The Great Commodities Bull of the 00's
Adam Hamilton April 27, 2001 4670 Words
Buy Low Sell High. These four simple words summarize millennia of financial truth. They are the pinnacle of wisdom of virtually infinite amounts of data and knowledge collectively gleaned on markets by humankind all throughout our history. They are the great “secret” of multiplying the assets to which we have been entrusted in the global marketplace. They impart a timeless truth so simple and profound that a child can understand it, yet from many sad historical episodes we know that most adults forget these words every few generations and get ensnared in a supercycle speculative mania.
Buying low and selling high sounds so simple. This timeless truth is implemented in different ways by different investment philosophies but the end goal is always the same… to multiply one’s assets. At the most basic and macro level, there are two camps of investors… the conventional investor and the contrarian investor.
Conventional investors are easy to find. They are everywhere. Conventional investors tend to follow trends and move with the herd, and are only comfortable throwing their capital at a market once it has already rallied substantially. This philosophy is also known as momentum investing. A conventional investor looks for last quarter’s or last year’s hot sector or stocks, and then reasons, “Well, this sector is hot and doing great so it will probably continue to do well into the future”, a linear assumption. Conventional investors are generally not concerned about archaic concepts such as valuation and price, as they focus on the boundless opportunities always presented by the future.
By their very nature, conventional investors tend to be followers, not leaders. They want evidence that a bull trend is already well established before they commit any capital. If an investment is over-priced relative to the cashflow it can spin-off for its owners, that is not a problem, as the conventional investor is a hardcore optimist and always assumes that it will be worth more in the future. Conventional investors usually end up buying “high” based on historical fundamentals and hoping to sell “higher” in the future. Taken to its logical extreme, history has amusingly labeled this investment philosophy “the greater fool theory”. The general idea is price and value don’t matter at the time of purchase because one can always find a “greater fool” to sell to at a higher price sometime in the undefined future.
In contrast to the legions of conventional investors galloping through the world markets, there is a relatively small group of investors known as contrarians. Contrarians are the black sheep who move “contrary” to the crowd and conventional market fashions. Contrarians seek to really literally implement the “buy low sell high” market wisdom. Contrarians want to buy when investments are cheap from a fundamental perspective. Of course, usually the only time investments are fundamentally cheap is when most investors have totally deserted and rejected a fire-bombed sector of the market. It takes a great deal of courage to be buying when “conventional wisdom” says a particular sector or market is doomed.
Contrarians seek to sell when markets reach mania proportions. When the general investing public grows really excited and frenzied about a particular sector or market, chances are it is near its top and the contrarians have already sold, realizing massive profits.
Contrarians are often dedicated students of financial market history. They realize that “new eras” happen over and over and over again, seducing the naive to their doom. Contrarians also believe that markets are cyclical and no trend runs forever. Markets become loved and wanted and they get overvalued. When fundamentals reach mania extreme levels, the markets are sold hard and they collapse. After the collapse, valuations are lower than normal as no one wants to jump back into the market in which many were just burned. Contrarians believe that the accumulated wisdom of all human financial market experience in history is more relevant than the lofty claims and hype of any one particular era.
Interestingly, in endless prominent academic studies of financial market history, the only investors who virtually always make money are the contrarians. Since the contrarians truly “buy low”, when no one else wants an investment, it is hard to lose capital. Since the contrarians “sell high”, they are almost always out in the early stages of a mania before a speculative bubble bursts. Conventional investors on the other hand, according to voluminous historical evidence, tend to buy very late in a bull market and then hold onto their investments through the burst and most of the way down to the ultimate bear market bottom in the bust.
While the general investing public is not usually familiar with the contrarian investment philosophy, they are familiar with its adherents. If one was to assemble a list of the ten greatest investors and speculators of our era, the list would probably be almost exclusively contrarians. The most famous contrarian alive today, and one of the wealthiest men on the planet because he learned how to practically implement “buy low sell high” is the legendary Warren Buffet. Interestingly, if one goes back through market histories of all the western nations, the names remembered by the history books are always the contrarians, those brave souls audacious enough to ignore the crowd and buy and sell based on fundamentals alone.
Fortunately for investors, wonderful macro large-scale contrarian investment opportunities generally occur every decade or so.
In the 1970s one could have made immense profits by buying up gold and commodity related stocks and ultimately selling when commodities went parabolic in the late 1970s. Realized gains of far more than 100 times one’s initial investment abounded for those who bought the last commodities boom near the bottom and sold near the top.
In the 1980s the legendary returns of the decade were found in equities, primarily consumer stocks. Some of the best performers of the decade included Circuit City, Home Depot, Wal-Mart, and Hasbro. Of course, to buy in near the bottom in 1982 an investor had to have great courage and HAD to be a contrarian, because the stock markets were universally hated and loathed in the early 1980s. At that time, the general public was enamored with commodities such as gold that had already topped. It took a special breed of investor to jump into equity markets when newsmagazines were widely heralding “the death of stocks”.
In the 1990s the ultimate place to park capital was technology stocks. The leaders of the last ten years are well known today. They include Dell, Cisco, America Online, and CMGI. All of these stocks exhibited trough to peak gains of over a mind-boggling 60,000%. Everyone today is well aware of the monumental extremes of the final gasps for breath of the tech bubble as it topped, but it took great courage to buy virtually unknown tech stocks back in the early 1990s. The US economy was in a recession, Papa Bush was busy raising taxes and bombing Iraq, oil was spiking, and the equity markets were still uneasy over the dramatic 1987 correction.
Most tech stock investors did not jump on the bandwagon until VERY late in the great tech bull, 1998 to early 2000. It took even more courage to sell the mania in early 2000, and longtime contrarian investors and fund managers who sold in late 1999 or early 2000 BEFORE the burst were often ridiculed and made fun of in the financial press. Conventional investors claimed the contrarians who sold the mania just “did not get it” and “do not understand we ARE in a new era”. Of course, one short year later we look back at the attacks on contrarians and chuckle, as the ones who sold extreme overvaluation in NASDAQ tech stocks were the smart ones and now EVERYONE wishes they had sold the tech mania when it went parabolic in early 2000.
The critical question for all investors today is… WHERE will the next boom be? In 2010, when we look back on the “double O’s”, where will we all wish we had deployed capital to reap the bountiful harvests of the great bull market of the decade? The investors fortunate enough to answer this question correctly today will have hundreds or thousands of times as much real capital in ten years as they have today… king’s ransoms will be won by the folks on the right side of this macro trade.
From where is the next mega-bull going to emerge and stampede to undreamed of heights in the coming decade? We believe there is a very high probability that the answer is COMMODITIES.
Commodities?!?! you say? But no one invests in commodities anymore! But commodities have declined in price for decades! But commodities are abundant and cheap! But commodities are so old-fashioned in our high technology world! But commodities are dead! But! But! But!
But exactly. Commodities are hated and loathed right now by conventional investors. Commodities are out of favor. Commodities are not sexy. Commodities are not lusted after at the moment. Capital has abandoned commodities. It is enough to warm the contrarian heart!
The all-important philosophy to remember for truly stellar investing, as everyone instinctively knows, is “buy low sell high”. Warren Buffet delightfully fleshes this out in his timeless market quote, “Be brave when others are afraid and afraid when others are brave.” Where are the vast majority of investors afraid of investing right now? Commodities.
You can execute your own quick and dirty empirical study on this assertion. Turn on bubblevision or a financial news program and record the amount of time spent discussing equities and tech stocks in particular. Compare this with the amount of time spent discussing commodities. Next do a web search for “investing”. For every Internet destination you are able to find for commodities investing, you will probably first have to slog through 10,000 on tech stock investing.
NO ONE can deny the fact that commodities are terribly out of favor right now, that the hearts and minds of the thundering herds of investing masses are still lusting after the tech stocks of old, yesterday’s game. The contrarians are looking out over the horizon, hand to their brow, trying to determine where capital will flow in the future, the next investing Great Game, not where speculative capital has sloshed in the past.
Of course, our assertions that commodities are cheap and unloved are meaningless without data to back them up. We ALWAYS encourage our clients and friends to do their own due diligence, to investigate themselves, and to not take our words (or anyone’s) for it. We encourage you to do the same. Do your own research. Do NOT believe some analyst just because she is on bubblevision or just because he writes a newsletter. Study history, study markets, study valuation, study supply and demand fundamentals, and then draw your own conclusions.
In order to gather tangible evidence that commodities are indeed undervalued and near a long-term bottom, there is no better place to start than the important Commodities Research Bureau Commodities Index.
The CRB index is without a doubt the most widely followed basket of commodities in the United States, and probably in the world. The CRB index was created in 1957 and currently contains 17 commodities, which we call the CRB 17. There are probably hundreds of other major commodities traded around the world, but the CRB 17 are generally representative of the whole commodities market. Just as the NASDAQ composite index is the most popular index to quickly measure the general health of the tech stock sector, the CRB index is the tool of choice to quickly glean the general level of commodity prices. When you ask a professional about general commodity price levels, they will inevitably mention the current state of the CRB index.
We are indebted to our contrarian value-oriented commodity investing friends at the Di Tomasso Group (www.ditomassogroup.com) for undertaking an utterly fascinating and tremendously important historical study of the CRB 17. They took the CRB 17 commodities and analyzed their individual price levels since 1921. They then created a hypothetical CRB index made up of the 17 commodities going back in time well before the official CRB index was born in 1957. Finally, they adjusted the CRB for inflation over the last 80 years yielding a constant real average commodity price level of the CRB 17 commodities basket.
The following graph is a summary of the fruit of Di Tomasso’s research labors. It shows the general real commodity price level from 1921 to today, with 1.0 on the graph equaling 1921 price levels. Please study this graph carefully.
In inflation-adjusted terms, the CRB 17 commodities, which represent the commodities markets as a whole, are near ALL-TIME lows! Remember the pinnacle of market wisdom, buy low sell high? Investing in commodities today in 2001 near an 80 year real low is certainly likely to be a near a major bottom! Since 1921, at least, there has never been a better buying opportunity in terms of the CRB 17 commodity basket.
Another critical point to note in addition to the absolute low of current real commodity price levels is the perpetually cyclical nature of the commodity markets. Observe the two great macro rallies in commodities of the last 80 years, denoted by the curved red lines. The first great commodities boom in the graph roared heavenwards shortly after the massive speculative equity bubble of 1929 imploded. In the brutal investing environment between the great 1929 crash and World War 2, commodities witnessed spectacular gains.
Hmmmm… is it just us or is anyone else detecting some deja vu here? A massive speculative equity bubble is bred, and commodities are sold off to major lows as the equity bubble grows and bursts, leaving its grisly aftermath. From the ashes of the stock market carnage, investors, once blinded by lust for the hot sector that led the bubble mania charge, realize that other crucial areas for the well-being of the economy were neglected as capital chased the popular bubble sectors. They realize that prices of commodities are WAY too low, often below the cost of production, and that commodity production and distribution infrastructure is falling apart because it couldn’t attract capital during the equity boom. Investors, only contrarians at first, begin to realize that human beings NEED commodities to survive and thrive, and that a decade or two of underinvestment HAS to be remedied to take the overall economy, which is highly commodity dependent, to the next level. This 1929 bubble burst to a mega-commodity rally scenario sounds eerily familiar TODAY, for some odd reason, but we just … can’t … quite … place … it.
Although most of us were merely children or a gleam in our father’s or grandfather’s eye during the first macro commodities rally of the last 80 years, virtually every long-time investor trading the markets today remembers the second spectacular commodities rally very well. The 1970s.
In the wild and crazy years of the 1970s, equity markets breached terrible bear market lows. OPEC nations had their act together and were agreeing to limit production of oil, inflation was raging as the money supply grew at previously unimaginable rates following the US default on the gold dollar, the Islamic world was trying to invade and destroy the tiny nation of Israel yet again for the third time, and commodity infrastructure had been ignored during the go-go stock market days of the mid to late 1960s. In this environment, which also sounds eerily familiar, commodities exploded in the 1970s.
While the aggregate CRB more than doubled in inflation-adjusted real terms as the graph above shows, individual commodities showed much larger gains and commodity related equities showed staggering gains, in some cases exceeding 100-fold runups in price. The only folks who realized these full gains, however, as usual, were the fearless contrarians.
It took a non-conventional investor to sell equities in the late 1960s when the stock market was doing really well. It took great courage to buy into commodities in the early 1970s, well before the average investor realized where the speculative money was going to slosh to next. It took even greater foresight and wisdom to sell into the resulting frothy commodity superbull of the late 1970s to realize legendary profits.
With our strategic historical perspective on the CRB, and there is no arguing commodities are now out of favor and prices are dismal in the aggregate, let’s drill down and look at the CRB 17 from a more tactical 10 year perspective. The CRB 17 commodities are equally weighted in the CRB index, and broadly divided into Metals, Tropicals, Grains, Meat, and Energy. The following graphs show inflation-adjusted real charts of each individual CRB 17 commodity from 1990 to the present. Prices are all in constant 2001 dollars.
Looking at decade-long price charts of CRB metals, it is obvious they have all been hammered in the 1990s. Even platinum, which has witnessed an awesome early-stage rally in the last year and a half or so is still far below its 1990 levels. Gold, of course, is widely believed to be artificially suppressed by a few western governments and central banks, for self-serving reasons, and is likely to explode at any moment.
The important strategic information to glean from all these CRB 17 graphs presented together in terms of this essay, however, is to REALIZE that commodities have been mercilessly pummeled in the 1990s. Many are at or near all time real lows, and many are at or near their cost of production. From a macro-contrarian perspective, is now the time to buy or sell commodities in general? Is this a classic “buy low” strategic investment play?
The CRB tropicals have also been roughed up pretty viciously in recent years. Notice all the trends, whether decade or several year trends, are DOWN, marked by the red arrows. Orange juice, which is not shown here, is the fifth CRB tropical commodity, and its chart is shown below in a subsequent graph.
In the Great Plains of the United States, where I hail from, the commodity markets have been extremely hard on those unbreakable men and women trying to scrape out a living by feeding America and the world. Wheat, corn, and soybeans, the CRB grains, are doing horribly, and are at major real lows. Cattle, one of the two CRB meats (hogs are graphed below), while rallying recently, remain near real lows. If anyone thinks crucial foodstuff commodities are not important to our modern world and its ever-ballooning population, try fasting for 40 days and see if your opinion changes. Agricultural commodity prices at or below their cost of production for most farmers and ranchers are NOT sustainable and will be forced to move up by irresistible free market supply and demand forces.
Moving on to the CRB energies, we finally see some positive commodity developments. Natural gas rocketed to an all-time real and nominal high last autumn, and after its parabolic spike it has fallen and currently is fairly stable at levels two and half times as high as recent historical norms.
This positive natural gas chart is actually really illustrative of commodity cycles in general. Since natural gas was dirt-cheap for so many years, producers were not encouraged to develop new supplies. Many oil drilling operations simply burned natural gas in great flares to get rid of it, and some used injection wells to store “waste” natural gas underground. Because natural gas prices had been low for years, natural gas consumers simply assumed that supplies were abundant and the status quo would remain forever. Electric utilities, forced by rabid environmentalists to shy away from nuclear or coal power, migrated en masse to clean, cheap natural gas.
With very low gas prices, gradually consumers increased their demand tremendously while capital invested in new production and distribution waned. Since there were minimal profits in cheap gas, capital went elsewhere and the gas market stagnated. All the while, like a ticking time bomb, demand was growing and growing. Finally, in 2000, there was not enough natural gas to go around, yet electric utilities and consumers alike demanded huge quantities of it.
The only solution, so elegantly described by Adam Smith two centuries ago, was the “invisible hand” of free markets had to push up the price of natural gas high enough so supply would meet demand. Higher prices attack supply/demand imbalances simultaneously on two fronts. First, higher prices retard general demand for a commodity. Second, higher prices entice out new production which increases supply. The net effect is a higher, stabilized commodity price at a new higher market clearing equilibrium price point.
The recent natural gas rally is a textbook example of how things usually work in commodities. There is over-investment during the boom phase (the 1970s for many commodities), and eventually much excess productive capacity comes online which floods the markets with supply and causes the bust, and prices plummet (1980). With low prices, few new production or distribution systems are built and gradually demand grows large enough to eclipse current supplies and fully utilize the now decaying infrastructure laid in during the earlier boom phase, and the commodity price is forced up as demand exceeds supply (the 2000s). A new boom occurs, culminating in a speculative commodity bubble (2010?), and the cycle begins anew like a phoenix rising from its ashes.
Jumping back to the graph above, heating oil has also seen recent rallies, but it is nowhere near real highs. The CRB tropical orange juice is having a tough time, as well as the “other white” CRB meat, pork. Of course, that may be because who wants to eat a pig when they can score a mouth-watering, exquisite, corn-fed beef filet mignon steak? Yummmm!
The final CRB 17 commodity is also a CRB energy, the ubiquitous crude oil, arguably the single most important commodity for the complex interconnected world economy today.
Now we all know from watching the news that oil is expensive, right? Wrong. In real terms, oil is still hovering around 1990 levels before Saddam Hussein got surly and decided to rob his neighbors. The yellow dashed line above represents the oil trend sans Gulf War. Even AFTER the incredible rally that began in 1999, crude oil is STILL only slightly above parity with real prices throughout most of the 1990s.
Of course, after Saddam ran out of playground space for his war games and moved his armored columns south into the appealing sandbox of Kuwait, oil spiked dramatically, reaching prices in today’s dollars of far over $50 per barrel. The trend from those real Gulf War oil highs to current price levels is obviously down, marked by the red line.
Interestingly, conditions today in crude oil are much like the early 1970s, with a few tiny unresolved issues remaining between the Muslims and the Jews. In 1973, the Islamic world was growing tired of Israel again, and it had been six years since the last time it launched an invasion to attempt to drive the Jews into the Mediterranean Sea in the 1967 surprise attack. So the Muslims invaded again on the holiest day of the Jewish year, Yom Kippur 1973. Miraculously, the miniscule nation of Israel expelled the Soviet-equipped Muslim hordes that attacked from Syria and Egypt, to the world’s amazement. OPEC, consisting of almost exclusively Islamic nations, was not happy at the loss in its ancient Jihad and the perceived support of Israel by the West, so it cut oil supplies, the great Arab Oil Embargo of the 1970s.
With OPEC still controlling global oil production at the margin and hence global prices, and finally getting its act together to cooperate again today, do you think Islamic nations like Saudi Arabia, Iran, Iraq, Libya, and Kuwait will sit by the wayside as the ages old Islamic-Jewish conflict in Israel heats up yet again? Will there be another Islamic oil embargo in the coming years to show solidarity to their “Palestinian freedom fighter” brothers still trying to destroy Israel? Another topic for another essay, but the key point to realize is that oil is NOT expensive right now in real terms, but it will be in a matter of weeks if there are any major supply disruptions like a new Middle East war.
To review, we have discussed the time-tested and fire-proven contrarian philosophy of “buy low sell high”, analyzed the cyclical nature of the commodities markets over the last 80 years, and zoomed in tactically to survey the carnage and lows in individual commodities. The weight of evidence strongly suggests commodities are cyclical, they are very low in price, and they are due for a mega rally. Two final questions remain… Why will commodities increase in price? And when should commodities be sold to realize vast profits in the coming bull?
Commodity prices will be forced to rise initially by pure supply and demand fundamentals. When a particular commodity price is low, as we discussed above with natural gas, demand rises and supply dwindles. Eventually, prices have to rise as production cannot keep up with consumption demand. The initial rallies in the coming commodities bull are likely to be mostly supply and demand based, such as the rally from 1999 lows of the crude oil market.
After a few years of supply and demand based rallies, speculative capital will once again lust after commodities as it has so many times in human history. At that stage in the coming commodities bull, commodity price increases will begin to spiral up, faster and faster, as fresh capital pours into the markets. Eventually, once most of the professionals are in, the general conventional investing public will see the commodity price gains and think “wow, that is the place to be and we better invest”. By this time the commodity bull will be in its late stages and nearing its ultimate bubble blow-off parabolic phase.
When to sell the coming great commodity bull of the 2000s? At that exact mania stage. When all your neighbors are jumping into the “hot commodities market”, and bubblevision plays commodity news 24 hours a day, and financial magazines focus almost exclusively on commodities, and the shoe-shine boy at the airport is telling you about the next hot commodities stock IPO, that is when to “sell high”. The commodities bubble top is probably 7-9 years away right now, but there will be no mistaking it when we see it. Any thinking investor who lived and traded through the NASDAQ bubble of 2000 will never again wonder how to recognize a speculative mania bubble!
Bottom line? We believe that the commodities market has a high probability of being THE great destination for capital in the coming decade. Like all bull markets, this coming commodities boom will began relatively slowly. The first ones in will be the brave contrarians who recognize true value in a market area that has been nuked and laid to waste. Gradually, as the 00’s progress, the commodities bull will gather more and more steam as more and more individual commodities rally and reach new highs. Ultimately, speculative capital will gravitate to the ever-increasing returns on commodities, commodities equities, and commodities derivatives, driving prices even higher. Finally, in the late stages of the bull market, the casual conventional investor will desperately throw in their lot, dumping massive amounts of capital into the markets that will push commodity prices to red-hot parabolic extremes.
Enough money can and will be made in the coming commodities bull to last a lifetime, and those in early and out early (before the ultimate bubble collapse) will likely be the new “Masters of the Universe” on Wall Street in 2011.
Remember, all market wisdom is distillable into four simple words, Buy Low Sell High. Imagine knowing what we know now about tech stocks back in 1990, and having a chance to saddle-up and ride the 1990s tech bull market from near trough to peak… We believe a similar macro-contrarian buy opportunity exists TODAY in beaten-down commodities.
Adam Hamilton, CPA April 27, 2001 Subscribe at www.zealllc.com/subscribe.htm