A lot has been written about commodities and precious metals in the recent past. While some investors believe that we are in the middle of a super cycle for commodities and precious metals, others think that there is already too much speculation built into current prices — that we are in a speculative bubble that will have to burst eventually.
Since discussions about commodity and precious metals prices are often conducted with a great deal of emotion, I hope this article serves the purpose of rationally analyzing what is going on in these markets, what the fair value of precious metals and commodities is today and what the risks and opportunities are going forward.
The investment case for commodities and precious metals is a bit more complex than it looks at first, so let’s start with a brief review of the underlying drivers of these asset classes.
First, I would like to point out that I am not a “gold bug,” but looking to invest money in commodities and precious metals is part of our job, and we think that holding investment exposures in commodities and precious metals should be part of a well- and globally diversified investment portfolio.
In an ideal world, our allocation to precious metals would be very moderate. Unfortunately, we are living in a world that is far from ideal. With the economic and political changes we are facing today, I think we have to deal with a number of very big challenges in coming years. These challenges might be even greater than what we have seen in the last decade.
Ten years ago, precious metals were not a big investment theme. Gold prices had been falling for the most part of the 80s and 90s when central banks were selling huge quantities of gold. This pushed the price down to about U.S.$250 per ounce.
Today, this has changed completely. Central banks have become net buyers again, especially Asian central banks. This, together with investors’ growing concerns about government deficits and money printing policies, has resulted in an almost perfect investment case for precious metals.
The ongoing rally of precious metals prices in the recent past is showing us that there is growing concern among investors worldwide about the health and stability of the financial system and that there is also a lack of trust in central banks and governments. Investors worldwide are worried about future inflation and forced money devaluation. The chart below shows how much gold and silver have gone up in the past 10 years (please note that the blue line is showing the relative performance of silver) as a reaction to those concerns.
In order to protect and preserve capital, investors are looking for a safe and stable storage of value, which has led to the strong demand for precious metals.
The reasons behind the strong increase of commodity prices in the past two years are different, but to some extent they are related to the precious metal boom. The strong rally in commodity prices has been equally impressive, as the following chart shows.
Remember, despite the strong recovery of equity prices in the past two years, Western equity markets have been flat for the past decade, as you can see from the chart below.
So considering the disappointing performance of equity markets and the very low yields in fixed-income markets, investors have been looking to put money into alternative investments such as commodities. Here, rising prices are driven by rapidly expanding demand, while supply is only growing at very moderate levels.
The growing number of people on our planet, especially the rise of Chindia (China and India), is creating the increased demand for a broad range of commodities. Let’s not forget that despite slow economic growth in the West, world gross domestic product is still expected to grow at about 4.5 percent this year. Emerging markets, and especially the BRICs (Brazil, Russia, India and China) countries, contribute almost 80 percent of global GDP growth this year. Investors not only expect a good long-term profit on their commodity investments, they also hope to get at least some hedge against future inflation.
No question, the basic investment case for precious metals and commodities is as good as it can possibly get, BUT have prices gone up too far too quickly?
No matter how good an investment case looks long-term, investors have to realize that market prices can go down dramatically within a short period of time. When short-term capital flows go against the long-term investment case, investors can experience huge losses. Therefore, you always have to know where market prices are and what can influence them.
Let’s look for example at energy prices, in 2008 when oil was trading at U.S.$140 per barrel and people thought it would be at U.S.$200 per barrel soon. A very severe correction followed and prices fell to U.S.$40 per barrel within a few months:
Commodity prices (especially energy) have unique supply and demand curves which are steeper than normal. This means small shifts in supply and demand can cause very large price swings.
The increasing amount of investment and speculative money has made that problem even worse in recent years. While we think the days of “cheap” oil are probably behind us, we have no doubt that oil prices could easily drop U.S.$30-$40 per barrel again should we see increasing evidence that demand is slowing. This could be caused by lower growth in emerging markets, for example. On the other hand, should global growth be stronger than expected in coming years, prices of U.S.$200 per barrel are possible as well.
So what is the true value of commodities and precious metals today and what is the impact of increasing amounts of investment money that has been moving to these asset classes in recent years? Let’s try to answer these questions by looking at historical prices and pricing relationships with other assets.
One of my favorite charts you can see below. It shows the pricing relationship between hard assets (such as precious metals) and soft assets (for example, the stock market).
What is very obvious is that hard assets have become more expensive relative to paper assets after reaching a bottom in early 2000. This relationship had been falling for almost two decades starting in the early 80s, and it shows that these trends can continue for a long period of time.
The period between the early 80s and the year 2000 was also a time when globalization of trade and production resulted in strong deflationary forces, which brought interest rates to the low levels we are seeing today. However, there is increasing evidence that the days of record low interest rates in many parts of the world are over.
Actually, rates have started to go up in some parts of the world, including Europe, despite the sovereign debt crisis in a number of European countries. The Federal Reserve in the U.S. has not done anything yet. Actually, it is trying to keep rates at very low levels.
Rates are being kept low by ongoing monetization of debt, which means that the Federal Reserve is buying a lot of bonds that are issued by the Treasury Department. This has resulted in a mind-blowing expansion of the Fed’s balance sheet.
The investment community often refers to this mechanism as money printing. While rates could be kept low, this strategy has been the main driver behind the recent devaluation of the U.S. dollar.
The chart above makes it obvious that the pricing relationships between precious metals, commodities and “paper” money can experience large swings over time, and investors should always know about these relationships because it contains valuable information for investing. Today, gold is trading at about U.S.$1,500 per ounce and has had a very impressive rally in the past few years. It is a clear indication that investors globally are worried about the health of the international money system and currencies worldwide.
The expansionary monetary policies of most central banks are clearly lowering the faith of investors in fiat currencies. Therefore, investors have a real need for assets that are preserving the purchasing power of their assets, and gold and other precious metals are seen as the ideal solution.
The price of gold has gone up from about U.S.$300 per ounce to today’s price of about U.S.$1,500 ounce. That’s a very impressive rally. But is gold now overpriced or still too cheap considering all the money printing that is going on?
One way to answer that question is to look at the Fear Index, invented by James Turk of GoldMoney. This index compares the price of gold, multiplied by the quantity of gold a country owns, divided by the country’s money supply (M3). This index hit a 16-year high last year, but still stands way below its all-time high reached in the early 80s.
Gold also doesn’t look overpriced when compared to the stock market. The Dow/gold ratio, which compares the value of gold against the value of the Dow Jones Industrial index, currently stands at 8.3. That’s only slightly higher than the low reached in 2009, which was 7.1.
The conclusion is that precious metals and commodities have been a great investment in recent years and, considering today’s problems and challenges, the long-term outlook remains positive. But, investors have to be very careful as significant short-term price corrections are very likely in the future, no matter how good the long-term investment case for both might be.
The long-term investment case for commodities and precious metals remains positive, but investors should be careful and only make such investments as part of an overall, well-diversified investment portfolio.