Blowing Hot and Cold

Studies have proven the negative correlation between the price movement of stocks and commodities…and Jim Rogers has theory as to why commodities flourish when stocks depreciate.

Historically, there has been a negative correlation between the price movement of stocks and commodities.

Commodities were hot in the period between 1906 and 1923, when stocks went nowhere-and the reverse was the case during the Roaring Twenties.

Many of us still remember the hot commodities-and cold stocks-of the 1970s. Quite the opposite was the case during the 1980s and 1990s. Now the cycle is turning in favor of commodities.

Studies have confirmed this negative correlation between stocks and stuff. Two recent studies, for example, headed by Barry Bannister, a capital-goods analyst for Legg Mason Wood Walker, Inc., the Baltimore-based financial services company, show that for the past 130 years "stocks and commodities have alternated leadership in regular cycles averaging 18 years." Bannister heard me talking up commodities in the early 2000s and kindly sent me his own research on bull markets in stocks and commodities since 1880.

When you look at these trends on a graph, it is positively eerie. It looks as if God himself were a trader who enjoyed playing the stock market for 18 years or so and then switched to futures, until he got bored again, after another 18 years or so, and went back into the stock market.

Commodities: Why This Negative Correlation?

Why the negative correlation? I’m not sure, but I have a theory. Consider the Kellogg Company, the world’s leading cereal producer, with $8 billion in total sales. When the price of the massive supplies of wheat, corn, sugar, and paper that Kellogg needs to make and box all those different cereals is low, the company is likely to make a lot more money. At worst, the cost of doing business is under control; at best, it’s declining, and Kellogg makes bigger profits at bigger margins. In the commodity bear market of the 1980s and 1990s, when commodity prices were very low, Kellogg stock did extremely well-moving from a $2 stock to more than $40 in 1999. By the end of that year-and the first year of the commodity bull market-Kellogg stock had sunk by 50 percent. The stock inched up over the next six years-Kellogg has made major acquisitions outside the cereal business-but it never got much beyond its 1999 range.

It stands to reason that when the prices of the commodities Kellogg needs are going up, the company is under more pressure to control costs and profit margins. And so a rising commodity market would hurt many companies and their margins, while decreasing prices for those same goods over long periods would help them. In theory. And that is my theory for this apparent reverse correlation between stock and commodity prices.

It would also explain why commodity-producing companies (oil and mining companies, for example) and those that support and serve them (oil-rig manufacturers, tanker and container owners, trucking firms that haul metals and scrap, and so on) tend to do well during commodity bull markets.

I have not sat down and done a study of this phenomenon. In fact, I always used to recommend it as a dissertation topic for ambitious graduate students, but the hard data has been coming in. Bannister and an associate actually began their analysis of the commodities and equities markets by asking their clients, "Do commodity-serving companies deserve your capital?"

They concluded that, while stocks for most companies went down during a commodity bull market, companies connected to the commodities business-their focus was manufacturers of heavy machinery used in agriculture, such as John Deere and Caterpillar- were likely to do quite well. That, too, would be explained by my theory. When oil prices were making record highs in 2004, the stock pickers on CNBC were shaking their heads about how awful the market was-except for oil and other energy-related companies, which, of course, was exactly what happened during the last bear market for stocks (and commodities bull) in the 1970s. While the stock market was going nowhere generally, there were some great success stories among oil and oil service companies.

This trend is no fluke, evidently-at least according to an even more recent, and extremely important, study from the Yale International Center for Finance entitled "Facts and Fantasies About Commodity Futures," which was published while I was writing my book. To study simple properties of commodities futures as an asset class, the authors created their own commodities index of returns on future contracts between July 1959 and March 2004.

They, too, found that returns from investments in commodities were "negatively correlated" with equity returns (and bonds, too). This result, they explained, was "due, in significant part, to different behavior [between stocks and commodities] over the business cycle." When the stock market is in decline or just going sideways, investors are always looking for a hedge. Ignoring commodities in a bear stock market, as so many tend to do, turns out to be quite irrational-and fiscally irresponsible.

Commodities: The Longest Bull Market

The twentieth century’s longest bull market in commodities began during the Great Depression in 1933 and grew even stronger during that period, a period that serves as the very standard for "hard times" in America. Economies all around the world suffered, yet commodity prices kept rising. And thirty-odd years later, during the famous worldwide recession of the 1970s, commodity prices skyrocketed again.

In both cases, supplies had dwindled during previous years, while demand rose or at least remained flat. Supply and demand, that’s what it’s about. When the stock market is on fire, as it was during the twenties and the sixties, investors ignore companies that specialize in raw materials and other goods. And then, no matter how badly the economy is doing, the necessities of life (food, heat, shelter) and the basic means for jump-starting the economy (construction, mining, agriculture) sustain demand for commodities.

And even when demand dwindles, prices can still climb. How? If the supply falls faster than current demand, the supply-and demand imbalances only increase – and so will prices. You can’t just turn on the spigot at a copper mine. Ramping up production of an existing mine takes years. And once the product is depleted there will be a supply vacuum. Finding new mines, exploiting them, and bringing the metals to market, as I have pointed out, can take decades.

The Yale study also concludes that, "commodity futures are positively correlated with inflation, unexpected inflation, and changes in expected inflation." That was pretty obvious to those of us who participated in the commodity bull market during the 1970s, when double-digit inflation was rampant. Investors worry about inflation, particularly the unexpected variety, because it cuts the purchasing power of their returns and other income. Looking for a hedge, some head for stocks, others head for short-term government bonds and treasuries. Back in the 1970s, as a young investor searching for ways to make money I actually drifted into commodities for the first time because I saw so little value anywhere else. I certainly had no idea that was the way the world worked during a long-term bull market for commodities. (At the time, I didn’t even know that I was in the middle of a big commodities boom.) According to the authors of "Facts and Fantasies About Commodity Futures," commodities have been a better hedge against inflation than stocks and bonds for the past 45 years.

Today, as a much more experienced investor, I would have been dumbfounded if Professors Gorton and Rouwenhorst had discovered otherwise. But many people are confused about inflation. I am constantly asked about inflation (and "deflation") during speaking engagements. People refer to it as if it were some kind of magical entity that existed on its own, independently of market mechanisms. But what is inflation but higher prices? And higher prices do not happen without a reason or cause. And if I’m right that current supply-and-demand imbalances will be pushing up most commodity prices for years to come, that’s the root of inflation. Most people just don’t notice it until those higher commodity prices are passed along to them-when more expensive oil and metals, for example, raise the price of their cars and gasoline. If inflation were a marching band, higher commodity prices would be the majorettes leading the musicians down the street.

And by investing in commodities you can beat the band.


Jim Rogers
for The Daily Reckoning

February 03, 2005London, England

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 recently released third book, Hot Commodities.

Poor Dick Grasso. There he is again on page 12 of the International Herald Tribune…his forehead wrinkled up with worry. He must be wondering how he will make ends meet in his old age. The man worked for 35 years at the NYSE and what thanks does he get? The New York State Attorney General is trying to take a way his pension. Grasso was paid nearly $140 million in 2003 – much of it accrued pension benefits. That seems like a lot of money to many people. Too much to some.

Did Grasso "steal" the money? Maybe, but he stole it fair and square…as near as we can tell.

Did his compensation board do its job? We don’t know. But we don’t think it’s any of our business. Or
any of Mr. Spritzer’s either. If his employers have a complaint, let them take it up with him directly. But New York’s top cop thinks he can squeeze Mr. Grasso…and maybe get some juice to help him on his way to Gracie Mansion, Albany, the White House…or whatever foul place he hopes to go. We know where we think he deserves to go; but again, it’s not up to us.

We pause to make a point. Often have we written that the average little stock buyer has no place…and no chance…on Wall Street. His money might as well go directly into the sharpies pockets – lawyers, brokers, venture capitalists, financiers, promoters…and those of the NYSE itself. Mr. Grasso has done us all a big favor; he’s shown how deep those pockets are.

But the little guys will not figure it out until it is too late. Their stocks will go down. Then, after a few years of misery they will wonder why they ever thought that buying tiny bits of businesses they didn’t understand was a good idea. They got only piddling little dividends – barely enough to cover the transaction costs. By most measures, stocks today are near the top end of their historic price range.

What ever made them think they would go up, they’d ask themselves. That day of humble reckoning is still in the future. How far in the future, we don’t know. But yesterday, it seemed a long way off. The Fed raised its famous rate by 25 little basis points -to 2.5% – bringing it almost even with the "core rate" of inflation. Stocks went up again. Gold and bonds held about where they were the day before.

Not so for our favorite tech stock, The lazy river-of-no-return’s stock went over the falls yesterday, as investors were disappointed with earnings. In the last quarter, earnings rose four times over those of a year ago – 82 cents vs. 13 cents in ’03. Still, investors have gotten in the habit of looking a little closer at the Big Muddy. What they discovered was that most of the reported earnings – more than 2/3rds – came from a one-time tax gain. Earnings on operations came to $1.39 per share for 2004. The stock fell 13% on the news, to $41.88.

As we noted more than a year ago, AMZN is still a good $10 stock.

Meanwhile, Google soared, proving once again that we don’t know what we’re talking about. So far, Mr. Frailey at Kiplingers is right. We are wrong. Google really is going to the moon…or, at least, it seemed headed in that direction yesterday – up more than 7% to a record intra-day high of $216.80.

And thank God! We are humbled again…and happily. Humility is our only virtue, after all, and even about that we are insincere. The more humble we become, the more certain we are that humility is the greatest virtue of all…and that the most humble people are, in fact, the most superior. Only those who have been humbled by the market can be expected to have a clear opinion of their own competence…and a decisive edge in the competitive marketplace.

More news, from our friends at The Rude Awakening:


Eric Fry, reporting from The World Money Show in Orlando…

"But are they talking now, we wondered? Are the markets talking to us, or are we merely hearing voices again? We caught up with Chris after his presentation to find out what the market voices might be saying."

Bill Bonner, back in London:

*** Markets must surprise. "Everybody under the sun thinks rates are going higher," said an analyst in Washington, following the Fed announcement. Everybody under the sun thought so six months ago.

Yet, only short rates rose. Long rates fell. The yield curve is less curvy than it was a year ago.

Now, if everyone really expects rates to go higher…wouldn’t they sell bonds now? There must be some surprise lurking in the shadows somewhere.

Six months ago, everyone also thought the dollar was going down. We found this surprising. If they really thought the world’s most ubiquitous asset was going down…wouldn’t people put two and two together? Wouldn’t they connect the dots…and sell their dollar assets before they went down? But then the dollar went down just like everyone thought. And no one seemed to worry about it. We were surprised again.

We don’t know what to make of the dollar…or bonds. In the long run, they will both be trash. But in the short term…we’re not so sure. This is one of those times that "neither a borrower nor a lender be," is our guess. America needs a recession. The falling dollar, alone, is not enough to straighten out the imbalance in the current account. Consumer demand in the U.S. must be dampened. Recession will be like a cold shower; it…and it alone…will do the trick. Borrowers will be ruined. They’ll be surprised by the strength of the dollar…as well as the shortage of them. When the slump comes, they’ll find it hard to get the dollars they need to repay their debts. And lenders? They’ll be surprised, too, when their borrowers stop making payments. Junk bonds will be even junkier than they expected. Real rates will rise…even as nominal rates remain relatively stable. Even good credits will be marked down…as spreads widen. In the longer run, even treasuries are likely to go down. When? We don’t know. But we’re happy to let someone else find out, while we watch from the sidelines.

Sell stocks. Buy gold. Be happy.

*** We reported on falling incomes last week. This week, we wonder, along with the Arizona Republic, how it is that people whose incomes are falling are able to pay more for their houses. "House prices are outpacing income gains," says the paper. In the Phoenix area, continues the report, existing house prices rose 22% last year. No figures are available on income gains in the area, but nationwide, real incomes fell 0.8% while nominal incomes rose only 2.5%. There is a big gap between 22% and 2.5%. How is it closed? With debt, of course. The average homebuyer must take out larger mortgages than ever before. And even at today’s low interest rates, this makes it harder for him to pay for a house. The "affordability index," according to the newspaper, is now at its lowest level in 15 years. Sticking to the essentials…let’s see…incomes falling, house prices rising…how long can this go on?

*** Why are incomes falling? Again, we look at the essentials. Labor rates in the U.S. are 10 to 100 times higher than in China. We have no chance in competing on the world market on price. We must compete on quality and innovation. But that requires massive, long-term investment in technology, machinery and training, which requires huge amounts of savings and a very disciplined, far-sighted approach. Alas, that is something that late, degenerate American capitalism doesn’t do. Instead, it specializes in quick mergers, acquisitions and cost cutting. Real capital investing, after depreciation, has been going down for many years.

*** A curious letter from a reader:

"As I’m am Anarchist, you may find it strange that I’m a daily reader of yours but I find your site very interesting, humorous and informative. Also, I quite agree with you regarding your opinions on the killing of human beings and the fact that all ‘World Improvers’ leave behind in their wake a long string of dead bodies, mostly of innocent people.

"Capitalism will fall and it rightly deserves to be buried next to socialism and communism. Let us just hope fascism doesn’t take its place. I would like to say that the Anarchists will bring capitalism’s downfall but, that would be giving us too much credit. Capitalism will fall under its own corrupt weight; it needs no help. And when it does, hopefully the World Improvers will go along with it, so we will finally be free and can decide for ourselves how to live our own lives.

"Keep up your fine website, and I’ll leave you and your readers with some good financial advise from an anarchist prospective. Never mind national currencies; put your money in a good local currency. If there are no local currencies where you live, start your own. The worst that could happen is that it would become only worth the paper it is printed on, just like the good old U.S. dollar.

"PS. ‘Anarchism does not mean bloodshed; it does not mean robbery, arson, etc. These monstrosities are, on the contrary, the characteristic features of capitalism. Anarchism means peace and tranquility to all.’"
-August Spies

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