Is it time for patient investors to increase commodity exposure?

Let’s start with a bullish thought to begin 2018. We, among others, have recently been pointing to the potential for higher inflation in 2018. To be clear, we are not calling for a massive shift upwards, more a gentle acceleration that has the potential to impact valuations in fixed income and equity markets. In this environment, we believe there is the potential for commodities to outperform. Chart 1 below (courtesy of Nautilus) has been doing the rounds in various guises in recent months.

Chart 1 – Commodities relative to US equities

In relative terms, commodities don’t really get much cheaper relative to equities, and as shown Nautilus ask the question whether a 15.5 year cycle is at play, opening a window for a great opportunity to switch from equities to commodities. Our own work supports this general thesis.

Of course, commodities cover a wide variety of “stuff”, all with different characteristics and supply/demand balances. We covered soft commodities (Sugar, Cocoa and Coffee) briefly last summer, and we still think that these commodities are broadly building a big price base at historically cheap levels. The agricultural commodities (Corn, Soybeans and Wheat) are displaying similar patterns. We will likely discuss these in more detail at some point in coming weeks.

Gold has been a core holding for us in the last couple of years, and here also, price appears to be building a big base that we believe is the prelude to a strong upside move. We have shown what we believe to be an important resistance line, which if broken, should allow price to start trending nicely higher. We have also shown how we think price may trade in the next few months, i.e. sideways to lower for a bit, before embarking on a sustained move higher.

Chart 2 – Weekly gold price chart

With our view that inflation is likely to move modestly higher this year, but remain at relatively low levels compared to truly inflationary periods, we are not necessarily looking for “massive” gains in commodities. Thinking back to chart 1, if commodities are about to embark on a sustained relative outperformance over US equities, we strongly suspect that equities have to decline a lot in the next few years to help this relative relationship – this will hardly be new news to our regular readers!

This week, Jeremy Grantham of asset manager GMO, released a paper speculating whether US equities are in the process of melting up. Mr Grantham is a highly respected value investor whose firm has been cautious of equities for some time. Yet, there is logic in his melt up argument. He is not suggesting that US equities are cheap; he still thinks they are absurdly valued. His argument is that we have not yet seen the true madness of the crowd that is usually associated with bubbles.

When we say that there is logic to the melt up argument, we say this in the context that anything is possible in markets, especially bubbles. Plenty of research exists to illustrate how the investment crowd latches onto bullish narratives late in the cycle (and especially in bubbles), that may seem logical at the time, but in hindsight, is nothing but madness. So the narrative today for a melt up seems to be that economic growth is just fine, corporate earnings growth is reasonably strong, central banks will not let anything bad happen and there is simply no alternative to stocks. Even long term investors who may be worried about generally expensive valuations say that as long as you buy good stocks and hold them, you will be alright.

What is missing from the bullish argument is any discussion on whether today’s price offers an attractive opportunity or not. Frankly, we fear greatly that investors today are buying into the bullish narrative (the madness of the crowd) and totally ignoring the current valuation and what potential future returns will be over the longer term. This is an all too easy trap to fall into. Even Ben Graham, the Grandfather of value investing lost pretty much everything during the great depression. Later, in 1934, in his book “Security Analysis”, we wrote about the 1929 period, and how investors ignored expensive valuations, eventually at great cost (emphasis ours and h/t to John Hussman);

“During the latter stage of the bull market culminating in 1929, the public acquired a completely different attitude towards the investment merits of common stocks… Why did the investing public turn its attention from dividends, from asset values, and from average earnings to transfer it almost exclusively to the earnings trend, i.e. to the changes in earnings expected in the future? The answer was, first, that the records of the past were proving an undependable guide to investment; and, second, that the rewards offered by the future had become irresistibly alluring.

“Along with this idea as to what constituted the basis for common-stock selection emerged a companion theory that common stocks represented the most profitable and therefore the most desirable media for long-term investment. This gospel was based on a certain amount of research, showing that diversified lists of common stocks had regularly increased in value over stated intervals of time for many years past.

“These statements sound innocent and plausible. Yet they concealed two theoretical weaknesses that could and did result in untold mischief. The first of these defects was that they abolished the fundamental distinctions between investment and speculation. The second was that they ignored the price of a stock in determining whether or not it was a desirable purchase.

The notion that the desirability of a common stock was entirely independent of its price seems incredibly absurd. Yet the new-era theory led directly to this thesis… An alluring corollary of this principle was that making money in the stock market was now the easiest thing in the world. It was only necessary to buy ‘good’ stocks, regardless of price, and then to let nature take her upward course. The results of such a doctrine could not fail to be tragic.” – Benjamin Graham & David L. Dodd, Security Analysis, 1934.

So although we agree with the bulls that economic and corporate earnings growth are both doing well at the moment and that central banks do not want to do anything to overly disrupt the party, we do believe that the current price that investors have to pay is absurd, and implies negative nominal total returns over the next decade or so, with the high potential for a crippling bear market in the next 1 to 3 years. We would add that the only other potential bullish factor to consider on top of the increasing madness of the crowd is that companies may well increase their share repurchases now that they can repatriate overseas profits at a lower tax rate.

We have illustrated numerous times in recent months why we think that US equities are overvalued, but let’s look at one more here. Warren Buffett, disciple of Ben Graham, famously explained how and why he uses stock market capitalisation to GDP as a great short hand for measuring the value of the equity market. Specifically, the Federal Reserve releases a quarterly flow of funds report in which the data for the value of all domestic non-financial equity (quoted and unquoted) is measured. With data available up to Q3 2017, the ratio of US domestic non-financial companies value relative to GDP stands at 132.2%. We have updated our model (chart 3 below) for the fact that the S&P 500 rose by 6% in Q4 2017, and also projected a 1% increase in nominal GDP over the same period (4% annualised).

We think this is as close an approximation we can get to where US stocks are valued today by this measure. As shown, the ratio now stands at 138.4% compared to the all-time high of 151.3%.

We would just take the time to point out here that with the above data series being quarterly, there have only been three observations higher than that apparent at the end of 2017 – Q4 1999 at 143.3%, Q1 2000 at 151.3% and Q2 2000 at 140%. As can be seen in chart 1, this indicator made a spike up to the high point, followed by a swift reversal. By Q1 2001, a year after the peak reading, the ratio was back at 99%. The point being that in the previous examples, when markets were this expensive, any short term gains (measured in months back at the time of the dotcom bubble) were enjoyable for only a short period of time, and were given back pretty quickly, and then some.

Chart 3 – US non-financial corporate value relative to GDP

For those that read Mr Grantham’s paper closely, you will see there is a second part to his melt up thesis. He says that if the melt up happens, then he believes there is a 90% chance that it will be followed by a 50% bear market. This perfectly describes the dotcom bubble experience, and basically every other bubble experience in history. Bubbles end in a spike higher, followed by a crash. The only question is whether we are in the early or later stages of the spike higher at the moment.

To put Mr Grantham’s lower S&P 500 target of 3400 in 9 months’ time in perspective, we have projected this increase in our model together with quarterly growth rates of 1.5% (6% annualised). For those that want to hang on for the melt up, you are simply betting that the market will move to the most extreme valuation ever in history, greater than at any bubble peak like 2000 and 1929, or other peaks like 1907 or 1966 that all preceded a decade or more of zero nominal returns.

Chart 4 – US non-financial corporate value relative to GDP projected forward for a melt up scenario

So to wrap up this week, with equity markets enjoying a great start to the year, the bullish narrative is fully intact. In fact, even the bears are admitting that there is logic behind a melt up in the months ahead – when noted bears capitulate, history shows that the end of the bull market is relatively near.

Predicting the end of the post GFC bull market has been a mugs game. All we can say is that solid valuation techniques are all in the vicinity of previous bubble peaks, and that a melt up would require valuation to reach the highest of all time – the mother of all bubbles. We are not saying that the melt up cannot happen, we are simply trying to point out what rising prices would do to these solid valuation techniques.

In terms of trying to find any value in a world where every asset appears expensive, we do think there is value to be had in selected commodities. Even if we are correct in this, we suspect that investors may need to be patient in allocating capital here, especially in the melt up scenario. However, we do strongly believe that in a few years, we will look back and see the current time period as a great time to make a switch from equities to selected commodities.

We wish all our readers a happy and prosperous new year.

Stewart Richardson
RMG Wealth Management



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