December 16, 2010

Commodities Long-Run Return is Zero, Says SoGen Analyst

'When you buy commodities, you’re selling human ingenuity,' argues Dylan Grice.

The blogosphere is heating up with comment on a provocative research report by SoGen analyst Dylan Grice blasting commodities investing.

Gotta give Grice credit for taking on today’s most cherished wisdom.

Gold and crude oil are up 22% year to date. The broader Dow Jones-UBS commodity index handily beats the S&P 500 by two percentage points, and over the past three years, about 15 percentage points separate the Philadelphia Stock Exchange gold and silver index and the S&P 500.

But in a report published Wednesday Grice asks: “Commodities aren’t productive assets, so how can they create wealth over time?”

He then produces charts showing even the real (i.e., inflation-adjusted) returns of T-bills have trumped commodities over the past 140 years.

(Those without access to SoGen research will find a detailed summary of the report on the Pragmatic Capitalism blogsite; and a shorter summary can be found on the Wall Street Journal’s MarketBeat blog and several other blogsites, like StraightStocks.  

Grice’s argument is important and worth hearing. Its most succinct statement is probably contained in these lines:

“A bushel of wheat, a lump of iron-ore or an ingot of silver today is identical to a bushel of wheat, lump of iron-ore or ingot of silver produced one thousand years ago. The only difference is that they’re generally cheaper to produce because over time, human innovation has lowered the cost of production. When you buy commodities, you’re selling human ingenuity.”

He’s doing great so far, in my judgment, and it’s this clever line about selling human ingenuity that seems to be getting the most attention. But the money shot, in my opinion, are his very next lines, which are honest and correct but take a little wind off the sails that carry Grice’s gripe against commodities.

Past performance is no guarantee of future results, obviously, but human ingenuity has a good track record of overcoming nature’s constraints so far. A commodity bull market is really just a bottleneck and as a species we’ve succeeded in bottleneck removal. Historically, most bull markets have ended up where they started.”

There’s the rub.

Grice is absolutely correct of course that commodities are inferior to goods and services that are improved by humans and that can grow in value. He points out that commodities do not generate cash flow, a fact he uses to buttress his argument that buying commodities is really a form of speculation and not an investment.

(And, to his credit, he again delimits his argument by adding: “The hardest commodity-like asset to categorize is land, an asset that is valuable to a future buyer because it will deliver cash flow, not because it will be sold to a future speculator.” Here he correctly concludes that land, though a real asset, is categorically distinct from commodities.)

So far so good.

The problem, however, is precisely that as a species we’ve succeeded in imposing bottlenecks now and then.

The run up in gold reflects weakness in our financial institutions, debased currencies, sovereign default risk and fecklessness in fiscal and monetary policy. If human ingenuity succeeds in solving these “bottlenecks,” then it would be time to rotate out of commodities.

Yes, commodities have returned close to zero over the past 140 years; but those past 140 years have been a period of exceptional growth in human history.  

As Grice points out, past performance — even over a century — is no guarantee of future results. Including commodities in a portfolio is therefore an affirmation of the first principle of investing: diversify.

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