Invest in Commodities - And Keep Your Shirt
Investors tend to steer clear of the commodities market, saying that it’s just "too risky." But, as Jim Rogers points out, there has been more volatility in the NASDAQ in recent years than in any commodities index. Read on…
Recently, at a party in New York, I mentioned that I had been talking to various groups in the United States and Europe about investment opportunities in commodities. Before I could get out one more word, a woman interrupted me. "Commodities!" she exclaimed, with the kind of incredulity in her voice that Manhattanites reserve for people moving to Los Angeles. "But my brother invested in pork bellies and lost his shirt. And he’s an economist!"
Everyone seems to have a relative who took a beating in the commodities market, and this fact (or fiction) is considered sufficient reason that no sane person would ever risk playing around with such dangerous things. That this particular victim was also a professional economist makes the warning seem even more ominous. I, however, couldn’t help laughing.
Billions of dollars are invested in commodities every day. Without the commodity futures markets, many of the things that you depend on in life, from that first cup of coffee in the morning to the aluminum in your storm door to the wool in your new suit, would be either scarce or nonexistent, and certainly more expensive.
To be sure, investing in anything has its risks. A lot of Ph.D.s in economics lost money in the dot-com debacle, too. (On New Year’s Day in 2002, the Wall Street Journal published its annual survey of economists for the upcoming year. Although the economy had been sagging for almost a year, not one of the 55 economists thought that it was in for a serious decline. One hundred percent were wrong – and proof that Ph.D. economists are as prone to mob psychology as the rest of us.)
There are several other bromides out there for why "ordinary people" should not invest in commodities, and I want to lay these myths to rest, once and for all, so that we can get on with the more interesting business of how you can begin to make some money investing in the next-generation asset class.
About That Relative of Yours Who Got Wiped Out – He was inexperienced. You can learn. Most likely, he was buying on thin margin – the minimum deposit a broker requires to take a position in a particular commodity – and when the market went against him he lost big-time.
Here’s how it happens: Like stocks, commodities can be bought on margin. Unlike stocks, however, where by law you have to put up at least 50 percent of the price of the shares, the margins on commodities can be even lower than 5 percent: You can buy $100 worth of soybeans for $5. If soybeans go up to $105, you’ve doubled your money. Beautiful. But if soybeans go down $5, you’re wiped out. Not so beautiful.
Experienced, smart speculators can make tons of money buying on margin. They also know that they can lose tons, too. But they can usually afford it. Your relative was in over his head. If he had bought $100 worth of soybeans in the same way that he can buy IBM – for $100 (or maybe even $50) – he would be happy when it goes up $5 and a lot less sad should it go down $5.
"But What About Technology?"
Whenever I mention commodities in public, someone always points out that we now live in a high-tech world where natural resources will never be as valuable as they were when we had a smokestack economy. But if you read your history you’ll discover that technological advances are as old as history itself: The introduction of the sleek and beautiful Yankee clipper ship dazzled the world in the mid-nineteenth century, loaded with cargo, sailing down the trade winds at 20 knots and more, averaging more than
400 miles in 24 hours and able to make it from U.S. ports around Cape Horn to Hong Kong in 80 days; within a decade, the clippers had been replaced by the steamship, no faster but not dependent on wind power; and before long the next big thing in transport had taken over, the railroad, which, of course, was the original Internet – and prices in commodities still went up.
In the twentieth century came electricity, the telephone, and radio (three more Internets) and then television (a fourth Internet). There was also the automobile, the airplane, the semiconductor – and in the midst of all of these truly revolutionary technological breakthroughs came periodic, multiyear commodity bull markets.
Even a revolutionary technological breakthrough in a particular commodity-related industry will not necessarily lower prices. For decades, drilling below 5,000 feet or offshore was virtually impossible. Then in the 1960s the Hughes diamond drill bit was invented and an explosion of technological advances in oil drilling and exploration followed. Drilling efficiency – and oil deposits – were available that had been unthinkable before this technological breakthrough. Soon there were wells 25,000 feet deep and offshore oilrigs multiplied around the world. Yet oil prices went up more than 1,000 percent in the 15-year period between 1965 and 1980.
When the supply and demand in raw materials is seriously out of whack, the emergence of new technology will not necessarily restore the balance quickly. To be sure, changes in technology, for example, have made the economy less dependent on oil. But we still use plenty of it, and whenever there isn’t enough prices will rise. Computers or robots may do amazing things, but they cannot find oil or copper where there is none or make sugar, cotton, coffee, or livestock grow faster than nature allows. We can put in orders all day long on our computers for lead, but all that Internet technology will be in vain if there are no new lead mines. Technology can neither feed us nor keep us warm, and the demand for commodities will never disappear.
"But Isn’t It Only Speculation and the Lower Dollar That Are Inflating Prices?"
Certainly, speculators who jump in and out of commodities can push up prices. And the dollar has been a pale remnant of itself – down against the euro almost 40 percent from the beginning of 2002 until the start of 2004 and at a three-year low against the
Japanese yen. Since commodities are traded in dollars, a weak dollar will make prices appear higher. Crude oil rose 64 percent in dollars over that two-year period, but only 16 percent in euros.
But the dollar strengthened in the spring of 2004, and a funny thing happened: Commodity prices kept going up. The global recovery, particularly in Asia, was for real. We are now watching a fundamental structural shift in commodities markets, and it is called "supply" – and "China," a nation that will be consuming extraordinary supplies of all kinds of commodities for years to come. I will explain why in more detail in a later chapter. For now, however, here’s the story: dwindling supplies and increasing demand.
And the dollar has nothing to do with either. Let me also re-mind you of the 1970s, when inflation in the U.S. was about 10 percent a year, the dollar wasn’t buying anywhere near what it used to, and the economy was in a major recession – and commodity prices kept rising. We’re talking another long-term bull market in commodities, and neither speculators nor a weak dollar can make that happen. Speculators can have a short-term effect only. For example, if they drive up the price of oil artificially, oil producers with excess supplies will gleefully dump their oil on the market driving the price back down. Both the dollar and speculation can have a marginal effect, but the market itself is bigger than they are.
"But My Stock Broker Tells Me That Investing in Commodities Is Risky."
Tell me again about all those Cisco shares you owned back in 2000. Or JDS Uniphase, or Global Crossing? So many risky stocks made the turning of the new millennium a not so happy time for many, who watched their portfolios evaporate.
If you do your homework and remain rational and responsible, you can invest in commodities with perhaps less risk than playing the stock market. You don’t need me to emphasize that investing in anything is a risky business. But let me point out something that you might not have realized: There has been more volatility in the NASDAQ in recent years than in any commodities index. Cisco, Yahoo!, and even Microsoft have been much more volatile than soybeans, sugar, or metals. Compared with the risk record of most tech stocks, commodities look safe enough to be part of any organization’s "widows and orphans fund."
According to "Facts and Fantasies About Commodity Futures," the Yale study cited in the first chapter, the "high risk" of investing in commodities does not square with the facts. Comparing returns for stocks, commodities, and bonds between 1959 and 2004, the authors found that the average annual return on their commodities index "has been comparable to the return on the SP500." The returns from commodities and the S&P 500 beat those from corporate bonds during that same period. They found that the volatility of the commodities futures under analysis was slightly below that of the stock in the S&P 500. They also found evidence that "equities have more downside risk relative to commodities."
How about buying shares in commodity-producing companies instead of buying commodities themselves? That’s about as far as some financial advisers will go in the direction of commodities. But investing in commodity-producing companies can turn out to be an even riskier bet than sticking with buying the things outright. Supply and demand will move the price of copper, for instance, while the share prices of Phelps Dodge, the world’s largest publicly traded copper company, can depend on such less predictable factors as the overall condition of the stock market, the company’s balance sheet, its executive team, labor problems, environmental issues, and so on. Oil skyrocketed in the 1970s, but some oil stocks did not do that well. The Yale study found that investing in commodities companies is not necessarily a substitute for commodities futures. The authors found that from 1962 to 2003, "the cumulative performance of futures has been triple the cumulative performance of ‘matching’ equities."
And let me remind you of one more important difference between commodities and stocks: Commodities cannot go to zero, while shares in Enron can (and did).
for The Daily Reckoning
November 22, 2006
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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.
Order your copy here:
The hardest thing for a man to do is simply to live with grace and dignity. He is always imagining that his wife is having an affair with the plumber, that the Muslims want to cut his throat, and that he can get rich without working. The next thing you know, he is making a fool of himself.
In his private life, he merely makes his friends embarrassed for him. But in his public life, he poses a threat to everyone. For when he looks in the mirror, he never sees himself as the pathetic, ignorant oaf he really is. In fact, he doesn’t see anything not to like. And he imagines that if everyone could be as he is – with his tastes, his virtues, his political philosophy and his religion – the world would be much improved. And so he gathers together with his fellow delusionals and bubbles up what he does like and declares war on what he doesn’t; and another great public spectacle is soon underway.
Google’s shares went over $500 yesterday.
We thought Google was a sell when the shares were $200 cheaper. We remember mocking the editor of Kiplinger’s magazine for buying them. It looked to us as though he was just going along with the mob, hoping to get rich. We said the shares were overpriced at $250. But now look who’s laughing!
Google is one of only two companies we can think of whose names have become verbs. ‘Google it,’ is an expression frequently used today. ‘Xerox it,’ was one that was common a few years ago.
Xerox was one of the great success stories – of yesteryear. And that’s the trouble with new technology. There is always newer technology. And the wunderkind of today’s stock market inevitably grow up…mature…and die.
And here’s the trouble with the old technology of the human brain: Now and again, people think time stands still.
"I do not think there is a bubble about to burst – not even close," said Benjamin Schachter, an analyst for UBS Securities. Schachter thinks Google will stay at $500 for a long time. "Over the long term, Google continues to outmaneuver all of its competitors. I think this is one of the most important companies on the planet."
But let’s look at Google. Is it really a technology company? Maybe not. It earns its money from what looks like the publishing business – advertising. People go online and Google for something. Google knows what they are looking for. It can target its advertising, and focus readers’ attention on new products and services just when they are most keen to buy – when they’re looking.
The technology behind it is the computer program that connects seekers to the sought after. We don’t know anything about it, but we can imagine that there are many other smart young people figuring out new and better computer programs to do this.
So, let’s look at Google as a publishing business. Roughly, it has a market cap of more than $150 billion, revenues of $10 billion, and profits of $2.8 billion. A very nice company…but what is it worth? If you project recent rates of growth into the future, it could be worth $500. If profits were to double…and double again…it would be trading at a reasonable multiple of earnings. But if earnings don’t go up 300%, it is over-priced.
What’s more, as a publishing business, Google has a major flaw – it has no firm connection with its readers. People do not think of themselves as ‘Google customers,’ the way they often identify themselves with a local paper, a newsletter, a magazine, or even a website. For example, many people are actually proud to be New York Times readers (if you can believe it). Google is largely invisible, like a pane of glass. It does not ‘own’ its customers. Instead, customers will desert it – as they did Yahoo – as soon as something newer, better, and faster comes along. Then, Google will be yesterday’s news.
That may be happening already. From the second quarter to the third quarter, Google earnings grew 11%…or only two-thirds the rate of the same period a year ago. Earnings growth is slowing down, in other words. Just like it always does with new technology companies. When investors realize what is happening…they are likely to desert Google too – and buy into the next hot thing.
Dan Amoss, reporting from a rainy Baltimore…
"…In this debate, it may be tempting to join one camp as if it were a political party. All of us can fall victim to groupthink and rigid adherence to our preconceived notions…"
For the rest of this story, see the latest issue of Whiskey & Gunpowder
And more thoughts…
*** "Recently, I had the honor of speaking at the New Orleans Investment Conference to investors eager to know if the resource markets are going to continue to explode – or if the ‘boom’ is, in fact, over," our friend and commodities guru, Kevin Kerr, tells us.
"For several months now, analysts, brokerage houses, and even the commentators on CNBC have been touting the end of the commodities boom. This kind of talk is enough to make most investors fold up their trading tent, figure the bull market was nice while it lasted, and move on. Not only is that unfortunate, this kind of thinking is incorrect.
"As I spoke at the New Orleans Conference, I made it clear that we are not facing the end of the commodities super cycle – we are actually just getting started. That’s right, we are only in the early stages of what is sure to be unprecedented growth and appreciation in these markets. As I spoke, I saw many individuals sit up and take note – after all, I’m sending a valuable wake up call for investors who didn’t jump on board for the first major rally, which led to commodities across the board to multi-year highs. In 2006 alone, my Resource Trader Alert readers saw gains from record corn prices (which hit 10-year highs), a record gold and silver price, multi-year all-time high sugar prices, 400-500% profits on 17-year highs for OJ…the list goes on and on.
"In the last few months, all of these markets have gone through a normal correction phase, which the bears and less enlightened have turned into the ‘meltdown’ or ‘demise of resources.’ However, for those of us who understand these markets, we can see that this is simply a normal – and necessary – correction, nothing more.
"And if you, dear reader, missed out on round one of the commodities boom, this is your second chance."
*** Today’s International Herald Tribune has a marvelous headline. Referring to the killing of a government minister in Beirut – the fifth in two years – the paper notes that the "Assassination widely condemned."
We have yet to read about the "Assassination widely applauded." But who knows…there are always tomorrow’s papers.
*** We forgot to complete our description of the great debate, between Susan Estrich out on the looney Left…Newt Gingrich out on the self-righteous Right…and Doug Casey, way, way out.
We had explained that the Left and the Right curled up together on the important issues. Both thought they had the right and the duty to look into the future and improve it before it happened. The War on Drugs, for example, improves the future for countless would-be drug addicts, they believe. The War on Terror, they add, helps prevent a grim future of terrorist attacks…and maybe even WWIII.
This position found support over the weekend in the comments of General John P. Abizaid, a man evidently gifted with the power not only of military command – he is America’s top man in the Middle East – but with the power of clairvoyance.
"If we don’t have guts enough to confront this ideology today, we’ll go through World War III tomorrow," Abizaid said in a speech at Harvard University’s Kennedy School of Government. If not stopped, he said, extremists would be allowed to "gain an advantage, to gain a safe haven, to develop weapons of mass destruction."
We doubt whether General Abizaid, Newt Gingrich or Susan Estrich can really see into the future. We doubt, also, that – even if they could – they would be able to improve it. Between pushing on lever A and getting result Z, there is a whole alphabet of unforeseen results…which of course, is the history of every world-improving public spectacle since language alpha met omega.
Does their meddling really reach into the future and improve it before it happens? The historical record on this point is inconclusive, because we never can know what would have happened in the alternative, but it offers little encouragement:
"War on Drugs…the War on Terror…the War on Poverty, let’s face it," said Doug, "all these pseudo wars are disasters."