William J. Bernstein
Over the past few years, I’ve done my best to avoid writing about commodities futures. I really have. They’ve gotten to be such a hot topic, however, that I’ve thrown in the towel. Better to write a piece I can link to, rather than type the same reply once a week, year after year.
If you want a superb overview of the topic, I highly recommend a working paper by Gary Gorton and Geert Rouwenhorst of Wharton and Yale, respectively. Between July 1959 and December 2004, they calculated that an equally weighted basket of commodities (defined by their spot prices), bought and held, had an annual return of just 3.47%. Since inflation for the period was 4.13%, this is about what you’d expect, inflation being defined, more or less, by commodity prices.
So far, so good. Next, they calculated that rebalancing those commodities to equal weights yielded a return of 6.66%, for a bonus of 3.19%. Again, no surprise here—rebalancing assets with approximately equal returns over a long enough period will usually provide a bit of extra juice. (I’m prejudiced towards geometric returns, which is how these are all quoted.)
Finally, they calculated that the equally weighted and annually rebalanced futures contracts for those assets yielded a return of 11.18%, which was 4.52% higher than the underlying commodities. Whoa! That compares quite favorably with the S&P over the same period, which returned only 10.48%.
Where did the four-and-a-half percent extra return come from? From Keynesian normal backwardation. Let’s imagine that it’s April 1960 and you’re watching wheat futures being traded. The spot price is currently $2.00 per bushel. Who are the most visible players? The farmers’ brokers. What do they want to do? Protect their clients against price deflation. Remember that last word—deflation. Every single one of their clients is scared skinny that prices will fall between today and this time next year, and they’d all give their right arms to lock in $2.00—a price they know they can make a decent profit at—now.
Trouble is, nobody’s buying at $2.00. First of all, there’s no one except for a few speculators willing to even consider taking the other side from all these farmers, and second, even those speculators are smart enough to know that this is a risky bet; yes, the price might rise or stay the same, but it also might fall. One broker yells out "$1.95!" No takers. Another: "$1.90!" Still no takers. Finally, the market clears at $1.85.
What just happened? We have been looking at a market dominated by players seeking to insure themselves against deflation, and a few speculators waiting around the edges to be offered a decent price for doing so—in this case, fifteen cents a bushel.
Now, we can see just where those wonderful returns on commodities futures came from: a market dominated by producers wishing to protect themselves from price declines. Even more importantly, we can see who that premium went to—a few speculators willing to bear that risk for a price. Yes, for every seller, there was a buyer. But in this case, equilibrium pricing strongly favored the latter.
It gets better. Not only did the above-described backwardation and rebalancing get you equity-like returns, but at a substantially lower standard deviation (SD) than stocks (an SD of 12.10% per year for commodities vs. 14.85% for stocks). Not only that, but the correlation with stocks was zero to strongly negative, depending upon the time period studied.
Better still, while stock returns were negatively skewed, those of commodities futures were positively skewed—that is, they had fewer nasty surprises. Finally, the cherry on top: commodities futures outperformed stocks just when it counted the most, early in the recessionary cycle.
How can you not own these things? Easy. The planet described by Gorton and Rouwenhorst is not the one you and I live on. Let’s fast forward forty-six years to the NYMEX crude pit in lower Manhattan today. It’s a few minutes before 2 P.M. and what you see boggles the senses: a pullulating mass of huge guys elbowing each other and howling at the tops of their lungs in fits of greed. What you don’t see is big offers coming from independent traders or even from brokers for the major oil companies. Now the largest offers are coming, ultimately, from folks with names like PIMCO and Goldman Sachs. And their clients are hardly scared stiff of deflation. Quite the opposite in fact—these big commodities funds and hedge funds are looking for insurance against inflation. How else does one explain $75 oil and a supply chain brimming with the stuff?
In a market whose major propelling force is the demand for insurance against inflation, those who supply it will demand a premium. Goodbye Keynesian normal backwardation, hello . . . . forwardation? (Your vocabulary word this day is "contango," which is not a dance performed in Buenos Aires, but rather the proper term for a condition where futures trade above, not below, the expected spot price.) And I wouldn’t bet on the rebalancing bonus either; as my kids would say, "That’s so 2005"; nothing makes a premium disappear faster than tout le monde chasing after it.
There’s not a breath of this in the Gorton/Rouwenhorst working paper, but between this version and the article that finally appeared in the March-April Financial Analysts Journal, someone definitely got to them:
The Keynesian theory of normal backwardation . . . may fit the context of undiversified farmers during the 1930s, but it has less appeal in the context of modern multinational companies operating in global capital markets . . .
In other words, the next time someone tries to sell you a commodities fund based on the Goldman Sachs Commodities Index, smile and say, "Sorry, but I’m from Earth and you’re from planet I Love Lucy. Let’s revisit this discussion in an alternate universe."
I’ve long since given up on my Link of the Month series, since over the years plenty of other folks have provided superb Web-based literature summaries. And frankly, seminal finance papers are few and far between. But here’s a must read from Dimson, Marsh, and Staunton, the authors of The Triumph of the Optimists, on the past and future of the global equity risk premium. You’ll have to click through to one of the download sites at the bottom of the page to actually see the paper. It’s a tad long and if your time is limited, I’d simply start with Table 4, then read the next five pages to the end of the piece. Make sure you’re in a good mood when you start and that you’ve already eaten.
Copyright © 2006, William J. Bernstein. All rights reserved.
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