It is amazing to reflect on the fact that the stock market last week experienced its worst 5-day span to open the year ever. I haven’t independently confirmed that; it seems incredible to me that in a hundred and whatever years we have never started with a 6% loss – but that is what is being widely reported. In any event, it has been a bad start and the market is back to the levels it last saw in August, before the inexplicable Q4 blast-off. Easy come, easy go.
Why is the market down? The harder question is the question of why it was up in the first place. Stocks have been persistently far above fair value measured by CAPE, Tobin’s Q, or any other traditional value metric. The argument that stocks were high because bond yields were low is perhaps the best explanation; this is after all part of the whole “portfolio balance channel” effect that the Fed has been trying to create with QE – raise the price of a good (bonds) and the prices of substitutes (corporate bonds, stocks) should also rise. (Left unsaid, of course, is why it is a good thing to move asset prices away from fair value. The ‘wealth effect’ is small, and zero-sum at best unless prices can permanently be moved away from fair value.)
But if this is the explanation for sky-high stocks, it doesn’t explain why commodity indices – which are obviously also a substitute for stocks and bonds – are at multi-decade lows. Why should the price of that substitute move in the opposite direction? Before you say “weak global growth,” or “overproduction” (as this article has it) remember that not only is oil low, but so is Corn. And Hogs. And Sugar. And Cocoa. What, are we overproducing everything? Is China not eating, either?
I actually really like that article. When oil was at $120, everyone (including fancy Wall Street dealers) published breathless articles about $200 oil. Today I saw an article saying oil is going to $10 – which would be the lowest real price, I think, since oil was discovered. This article could have been written any time in the last 20 years and pointed to some new mine, or crop production technique, or oil field, or railroad, or the development of horizontal drilling, etcetera. It’s just when prices are very low that this is suddenly viewed as an epiphany that Aha! This must be why prices are low! There are big mines opening!
There are, of course, some problems of overcapacity in some commodities because cheap money made possible, for example, the massive draws from Baaken shale. But overcapacity in every commodity? Overcapacity in gold?
And global growth is, indeed, weakening. I would caution any analyst that wants to read into the surprising strength of Friday’s Payrolls report. It is a December measurement of the employment picture: notoriously difficult to seasonally adjust. Some have argued that exceptionally warm weather in December may have increased payrolls beyond what the seasonal adjustment calls for. I am not sure that argument works, since most of the seasonal adjustment is due to seasonal workers and I am not sure why you need more seasonal workers if it is warm. More in construction, perhaps…but the important point is that the error bars on the December are so large that you are supposed to ignore it in almost all circumstances. You simply cannot reject virtually any null hypothesis. What you believed before the number was released, in other words, you should still believe. And as for me, I believed that global growth was weakening – not collapsing, but weakening and probably headed for a recession.
And what a shame. What a shame that central bankers didn’t re-load when they had the chance, and let markets and economies get back to normal. What a shame that the federal deficit wasn’t pushed close to balance when the economy was growing over the last few years.
As David Bowie almost said, [What a] shame [they]’ve left us up to our necks in it.
But if in reaching that conclusion you have come to hate commodities along with stocks, you have come too late. Commodities were worth hating four years ago. But it is hard to see the upside of their downside, now.
This is not true, however, with equities.
An uneducated fellow was laid up in bed with a broken leg. The vicar’s wife, visiting him, asked what he did to pass the time, since he was unable to read and couldn’t leave the bed. His answer was “sometimes I sits and thinks, and sometimes I just sits.”
The reason I haven’t written a column since the CPI report is similar. Sometimes I sits and writes, and sometimes I just sits.
That isn’t to say that I haven’t been busy; far from it. It is merely that since the CPI report there really aren’t many acts left in the drama that we call 2015. We know that inflation is at 6-year highs; we know that commodities are at 16-year lows (trivia question: exactly one commodity of the 27 in the Goldman Sachs Commodity Index is higher, on the basis of the rolling front contract, from last year. Which one?)
More importantly, we know that, at least to this point, the Fed has maintained a fairly consistent vector in terms of its plan to raise interest rates this month. I maintained after the CPI report that the Chairman of the Federal Reserve, and at least a plurality of its voting members, are either nervous about a rate hike or outright negative on the desirability of one at this point. I still think that is true, but I also listen. If the Fed is not going to hike rates later this month, then it would need to telegraph that reticence well in advance of the meeting. So far, we haven’t heard much along those lines although Yellen is testifying on Thursday before the Congressional Joint Economic Committee; that is probably the last good chance to temper expectations for a rate hike although if the Employment data on Friday are especially weak then we should listen attentively for any scraps thereafter.
The case for raising rates is virtually non-existent, unless it is part of a policy of removing excess reserves from the financial system. Raising rates without removing excess reserves will only serve to accelerate inflation by causing money velocity to rise; it will also add volatility to financial markets during a period of the year that is already light on market liquidity, and with banks providing less market liquidity than ever. It will not depress growth very much, just as cutting rates didn’t help growth very much. So most of all, it is just a symbolic gesture.
I do think that the Fed should be withdrawing the emergency liquidity that it provided, even though the best time to do that was several years ago. Yes, we know that Chinese growth is slowing, and US manufacturing growth is slowing – the chart below, source Bloomberg, shows the ISM Manufacturing index at a new post-crisis low and at levels that are often associated with recession.
To be fair, we should observe that a lot of this is related to the energy sector, where companies are simply blowing up, but even if the global manufacturing sector is heading towards recession, there is no need for emergency liquidity provision. Actually, as the chart below illustrates, banks have less debt as a proportion of GDP than they have in about 15 years.
Households have about as much debt as they did in 2007, but the economy is larger now so the burden is lower. But businesses have more debt than they have ever had, in GDP terms, other than in the teeth of the crisis when GDP was contracting. In raw terms, there is 17% more corporate debt outstanding than there was in December 2008. Banks have de-levered, but businesses are papering over operational and financial weakness with low-cost debt. Raising interest rates will cause interest coverage ratios to decline, credit spreads to widen, and net earnings to contract – and with the tide going out we will also find out who has been swimming naked.
In 2016, if the Fed goes forward with tightening, we will see:
- Lower corporate earnings
- Rising corporate default rates
- Rising inflation
- Lower equity prices; higher commodity prices
- Banks vilified. I am not sure why, but it seems this always happens so there will be something.
All of that, and raising rates the way the Fed wants to do it – by fiat – does not reduce any of the emergency liquidity operations.
To be clear, I don’t see growth collapsing like it did in the global financial crisis. Banks are in much better shape, and even though they cannot provide as much market liquidity as they used to – thanks to the Volcker rule and other misguided shackles on banking activities – they can still lend. Higher rates will help banks earn better spreads, and there will be plenty of distressed borrowers needing cash. Banks will be there with plenty of reserves to go. And if the financial system is okay, then a credit crunch is unlikely (here; it may well happen in China). So, we will see corporate defaults and slower growth rates, but it should be a garden-variety recession but with a deeper-than-garden-variety bear market in stocks.
The recipe here is about right for something that rhymes with the 1970s – higher inflation (although probably not double digits!) and low average growth in the real economy over the next five years, but not disastrous real growth. However, that ends up looking something like stagflation, which will be disastrous for many asset markets (but not commodities!) but doesn’t threaten financial collapse.
 This story is attributed variously to A.A. Milne and to Punch magazine, among others.
 Cotton is +3% or so versus 1 year ago.
Officially, Crude Oil has had the worst bull market ever.
According to a headline on Bloomberg on Monday, Crude is in a bull market. The headline screamed “WTI CRUDE CLOSES UP 29% FROM AUG 24 LOW, ENTERS BULL MARKET”! On Tuesday, after a 7.7% fall from Monday’s close (-100%, annualized), the bull market doesn’t seem so…well, ebullient.
Okay, sure, this is a pet peave of mine. I don’t know whose idea it was to call a 20% advance from the prior low a bull market, and a 20% decline from the prior high a bear market, but I am pretty sure that they didn’t intend for that 20% to be applied to all markets, at all times. So a 5-year Treasury Note is not in a bear market until it falls 20 points (or…is that 20% of the current yield? I guess it depends who writes the headlines!), but energy futures which can move 20% in a couple of days, or corn futures which can double literally overnight if there is a drought, can be in bull and bear markets a couple of times per month. Does this make sense?
Add to this the obvious absurdity of the idea that we can know in advance whether an asset is in a bull or bear market. If you are telling me that Crude rallying 20% off the lows means that it is in a bull market, and that means I can be long Crude comfortably, knowing it is likely to rally from here – then you need to quit telling me anything and go make a fortune trading.
We can only know a bull market or a bear market in hindsight. That is, even if 20% is the magic number (and I can’t think of why that would be so), the best we can say is that Crude was in a bull market on Thursday, Friday, and Monday when it rallied about 27%. Does that help us, going into Tuesday?
The recent commodities sell-off has been breathtaking. This is especially true since the most-recent downturn occurred from a level where the expected future returns from commodity index investment were reasonably good – and, as a spread above expected equity or bond returns, probably around the best levels ever.
But investors have a strong tendency to use the current level, rather than some esoteric measure of value, as the level from which expected market moves are evaluated. What I mean by that is this: in theory, if some event happens in the capital markets, the reaction in the market should depend on whether that event has already been “discounted” in the current price. That is, if we are all expecting Microsoft to raise its dividend, then the price of Microsoft should reflect that change already, and when it subsequently actually happens it should have no effect on price. Indeed, if the market has overestimated the change in fundamental value, then the price of Microsoft should retrace somewhat when the news is actually announced. From that, we get the old saw that one should “buy the rumor, sell the news.”
The fact that this isn’t really what happens is not exactly news. In the early 1980s, Bob Shiller demonstrated that the volatility in the equity marketplace was much greater than the changes in the real underlying values should support.
In practice, investors don’t behave rationally. The same event can be discounted over, and over, and over again. Each investor, it seems, hears news and assumes the current price does not incorporate that news, no matter what has happened previously to the price. Based on my own unscientific observation, I think this is more true now that there are more retail investors, and news outlets that benefit from making everything sound like new information. If my supposition is true, one implication is that markets can deviate further and further from fundamental values. In other words, we get more bubbles and inverse bubbles than we would otherwise.
As a great current example, we might consider commodities. The slowdown in China’s economic activity is discounted anew almost every day, as more information comes out from that country that its economic engine is (at least) sputtering. One would think that China was the only consumer of industrial metals and energy, and that its consumption is going to zero, based on the behavior of these markets. And with every tick higher in the dollar, every commodity seems offered. It’s risk-off, then risk-off again, then risk-off again, ad infinitum.
Now, there is no doubt that commodities in 2008 were overvalued, and arguably in 2011 they were also expensive. But the four-year beat-down of commodities – pretty much the only asset class that has declined in value over that time period – is breathtaking in its depth and, as it turns out, its breadth. I was curious about whether the recent break of major commodities indices to new lows – below the lows of 2008, when it felt like the world was ending (see chart above, source Bloomberg) – was broader, in that it seemed like every commodity was participating. So I put together a chart that shows the proportion of commodities (considering only the 27 major traded commodities that are in the Bloomberg Commodity Index) that were above their 200-day moving averages. The chart is below (Source: Enduring Investments).
It isn’t quite as bad as I had thought. The recent slide has taken the proportion back to 18% (meaning 82% are below their 200-day moving averages), but commodity prices have been sliding for so long that the 200-day averages are now generally declining pretty smartly. Notice in general the post-2011 average, compared to the pre-2008 average. Even without seeing the price chart, you can tell the 2011-2015 bear market from the 2002-2008 bull market!
One other observation about commodities, to be fair. The chart I showed, above, of the Bloomberg Commodity Index, incorporates carry in commodities. That is, it adds the futures roll, and collateral return, to the movement in spot commodities. Over the last few years, the collateral return hasn’t been very good and the roll return has actually been substantially negative, so that the return of spot commodities has in fact been better than the return to commodity indices. The chart below (source: Bloomberg) shows the Bloomberg Spot Commodity Index; you can see that we are still above the 2008 lows.
Being “above the 2008 lows” doesn’t strike me as a strong performance. Stocks are also above the 2008-09 lows, by 200% or so. LQD, the investment-grade bond ETF, is about 45% higher. HYG, the high-yield ETF, is 41% higher. Heck, M2 money supply is around 50% higher than it was in early 2009.
And yet, every time we hear more news about China, investors behave as if it is new information, and sell commodities off some more. As I said above, these moves can last longer these days than they did in the past – but this is unsustainable. With commodities, an added complexity is that investors don’t know how to evaluate expected return (since there are no cash flows), and so it is hard for them to compare “value” to other asset classes. But the value is there.
Money: How Much Deflation is Enough?
Once again, we see that the cure for all of the world’s ills is quantitative easing. Since there is apparently no downside to QE, it is a shame that we didn’t figure this out earlier. The S&P could have been at 200,000, rather than just 2,000, if only governments and central banks had figured out a century ago that running large deficits, combined with having a central bank purchase large amounts of that debt in the open market, was the key to rallying assets without limit.
That paragraph is obviously tongue-in-cheek, but on a narrow time-scale it really looks like it is true. The Fed pursued quantitative easing with no yet-obvious downside, and stocks blasted off to heights rarely seen before; the Bank of Japan’s QE has added 94% to the Nikkei in the slightly more than two years since Abe was elected; and today’s announcement by the ECB of a full-scale QE program boosted share values by 1-2% from Europe to the United States.
The ECB’s program, to be sure, was above expectations. Rather than the €50bln per month that had been mooted over the last couple of days with little currency-market reaction, the ECB pledged €60bln. And they promised to continue until September 2016, making the total value of QE around €1.1 trillion. (That’s about $1.3 trillion at today’s exchange rate, but of course if it works then it will be much less than $1.3 trillion at the September 2016 exchange rate). To be sure, a central bank always has the prerogative to change its mind, but on the risks of a sudden change in policy please see “Swiss National Bank”. It really is remarkable that Draghi was able to drag the Bundesbank kicking and screaming into this policy choice, and it is certain to end the threat of primary deflation in Europe just as it did in the U.S. and in Japan. It will likely also have similar effects on growth, which is to say “next to nothing.” But in Europe, deflation risks stemming from slow money growth had been a risk (see chart, source Bloomberg).
Interestingly, y/y money growth had already been accelerating as of late last year – the ECB releases M2 with a very long lag – but this puts the dot on the exclamation point. The ECB has said “enough!” There will be no core deflation in Europe.
Commodities: How Much Deflation is Enough?
Last week, in “Commodities Re-Thunk” and “Little Update on Commodities Re-Thunk”, I presented the results of using a generalization of the Erb & Harvey approach to forecast expected long-term real returns for commodities. It occurred to me that, since I have previously played with long-term real equity returns, and we have the real yield on 10-year TIPS as well, that it would be interesting to see if using these figures might produce a useful strategy for switching between assets (which doesn’t change the fact that I am a long-term investor; this is still based on long-term values. We merely want to put our assets in whatever offers the best long term value at the moment so as to maximize our expected long-term return).
The answer is yes. Now, I did a more-elegant version of what I am about to show, but the chart below shows the results of switching 100% of your assets between stocks, commodities, and TIPS based on which asset class had the highest expected real yield at a given month-end. Each line is an asset class, except for the blue line which shows the strategy result.
The labels at the top show the asset class that dominated for a long period of time. In 2005 there were a couple of quick crossovers that had little impact, but by and large there were three main periods: from 1999-2005, commodities offered excellent expected real returns; from mid-2005 through early-2008 the strategy would have been primarily in TIPS, and subsequent to that the strategy would have been primarily in equities. Fascinating to me is that the overall strategy does so well even though it would have been invested in equities throughout the crash in 2008. The crash in commodities was worse.
Now what is really interesting is that there is a vertical line at the far right-hand side of the chart. That is because at the end of December, the expected real return to commodities finally exceeded that of equities for the first time in a very long time. For this “selling out” strategy, that means you should be entirely out of stocks and TIPS and entirely in commodities.
As I said, that is the coarse version of this approach. My more-elegant version optimized the portfolio to have a constant expected risk in real terms. It was much less risky as a result (10.5% annualized monthly standard deviation compared to 15.5% for the strategy shown above), had lower turnover, but still sported returns over this period of 9.5% compounded compared to 11.2% for the strategy above. I am not, in other words, suggesting that investors put 100% of their assets in commodities. But this method (along with lots of other signals) is now suggesting that it is time to put more into commodities.
Balls: How Much Deflation is Enough?
Being a football fan, I can’t keep from weighing in on one mystery about deflate-gate (incidentally, why do we need to put ‘gate’ on the end of every scandal? It wasn’t Water-gate, it was the Watergate Hotel that proved Nixon’s undoing. “Gate” is not a modifier). Really, this part isn’t such a mystery but I have seen much commentary on this point: “How did the balls get deflated during the game since they were approved before the game?”
The answer is really simple in the real world: the official picked up one of the balls, said “fine”, and put them back in the bag. He has a million things to do before the championship game and in years of refereeing he has probably never found even one ball out of spec. This sort of error happens everywhere there are low reject rates, and it’s why good quality control is very difficult. (Now, if you fired the ref every time a bad ball got through, you damn betcha those balls would be measured with NASA-like precision – which is perhaps a bad metaphor, since similar issues contributed to the Challenger disaster). The real mystery to me is: if the Patriots truly think they are the better team, why would they cheat, even a little? As with the CHF/EUR cross that we discussed yesterday, the downside is far worse than the gain on the upside.
Or, is it? The NFL will have a chance to establish the cost of recidivism in cheating. Maybe the Patriots were simply betting that the downside “tail” to their risky behavior was fairly short. If the NFL wants to put a stop to nickel-and-dime cheats, it can do that by dropping the hammer here.
I want to talk about commodities today.
To be sure, I have talked a lot about commodities over the last year. Below I reprise one of the charts I have run in the past (source: Bloomberg), which shows that commodities are incredibly cheap compared to the GDP-adjusted quantity of money. It was a great deal, near all-time lows this last summer…until it started creating new lows.
Such an analysis makes sense. The relative prices of two items are at least somewhat related to their relative scarcities. We will trade a lot of sand for one diamond, because there’s a lot of sand and very few diamonds. But if diamonds suddenly rained down from the sky for some reason, the price of diamonds relative to sand would plummet. We would see this as a decline in the dollar price of diamonds relative to the dollar price of sand, which would presumably be stable, but the dollar in such a case plays only the role of a “unit of account” to compare these two assets. The price of diamonds falls, in dollars, because there are lots more diamonds and no change in the amount of dollars. But if the positions were reversed, and there were lots more dollars, then the price of dollars should fall relative to the price of diamonds. We call that inflation. And that’s the reasoning behind this chart: over a long period of time, nominal commodities prices should grow with as the number of dollars increases.
Obviously, this has sent a poor signal for a while, and I have been looking for some other reasonable way to compute the expected return on commodities. Some time ago, I ran across an article by Erb and Harvey called The Golden Dilemma (I first mentioned it in this article). In it was a terrific chart (their Exhibit 5) which showed that the current real price of gold – simply, gold divided by the CPI price index – is a terrific predictor of the subsequent 10-year real return to gold. That chart is approximately reproduced, albeit updated, below. The data in my case spans 1975-present.
The vertical line indicates the current price of gold (I’ve normalized the whole series so that the x-axis is in 2015 dollars). And the chart indicates that over the next ten years, you can expect something like a -6% annualized real return to a long-only position in gold. Now, that might happen as a result of heavy inflation that gold doesn’t keep up with, so that the nominal return to gold might still beat other asset classes. But it would seem to indicate that it isn’t a great time to buy gold for the long-term.
This chart was so magnificent and made so much sense – essentially, this is a way to think about the “P/E ratio” for a commodity” that I wondered if it generalized to other commodities. The answer is that it does quite well, although in the case of many commodities we don’t have enough history to fill out a clean curve. No commodities work as well as does gold; I attribute this to the role that gold has historically played in investors’ minds as an inflation hedge. But for example, look at Wheat (I am using data 1970-present).
There is lots of data on agricultural commodities, because we’ve been trading them lots longer. By contrast, Comex Copper only goes back to 1988 or so:
Copper arguably is still somewhat expensive, although over the next ten years we will probably see the lower-right portion of this chart fill in (since we have traded higher prices, but only within the last ten years so we can’t plot the subsequent return).
Now the one I know you’re waiting for: Crude oil. It’s much sloppier (this is 1983-present, by the way), but encouraging in that it suggests from these prices crude oil ought to at least keep up with inflation over the next decade. But do you know anyone who is playing oil for the next decade?
For the sake of space, here is a table of 27 tradable commodities and the best-fit projection for their next 10 years of real returns. Note that most of these fit a logarithmic curve pretty reasonably; Gold is rather the exception in that the historical record is more convex (better expectation from these levels than a pure fit would indicate; see above).
I thought it was worth looking at in aggregate, so the chart below shows the average projected returns (calculated using only the data available at each point) versus the actual subsequent real returns of the S&P GSCI Excess Return index which measures only the return of the front futures contract.
The fit is probably better in reality, because the actual returns are the actual returns of the commodities which were in the index at the time, which kept changing. At the beginning of our series, for example, I am projecting returns for 20 commodities but the 10-year return compares an index that has 20 commodities in 1998 to one that has 26 in 2008. Also, I simply equal-weighted the index while the S&P GSCI is production-weighted. And so on. But the salient point is that investing in spot commodities has been basically not pretty for a while, with negative expected real returns for the spot commodities (again, note that investing in commodity indices adds a collateral return plus an estimate 3-4% rebalancing return over time to these spot returns).
Commodities are, no surprise, cheaper than they have been in a long while. But what is somewhat surprising is that, compared to the first chart in this article, commodities don’t look nearly as cheap. What does that mean?
The first chart in this article compares commodities to the quantity of money; the subsequent charts compare commodities to the price level. In short, the quantity of money is much higher than has historically been consistent with this price level. This makes commodities divided by M2 look much better than commodities divided by the price level. But it merely circles back to what we already knew – that monetary velocity is very low. If money velocity were to return to historical norms, then both of these sets of charts would show a similar story with respect to valuation. The price level would be higher, making the real price of commodities even lower unless they adjusted upwards as well. (This is, in fact, what I expect will eventually happen).
So which method would I tend to favor, to consider relative value in commodities? Probably the one I have detailed here. There is one less step involved. If it turns out that velocity reverts higher, then it is likely that commodities real returns will be better than projected by this method; but this approach ignores that question.
Even so, a projected real return now of -2% to spot commodities, plus a collateral return equal to about 1.9% (the 10-year note rate) and a rebalancing return of 3-4% produces an expected real return of 2.9%-3.9% over the next decade. This is low, and lower than I have been using as my assumption for a while, but it is far higher than the expected real returns available in equities of around 1.2% annualized, and it has upside risk if money velocity does in fact mean-revert.
I will add one final point. This column is never meant to be a “timing” column. I am a value guy, which means I am always seen to be wrong at the time (and often reviled, which goes with the territory of being a contrarian). This says absolutely nothing about what the returns to commodities will be over the next month and very little about returns over the next year. But this analysis is useful for comparing other asset classes on similar long-term horizons, and for using useful projections of expected real returns in asset allocation exercises.
 In what follows, I will focus on the expected return to individual spot commodities. But remember that an important part of the expected return to commodity indices is in rebalancing and collateral return. Physical commodities should have a zero (or less) real return over time, but commodity indices still have a significantly positive return.