re: Commodities: Boom or Bust? (Jeremy Siegel)
finance.yahoo.com
J. Siegel's Advice: Buy the Producers, not the commodities themselves ! I certainly agree with that.
Commodities: Boom or Bust?
by Jeremy Siegel Ph.D.
Utility Links
May 19, 2006
The commodity price boom is grabbing headlines. At about $660 per ounce, gold is up sharply this year even after pulling back from a quarter century high of $728 per ounce reached recently. And gold is not only metal that is surging. Silver, platinum, and industrial metals such as aluminum, copper, and zinc, are reach reaching multi-year, if not all-time high prices.
Many money managers are recommending that investors put a portion of their money in commodities to hedge against inflation and diversify their portfolio. Is the recent run-up a bubble? Or are commodity prices going even higher? And what does this mean for your investments?
Long-Run Data Dim Gold's Glow
Let's look at some very long term data. If an individual purchased an ounce of gold in 1802, it would have cost him about $20. Today, that ounce is worth over $700, a return that is well under 2% a year. Twenty dollars put in the bank at compound interest would be worth almost $100,000 today. And if our investor bought $20 of stocks in 1802 and reinvested the dividends, those stocks today would be worth over $200 million! That is a return of over 8% per year. Gold doesn't measure up in the very long run.
Even over the past 50 years, which starts during a period when gold was kept by the government at an artificially low price of $35 per ounce, stock returns have trounced the precious metal by more than 4% a year.
In fact, over the long haul, gold and other precious metals have only given investors a return that is just a tad over the rate of inflation. In other words, commodities in the long run may preserve your purchasing power, but little else. Stocks do far better.
One of the reasons why commodities do so poorly is that there is no return from holding commodities except price appreciation. While most stocks pay dividends and bonds pay interest, commodities yield nothing. In fact buying commodities outright involves storage and insurance costs that in the long run turn out to be a big handicap.
Are Futures Markets the Answer?
Many financial advisors who sing the praises of commodities say that this handicap can be avoided by buying futures contracts in commodities. Futures involve promises to buy or sell a commodity at a fixed price at a fixed date in the future. All that is required in trading a futures contract is that you put up a collateral deposit, called margin, against which your account is either debited or credited as prices change. This collateral can be held in treasury securities that earn interest and in addition you do not incur any storage and insurance costs.
For gold and other precious metals, such as silver and platinum, buying in the futures market offers no advantage. This is because the price that you pay in the futures market is considerably above the price you can buy these metals for in the spot market, or the market for immediate delivery.
"Backwardation"
It's true that for some commodities the futures price is lower than the price for current delivery. When the futures price is lower than the spot price, this phenomenon is called "backwardation." It arises when producers want to hedge the price of future production and are willing to accept a guaranteed price below the price in the spot market.
Hedging is particularly attractive for farmers who want to lock in a price so that they will not be at the mercy of the market when their crops are harvested. Historically, backwardation was also prevalent in the oil market, where oil producers, like farmers, seek to hedge the price of oil that will be extracted at some future date.
Investors in commodity markets that have displayed backwardation have generally done well. Not only are they able to buy the commodity at a price lower than the spot price, they are also able to receive interest on the collateral that back the futures contracts. That is why some long-term studies that have shown that investments in commodities using futures markets can be as good as, and in some cases better than in stocks.
Hedge Funds Push Prices Upward
But the number of commodities that display backwardation is rapidly diminishing. Purchases by hedge funds and other commodity pools have driven futures prices higher, frequently above the spot price for current delivery.
The futures market for oil has shifted away from backwardation. In the past, whenever the price of oil would spike upward, because of a temporary shortage of petroleum or other factors, very little would happen to the far-out futures prices. For example, two years ago when the price of oil was $41 a barrel, the futures price for delivery in June of this year was only $32 a barrel, more than 20% lower than the spot price. Therefore those buying oil in the futures market received a sizable discount.
Today, the situation is reversed. Prices for oil for immediate delivery closed at about $72 a barrel recently, while oil for delivery two years hence in June 2008 was selling at $74 a barrel, two dollars higher than the spot price. This means that the built-in cushion that oil investors had through buying futures has vanished. This has also happened in other commodities, making investments through the futures market now far less profitable than in the past.
Summing Up
If you want to invest in commodities, it is much better to hold stock in the companies that own, mine and extract these resources. Energy stocks have been great investments over the past half century, even before the latest oil price surge.
But don't become too enthusiastic about commodities. When everyone is talking about any asset, as they are now about gold, silver, and other commodities, it is an excellent sign that prices have gone too high. The bulls maintain that the world economy is strong and China has an insatiable demand for oil and other industrial metals to feed its manufacturing base. But commodity prices peaked a quarter century ago amid very similar talk of worldwide shortages, but then suffered a twenty year bear market.
The long-term trend of commodity prices relative to other assets is downward. Better extraction processes, cheaper substitutes, and incentives to economize on high-priced resources put a lid on long-term prices. Don't commit your investment dollars to what will be viewed years from now as a top of the commodity price bubble. |
