Global Real Assets
A bi-weekly discussion of the recent commodity, REIT, and real asset markets and what it may mean for investors.
John LaForge, Head of Real Asset Strategy
How One May Benefit During Commodity Bears
- History shows that returns are possible during commodity bear super-cycles.
What it may mean for investors
- Active managers have a history of outperforming the underlying passive commodity prices, during commodity bear super-cycles.
For the past few years, our advice has been to shy away from over-allocating to commodities tactically (6-18 months), cyclically (18 months –to three years) and strategically (10+ years). And at times, like now, we have even suggested steering clear of commodities altogether, tactically. To be clear, though, we are not suggesting this strategically. As we’ll discuss in a moment, we believe that portfolios may benefit by holding commodities over the long run.
Our main reason for being lukewarm on commodities over the short-to-intermediate term is that they remain knee-deep inside a bear super-cycle. A commodity bear super-cycle is a multi-year period (the average is 20 years) during which commodities struggle to make gains. We believe that this current bear super-cycle began in 2011, which means that it is roughly six years old so far. And yes, in case you were wondering, most individual commodities get caught in the snare of the bear super-cycle.
We are often asked the question, “if bear super-cycles have lasted 20 years (on average), why are we allocating to commodities at all in 2017?” It is a good question, and one that needs answering. The bottom line is that: yes, we believe that investors should own commodities strategically. Today, we’ll explain why.
Reason #1—Most of the downside price damage likely has been seen.
Most of the price damage during commodity bear super-cycles has typically been done in the first five years (or so) of the bear super-cycle. This is using data back to the year 1800. This means that most commodities have likely seen their ultimate bottoms as of 2017, and the rest of the super-cycle bear will be marked with lots of sideways/range-bound price action. In Wall Street parlance, this means that we are effectively “neutral” on commodities strategically.
Reason #2—We doubt that today’s bear super-cycle lasts the average 20 years.
Chart 1 gives us perspective on how commodities move through super-cycle bear and super-cycle bull markets. Notice the long waves in commodity prices; swinging from bull to bear over multi-year periods. The grey shaded areas represent the bear markets; the white areas show the bull markets. Included are performance statistics below the chart comparing bull and bear markets. There are three important points to highlight:
- Commodity bear markets have lasted longer than bull markets. Since 1800, the average bear market has lasted nearly 20 years, while the average commodity bull market has lasted only 16 years.
- Historically, bull markets have ended with a parabolic move higher, followed by a thundering crash. We just witnessed the thundering crash from 2011-2016.
- The super-cycles have been shortening in length over the past 100 years. With the advent of the Federal Reserve (Fed) in 1913, and its ability to create liquidity and stop price slides, the make-up of super-cycles has changed somewhat. The shortening cycle lengths can be seen by looking at the shadings in the 1800s versus the 1900s. Notice how much longer the cycles were in the 1800s. We doubt that today’s bear super-cycle lasts the average of 20 years. As of 2017, we are already six years deep into the bear.
Reason #3—Money managers can perform quite well, during commodity bear super-cycles.
When we talk about commodity bear super-cycles, we are explicitly pointing out how commodity prices perform. But weak spot or futures prices does not mean that smart money managers can’t find ways to make money. In fact, they often do.
Investing in individual commodities is not the same as investing in individual stocks. Commodity investors don’t typically just buy some physical gold, as an example, and pack it away in a bank vault. Most professional commodity investors buy and sell commodities on a continual monthly basis. This is because these investors trade commodities by using futures contracts, which expire on a monthly basis. And each monthly contract trades at a different price. As an example, as a March futures contract expires, investors must take their cash from this contract or “roll” their positions into the April contract (or whichever contract is available next). This constant rolling of contracts provides professional commodity investors with opportunities to outperform the commodity prices themselves. Commodity bear super-cycles, especially, are periods in which professional commodity managers can outperform individual commodity prices. This can be seen in Chart 2.
Chart 2 has three panels. The blue line in each panel represents the performance of professional commodity managers. The red line represents the performance of commodity prices. The top panel shows performance during the last commodity bear super-cycle, from 1980 to 1999. The middle panel shows performance during the last commodity bull market super-cycle, from 1999 to 2011. The bottom panel shows performance during our more recent commodity bear super-cycle, which began in 2011. Notice that the blue line, showing professional (active) commodity managers, performed much better than the commodity prices themselves, during the last two commodity bear super-cycles (panels 1 and 3). The point of Chart 2 is to show that professional (active) commodity managers can, and often do, outperform the commodity prices themselves, during commodity bear super-cycles.
After we point this out to investors, they like to say, “ok, so we should love commodity managers today, right?” Our answer is, “not so fast.” Yes, commodity managers often can perform better than the commodity prices themselves, but that does not mean that commodity managers will necessarily outperform other asset classes. In fact, during the last two commodity bear super-cycles, commodity managers, while outperforming commodity prices, have consistently underperformed the S&P 500 Index. This is shown in Chart 3.
Chart 3 has three panels. The blue line in each panel represents the performance of professional commodity managers, similar to Chart 2. The green line represents the performance of the S&P 500 Index. The top panel shows performance during the last commodity bear super-cycle, from 1980 to 1999. The middle panel shows performance during the last commodity bull market super-cycle, from 1999 to 2011. And the bottom panel shows performance during our more recent commodity bear super-cycle, which began in 2011. Notice that the blue line, professional (active) commodity managers, performed worse than the S&P 500 Index, during the last two commodity bear super-cycles (panels 1 and 3). The points of Charts 2 and 3 are to help highlight that professional (active) commodity managers can, and often do, outperform commodity prices, but underperform stocks, during commodity bear super-cycles.
Owning commodities, as part of an overall diversified portfolio, has historically been a smart move. Over time, portfolios have the potential to gain more return, albeit with added risk. This dynamic is shown in Chart 4. The vertical scale is return, the horizontal scale is risk (measured by standard deviation). The blue line represents a portfolio of stocks, bonds, and cash alternatives, since 1975. The green line represents a portfolio of stocks, bonds, cash alternatives, and commodities. The green line consistently sits above the blue line, which tells us that adding commodities can pad portfolio returns, albeit with added risk. And now that most of the price damage from the commodity bear super-cycle has likely been seen for this cycle (in our view), as of 2017, adding commodities to portfolios, on a strategic basis, could make even more sense.
The bottom line for today’s report is that commodity bear super-cycles, as bad as they sound, do not necessarily have to be bad for your portfolio. Professional commodity managers, historically, have performed positively, and better than the underlying commodity prices. Keep in mind, however, that those same professional commodity managers have historically trailed S&P 500 Index returns, as long as the commodity bear super-cycle endures. We suspect that this commodity bear super-cycle will last at least another five years. The point is that we believe active commodity managers should outperform commodity prices, but underperform stocks, during the remainder of the commodity bear super-cycle.
There is no assurance that any of the target prices or other forward-looking statements mentioned will be attained.
Investing in commodities is not suitable for all investors. Exposure to the commodities markets may subject an investment to greater share price volatility than an investment in traditional equity or debt securities. The prices of various commodities may fluctuate based on numerous factors including changes in supply and demand relationships, weather and acts of nature, agricultural conditions, international trade conditions, fiscal monetary and exchange control programs, domestic and foreign political and economic events and policies, and changes in interest rates or sectors affecting a particular industry or commodity. Products that invest in commodities may employ more complex strategies which may expose investors to additional risks, including futures roll yield risk.
Bloomberg Barclays US Long Term Government Bond Index includes U.S.-dollar-denominated, fixed rate, nominal U.S. Treasury securities and U.S. agency debentures
Commodities (CCI Index) The Thompson Reuters Continuous Commodity Index (CCI Index) comprises 17 commodity futures that are continuously rebalanced: Cocoa, Coffee Copper, Corn, Cotton, Crude Oil, Gold, Heating Oil, Live Cattle, Lean Hogs, Natural Gas, Orange juice, Platinum, Silver, Soybeans, Sugar No. 11, and Wheat.
Commodities (Commodity Composite) Index Measures a basket of commodity prices as well as inflation. It blends the historical commodity index introduced by George F. Warren & Frank A. Pearson, former academics at Cornell, collected and published commodity price data in their book, Prices, and the producer price index for commodities (PPI-Commodities), and the National Bureau of Economic Research (NBER) Index of Wholesale Prices of 15 Commodities and the Reuters Continuous Commodity Index. The index components and weightings, from Warren and Pearson’s Prices, change over time but the 11 commodity groups used from 1786-1932 are: Farm Products, Foods, Hides and Leather products, Textile Products, Fuel and Lighting, Metals and Metal Products, Building Materials, Chemicals and drugs, Spirits (stopped tracking 1890), House furnishing Goods, and Miscellaneous. The PPI-Commodities is compiled by the Bureau of Labor Statistics and shows the average price change from the previous month for commodities such as energy, coal, crude oil and the steel scrap. The NBER Index of Wholesale Prices of 15 Commodities is a measure of price movements of 15 sensitive basic commodities whose markets are presumed to be among the first to be influenced by changes in economic conditions. The Reuters Continuous Commodity Index comprises 17 commodity futures that are continuously rebalanced: cocoa, coffee, copper, corn, cotton, crude oil, gold, heating oil, live cattle, live hogs, natural gas, orange juice, platinum, silver, soybeans, sugar no. 11, and wheat.
Warren and Pearson- Prices: 1720-1932, BLS PPI-Commodities: 1933-1946, NBER: 1946-1956, Reuters Continuous Commodity Index: 1956-Current
Commodity Trading Advisors Index – BarclayHedge CTA Index provides a benchmark of representative performance of commodity trading advisors (CTAs). In order to qualify for inclusion in the Index, a CTA must have four years of prior performance history. When a CTA already in the Index introduces an additional program, this additional program is added to the Index after its second year. In order to limit potential upward bias, only CTAs with at least four years of performance history are included in the Index and the performance history begins with year five, ignoring the first four years of performance. Unweighted and rebalanced at the beginning of each year.
S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market.
S&P Goldman Sachs Commodity Index (S&P GSCI) is a trade-weighted index of commodity sector returns representing unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The index includes futures contracts on 24 physical commodities, of which Energy represents nearly 70 percent.
90-Day T-Bill Index Index includes U.S.-dollar-denominated, fixed rate, nominal short term U.S. Treasury securities.
Global Investment Strategy (“GIS”) is a division of Wells Fargo Investment Institute, Inc. (“WFII”). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.
The information in this report was prepared by the GIS division of WFII. Opinions represent GIS’ opinion as of the date of this report and are for general informational purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.
This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.
Additional information is available upon request. Past performance is not a guide to future performance. The material contained herein has been prepared from sources and data we believe to be reliable but we make no guarantee as to its accuracy or completeness. This material is published solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or investment product. Opinions and estimates are as of a certain date and subject to change without notice.
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