While the stock market has recovered from its most recent short term stumble, commodities continue to provide richer returns. For example, silver (which my contrarian instinct forces me to ignore) rose 20% compared to the S&P 500’s rise of 6%.
Of course, such outperformance by raw materials has been the case for some time. Over the past 10 years while equities have provided appx. zero net returns, commodities have been the place to be.
This interplay between commodities and equities is one of the most important and all to often overlooked cycles that rule the financial markets. I suppose this is because it occurs over the long term, where most don’t care to linger.
I’ve mentioned the equity and commodity cycle a few times in the past in order to orient ourselves within the grander scheme of things. When commodities are in a bull market, as they are now, the result is that equity returns suffer. And when the equity market is in a secular bull market, commodity prices invariably fall.
The explanation for such reversal is rather simple. Commodities are the raw material that businesses use to produce goods and to transport them to market. As the costs of a business rise, they are able to pass on some but not all of this marginal expense. The result is that profit margins are squeezed and earnings become anemic. When commodities decline in price, the reverse occurs.
To put this in perspective, below is a 200 year chart showing the 10 year average rate of return for all commodities:
Source: Hackett Financial via Maclean’s
You can see in the above chart that as commodity prices fall from major cycle highs, they provide the fuel for a new equity bull market. I’ll briefly go over the most recent few cycles.
A Brief History of Raw Materials
The early 1920’s iss certainly a good place to start. As the chart shows, commodity prices fell quite sharply during the whole decade. Had you been invested in commodities, no matter your skill, in all probability, you would have lost money. But during that same time, the stock market was going absolutely gangbusters. You didn’t even need any skill. All you had to do was buy.
The next commodity top occurred in the early 1950’s. Again, as commodities fell, the equity market suddenly woke up from its long slumber of sideways trading and shot higher like a rocket. Until the 1960’s when commodities stabilized and started to rise. We all know the inflation of the 1970’s of course and the devastating equity bear market that coincides with the raw material boom of that same time period.
The next cycle top brings us to the early 1980’s when the hyper-inflation of the past decade ended and commodity prices started to recede. That set the stage for a new bull market in equities that lasted until the late 1990’s.
Right now, we are clearly closer to the end of the commodity boom than to its start. Depending on which index you decide to use, we’ve been in a bear market for appx. 12 years. So commodities have a few more years to go. And those remaining years could be spectacular as more and more retail interest enters this aging bull market. Those entering now will mistakenly believe that “things are different this time” and that the normal rules of all previous cycles just don’t apply.
China and India
John Carney, the governor of the Canadian central bank argued recently in a similar way. He pointed to the rapid development of countries like India and China who have an insatiable appetite for raw materials. But that smacks of rationalization to me. After all, during each and every single boom (or bubble) there were many persuasive arguments put forward why “it is different this time”. And each time it certainly was not different. We saw reversion to the mean and all those carefully crafted arguments came tumbling down.
For the record, John Murray, the deputy governor of the Canadian central bank disagrees with his boss.
Also, we should not lose sight of the fact that as most are celebrating the rise of the middle class in India and China, there is a massive Chinese property bubble being inflated. Like all previous manias, predicting when exactly it will implode is a fool’s errand. But we do know that it is simply unsustainable. So when the inevitable happens, all that demand will come to a screeching halt and commodity prices will plummet.
If that happens abruptly, it could cause some serious volatility in the financial markets. Just as now, there will be losers and winners. But the difference is that after passing the cusp of the commodity boom and entering into a bust, the winners and losers will switch places. Countries that are now experiencing a boom like Canada, Australia, Brazil, etc. will suddenly find that a large component of their economy is left sputtering.
The silver lining in such an approaching dark cloud is that as the commodity boom dies, it will birth a new secular bull market for equities for us to enjoy.