Market Commentary September 2017: Back to the Basics — Milk, Bread and Eggs

Investment ideas are everywhere, sometimes it is just a matter of connecting the dots around you. While reading through a recent Bureau of Labor Statistics report on inflation, it caught my eye that one of the special baskets they track consisting of bread, milk, and eggs reached a decade low, the cheapest levels for these three combined commodities since March of 2007. This caught my attention because I’ve been buying the groceries in our house for twenty years and do not typically expect food prices to decline over the long run. Historically, such moves lower are often just corrections led by broader trends in the economy before the prevailing path higher of the last 100 years continues. Could these food commodities be telling us something about the state of all commodities, i.e. they are cheap and worth a further look? I figured with an equity market that offers few values at current valuation multiples this is worth exploring.

Chart I: BLS Food Inflation: Milk/Eggs/Bread Source: Bloomberg L.P.

As with any theory, we need to look back at history and test the hypothesis to see if commodities are in fact ‘cheap’ and then look at the reasons why they have dropped to avoid the ever-present risk of a value trap. In the chart below, we look at the Goldman Sachs Commodity Index in U.S. Dollars which Bloomberg describes as “widely recognized as the leading measure of general commodity price movements and inflation in the world economy.”  Since peaking ahead of the Great Recession in early 2008, the GSCI declined 83% peak to trough to the bottom in early 2016 and is still down approximately 75% through the end of August 2017. This certainly qualifies as being beaten down, but does the price decline in and of itself mean that commodities are cheap?

Chart II: Goldman Sachs Commodity Index 2002 to 2017 Source: Bloomberg L.P.

Before we answer that, let’s look at why commodities crashed the last ten years and acknowledge there was a commodity bubble introduced from the mid-2000s to 2008 largely driven by emerging market and specifically Chinese demand as these economies grew GDP at red hot to white hot percentage levels. This all culminated with the 2008 Beijing Summer Olympics which was the worldwide platform to announce the arrival of China on the global stage.

History tells us that following a bubble, we see losses of approximately 80% in the years to follow. In this case, commodities were down over 70% in the following year from 2008 into 2009 and were range bound for years until the collapse of crude oil led to another leg lower. The drop in oil prices was due in large part by increased supply with the rise of shale oil and the U.S. fracking boom beginning in 2014-2015 that took the entire energy complex down and in addition to the broad commodity complex along with it. With high oil prices, we had commodities such as corn and sugar that were part of the ethanol substitute trade higher with increased demand as oil soared over $100/barrel. With lower oil prices the last few years, demand for these agricultural products which were a part of the oil boom also declined, leading to lower prices.

Let’s not forget we also had the collapse of the housing bubble leading to significantly lower demand for commodities involved in housing and construction (i.e. copper). Finally, we also saw the U.S. Dollar breaking out in 2014 to multi-decade highs which provides a natural headwind for commodities prices around the globe (commodities are priced in U.S. Dollars and a stronger dollar means these commodities cost more to countries around the globe cutting into demand).

If you’ve invested in commodities at some point over the last 10 years, you most likely have developed a fairly nasty taste in your month from the experience and might have sworn off ever even thinking about returning to the space again. It is only natural to not want to touch the hot stove again if you’ve previously been burned. Yet I am reminded of Warren Buffett, who swore off airlines for nearly three decades calling such investments ‘death traps,’ who did eventually return to the industry because he saw value (he bought airlines in late 2016 for the first time since 1989).

Since commodities are an asset class just like equities I think it fair to look at the price performance of both over long time periods to develop a framework to help decide if commodities appear cheap or expensive to stocks. Not surprising, over time we see multi-year periods where the pendulum swings back and forth as shown in the chart below.

Chart III: Goldman Sachs Commodity Index Relative to S&P 500: 1970 to 2017

Source: Bloomberg L.P. / IFS Securities


The median value for the nearly 50-year sample size is 4.1 (i.e. the nominal value of the GSCI was 4.1x higher than the nominal value of the S&P 500). In periods where the value is 1x, it means these two indices traded at the same nominal value and could indicate commodities cheap relative to stocks. Conversely, in periods where this was at a multiple of 8x it shows the nominal price of the GSCI was 8 times higher than the nominal value of the S&P 500 and could indicate periods where commodities were expensive.

As you can see in the chart (Chart II), the ratio is now less than 1x and is at the lowest relative level to stocks since 1970. Could commodities be poised for a generational opportunity over the next several years?

We can backtest the data looking at peaks and troughs in this ratio and look at the performance over both indices to see how we might perform if we had bought low and sold high. Although no data set and analysis provides a ‘silver bullet’, it can help guide longer term investment decisions as well as top down asset allocation decisions, especially when we are at generational levels as the chart above suggests.

In the table below, we look at the dates where commodities were below the mean and cheap to stocks according to our thesis (on the left) and where commodities were expensive to stocks according to our thesis (on the right). These periods correlate to the arrows on the previous chart.

From 1970 to 1974 when the ratio when from 1.08 to 7.88, commodities had an annual return of 39.3% versus an annual return of the S&P 500 of -7.0%.

From 1977 to 1980 when the ratio when from 3.27 to 6.43, commodities had an annual return of 26.8% versus an annual return of the S&P 500 of 5.9%.

We see time and time again that when this ratio was below the mean and turned higher, there was a multi-year period where commodities significantly outperformed stocks and the inverse is true from the data on the right when commodities appeared over the mean and were expensive.

What we have here is a framework that suggests commodities deserve a place in a broadly diversified portfolio. Since 1970, the Goldman Sachs Commodity Index has a correlation to the S&P 500 of -0.05 which indicates there is no long-term correlation between stocks and commodities and the two operate independently. In a period where equities appear expensive on many key valuation metrics (price/earnings, price/sales) and we are nine years into a straight up bull market with no negative year (no bull market in U.S. history has lasted ten straight years without a down year), it might be the right time to look outside the box for value in the market. Granted, this does not mean we should go ‘all in’ in commodities but a 10%-20% allocation can help diversify portfolios and provide a place for proceeds after lowering equity allocations and taking some gains off the table.

Can commodities go down over the short-term? Of course, one of the key short-term drivers is the directional trend of the U.S. Dollar. With the U.S. Dollar down nearly 10% year to date we could see a short-term bounce relieving the oversold condition that in turn puts pressure on commodity prices. The point I want to make is that with this analysis we are looking at positioning for the next 2-4 years instead of 2-4 months to provide diversification while maximizing the risk/reward parameters and profile of our portfolios. One thing to remember, unlike a stock, commodities will not go bankrupt and go to zero. There will continue to be a market for cattle, crude oil, corn, soybeans, copper, and gold (especially with geopolitical risk) at some price. With commodities prices down 80% over the last decade, I feel comfortable that downside is limited from here especially when looking at the historical relative valuations to stocks at current prices for both indices.

With the proliferation of exchange traded funds and notes, we no longer operate solely in the futures markets to build exposure to commodities. There are many diversified funds available and ETFs and ETNs that specialize in almost every traded commodity in the marketplace. I recommend doing some homework on these funds, especially with regards to tax treatment to know how to best focus to maximize the after-tax return in accounts that are not tax sheltered.

Sometimes, looking at grocery prices leads to a question that with some digging and research leads to an interesting investment thesis. It might be outside the box and not suitable for all clients and risk levels due to the inherent day to day volatility in the commodity markets. This would be a longer-term recommendation–lowering allocations high beta stocks or high duration bonds to reduce risk and provide increased diversification. Feel free to let me know if you have any questions about the commentary or want to discuss the implications. Next month we will delve into the implications for the global equity markets, the economy, and central bank policy if we do in fact see commodities begin to move higher over the next 6-12 months.


…by John Bliss, Director of Research