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Where are we in the commodity inflation cycle? Thats the triple-your-money question



February 19, 2010 – Comments (6)

Bannister, Lintner, and Conners of Stifel Nicolaus published a report on Jan 21, 2010 called Macro Update:  1Q10 correction, "growth scare".  In the opening lines they predicted an 8-10% correction in the S&P to 1050 or so.  Nice call, but...

Thats not the highlight of the summary to me.  The highlight of the summary comes late in the document in the form of a discussion of the historical performance of stock indices to commodity indices, specifically the S&P to the CRB Futures index, whatever that is.  It shows data in stock index relative to commodity index going bcak to 1870.

Over those ~140 years stocks, of course, have vastly outperformed commodities.  In 1870 the ratio is shown as about 0.2, rising to the low teens at the 2000 peak, before falling to around 4 today.  So stocks, excluding dividends, have outperformed by about 20 times in 140 years (once this was 60+x).   But this outperformance has been cyclic, with several extended periods where commodiies outperformed stocks.  Commodities outperformed dramatically from 1907 to 1920 (encompasses WW1),   From 1930 to the late 1940's (depression, huge wall street crash, and a war which no doubt drove up commodity prices),from the end of the "go-go" stock market in 1968 until 1980, and again from the peak of the Nasdaq bubble until now and ... and somewhere into the future?  So of those 140 years, stocks have outperformed dramatically (extremely dramatically if you consider dividends), but commodities have outperformed over 4 distinct periods totalling nearly half of the period, more than 50 years.  

So commodity prices and equity prices seem to be counter-cyclic, which is absolutely fantastic from an investors perspective as it may offer something to move money into when stocks become overvalued.  Certainly moving out of stocks and into commodities in 1999/2000 would have done you very well over the last 10 years.  

Compared to past commodity-inflation cycles, this one is already fairly advanced.  The first two on the chart had world wars to help them along and the one in the 1970s lasted barely longer than this one already has.  The cycle in the 1970's bottomed within a few years, this one may have bottomed in 2008/9, but was both deeper and longer from onset to bottom than the 1970s cycle, and was deeper than the Great Depression/WW2 cycle.  

So, based on history, it is wrong to think that we are "going to have" inflation or that commodities "are going to start to rise", the commodity inflation cycle we are experiencing now is already advanced in age and severe in scope compared to historical cycles.  That, of course, doesn't mean it couldn't go on longer or become more severe, but we are not at the onset of such a cycle, its been going on for a long time now (10 years).  

I'll go out on a limb and say that further research may reveal that a nice signal that a new secular bull market in equities is beginning is equity prices beginning to outperform commodity prices.  We have not seen that at this time in this cycle.  From bottom to top, oil has outperformed the S&P for example, more than doubling while the S&P has not nearly doubled.  That would seem to be a sign that a new secular bull in equities may not yet be at hand...  (but the next year could, of course, see stalled or deflating commodity prices and an ongoing advance in equity prices).  

Also, historically, commodity prices don't deflate for long and post-bubble tend to fall into a trading range higher than the level before the onset of the rise to bubble status, but lower than the bubbe peak.  On to the next bubble...  

So the biggest and most important question for investors today, in my view, is probably this one:

Where are we in this commodity inflation cycle?  Does it become even more dramatic, commodities go higher than stocks even more dramatically (its already as bad as any cycle in the last 140 yhears save the 1907-1920 one), or has the cycle seen its peak?  If the former is the correct answer then equities will experience some difficulties.  If the latter is correct, holding equities from here may be a good strategy.  

And this my fine fellow folks - this apparently counter-cyclic behavior of commodities and equities - may just represent the missing link in a long term, lifetime investment strategy.  Asset allocate not between fixed income and equities, but between equities and commodities, or significantly shift equity portfolios towards commodity stocks when it seems like an equity-outperformance cycle is coming to an end.  Shift away from commodities or commomdity stocks when it seems like a commodity outperformance cycle is coming to an end.

I wish I could post pictures...  in this case they are really worth 1000 words.


6 Comments – Post Your Own

#1) On February 19, 2010 at 12:23 AM, Tastylunch (28.55) wrote:


to post pictures type


surrounded by < and >

yeah this is a tough question and one I don't know the answer to, If I recall correctly the Harvard paper I read on this back in 2001 suggested these cycles tend to be about 17-18 years on average.

I think China's command economy really distorts everything though. Their buying doesn't follow normal laws of supply and demand and it throws everything out of whack.

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#2) On February 19, 2010 at 12:41 AM, checklist34 (98.40) wrote:

tasty, thanks alot for hte help.  the photos are stuck in a .pdf so i'd have to alt-printscreen them from that into photoshop and then actually get them on the web, and that I don't konw how to do...  unless I post them on a car forum from my hard drive, but that'd be weird.  I guess I could post this on a car forum and see what they think, lol. 

The length of the commodity cycles can be influenced alot (same with stocks -vs- bonds) by choosing your starting points.  

Choosing starting points as when stocks start to significantly drop relative to commodities we have ~11-12 years (1907/8-1919/20), ~17-18 years (1930/31 to late 40s), just 8 years in the 70s (72-80) and already 10 years now.

Choosing starting points of when stocks stop outperforming commodities gives 18 years at hte beginning of the 20th century, 18 years Great Depression/WW2 era, 12 years (70s era) and already 10 years today.

We have already 10 years not since stocks stopped outperforming commodities, but since commodities began drastically outperforming stocks this time.  

Its not ancient, but it is far, far from a young commodity inflation cycle.  I would say its fair to call it advanced.  That doesnt mean we can't have another bump, another cyclic commodities-up cycle inside the secular commodities-up cycle...  

But we are not, nor hardly, just getting started here.

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#3) On February 19, 2010 at 4:33 PM, awallejr (34.72) wrote:

"I think China's command economy really distorts everything though."

Bingo.  The problem with using older data (50+ years for example) and extrapolating into the future is that relative circumstances can be dramatically different.  It's a main reason why I have little use for any longterm technical analysis such as trying to analyize DOW patterns starting from 1900s to present and future.  Afterall companies in the DOW then no longer exist today, and companies in the DOW today didn't exist back then. It's like comparing baseball statistics past to present.  Apples to oranges.  Anyone honestly think Cy Young would accumulate 511 wins if he started pitching today?  Of course not.

China and other emerging markets are a much bigger influence now than in the early 1900s.  Their demand for natural resources may even surpass the US's down the road.  How this will all play out, time will tell.

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#4) On February 19, 2010 at 7:20 PM, APJ4RealHoldings (37.57) wrote:

It's a crazy question indeed.

The point of purchases stemming from Asia is an important one. 

I must add two real important thoughts to ponder here:

1) The past 10 years, we have seen more correlation between different asset classes than I believe ever in history.  I believe the correlations between commodities & stocks these past 5 years especially is far beyond any correllation in that 140+ year time period. is that correct?

2) especially these last 30-50 years, we have seen appreciation in stocks to be correlated with overall credit expansion.  The more amount of credit/loans/money thrown into the wild, the higher we have seen equities move, and vice versa. 

Now these two points are inter-related and we come to one big question today that will drive commodities and the same direction...

...are we going to see expansion in total credit outstanding from today's levels, or will today's credit levels contract for some time?

That is the big question.

Do you or anyone have any stances on the answer to this?

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#5) On February 20, 2010 at 3:38 AM, awallejr (34.72) wrote:

In the US I suspect credit will be contracting not expanding, while in emerging markets we might see the opposite.

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#6) On February 20, 2010 at 11:52 PM, walt373 (99.85) wrote:

Another factor to consider is peak commodities and especially peak oil. I'm guessing that commodities will probably outperform equities when we reach peak commodities. When that will happen is anyone's guess, but it will happen eventually (unless we are able to get off planet Earth in time).

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