By Ian McAvity –
TORONTO (ResourceInvestor.com) — With reference to the article written recently – Benchmarking Commodity Investments – I would urge a great deal of caution in this arena. The CRB Index data, for example, has just been radically altered with energy components jumping from 17.6% to a 39% weighting as of June 30, 2005, just after Crude Oil touched $60 for the first time. In its first month, it is already apparent that day-to-day volatility has changed.
The newly named Reuters-Jefferies CRB Index is the 10th revision of this venerable brand name in the commodity index sphere, and may be one of the more extreme. It has been redesigned to account for futures trading liquidity and to compete with the energy over-weightings of the GSCI and DJ-AIG Indices in the race to be the link for the latest fad of commodity indexed products as ‘alternative investments’ and portfolio diversifiers.
There have been many academic studies produced to support this case, with many citing historical CRB Index data, largely because it dates back to 1957.
But, for example, if you think back to the 1960’s and 1970’s, how could one not immediately recall oil running from $2 to $40 bbl, and gold running from $35 to $850. They were probably the two biggest and most widely followed commodity runs of that era.
Those two items were NOT included in the CRB Index until 1983… AFTER those respective bubbles burst. Most investors looking at pre-1983 charts of the CRB probably have no idea of these exclusions.
The academic paper cited does deal with this issue to a degree, including silver from 1963, and adding gold at 31-Dec-74 when it was just peaking out at $197.50 (after running from $35 in 1968 and 1971), just in time to catch the 20 month decline back down to $103 in 1976 when 200 hundred million Americans failed to jump in when their right to own gold bullion was restored on 1-Jan-75.
The academics included Heating Oil from 1978, but WTI Crude didn’t start trading until 1983, when they did include it.
The new CRB added Nickel and Aluminum for the first time as of June 2005, after an extraordinary LME nickel run from $5000/mt to $17,000/mt in 2001/04 demanded respect. Less volatile Aluminum achieved a 50% rise in that same period, while much more volatile Platinum was dropped from the index.
The combined weights of Gold, Silver & Platinum were 17.6%, but now gold is 6% and Silver is only 1% by weight.
The bottom line is that the new CRB will behave very differently from the old one, and investment funds being allocated on the basis of academic studies utilizing old data such as these anecdotal examples may be in for some major league surprises.
The study cited was 41 pages, and does note that many of the popular modern markets did not exist for much of the study period. They attempt to deal with some of these problems, but clearly had no actual market experience in terms of where the broadest and most widely followed activity was focused.
How many fund managers or asset allocators will actually read beyond the executive summary and conclusions?
I am sympathetic to the notion of commodity related instruments as a distinct asset class that may warrant some representation in large, broad portfolios. But I am very uncomfortable with apparently blind acceptance of this premise based on academic studies that span extensive periods of time in which the data and markets they purport to measure have so radically changed.
There will undoubtedly be many more radical changes in the years ahead. How many Index-linked products that imply repetition of these “historical” returns and relative portfolio behavior characteristics, allow for future changes? Should prospective investors not have some idea of how that might be dealt with? The Reuters-Jefferies people have put out an excellent 23-page report detailing the history and changes made to the “CRB” that can be located at www.nybot.com or at www.crbtrader.com. Any investor reviewing long-term charts of “the CRB” or contemplating investment in any product linked or bench-marked to it, should be aware of this history.
Another factor that troubles me greatly is that global trade in commodities has increasingly become Dollar denominated over the last three decades. In 2001-2004, the most recent commodity “boom” period saw the US Dollar Index decline from 122 to 80. How much of the recent commodity boom was a reflection of that exchange rate turbulence? I suspect more than many people realize.
From the breakup of the Bretton Woods Agreement and the US gold window closure in 1971, the Dollar declined from 360 Yen to less than 100 Yen; and fell from 4.30 to 1.15 Swiss Francs. The gold bug in me also would argue the revaluation of gold from $35 to a post-bubble stabilization around $350/400 by the mid-1990’s was also a reflection of the long term trend of Dollar devaluation.
Looking forward a decade or so, I share the popular view that the Dollar will continue to devalue over time due to the US addiction to debt, the absence of any US fiscal discipline and the exploding US trade deficits. But there will be periods of substantial rallies by the Dollar as well, just as there have been since 1971 in spite of its long secular downtrend against other major currencies.
For example, 1978-1985 saw the Dollar recover from 1.50 to 2.85 against the Swiss Franc. 1995-2000 saw another dramatic recovery from 1.15 to 1.80 against the Swiss Franc. The British Pound declined from $2.60 to $1.05 against the Dollar from 1971 to 1985, but included a substantial rally phase from $1.60 to $2.40 in 1977/79. In 1985-1990, it rebounded again from $1.05 to $2.00, before coming back to $1.40 in 2001.
My point in highlighting these broad swings in exchange rates is that they heavily influenced global commodity prices. The long term decline of the Pound from over $4 in the early 1950’s contributed to the increased use of the US$ in global commodity trade.
Obviously global growth in demand, and production has been substantial for virtually all commodities as well. Investments related to them would clearly be driven by a presumption of substantially rising standards of living in many less developed countries, as the ongoing source of continuing future growth. I strongly agree with this premise.
But my caution comes back to recognizing that data gaps and flaws, as well as exchange rate volatility are drivers that may materially alter future results in commodity indexed investments from those of the academic studies that marketers of the new investment products are so aggressively flogging.
One of my favorite examples would be to challenge the canard that US common stocks appreciated at 10% per annum over the last century, which most take to imply more of the same for the future. About half that growth came from dividends rising, with S&P 500 yields averaging 4% per annum from 1928 to 2004. With current dividend yields on the broad market at 1.8%, anything close to a 10% total return may be a struggle to attain for some time to come.
The other anecdotal aspect would be to point out that it’s likely many investors would not have been attracted to the stock market in the last century until the publicity and promotion of the late 1920’s finally got their attention. The average pre-crash prices of 1929 were not seen again until 1954… a generational 25 year test of one’s patience and commitment to the “long term total returns” theme that seems to be attracting so much attention today in the commodity indexing arena.
I use the term “arena” intentionally. [Latin: harçna, arçna, sand, a sand-strewn place of combat in an amphitheater, perhaps of Etruscan origin.] An arena, thinking of a bullring for example, or the ancient Roman coliseums, typically sees some combatants dead at the end of the event, and the audience suitably entertained. The operator selling admission tickets is the only sure winner…
The history of financial markets is replete with rushes of new products after the item in question has run up sufficiently to gain a following that in turn stimulates speculative demand. Many will recoil against the term speculative, but if crowds of new players are attracted to a market traditionally populated by consumers and producers of primary commodities, after a dramatic rise in price levels has attracted attention, I believe “speculative” is the more appropriate term for what others would call “investment” demand. By the time new investment products are rolled out for the retail investor, the lion’s share of the run is typically over.
Deliberations on World Markets Newsletter
Source: Resource Investor