February Newsletter: The Commodity Markets Just Went Through Their Version of a Depression - Here's What We Can Learn.

Posted by Alex Frey (@alexhfrey )

One of the best-known investment prognosticators of the last decade was “commodity-bull” Jim Rodgers, who obtained celebrity—like status by consistently predicting a period of rising commodity prices that he called a “commodity supercycle.” 

The blurb for Rodger's 2004 book Hot Commodities read “The next bull market is here. It's not in stocks, it's not not in bonds, it's in commodities... and some smart investors will be riding that bull to record returns in the next decade.” 

For a while, Rodgers seemed prescient, and was invited on all of the financial TV shows to share his expertise. He is still credited with “calling” the commodity supercycle and makes regular appearances on CNBC, Bloomberg, and others.

Given his celebrity, you would think that an investor that heeded Rodger's call would have made a lot of money over the twelve years since the publication of his book, right? Better than what the investor could or should could have done by investing in stocks or bonds at least, right?

It's instructive to walk through the various commodity markets to find out. 

We start with oil. Figure 1 shows the price of oil for the last five years and from 1987 to present. 

Over the last year and a half, prices have dropped from circa $110/barrel to circa $30/barrel. This is an incredible drop which was predicted by almost no one. A drop of this magnitude has a major effect on the world economy, sharply reducing income in oil producing nations and saving many billions of dollars in oil importing nations. However, viewed from a slightly longer perspective, the years between 2000 and 2013 appear to be unusual. Oil prices rose dramatically in this period and are only now returning to about where they were in 2004 – the year Rodgers made his call.

Figure 1: The price of Brent oil from 2011 to present (left) and from 1987 to the end of 2015 (right). Prices have declined about another $10/barrel as of 1 February 2016. 


Many back then were arguing that the breakout of oil prices from their 1980 – 2005 range heralded the start of a “commodity supercycle.” It is still possible that prices will recover and this argument will remain true – but at the current time a second possibility is that 2005-2015 was actually the aberration – a time when abnormal growth from emerging markets temporarily overdrew oil inventories – and that prices are now headed back to their old trading range. Time will tell. 

A logical question to ask is what factors possibly could have caused a barrel of oil to go from being worth $30 to nearly $150 and then back again all in a 15 year period?

Before getting to this, let's take a look at some other commodities. Many other commodities have had similar, if less dramatic, recent declines. Figure 2 shows the price of copper over the last five years and over a longer period. The picture is remarkably similar to that for oil. In the case of copper, the decline began sooner, in 2011, and has been slightly less severe, but as with oil, there was a price explosion in the 2000 to 2011 time frame. 


Figure 2: The global price of copper over the last five years (left) and since 1980 (right)

Many other commodities show a similar pattern: strong increases in the 2000 to 2010 period and strong decreases more recently. Figure 3, 4, and 5 show similar patterns for iron, silver, and aluminum. The data for iron is particularly interesting, because the rise in price in the early 2000s was particularly strong. Silver presents a slightly different picture in that it had a strong but brief run-up in price in the late 70s when inflation was very high in the U.S. Silver is an industrial commodity, but it also has a history as a monetary asset, and many people consider it to be an inflation hedge. In any case, the history of silver for the last 20 years reflects the same trends as other commodities. The data given for aluminum is somewhat different in that the aluminum price has been very volatile over the years, but the trend of a peak around 2010 and decline since is apparent.


Figure 3: Global price of iron ore for the past five years (left) and over a longer period (right).


Figure 4: Global price of silver for the past five years (left) and over a longer period (right). Data comes from goldprice.com.


Figure 5: Global price of aluminum for the past five years (left) and over a longer period (right).

One might think that agricultural commodities would move to a different beat, but in fact they have also followed the same general trend. Figures 6, 7, and 8 show the data for corn, wheat, and soybeans. The volatility is somewhat greater than with most of the industrial commodities, but the peak in the 2008 to 2012 time period is evident (despite a marked drop in 2010).


Figure 6: The global price of corn over the past five years (left) and since 1980 (right).


Figure 7: The global price of wheat over the past five years (left) and since 1980 (right).


Figure 8: The global price of soybeans over the past five years (left) and since 1980 (right).

As a commodity, gold is somewhat different in that its industrial uses are minimal and its value is largely as a monetary asset and an inflation hedge. As such, its value reflects sentiment about inflation more than anything else. But, in recent years, it has followed the same pattern as other commodities, as shown in Figure 9. The peak occurred a little later than it did with most other commodities, and the decline after the peak has been somewhat less, but the general pattern is the same.


Figure 9: London gold price over the past five years (left) and since 1980 (right).

All of this raises several questions that we will need to address before returning to the matter of Roders and his prediction.

The first is why are all of these commodities behaving in basically the same way? Shouldn’t the supply demand characteristics of different commodities be somewhat different? In truth, the curves are not identical, so there clearly are differences, but the similarity is great enough to look for underlying causes. One factor commonly cited by the media is the weakness or strength of the US dollar. Although many pundits have been predicting its demise for years, the dollar has gained strength against other currencies recently. Figure 10 shows value of the dollar versus other major currencies. To some extent, the value of the dollar in recent years has been the reverse of commodity prices. It declined in the years from 2000 to 2010 and has increased since then. However, the magnitude of the changes are too small to explain the movement in commodity prices.


Figure 10: The value of the dollar versus a broad trade weighted group of other currencies (left) and against major currencies (right).

A bigger explanation for this behavior lies in the rapid growth of China. From 2000 to 2011, the Chinese economy grew at the incredibly rapid rate of 10.4% per year (inflation adjusted). Writing in Bloomberg View, Gary Shilling states that “From 2000 to 2014, China’s share of global copper consumption leaped to 43 percent from 12 percent. China's portion of iron ore purchases similarly zoomed to 43 percent from 16 percent, while aluminum went to 47 percent from 13 percent.” China’s appetite for commodities is the principle reason for the rapid growth in prices from 2000 to 2010. Now, growth in China has slowed. The Chinese government is reporting current growth rates in the vicinity of 7%, and some people believe that the real growth rate is lower. While this is slower than in the recent past, it is still quite fast and certainly doesn’t, by itself, explain the recent drop in prices. 

Of course, economic growth has also been slow in Europe and Japan (and to a lesser extent in the U.S.). However, overall demand for most commodities is not falling. What seems to have happened, not surprisingly, is that the rapid growth in price in the early 2000s stimulated rapid growth in supply, and supply has now gotten ahead of demand. This is illustrated by the situation with iron, which is depicted in Figure 11. The left side of this chart shows the growth in production and prices from 2001 to 2007. The right side makes the point that most of this new production was going to China. So, the capitalist system did what it is supposed to do: When demand is tight, higher prices bring about higher production and that eventually causes prices to fall. In the present situation, falling prices for industrial commodities seems to have caused falling expectations for inflation, and this in turn causes falling prices for gold and silver.


Figure 11: World iron ore production and price (left) and growth in seaborne shipments of iron ore (right).

The second question is what are commodity prices likely to do in the future? The issue will likely be decided by demand in China. If Chinese growth is slower than the government claims, prices may fall even further. Otherwise, less efficient commodity producers will leave the market and prices are likely to rebound to some extent. 

Finally, what has this done and what will it do to stock prices? In principle, we have been observing a great shift in wealth from commodity producers to commodity consumers. So, one might expect that the developing country stock markets would be falling and developed country stock markets would be rising. The first half of this statement is true. The Vanguard Emerging Markets Index fund has fallen by 27% over the last year. However, the developed markets aren’t doing very well either. The Vanguard European Stock Index Fund has fallen 16% over the past year, and the Vanguard Total Stock Market Index Fund, which tracks the total U.S. market, has fallen about 9%. Of course, the U.S. and Europe have commodity producers as well as commodity consumers. The producers feel the pain of falling prices immediately, but the consuming companies may take some time to realize the benefits. In any case, we believe that low commodity prices are positive for the developed country markets and especially for the U.S. market. Of course, other factors influence market prices, and the U.S. market was very fully priced at its peak, so this may counteract any benefits from falling commodity prices. 

Back to the matter of Jim Rodgers' "prophetic" prediction. In 2004 when Rodgers was writing his book, oil was trading around $40 dollars a barrel. We know it went into the triple-figures over the next five years, so his timing at least was pretty good. But you would have had to get out at the right time to make money following his calls - this past week it was at about $30 a barrel, a 25% decrease over the entire period. Copper was trading at around $1.50 per pound when Rodgers got bullish. Recently it was at $2.00, a 33% increase over twelve years. Platinum is relatively flat over the period. 

What about stocks and bonds -- the asset classes that Rodgers singled out as "not" being the next bull market? Over the same time period the Vanguard Total Stock Market ETF (VTI) went from 54 to 96, an 80% return. An intermediate-term Treasury Bond ETF was up 40% over the same period, while paying out interest the whole time. So it seems an investor that followed Rodger's strategy may have actually lost money over twelve years, while one that bought stocks and bonds (the two things he was saying would not have a bull market) would have done quite well.   

We pick on Rodgers to make a larger point about how we should cope with a world in which one year can wipe out all of the gains of the previous ten, in which a career-making call can seemingly overnight turn into a money-losing call, in which no one's “genius” is safe from the vagaries of the markets. 

As to be expected, our response is not to call Rodgers either “dead wrong” or a “genius”, but rather to suggest that the vast majority of individual investors would be much better off ignoring these kinds of clarion “calls” altogether, and instead saying diversified, staying dynamic, and controlling what they can by minimizing the expenses they pay. Following this strategy might not have made for as interesting of cocktail-party talk as going all-in on commodities, but it would have gotten much better returns at a fraction of the volatility. 

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By Alex Frey