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Yesterday I wrote about the crowded short trade that boosted energy futures 40-50% from the lows of only a few weeks ago. A related crowded trade was the short-inflation trade, and it also was related to carry.
TIPS, as many readers will know, accumulate principal value based on realized inflation; the real coupon rate is then paid on this changing principal amount. As a rough shorthand, TIPS thus earn something like the real interest rate plus the realized inflation (which goes mainly to principal, but slowly affects the coupon over time). So, if the price level is declining, then although you will be receiving positive coupons your principal amount will be eroding (TIPS at maturity will always pay at least par, but can have a principal amount less than par on which coupons are calculated). And vice versa, of course – when the price level is increasing, so does your principal value and you still receive your positive coupons.
This means that, neglecting the price change of TIPS, the earnings that look like interest – those paid as interest, and those paid as accumulation of principal, which an owner receives when he/she sells the bond or it matures – will be lower when inflation is lower and higher when inflation is higher. It acts a little bit like a floating-rate security, which is one reason that many people believe (incorrectly) that FRNs hedge inflation almost as well as TIPS. They don’t, but that’s something I’ve addressed previously and it’s not my point today.
My point is that TIPS investors behave as if this carry is a hot potato. When carry is increasing, everyone wants to own TIPS; when carry is decreasing no one wants to own TIPS. The chart below (Source: BLS) shows the seasonal adjustment factor used by the Bureau of Labor Statistics to adjust the CPI. The figure implies that prices tend to rise into the summer and then decline into year-end, compared to the average trend of the year, so we should expect higher increases in nonseasonally-adjusted CPI in the summer and lower increases or even outright decreases late in the year.
Now, the next chart (Source: Enduring Investments) shows what 10-year breakevens have done over the last 16 years, on average, compared to the year’s average.
Do these two pictures look eerily similar?
From a capital markets theory perspective, this is nuts. It says that breakevens expand (TIPS outperform) when everyone knows carry should be increasing, and narrow (TIPS underperform) when everyone knows carry should be decreasing. And from a P&L perspective, a 30bp increase in 10-year breakevens swamps the change in accruals that happens as the result of seasonal changes in CPI. Moreover, these are known seasonal patterns; one should not be able to ‘outsmart’ the market by buying breakevens in January and shorting them in May. Theory says that while you’re owning negative carry, you should make it up in the rise of the price of the bond to meet the forward price implied by the carry. Nevertheless, for years you were able to beat the carry, at least if you were a first mover. (Incidentally, an investor doesn’t try to beat the average seasonal, but the actual carry implied by movements in energy too – which are also reasonably well-known in advance).
But as liquidity in the market has suffered (not just in TIPS, but in many non-benchmark securities, thanks to Dodd-Frank and the Volcker Rule), it has become harder for large accounts to do this. More importantly, the market has tended to drastically overshoot carry – either because less-sophisticated investors were involved, or because momentum traders (aka hedge funds) were involved, or because investor sentiment about inflation tends to overshoot actual inflation. Accordingly, as energy has fallen over the last year-and-a-half, TIPS have gotten cheaper, and cheaper, and cheaper relative to fair value. In early January 2015, I put out a trade recommendation (to select institutional clients) as breakevens were about 90bps cheap. The subsequent rally never extinguished the cheapness, but it was a profitable trade.
On February 11th of this year, TIPS reached a level of cheapness that we had only seen in the teeth of the global financial crisis (ignoring the period prior to 2002, when TIPS were not yet a widely-held asset class). The chart below shows that TIPS recently reached, by our proprietary measure, 120bps cheap.
But, as with energy, the short trade was overdone. 10-year breakevens got to 1.20% – an almost inconceivable level that would signal a massive failure not only of Fed policy, but of monetarism itself. Monetarism doesn’t make many claims, but one of these is that if you print enough money then you can create inflation. Since then, as the chart below (source: Bloomberg) shows, 10-year breakevens rallied about 35 bps before falling back over the last couple of days. And we still show breakevens as about 100bps cheap at this level of nominal yields.
Yesterday I noted that the structural negative carry for energy markets at present was likely to limit the rally in crude oil, as short futures positions get paid to stay short. But this is a different type of carry than the carry we are talking about with TIPS. With TIPS, the carry is caused by movement in spot energy (mostly gasoline) prices; with crude oil markets, the carry is caused by rolling futures positions forward. The TIPS carry, in short, will eventually stop being so miserable – spot gasoline is unlikely to continue to decline without bound. But even if spot gasoline stabilizes, short futures positions can still be profitable if oversupply into the spot market keeps futures curves in contango. Accordingly, while I think energy futures will slip back down, I am much more confident that TIPS breakevens have seen the worst levels we are likely to see.
Unfortunately, for the non-institutional investor it is hard to be long breakevens. The CME has never re-launched CPI futures, despite my many pleadings, and most ETF products related to breakevens have been dissolved – with the notable, if marginal, exception of RINF, which tracks 30-year breakevens but has a very small float. It appears to be approximately fair, however. Other than that – your options are to be long a TIPS product and long an inverse-Treasury product, but the hedge ratios are not simple, not static, and the fees would make this unpleasant.
However, as I wrote recently what this means for the individual investor is that there is no strategic reason to own nominal bonds now. If I own nominal Treasury bonds, I would be moving into TIPS in preference to such a low-coupon, naked-short-inflation-risk position.
Would you rather have a bar of chocolate today, or one year from today?
Most of us, if we like chocolate, would prefer to have a bar of chocolate today rather than at some point in the future. If you don’t care for chocolate, how about money? Would you rather have $100 today, or $100 next year?
The reason that Wimpy’s “I’ll gladly pay you Tuesday for a hamburger today” ploy doesn’t work is that we would prefer to have the money today compared to the money on Tuesday. If Wimpy wants his burger today, but doesn’t have the money for it, then he must borrow the money and pay that money back on Tuesday. Because of our time preference for money, this will cost Wimpy something extra, as he needs to incentivize us to part with the money today so that he can get his burger now.
This is where it gets weird.
We are now in a Wimpy world. Not only can Wimpy get his burger today, it costs him less if he borrows the money because interest rates are negative. That is, “I’ll gladly pay you less money than the burger costs, and not until Tuesday, for the burger today.” And we are enthusiastically answering, “Sure! Sounds like a great deal!”
This is one weird implication of negative interest rates. If the yield curve was flat at a negative interest rate, it would imply that the further in the future something is, the more valuable it is. A dollar next week is worth more than a dollar today. With negative discount rates, a chocolate bar next year is preferable to a chocolate bar today. And poor Wimpy…being forced to have a hamburger today when a hamburger on Tuesday would be so much better!
It gets even weirder if the yield curve is initially negative but slopes upwards and eventually becomes positive. That implies that discount rates (time preferences) are negative at first, but then flip around and become normal at some point in the future. So there is one day in the future where value is maximized, and it’s less valuable to get money after that date or before that date.
You think this is mere theory, but this is happening internally to derivatives books even as we speak. The models are implying that money later is worth more than money now, because money now costs money to have. And from the standpoint of bank funding, that is absolutely true.
Another strange implication: in general, stocks that do not pay dividends should trade at lower multiples (relative to the firm’s growth) because, being valued only on some terminal cash flow date (when a dividend is paid or when the company is bought out), they’re worth less. But now it is better for a stock to not pay dividends; those dividends have negative value. Technically speaking, this means that companies which cut their dividends should trade at higher prices after the cut.
I can think of more! Ordinarily, if your child enters college the institution will offer you an incentive to pay four years’ tuition at a reduced rate, up front (or at a frozen rate). But, if interest rates are negative, the college should demand a premium if you want to pay up front. Similarly, car companies should insist that you take out a zero-interest-rate loan or else pay a premium if you feel you must pay cash.
In this topsy-turvy world, it is good to be in debt and bad to have a nest egg.
Neighbors appreciate you borrowing a cup of sugar and frown at you when you return it.
Burglars put off burglaries. Baseball teams sign the worst players to the longest deals. Insurance companies pay out life insurance before you die.
And all thanks to negative interest rate policies from your friendly neighborhood central bank. I will thank them tomorrow, when they’ll appreciate it more.
“The market,” said J.P. Morgan, when asked for his opinion on what the market would do, “will fluctuate.”
Truer words were never spoken, but the depth of the truism as well is interesting. One implication of this observation – that prices will vary – is that the patient investor should mostly ignore noise in the markets. Ben Graham went further; he proposed thinking about a hypothetical “Mister Market,” who every day would offer to buy your stocks or sell you some more. On some days, Mister Market is fearful and offers to sell you stocks at a terrific discount; on other days, he is ebullient and offers to buy your holdings at far more than they are worth. Graham argued that this can only be a positive for an investor who knows the value of the business he holds. He can sell it if Mister Market is paying too much, or buy it if Mister Market is selling it too cheaply.
Graham did not give enough weight to momentum, as opposed to value – the idea that Mister Market might be paying too much today, but if you sell your holdings to him today, then you might miss the opportunity to sell them to him next year for double the stupid price. And, over the last couple of decades, momentum has become far more important to most investors than has value. (I blame CNBC, but that’s a different story).
In either case, the point is important – if you know what you own, and why you own it, and even better if you have an organized framework for thinking about the investment that is time-independent (that is, it doesn’t depend on how you feel today or tomorrow), then the zigs and zags don’t matter much to you in terms of your existing investments.
(As for future investments, young people should prefer declining asset markets, since they will be investing for long periods and should prefer lower prices to buy rather than higher prices; on the other hand, retirees should prefer rising asset prices, since they will be net sellers and should prefer higher prices to lower prices. In practice, everyone seems to like higher prices even though this is not rational in terms of one’s investing life.)
We have recently been experiencing a fair number of zigs, but mostly zags over the last couple of weeks. The stock market is near the last year’s lows – but, it should be noted, it still holds 84% of its gains since March 2009, so it is hardly disintegrating. The dividend yield of the S&P is 2.32%, the highest in some time and once again above 10-year Treasury yields. On the other hand, according to my calculations the expected 10-year return to equities is only about 1.25% more per annum than TIPS yields (0.65% plus inflation, for 10 years), so they are not cheap by any stretch of the imagination. The CAPE is still around 24, which about 50% higher than the historical average. But, in keeping with my point so far: none of these numbers has changed very much in the last couple of weeks. The stock market being down 10%, plus or minus, is a fairly small move from a value perspective (from a momentum perspective, though, it can and has tipped a number of measures).
But here is the more important overarching point to me, right now. I don’t worry about zigs and zags but what I do worry about is the fact that we are approaching the next bear market – whether it is this month, or this year, or next year, we will eventually have a bear market – with less liquidity then when we had the last bear market. Dealers and market-makers have been decimated by regulations and constraints on their deployment of capital, in the name of making them more secure and preventing a “systemic event” in the next calamity. All that means, to me, is that the systemic event will be more distributed. Each investor will face his own systemic event, when he finds the market for his shares is not where he wanted it to be, for the size he needed it to be. This is obviously less of a problem for individual investors. But mutual fund managers, pension fund managers – in short, the people with the big portfolios and the big positions – will have trouble changing their investment stances in a reasonable way (yet another reason to prefer smaller funds and managers, but increasing regulation has also made it very difficult to start and sustain a smaller investment management franchise). Another way to say this is that it is very likely that while the average or median market movement is likely to be similar to what it has been in the past, the tails are likely to be longer than in the past. That is, we may not go from a two-standard-deviation event to a four-standard-deviation event. We may go straight to a six-standard-deviation event.
If market “tails” are likely to be longer than in the past because of (il)liquidity, then the incentive for avoiding those tails is higher. This is true in two ways. First, it creates an incentive for an investor to move earlier, and lighten positions earlier, in a potential downward move in the market. And second, in the context of the Kelly Criterion (see my old article on this topic, here), rising volatility combined with decreased liquidity in general means that at every level of the market, investors should hold more cash than they otherwise would.
I don’t know how far the market will go down, and I don’t really care. I am prepared for “down.” What I care about is how fast.
Yesterday, I mentioned the likelihood that a recession is coming. The indicators for this are mostly from the manufacturing side of the economic ledger, and they are at this point merely suggestive. For example, the ISM Manufacturing Index is at 50.2, below which level we often see deeper downdrafts (see chart, source Bloomberg).
Capacity Utilization, which never got back to the level over 80% that historically worries the Fed about inflation, has been slipping back again (see chart, source Bloomberg).
Now, we have to be a bit careful of these “classic” indicators because of the increased weight of mining and exploration in GDP compared with the last few cycles. A good part of the downturn in Capacity Utilization, I suspect, could be traced to weakness in the oil patch. But at the same time, we cannot blithely dismiss the manufacturing weakness as being “all about oil” in the same way that Clinton supporters once dismissed Oval Office shenanigans as being “all about sex.” Oil matters, in this economy. In fact, I would go so far as to say that while historically a declining oil price was a boon to the nation as a whole (which is why we never suffered much from the Asian Contagion: the plunge in commodity prices tended to support the U.S., which is generally a net consumer of resources), in this cycle low oil prices are probably neutral at best, and may even be contractionary for the country as a whole.
Whether we have a recession in the near term (meaning beginning in the next six months or so) or further in the future, here is one point that is important to make. It will not be a “garden variety” recession, in all likelihood. That is not because we have boomed so much, but because we are levered so much. There are no more “garden variety” recessions.
Financial leverage in an economy, just as in individual businesses, increases economic volatility. So does operational leverage (which means: deploying fixed capital rather than variable inputs such as labor – technology, typically). And our economy has both in spades. The chart below (source: Bloomberg) shows the debt of domestic businesses as a percentage of GDP. Businesses are currently more levered than they were in 2007, both in raw debt figures and as a percentage of GDP.
Investors fearing recession should shift equity allocations (to the extent some equity allocation is retained) to less-levered businesses. But be careful: some investors think of growth companies as being low-leverage but tech companies (for example) in fact have very high operating leverage even if financial leverage is low. Both are bad when earnings decline – and growth firms typically have less of a margin of safety on price. I tried to do a screen on low-debt, low-PE, high-dividend non-tech companies with decent market caps and didn’t find very much. Canon (CAJ), Guess? Inc (GES) to name a couple of examples…and neither of those have low P/E ratios. (I don’t like to invest in individual stocks in any event but I mention these for readers who do – these aren’t recommendations and I neither own them nor plan to, but may be worth some further research if you are looking for names.)
On the plus side, economically-speaking, relatively heavy personal income taxation also acts as an automatic stabilizer. On the minus side, this is less true if the tax system is heavily progressive, since it isn’t the higher-paid employees who tend to be the ones who are laid off (except on Wall Street, where it is currently de rigueur to cut experienced, expensive staff and retain less-experienced, cheaper staff). Back on the plus side, a large welfare system tends to be an automatic stabilizer as well. On the minus side, all of these fiscal stabilizers merely move growth from the future to the present, so the deeper the recession the slower the future growth.
And, of course – there is nothing that central banks can really do about this, unless it is to make policy rates negative to spur additional extension of negative-NPV loans (that is, loans to less-creditworthy borrowers). I am not sure that even our central bank, with its unhealthy fear of the cleansing power of recession, thinks that’s a good idea.
There is some good news, as we brace for this next recession: while overall levels of debt are higher for businesses, financials, and households, the debt burden compared to GDP is lower for households and especially for domestic financial institutions (see chart, source Bloomberg).
Our banks are in relatively good health, compared with their condition headed into the last downturn. So this will not be a calamity, as in 2008. But I don’t expect it to only be a “mild” recession, either – as if any recession ever feels mild to individuals!
Whoever is selling stocks these days is really appreciative of those who are pushing the market higher. Thanks to overnight rallies in China and Japan on Tuesday night, US stocks launched higher at the open on Wednesday. Now, neither the modest rally in Shanghai (led by official buying) and the bigger rally in Japan (on Prime Minister Abe’s pledge to cut corporate taxes next year) had the slightest thing to do with items that impact the US, but the rally led a wave that rolled through futures markets around the globe until about seven minutes after traditional stock trading hours opened in New York, when the high of the day was set. The next six-and-a-half hours saw a 440-point decline in the Dow and around 50 in the S&P to a net loss of about 1.4% on the day.
“Gee, thanks!” said the pension fund guys who got to unload stocks about 3% higher than they otherwise would have. Who says the fast money monkeys don’t have salutatory effects?
The clue that today’s rally was not going to be sustained was actually in the energy markets. Prior equity oscillations had been mirrored with quite reasonable fidelity in the last week or two, but this morning energy markets were noticeably flat-to-down. Equities soon joined them.
Now, yesterday I mentioned that real yields are near their highest levels of the last five years, and that nominal yields are essentially in the middle of that range. I didn’t illustrate the latter point; but see below (source: Bloomberg).
So it is clear, to me, where you would rather place your bets in fixed-income: with real yields around 65bps and nominal yields at 2.20, you only want to own nominal bonds if inflation is less than 1.55% for ten years. Note that if inflation is negative, then you do approximately the same with TIPS as with nominal bonds, since in both cases your nominal principal is preserved. So it is a narrow set of circumstances in which you do better owning nominals, and you don’t do much better. On the other hand, there are long tails on the other side: ways that by owning TIPS you will do dramatically better.
I mention this, even though both nominal bonds and TIPS offer poor prospective returns, because it is the time of year when seasonally it is difficult to lose by owning fixed-income. The chart below (source: Bloomberg) shows the average change in nominal 10-year yields over the course of a calendar year for the last 30 years (gold), 10 years (white), and 5 years (red). Note that this isn’t a pure seasonal chart because it doesn’t correct for the average drift over the course of the year, but it suffices to show that buying bonds after the early-September backup has been a good strategy for many years…really, until the last five years, and even then it was a push between mid-Sep and mid-Nov.
So what I want to do in a period of uncertainty, headed into the fourth quarter, is to own TIPS, either outright or via an ETF like TIP. If the market comes unglued, then all interest rates should decline; if the market drops because real growth is weakening, then real rates should fall more than nominal rates (and in any event, owning TIPS gives you the positive tail exposure I mentioned above). If the market turns around and rallies, then energy probably recovers somewhat and this will help TIPS compared to nominals. But in any event, I am reducing risk into a very risky period.
I am not one of those people who believe that if the Fed is dramatically easing, you simply must own equities. I must admit, charts like the one below (source: Bloomberg), showing the S&P versus the monetary base, seem awfully persuasive.
But there are plenty of counter-examples. The easiest one is the 1970s, shown below (source: FRED, Bloomberg). Not only did stocks not rise on the geyser of liquidity – M2 growth averaged 9.6% per annum for the entire decade – but the real value of stocks was utterly crushed as the nominal price barely moved and inflation eroded the value of the currency.
If you do believe that the Fed’s loose reins are the main reason for equities’ great run over the last few years, then you might be concerned that the end of the Fed’s QE could spell trouble for stocks. For the monetary base is flattening out, as it has each of the prior times QE has been stopped (or, as it turns out, paused).
But for you bulls, I have happy news. The monetary base is not the right metric to be watching in this case. Indeed, it isn’t the right metric to be watching in virtually any case. The Fed’s balance sheet and the monetary base both consist significantly of sterile reserves. These reserves affect nothing, except (perhaps) the future money supply. But they affect nothing currently. The vast majority of this monetary base is as inert as if it was actually money sitting in an unopened crate in a bank vault.
What does matter liquidity-wise is transactional balances, such as M2. And as I have long pointed out, the end of QE does nothing to slow the growth of M2. There are plenty of reserves to support continued rapid growth of M2, which is still growing at 6% – roughly where it has been for the last 2.5 years. And those haven’t been a particularly bad couple of years for stocks.
So, if liquidity is the only story that matters, then the picture below of M2 versus stocks (source: Bloomberg) is more soothing to bulls.
Again, I think this is too simplistic. If ample liquidity is good today, why wasn’t it good back in the 1970s? You will say “it isn’t that simple.” And that’s exactly my point. It can’t be as easy as buying stocks because the Fed is adding liquidity. I believe one big difference is the presence of financial media transmitted to the mass affluent, and the fact that there is tremendous confidence in the Fed to arrest downward momentum in securities markets.
What central bankers have done to the general economy has not been successful. But, if you are one of the mass affluent, you may have a view of monetary policy as nearly omnipotent in terms of its effect on securities and on certain real assets such as residential real estate. What is different this time? The cult.
I am no equity bull. But if you are, because of the following wind the Fed has been providing, then the good news is: nothing important has changed.
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.