Market Observation with James J Puplava CFP

James J Puplava CFP

Unloved, Undervalued and Underowned

By James J Puplava CFP, January 24, 2005

unloved undervalued and underownedIf you have ever taken an investment course, read a book about investing, or talked to an investment advisor, you've been made aware of the importance of diversification. Diversification means different things to different people. To some it’s having money in stocks, bonds, and cash. To others it’s owning stocks in different sectors. To many it means owning domestic as well as foreign stocks and bonds. Diversification is used as a means of reducing risk. Yet today the application of diversification strategies is seriously flawed. Most advisors simply put their clients in diversified portfolios primarily made up of paper assets.

The basic elements of modern portfolio theory emanate from Professor Harry Markowitz as outlined in his 1959 paper "Portfolio Selection: Efficient Diversification of Investments."[1] The central theme of Markowitz's work is that rational investors should conduct themselves in a manner which reflects their inherent aversion to absorbing increased risk without compensation by an adequate increase in expected return. Risk was defined by Markowitz as the uncertainty, or variability of returns measured by the standard deviation of returns around the mean. Starting with the conception of risk and the assumed aversion to risk, investors should try to minimize deviations from expected portfolio returns by diversifying their security selections. This meant holding either different types of securities and/or securities of different companies. Markowitz pointed out that holding different issues wouldn't significantly reduce risk if the different securities contained a high degree of positive covariance. What Markowitz meant by that statement is that if the different securities held in the portfolio all moved in the same direction and magnitude or if their price movements were similar, risk would not be reduced.

To reduce risk in a portfolio it would be important to own securities that did not fluctuate in similar fashion. If one component of the portfolio was moving down, you would want to own assets that moved in the opposite direction. In other words, various components of the portfolio should be negatively correlated.

Markowitz's approach to investing has been criticized from both a theoretical and practical point of view. The greatest criticism relates to the assumption that rational investors are risk averters. In the bubble markets of the 1990s and the bubble markets of today investors have shown remarkable and consistent behavior in ignoring risk. One only has to look at stocks such as Google and Yahoo!, which sport triple digit P/Es. Then there are the IPOs such as last year's Marchex, which had only $23 million in sales and no earnings and yet the stock sports a $500 million market cap. Irrational behavior isn't confined only to individual investors. Professionals have been buying these stocks in addition to high risk assets such as junk bonds and foreign sovereign bonds with low credit ratings. The result is that credit spreads have narrowed considerably. So today's high risk investments offer very little in the way of a premium for taking on higher risk.

This criticism of Markowitz doesn't invalidate the concept of negatively correlated assets as a means of reducing risk. If everything in the portfolio moves in the same direction, then risk is not reduced. To reduce risk, various assets held in a portfolio should be negatively correlated. The investment class that is negatively correlated to stocks and bonds is commodities. In their research paper "Facts and Fantasies About Commodity Futures" professors Gary Gorton of Wharton and K. Geert Rouwenhorst of Yale show conclusively that commodities are negatively correlated with equity and bond returns. The main reason is due to the business cycle. The other is that commodities are positively correlated with inflation, unexpected inflation, and changes in expected inflation.[2]

In their study of investment markets and commodities from 1954-2004 the professors found the following:

  1. Commodity futures were negatively correlated with returns on the S&P 500 and long-term bonds.
  2. The negative correlation between stocks and bonds increase with the holding period.
  3. Commodity futures returns are positively correlated with inflation.[3]

What the professors showed from their research was that commodities as an asset class were negatively correlated to paper asset classes. When the financial markets did well as they did between 1982-2000 commodities did poorly. When paper markets performed poorly as they did in 2000-2002 commodities produced positive returns. This has a lot to do with the business cycle and inflation, which I will get to in a moment. More importantly, what the professors' work illustrated is that as an asset class commodities performed well when they were needed the most. As shown in the graph below, commodities produced a positive return when stocks and bonds were performing poorly.

sp500 and reuters crb index 1979-2004
Chart courtesy, Ron Greiss note that the grey areas are noted as recessions

Commodities and Inflation

They did well in 1980, 1985-87, 1998-99, and in 2001-2004. These were periods of rising inflation and dollar weakness and periods of monetary expansion. When inflation begins to rise and the dollar declines, traditional assets such as stocks and bonds perform poorly. Inflation threatens the returns from fixed assets such as bonds eroding their purchasing power. They also threaten the returns from stocks. Inflation increases raw material and labor costs, which increases costs for companies and thereby reducing profit margins. Because of increased competition, these costs may not be able to be passed on to customers and therefore reduce company profit margins.

This correlation can be seen in the most recent profit reports from the third and fourth quarter of last year. Many companies reported higher costs, which couldn't be completely passed on to the consumer or customer. This was evident with companies like Alcoa, Kimberly-Clark, and GM. Companies are having to pay more for raw materials, health care costs and for energy. While they are able to raise prices, they aren't able to raise prices sufficiently to recover cost increases so margins shrink which reduces profits. In addition to rising costs, unexpected inflation can produce negative shocks to aggregate output, which is also negative news for equities.

The Business Cycle

business cycle phasesAnother reason that fits well with explaining the better performance of commodity type investments during periods of inflation is the nondiversifiable component associated with beta and the Capital Asset Pricing Model. This relates to the business cycle. Stocks and bonds perform poorly at the peak of a business expansion and during the early stages of a recession. As shown in the graph below of the business cycle, as the economy recovers and expands, this is a period when profits rise and interest rates fall. This is good for profits, which produces higher stock prices. Another influence on stocks and bonds is falling interest rates. Once an economy falls into recession, monetary policy becomes expansionary. The Fed reduces interest rates and expands credit through the banking system. Falling interest rates reduce the cost of borrowing and artificially increases the return from capital investments. This produces an economic boom. The increase in the supply of money and credit in the economy increases demand, which leads eventually to higher rates of inflation in either asset prices or in the cost of goods and services. As inflation rates heat up, the Fed is forced to curtail its expansionary policies by raising interest rates and contracting credit.

During various stages of the business cycle various asset classes perform differently. As shown in the graph above stocks and bonds begin to perform poorly at the peak of a business cycle as the Fed begins to raise interest rates. Stock and bond returns are also negative during the early phases of a recession. In contrast to stocks and bonds, commodities produce positive returns at the peak of a business cycle and during the early stages of a recession.

Examining the returns over seven business cycles from 1959 to the present, the professors quote the works of Weiser. In his study of seven business cycles, Weiser produced the following results in his study of asset classes:

  1. Between July 1959 and March 2004 average monthly returns on the S&P 500 and equally weighted commodity futures were remarkably similar at 10.8%, and 10.5%, respectively.
  2. They are also similar over economic expansions with 12.8% returns for the S&P 500 and 12.9% on equally weighted commodity futures.
  3. During late stages of expansion when stock and bond returns are below average commodity returns are positive and outperform both stocks and bonds.
  4. During the early stages of recession stocks, bonds and commodity returns are negative -15.5% and -2.9% respectively. By comparison the returns on commodity are positive by 3.5%. [4]

Defining this relationship further the professors looked at individual commodity returns during each phase of the business cycle. They found that certain commodities performed well during the late stages of an expansion and the early phase of a recession, but did poorly as the recession hit a trough. Specifically, energy, industrial materials, base metals, and food did particularly well. This can be seen not only in returns from individual commodities, but also from the performance of companies that produce them.

xom rtp bg 24 jan 2005

commodity futures 1962-2002

The study of commodity futures showed a positive correlation between commodities and their related equities. However, the performance of futures has been triple the cumulative performance of matching equities until recently. As the charts of ExxonMobil, BHP, and Bunge illustrate, stocks have performed relatively well in comparison to their respective commodities and in certain circumstances have performed even better.

A good example is the returns on Bunge in comparison to the performance of the commodities it processes: corn, wheat, and soybeans.

I believe the recent performance of commodity-related equities has a lot to do with our equity culture and the amount of money sloshing around the globe. Not all investors are sophisticated enough or knowledgeable enough to invest in commodity futures, so commodity equivalents are sought. There are only a few commodity related funds at this time - Rogers Raw Material, Pimco Commodity Real Return, and Oppenheimer Real Asset Fund, so investors and fund managers may find it more convenient to invest in commodity-related equities. In a world where asset markets from currencies to stocks and bonds have grown to tens of trillions of dollars, the commodity market is small by comparison. Commodities trade over $2 trillion dollars a day so on the surface the market is large. But imagine what would happen to the silver or gold markets, if only 5% of the money now held in stocks and bonds went into silver and gold bullion! We would be talking about prices considerably higher than where they are today. Therefore, I believe that commodity-related equities can do well in this environment.

As this new bull market in "things" as I like to call commodities unfolds, I'm sure the various exchanges will be coming out with commodity-related ETFs, so choices for investors will expand. However, we are just in the beginning stages of this new bull market that has much longer to run. What is important for investors to understand at this point is that every portfolio should include some form of commodity-related investments as a true means of diversifying a portfolio. As the chart above shows, commodity-related investments are inversely related to the returns on equities and bonds. If all you have in your portfolio is stock and bonds that are not commodity-related, then you really aren't diversified. If paper assets perform poorly as they did during 2000-2003, you need to be in other asset classes, especially those that perform well in recessions and periods of inflation or dollar devaluation. A chart of the S&P 500 Index, the US Dollar Index, and the Amex Gold Bugs Index (HUI) illustrates this point.

spx usd hui 24 jan 2005

The Fundamentals

risk premium asset classPerhaps you may be asking yourself or your investment advisor has told you that rising gold, oil, and various commodity prices are just a fluke. You need to dig deeper and your advisor (salesman) needs to give you a better explanation. If you don't own energy, precious metals, food, water, or base metal stocks in your account, you should ask why. As professors Gorton and Rouwenhorst have demonstrated in their research, commodity-related investments whether it is futures or matching equities are negatively correlated with equity and bond returns. They outperform general equities and bonds at the peak of a business cycle, which is where we are now and during the early stages in a recession, which is where we are headed. As far as risks are concerned, stocks and commodities are more volatile than bonds. To say commodity investments are risky and to not say the same for general equities is a falsehood. As shown in the graph of risk premiums taken from the Gorton/Rouwenhorst study, the risk are almost equal between futures and stocks.

I would argue it is even less for commodity-related companies such as an ExxonMobil or other high dividend paying resource stocks. As I wrote in a previous Observation from last year (see Trading Places) some of the best total returns (dividends plus capital appreciation) have been realized from the natural resource sector. As pointed out in Trading Places, utilities and natural resource stocks like energy have outperformed or exceeded the returns from the technology sector. They not only have outperformed, but have provided investors higher dividend yields that keep growing.

capital gains versus total returns

In his new book to be released this spring professor and author Jeremy Siegal argues that one of the biggest mistakes made by investors is overpaying for stocks. In their enthusiasm to embrace the latest rage or fad, investors pay too high a price resulting in poor returns. Siegal illustrates this by comparing the total return on IBM and Standard Oil of New Jersey now ExxonMobil going back to 1950. Both stocks did well over this time period, however the returns on ExxonMobil were 14.4% per year versus IBM's 13.8%. IBM was considered to be the premier growth stock of that era. Nevertheless, a $1,000 investment in IBM grew to 958,000. The same $1,000 invested in ExxonMobil grew to $1,260,000 some 25% greater.

The reason ExxonMobil outperformed IBM was because Exxon paid a higher return and sold for a much lower P/E multiple than IBM. The average P/E for Exxon was half of IBM's. In addition to a lower P/E multiple, ExxonMobil (then Standard Oil of New Jersey) offered a higher dividend yield enabling an investor who reinvested those dividends to accumulate 15 times as many shares. The combination of higher dividends and lower P/E multiple resulted in far superior returns with less risk.

Supply and Demand

While the lower P/E multiples and higher dividend yields of the resource sector look far more attractive than anything else in today's overvalued equity markets, there is another reason to own resource stocks. Plain and simple: they are in a new bull market. This new bull market in commodities is bound to be with us for a long, long time. The reason is basic; it’s called supply and demand. There is simply more demand for commodities than there is supply. Demand has steadily increased each year as the world's population grows and emerging markets industrialize. At the same time that demand keeps growing, supplies of commodities are declining. Most major commodities are running a supply deficit that is made up of above ground stockpiles that are diminishing.

These supply deficits are the result of a long and protracted bear market in commodities. The laws of supply and demand dictate that when supplies are plentiful prices decline. However, when supplies are allowed to be depleted and demand continues to increase, the result is rising prices and a new bull market. In this regard the global supply-and-demand imbalance is completely out of sync. China is short just about every commodity it consumes from rice and soybeans to iron ore, steel, copper, and cement. What we now have occurring globally is the simultaneous industrialization of emerging economies such as China and India, which are now competing for commodities with the developed countries. The result is that demand is exploding at the same time that supplies are diminishing.

stock prices since 1871-2004
Click here to enlarge

Source: All formats Barry Bannister, Legg Mason Wood Walker, Inc. Used by permission of Barry Bannister. For the U.S. stock market index: For the period 1871 to present the Cowles Commission U.S. stock market composite data from Standard & Poor's Corporation are joined with S&P 500 12-month annual average prices. For the PPI for All Commodities: For data from 1871 to 1890, the Warren & Pearson study, a U.S. commodity average constructed from the following components: farm products, foods, hides and leather, textiles, fuel and lighting, metals and metal products, building materials, chemicals and drugs, household furnishing goods, spirits, and other commodities. For the periods 1891 to 1913, the source is the Wholesale Commodities Price Index from the Bureau of Labor Statistics (BLS) and other agencies. For the period 1914 to present, the source is the PPI for All Commodities modern series.

Over the last two decades of the bull markets in stocks very little money went into maintaining or expanding the natural resource sector. Money flowed into Wall Street and Silicon Valley. The financial sector of the economy expanded, while the natural resource sector of the economy contracted. It has been close to 30 years since there has been a major oil discovery of equivalent size such as Prudhoe Bay or the North Sea. It has been equally as long since the last oil refinery was built in the U.S. In fact the number of oil refineries operating in the U.S. has dropped in half. At the same time the production of oil and natural gas in the western world, especially the U.S., has fallen consecutively each year. In addition to the supply of resources it has been decades since we've built a nuclear power plant in this country despite annual growth in electricity demand. From industrial to precious metals there have been very few large discoveries or new mines that have come on stream. As I wrote in Pac-Man, Clicks, & Bricks there have been very few gold discoveries made in the last decade despite rising demand for both gold and silver. At the same time as emerging markets industrialize, rural populations migrate to the city with prime agricultural land plowed under to put up a building or a parking lot. As a consequence, the food stock supplies have fallen to dangerously low levels.

Gold Discoveries 1991 - 2002
3Fields > 10 Million Ounces
7Fields > 5 Million Ounces
5Fields > 4 Million Ounces
2Fields > 3 Million Ounces
2Fields > 2 Million Ounces
2Fields > 1 Million Ounces

Source: H.R. Bullis, "Gold Deposits, Exploration Realities, and the Unsustainability of Very Large GoldProducers," Canadian Institute of Mining, Metallurgy& Petroleum, EMG Vol. 10, No 4, March 24, 2003.

The result is that the world has grown over the last thirty years, but the basic infrastructure to support that world has fallen behind or in many cases has gone into disrepair. It takes 3-5 years from discovery to production of a new oil or gas well. It takes even longer, 5-7 years to discover and bring a new mine into production. It takes money, time, and effort to bring new agricultural land on line. The plain fact is that the world, especially the western world, has spent very little time, money or effort to expand, much less maintain its natural resource base. The result is the supply imbalances and deficits that we now see today. These imbalances won't go away any time soon. The world is just waking up to these supply imbalances. Even then because the price of finding new oil, natural gas, copper, lead, zinc, uranium, silver or gold, costs money, and the price for these commodities remain relatively cheap, it is easier for existing resource companies to buy existing reserves by acquiring other companies. The fact that the big boys in natural resources aren't spending as much as they should tells us a lot about the existing supply of most natural resources. Companies can find more oil, but they have to go to more remote and more dangerous parts of the globe to get it. Until prices rise substantially and for a considerable time, existing resource companies from mining companies to energy companies are unlikely to invest sufficient amounts of new capital. Companies need higher prices and those higher prices have to be maintained before capital flows freely into the sector.

What this means is that the new bull market in commodities or �things� is just in its formative stages. It should last at least another decade. These cycles keep repeating themselves. Over the last 130 years according to Barry Bannister of Legg Mason Wood Walker, paper asset and commodity cycles alternate every 18 years. Paper assets and commodities are once again trading places. The latest commodity cycle began in 1998 according to Jim Rogers, the year Rogers started his raw material fund at the bottom of the cycle. Since inception, the Rogers Raw Material Fund is up 176.11% as of December 2004.

For investors this means it is time to rethink your portfolio. We are now at the peak of an economic cycle, which means we are likely to head into a recession in the next 12 months. This is the time that commodities outperform nonresource equities and bonds. It is time to adequately diversify your portfolio. That means changing the way you think about investment markets.

stocks bonds commoditiesThe world changes as does the economic cycle. What worked in the last cycle won't work in this new cycle. The problem you may have is that commodities are the Rodney Dangerfield of investing�they get no respect. Too many investors, private and professional, have ignored this asset class. Most investment banks and brokerage firms don't even cover the sector or have only a few analysts that do. Many firms have shut down their commodity departments. Compare the number of analysts covering energy stocks, uranium or precious metals companies to the number of analysts following Cisco or Intel.

As the good professors Gorton and Rouwenhorst have shown, commodity investing has been plagued by ignorance, myths, and neglect. Commodities are truly worthy of their own investment merit, especially now as the economic cycle peaks. Commodities as an investment class "whether in raw material form or elated equities" is a smart way to diversify a portfolio as well as offer superior returns. As I wrote several years ago, they are about to become the Next Big Thing.

To learn more about commodity investing, I highly recommend reading "Facts and Fantasies About Commodity Futures" and Jim Rogers' excellent new book "Hot Commodities: How Anyone Can Invest Profitably in the World's Best Market."*

Today's Markets

Stocks started out in positive territory on Monday before worries over the pace and future course of earnings sent prices heading south. The Dow Industrials lost 24.38 points to close at 10,368.61, the S&P 500 gave back slipped 4.12 points to 1,163.75 while the Nasdaq dropped 25.57 points to finish the session at 2,008.70.

The major indexes extended their fourth straight day of losses giving back all of the gains of last year for the Dow. On Monday investors received warnings from Infineon Technologies. Many firms are blaming the inability of stocks to head North due to the slowdown in earnings. In addition to a slowdown in earnings there is also a more hawkish sounding Federal Reserve which is widely expected to raise rates at its February 1-2 meeting and subsequent meetings. The markets are facing incredibly strong headwinds- the ending of monetary and tax stimulus to name just a few.

In other markets March oil futures rose 28 cents to close at $48.81 a barrel on the New York Merc. IN overnight trading the price had risen to as high as $49.24. Bonds rose slightly with the 10-year note up 6/32nds with the yield falling to 4.12 percent. Gold futures closed up $.20 to $427.10. The dollar fell against the Euro. It remained flat against the yen.

[1] Harry M. Markowitz, Portfolio Selection: Efficient Diversification of Investments, Yale University Press, 1959.
Gorton, Gary & Rouwenhorst, K. Geert, Facts and Fantasies About Commodity Futures, NBER Working Paper Series, Working Paper 10595, National Bureau of Economic Research, June 2004, p.16.
Ibid., p.14.
Ibid., p.21-25.

* [Note: Mr. Rogers will be Jim's guest expert on Saturday, February 5]

chart courtesy: &

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