The Asset Class to Avoid.

Whats the worst asset class to invest in right now?

Research suggests the asset class that offers the poorest long-term returns from today’s valuation levels is commodities.

Historically, commodities have generated astonishingly low returns. Based on the Foundation for the Study of Cycles data, from 1264 to 2010 commodities went up 0.70% on an annualized basis. That is rather unattractive.

Using data obtained from measuringworth.com spliced with modern day US CPI figures, over the same time period inflation increased by 0.75%.

After looking at different data sets for inflation indices and commodities over different time periods (spanning centuries in some cases), a pattern begins to emerge. When viewed over very long periods of time, there is a very high correlation between commodities prices and inflation indices.

Perhaps this is not so surprising when one considers that the commodities are a significant component of inflation indices. However, it is always nice to run the data and observe the actual correlation. It is real.

Now this may sound like a rather elementary deduction. But understanding this seemingly simple phenomenon is the key to unlocking the mystery of the commodity cycle.

The commodity cycle is as follows: Commodities do not do much for a long time. Then there is a fantastic spike up for a number of years. Then there is a crash. Lather, rinse and repeat.

What causes these spikes?

The most dramatic catalyst for commodity spikes occurs when a country takes itself off the gold standard. This occurred in the US Civil War, in 1933 when FDR took the United States off of the gold standard on a domestic basis and in 1971 when Nixon cut the final ties to the gold standard on an international basis.

Commodity spikes also often occur when a country runs big deficits. This almost invariably occurs during wars. Since 1900, there have been nine years when the deficit/GDP was above 9%. All were during times of war. All had commodity spikes. The quintessential example of this would be the World War I commodity spike. The most recent nine-year spike would also fit into this category. The US also had big deficits in the Civil War and World War II which contributed to those commodity spikes in addition to being taken off the gold standard which produced a “double whammy” effect.

What causes the crashes?

The high profit margins (due to the spike in prices) attract competition. Competition causes overproduction. Overproduction causes crashes. Eg . like what had happened to Tin prices in the 70s!

Another reason why commodities are poor investments is they have no yield. Actually with storage costs and security costs they have negative yield. This stands in marked contrast to pretty much almost all other asset classes which provide some sort of return on investment.

So after reading all this why would anybody ever buy commodities at all?

Well this is a good question. You can do just fine if you avoid commodities entirely for the rest of your life. However, one can argue you may do even better by keeping all your options open and wait for a time when commodities are poised for a big run.

This begs the question: How do you tell when commodities are dramatically undervalued? While the question is simple, the answer is complicated. The main problem, once again, is commodities have no yield, which makes it difficult to compare them to other asset classes. However, perhaps the mere fact that it is difficult to value commodities because they have no yield is telling you something. Moving forward, another valuation alternative is comparing ratios. This also presents issues as well because the ratios between other asset classes and commodities exhibit a secular upward creep. That is because most asset classes outperform inflation and therefore commodities. This makes timely buy and sell signals by this method impossible in most instances.

There are actually some ways of figuring out when it is a good time to buy commodities for a secular buy and hold strategy. A pretty good time to take a look at commodities is when they have been in a bear market for many years. Since the US was founded, commodity bears have lasted 11-33 years. Another good buy indicator is a lack of investment demand.

Clearly the current situation does not fit either of the above criteria at all. Rather than wasting time trying to figure out whether or not one should still be buying commodities, perhaps people should focus their efforts on figuring out if this is a good time to sell. As mentioned earlier, a telltale sign of the end of a commodity bull is a spike. History says you don’t want to buy them after a nine-year spike such as what we just had. While it is possible that the spike can go higher and longer, the laws of probability simply are not in your favor at this point.

In every instance without exception over the last three quarters of a millennium, if you had bought commodities when they had at least a 176% rally over the last nine years, you had extremely unattractive returns over the next 13-50 years.

1613-1622: Up 254%. Commodities went immediately into a 50-year 78% bear market.

1938-1947: Up 240%. Commodities went down 16% in 1948, 19% in 1949, up 58% in 1950 and peaked in February 1951. Then they had a 37% 18-year bear market. Therefore, in the quarter century after 1947 the upside was 12% (early 1951) and the downside was 32% (August 1968).

2001-2010: Up 238%. (???)

1910-1919: Up 202%. Commodities went immediately into a 13-year 66% bear market.

1971-1980: Up 198%. Commodities went immediately into a 19-year 45% bear market.

In all four prior instances since 1264 when commodities went up 176% in nine years, they went down the next year AND the year after that. If history repeats commodities will go down in 2011 and 2012. I am shorting the CPO big-time, @ RM3900/MT!