Investing for value over the long run is not new. Many investors know about various long-term stock market models, such as the Cyclically Adjusted Price Earnings (CAPE) of Schiller or the Q-ratio of Tobin.
Last year the Vanguard Group did a study on the performance of a variety of models (see https://personal.vanguard.com/pdf/s338.pdf). The conclusion was that valuation-based models, such as CAPE, did the best. In fact, the models explained about 45% of the variation in stock market index prices. That’s a substantial investment edge. The catch is that the explanations only work at long-term time frames. The best fit was at a 10-year time horizon! Obviously, these are not trading models.
But could these models do the same thing for commodities? If so, they could help us adjust the percentage of commodities in our long-term investment portfolios. Indeed, there is a class of models that works well for this purpose. The catch is it is only valid for extended time frames.
As an illustration of this approach, let’s start with gold. The analytical theory behind the model is simple. First, consider the main purpose of gold as an investment vehicle: It is a store of value. Gold may not pay a dividend, but it also is not susceptible to government-driven inflation. So over the long run, the price of gold in dollars should rise to offset fiat currency inflation. Another way to think of this is to view gold as an alternate currency. Over the long run, its value should mean revert to purchasing power parity (PPP).
Over the shorter run, gold will go up and down depending on investor sentiment. In fact, it can do so quite a bit; just look at the gold market’s variation over the last 10 years. The key for the long-term commodity trader is to invest against these shorter-run moves and keep your eye on the long-term trend. This might lead us to suspect that when gold is trading below its PPP, it should be a long run buy — and, of course, vice versa.
The model itself is based on this theoretical base. The heart of it is in the scatter graph shown in “Gold vs. inflation” (below). For example, in January 2002 gold was trading at $281 per oz. That’s equivalent to $368 in 2013 dollars. In January 2012 gold was at $1,656; that’s equivalent to $1,688 in 2013 dollars. So the real return over the 10 years after 2002 was $1,688/$368 or 4.6 times. The series ends in July 2003 because that’s the last month for which a future 10-year return exists. Note that the axes are plotted on a ratio (logarithmic) scale. The fit on the model is quite good. The R-squared, a measure of how well our model explains variations in the dependent variable, is 82%. All the other standardized test statistics are fine.
Right now, with gold at about $1,330 (the red line on the graph), the model is forecasting a future 10-year annualized real return of 0.46%. So if you assume that inflation will continue to run at about 2% per year, gold in 2023 will only be at $750. Of course, the rationale for buying gold is that inflation will be much higher. The point that should be driven home by this model is that it has to be much higher to justify holding gold at current prices.
As a forecasting tool, the model’s fit was good enough that it was logical to extend it to other commodity markets. The economic theory is the same as that for gold. Commodities are hard assets and stores of value in an inflationary environment. Of course, most commodities are more than simply stores of value. They also are important flow variables in the world economy. Moreover, commodity production costs are continually changing. They may be in long-run uptrends because, for example, a metal’s easily minable ores are being exhausted. Or, they may be in extended downtrends because of the development of more-effective production techniques, such a horizontal drilling for natural gas. These factors are not reflected in the model, so won’t be as good of a fit as that for for gold.
“Coffee matters” (below) shows the same scatter graph for New York Arabica coffee. Coffee was selected because it has had a major downtrend, hence it might be undervalued.
The fit is still fairly good; the R-squared is 55%. Sure enough, the model is forecasting that coffee in 10 years will rise from the current $1.22 per pound to $1.73. This sounds fairly bullish, although owning coffee on the futures’ board will cost you carry.
Fortunately, there are cheaper ways of going long coffee for the long run. For example, you could invest in coffee-producing plantations. Larger traders with experience in physicals can store coffee at costs much lower than those afforded by the futures market. Another idea would be to take advantage of the undervaluation by buying companies that use coffee as an input, such as Smuckers (SJM), which sells Folgers.
This analysis has been conducted for all the commodities in the International Monetary Fund’s Commodity database. But some of the best opportunities come in commodities not traded on public exchanges. For example, hardwood (mahogany) prices (see “Wood gains,” below) are forecast to increase by an inflation-adjusted 40%. After inflation, that’s 70%. Because there is no public futures market for this particular commodity, an investor would have to find a timber or lumber company that would benefit from the coming bull market.
Burton Rothberg is a professional trader and a consultant to hedge funds. He can be reached at firstname.lastname@example.org.