’s because of the large outstanding short position in them. The increase in the demand for oil and food year over year for the last ten years does not correlate to the increase in the prices for the contracts on those products. Nor do the projected increases in demand year over year for the next ten years reflect the current prices on future contracts. The pricing mechanisms’ that are currently being used to price commodity futures do not take into account the amount of investment or speculative dollars chasing those contracts. The fact that prices on food futures contracts have been stable for the greater part of the last 30 years is indicative of how the hedging mechanisms’ worked in relation to the risk premium. It is only in the last couple of years that there has been a influx of speculative dollars into the commodities futures market creating a risk premium that is historically out of the normal ranges. In short; there are too many speculative dollars chasing too few future contracts.
Posted by: Michael Grace at May 27, 2008 1:21 PM