Black Sheep in the Marketplace

If stocks, bonds, and commodities were part of the same family, commodities would be the sibling who never measured up, says the Investment Biker in his book, Hot Commodities. Why don’t commodities get the respect they deserve? Jim Rogers explores…

Commodities have never gotten the respect they deserve, and it’s been something of a mystery to me why.

More than three decades ago, as a young investor searching for value wherever I could find it, I realized that by studying just a commodity or two one began to see the world anew. Suddenly, you were no longer eating breakfast but thinking about whether the weather in Brazil would keep coffee and sugar prices up or down, how Kellogg’s shares would respond to higher corn prices, and whether demand for bacon (cut from pork bellies) would go down during the summer months. (Consumers prefer lighter fare for breakfast.) Those headlines in the newspaper about oil prices or agricultural subsidies were no longer just the news; you now knew why OPEC prefers higher oil prices than Washington and why sugar farmers in the U.S. and Europe have a different opinion about price supports than do their counterparts in Brazil and elsewhere in the Third World.

But knowing about the commodities markets does much more than make you interesting at breakfast; it can make you a better investor – not just in commodities futures but in stocks, bonds, currencies, real estate, and emerging markets. Once you understand, for example, why the prices of copper, lead, and other metals have been rising, it is only a baby step toward the further understanding of why the economies in countries such as Canada, Australia, Chile, and Peru, all rich in metal resources, are doing well; why shares in companies with investments in metal producing countries are worth checking out; why some real-estate prices are likely to rise; and how you might even be able to make some money investing in hotel or supermarket chains in countries where consumers suddenly have more money than usual.

Of course, I’ve made a much bolder claim in this book: that a new commodity bull market is under way and will continue for years. I have been convinced of this since August 1, 1998, when I started my fund, and have been making my case for commodities ever since. I have written about commodities and given scores of speeches around the world filled with experienced investors and financial journalists. I have met with bankers and institutions. I have even been asked to confer with some mining companies to explain why I think they’re going to do so well. But, as kind and hospitable as my audiences have been, some seemed no more eager to invest in commodities when I finished talking.

It was as if the myths about commodities had overtaken the realities. For most people, when you mention the word commodities, another word immediately comes to mind: risky. Worse still, when investors who are curious about commodities raise the subject with their financial advisers, consultants, or brokers at the big firms, the "experts" are likely to flinch in horror – as if Frankenstein himself had just stepped into the room. And then they launch into sermons about the dangers of such "risky" investments or that colleague who specialized in commodities but "is no longer with the company."

It’s weird. From my own experience, I knew that investing in commodities was no more risky than investing in stocks or bonds – and at certain times in the business cycle commodities were a much better investment than most anything around. Some investors made money investing in commodities when it was virtually impossible to make money in the stock market. Some made money investing in commodities when the economy was booming and when the economy was going in reverse. And when I pointed out to people that their technology stocks had been much more volatile than virtually any commodity over time, they nodded politely and kept looking for the next new thing in equities.

One of the main reasons I wanted to write this book was to open the minds of investors to commodities. I was eager to point out that every 30 years or so there have been bull markets in commodities; that these cycles have always occurred as supply-and-demand patterns have shifted. I wanted people to know that it took no measure of genius on my part to figure out when supplies and demand were about to go so out of whack that commodity prices would benefit.

How hard could it be to make the case that during bull markets in stocks and bear markets in commodities, such as the most recent ones in the 1980s and 1990s, few investments are made in productive capacity for natural resources? And further, if no one is investing in commodities or looking for more resources, no matter how much of a glut there is, how difficult is it to understand that those supplies are bound to dwindle and higher prices are likely to follow?

The next step is as clear and logical as anything in economics can be: that if, in the face of dwindling supplies, demand increases or even just stays flat or declines slightly in any fundamental way, something marvelous happens, and it is called a bull market. But even with the formidable forces of supply and demand on my side, I couldn’t prove beyond anyone’s doubt that without commodities no portfolio could be called truly diversified. I could make my arguments, cite examples from my own experience, point to historical and current trends. Still, I hadn’t done the heavy lifting, the professorial analysis and detail, to prove academically, with charts and graphs, how commodities performed vis-à-vis stocks and bonds. I was an investor, not a professor. But then I got lucky. As I was deep into the writing of this book, two professors who had actually done the research and analysis of how commodities investments performed relative to stocks and bonds reported their results.

And that is why I am of the opinion that the 2004 study from the Yale School of Management’s Center for International Finance, "Facts and Fantasies About Commodity Futures," is a truly revolutionary document. Professors Gary Gorton, of the University of Pennsylvania’s Wharton School and the National Bureau of Economic Research, and Professor K. Geert Rouwenhorst, of the Yale School of Management, have finally done the research that confirms that:

? Since 1959, commodities futures have produced better annual returns than stocks and outperformed bonds even more. Commodities have also had less risk than stocks and bonds, as well as better returns.

? During the 1970s, commodities futures outperformed stocks; during the 1980s the exact opposite was true – evidence of the "negative correlation" between stocks and commodities that many of us had noticed. Bull markets in commodities are accompanied by bear markets in stocks, and vice versa.

? The returns on commodities futures in the study were "positively correlated" with inflation. Higher commodity prices were the leading wave of high prices in general (i.e., inflation), and that’s why commodity returns do better in inflationary times, while stocks and bonds perform poorly.

? The volatility of the returns of commodities futures they examined for a 43-year period was "slightly below" the volatility of the S&P 500 for the same period.

? While investing in commodities companies is one rational way to play a commodity bull market, it is not necessarily the best way. The returns of commodities futures examined in the study were "triple" the returns for stocks in companies that produced those same commodities.

Therefore commodities are not just a good way to diversify a portfolio of stocks and bonds; they often offer better returns. And, contrary to the most persistent fantasy of all about commodities, investing in them can be less risky than investing in stocks.

This is dramatic news. I call it "revolutionary," because it will change in a major way how financial advisers, fund trustees, and brokers treat commodities. To dismiss investing in commodities out of hand will now be liable to criticism and reproach – backed up by a reputable academic study. In the late 1970s, there was an academic study that examined one of the more controversial financial instruments ever devised, the junk bond, which bestowed credibility on investing in junk bonds and turned them into an acceptable asset class. I recall another academic report in the late 1960s, after stocks had been suspect for decades, giving a boost to buying shares in companies again. It helped reinvigorate the stock market. This Yale report will do the same for commodities.

Frankenstein is dead.

But please keep this in mind: Even in a bull market, few commodities go straight up; there are always consolidations along the way. And not all commodities move higher at the same time. Just because it’s a bull market doesn’t mean you can throw a dart at a list of things traded on the futures exchanges around the world and hit a winner. You might, for example, hit copper, and copper may already have peaked. In the last long-term bull market, which began in 1968, sugar, as we have seen, reached its peak in 1974, but the commodity bull market continued for the rest of the decade. A bull market by itself, no matter how impressive, cannot keep every commodity on an upward spiral.

Every commodity, as we have seen, is guided by its own supply and- demand dynamic. Not all commodities in a bull market will reach their peak at the same time – any more than all stocks do during their own bull market. Some company shares will soar in one year and others might make their highs a year or two or three later. That is also true of commodity bull markets.

During the question-and-answer periods after my speeches, someone usually pipes up to say, "So I invest in commodities, and it is a bull market. When do I know it’s over?" You will know the end of the bull market when you see it, and especially once you have educated yourself in the world of commodities and get some years of experience under your belt. You will notice increases in production and decreases in demand. Even then, the markets often rise for a while. Remember that oil production exceeded demand in 1978, but the price of oil skyrocketed for two more years because few noticed or cared.

Politicians, analysts, and learned professors were solemnly predicting $100 oil as late as 1980. Bull markets always end in hysteria. When the shoeshine guy gives Bernard Baruch a stock tip, that’s high-stage hysteria, and time to get out of the market. We saw it again in the dot-com crash. In the first stage of a bull market, hardly anyone even notices it is under way. By the end, formerly rational people are dropping out of medical school to become day traders.

Wild hysteria has taken over – and I am shorting by then. I usually lose money for a while, too, as I never believe how hysterical people can get at the end of a long bull market. Remember all the giggling and drooling over dot-coms on CNBC in 1999 and 2000. Of course, no one ever admits that they never saw it coming. If I had told you in 1982-83 that a bull market in stocks was under way, you would have laughed at me. Everyone knew back then stocks were dead – except that over the next seven years the S&P 500 almost tripled. Had I advised you then to put all your money in stocks, you would have hooted me out of the room: Surely, no rational being would believe that stocks could continue to rise after already tripling in a few years. But between 1990 and 2000, the S&P 500 continued upward, almost quintupling – while the Nasdaq composite rose tenfold.

The commodities version will come in its own form of madness. Instead of CEOs and VCs in suspenders, you will see rich, smiling farmers and oilrigs on the covers of Fortune and Business Week. CNBC’s "money honeys" will be broadcasting from the pork-belly pits in Chicago, and the ladies down at the supermarket will be talking about how they just made a killing in soybeans. Small cars will be the norm, homes will be heated five degrees below today’s preferred room temperature, and there might be a wind farm on the outside of town as far as the eye can see. When you see all that, then it’s time to get your money out of commodities. The bull market will be over.

Regards,

Jim Rogers
for The Daily Reckoning

P.S. Those days, in my opinion, are a decade away, at least. It is now up to you. Consider this book the beginning of your new expertise as a commodities investor. Do your homework and keep learning. Luck always follows the prepared mind.

Editor’s Note: Jim Rogers helped found the Quantum Fund with George Soros. He has taught finance at Columbia University’s business school and is a media commentator worldwide. He is the author of Adventure Capitalist and Investment Biker. He lives in New York City with his wife, Paige Parker, and their 18-month-old daughter, who is learning Chinese and owns commodities but doesn’t own stocks or bonds.

The essay you just read was taken from Jim’s third book, Hot Commodities. You can order your copy here:

Hot Commodities

Yesterday, Brazil fell 3.5%. Mexico was down 2%. Japan, almost 2%. And China, down 5.3%.

Even the Dow went down – to under 11,000.

Over in the commodity pits, the action was mixed. But silver is already down 20%. Copper, too. And gold, yesterday, was selling for about $100 below its peak, set only a few weeks ago.

It’s a "worldwide sell-off" says the International Herald Tribune, triggered by "disappearing liquidity."

And now, the papers are blaming poor Ben Bernanke. The new man on the job at the Fed let it be known that inflation was "unwelcome." This is widely described as "tough talk," though to us, it seems rather gentlemanly. It is also, of course, a bald-faced lie. What would really be unwelcome is the absence of the inflation…the lack of increases in consumer prices…the sudden stiffening of the usually pliant U.S. dollar.

The Japanese lived through such an era for the last 10 years, with Ben Bernanke watching. Fed chiefs would sooner poke their own eyes out than have to watch it here in the United States. For they know as well as anyone, the Japanese could afford it; Americans cannot. Americans are too deep in debt. They need inflation. It keeps the cash coming to pay interest, while lightening the debt load, little by little, over time.

No, there’s no real danger of Ben Bernanke suddenly becoming Paul Volcker. Even with lifts in his shoes, he lacks the stature. And he’s 30 years too late. Volcker could turn off the money taps in the late ’70s, because America was still a healthy economy back then. It could take a little dry weather. Three decades later, his successor, plucked from Princeton’s towers like a sprig of ivy, will wilt quickly.

That is why the "worldwide sell-off" is likely to have very different results for the bond, the dollar and stocks on the one hand, and commodities, selected emerging markets and gold on the other.

As Jim Rogers puts it in Barron’s, "[Ben Bernanke] is an amateur with no knowledge of markets whose academic work revolved around how nations could avoid depressions by printing more money."

Put the new man under a little pressure and the lifts in his shoes will disappear overnight. Rather than imitate the straight-talking giant, Volcker, he will hunch over and mumble. Yes, dear reader, Alan "Bubbles" Greenspan will be back. But, alas, without the old magic. For now all that liquidity that the maestro pumped into the world market is leaking into consumer prices (which is why central bankers are so eager to mop it up). And adding more liquidity now just makes the situation worse or better, depending on how you look at it. If you are invested in Dow stocks and the dollar, you will suffer. If you are invested in commodities, gold, oil, and maybe even a few carefully selected emerging markets…you will rejoice.

This bull market in commodities is likely to be far bigger than the last one, claims Jim Rogers:

"Add to that [American consumption] 1.3 billion Chinese and 1.1 Indians – all walled off from the global economy during the last commodities boom – joining the global scrum for natural resources…it’s delusional to deny that competition for commodities will continue to heat up as a result of China’s pell-mell rush from a peasant economy to economic giant."

We have a feeling that China, not looking where it is going, is going to fall on its face. But we don’t dispute his main point: there are a lot more people bidding for copper, cotton and gold than there were when Paul Volcker ruled the Fed. And we also agree that a lot of those people are not particularly keen to protect the dollar, nor the U.S. economy.

This news item came across our desk yesterday:

"President Vladimir Putin, a frequent critic of U.S. dollar hegemony, has ordered the Russian central bank to raise the gold share of foreign reserves from 5 per cent to 10 per cent.

"Russia’s reserves have surged to $US237 billion, the world’s fourth biggest, after rising 61 per cent in 2004 and 40 per cent in 2005. With a current account surplus of 10 per cent of GDP, it must buy a big chunk of the world’s gold output just to stop its bullion share of reserves from falling."

We recall also last week’s report that China’s top economic advisor urged the Reds to move more of their money out of the dollar and into gold, oil and other useful commodities.

Bad news for the dollar, U.S. bonds, U.S. housing…and the Dow.

More news from our team at The Rude Awakening…

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Dan Denning, reporting from Melbourne, Australia:

"A currency only retains its value if its issuing government is not a deadbeat borrower. The U.S. government is not exactly a deadbeat borrower…at least not yet."

For the rest of this story, and for more market insights, see today’s issue of The Rude Awakening.

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And more thoughts…

*** Daily Reckoning correspondent, Lila Rajiva, finds a scoop…in India:

"After years of being called crackpots in tin – or gold – foil hats, GATA (the U.S.-based Gold Anti-Trust Action Committee) seems to look saner by the day, next to the thorough-going loopiness of the financial establishment. The latest evidence is an IMF report that shows how IMF rules wink – if they do not actually blow kisses – at central banks that double-count the gold reserves they’ve lent out for sale in the open market. Apparently, being a central bank means never having to say you’re short.

"Aha, says GATA, which has charged all along that the IMF along with the U.S. Federal Reserve and other central banks have tried to hold down gold prices. The shady rules suggest that when they lent gold out for cash, the banks actually got to double their reserves by counting the leased gold as an asset on their books, as well as the cash. That was pretty sweet both for the lenders – the central banks, who got a small return for their gold – and for the borrowers, the bullion banks who got to sell and reinvest the proceeds for a higher return in what’s called a ‘carry trade.’

"Even the IMF report admits, delicately, that IMF rules have encouraged ‘overstating reserve assets because both the funds received from the gold swap and the gold are included in reserve assets.’ But except for a lone article yesterday in The Financial Express in India, (Sangita Shah, Double counting of gold may have aided the price suppression, June 7, 2006), the mainstream media has ignored the story."

So much the better. If people really knew what was going on, the price of gold would already be over $1,000 an ounce. We tip our hats and bow in thanks; the manipulators give us an extended opportunity to buy at deep discount.

*** As reported last week, the Japanese are said to be at the source of the worldwide sell off in investment markets. After many years of making cheap money available to hedge funds and Goldman traders, Japan is thought to be tightening up. If so, the yen carry trade that has brought the world so much cash and credit, may be coming to an end.

"Carry trading" is not something the average dear reader is likely to run across in his spare time, so we will expand. What it amounted to was borrowing yen at low interest rates, converting them to dollars and re-investing the money at a higher rate of return. Simple enough in theory, but you need large amounts of money to do it. And it involves a fair amount of risk; while yen lending rates may be low, a rise in the value of the yen could wipe you out. It helps when you have friends in high places, which is why Goldman is happy to have its top man at the U.S. Treasury department. Goldman’s traders do not have to ask for "inside" information from Mr. Paulson. They all know exactly what he will do. They are all insiders now.

As the real cost of money rises in Japan (the Japanese economy is growing…the Nikkei Dow is up 80% in the last three years), the yen carry trade stops working. It needs to be "unwound." In anticipation, speculators sell their high-yielding investments (that is why the papers are reporting a world-wide sell off). But the process of unwinding carry trades does not affect all assets equally.