Sometimes our current era is known as “the everything bubble”. Fuelled by low interest rates and money printing, everything has become expensive: equities (admittedly mainly in the US), government bonds, corporate bonds, art, classic cars.
But in fact, one major asset class has had a terrible time of it in the last decade or so: commodities. Commodities are cheap in absolute terms, and relative to everything else, they’re downright dirt cheap (no pun intended).
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Here’s why commodities are oddly predictable markets
I’m generally a fan of Jeremy Grantham’s work. The founder of US asset manager GMO has consistently been one of the most interesting thinkers in investment and one of the better contrarian investors out there.
In common with everyone else, he doesn’t get everything right. But I do remember very clearly that he was one of the few people who was extremely bearish in the run-up to the financial crisis, but then also managed to call the bottom almost to the day. He then admittedly became too bearish during the recovery, although he also eventually came around to the idea of a Fed-fuelled melt-up, which looks increasingly likely to me.
But in any case, it’s this flexibility of thought – this capacity to flip and turn bullish, and resist the desire to just lie back and luxuriate in being proven right on the initial bearish position – that makes me pay attention to a thinker.
(I draw on Grantham a lot in my book, The Sceptical Investor, so have a read at that if you want to get more on his views.)
Anyway, at the end of April, he and a colleague, Lucas White, put out another interesting paper on one of the biggest opportunities they see in the market right now – the commodity sector. More specifically, the equities of commodity producers.
So what’s the story?
The great thing about commodities is that they may be one of the most cyclical markets on the planet, which means they follow predictable patterns. That doesn’t mean they are easy to time (no market is), but it can often be quite obvious when the participants are either overly gloomy or over-excited.
Why the cyclicality? I’ve run through this before, but here’s what happens. Commodity producers dig stuff up and sell it. If there isn’t enough stuff, the price goes up. The producers get excited and try to find more so they can sell more. As the producers dig more stuff up, more supply hits the market, and the price goes down.
When the price is at rock bottom, half of the producers have gone bust and the rest are too scared to do anything more than dig away at the little holes they’ve already dug. Supply goes down. Prices go up. It takes ages for the scarred producers to react.
Prices keep going up. Producers get a glimmer of hope and start exploring again. And thus the cycle begins anew. And most of the time, the clues are in the price.
Resources shares haven’t been this cheap in nearly a century
Now, among other things, we’ve just seen most commodities fall to where they were at their last major lows – near the start of 2016, which was also a great buying opportunity – and the price of oil collapse to the point where one benchmark actually turned negative.
So where are we now? GMO points out that resources stocks tend to trade at a discount to the wider market (judging by the US S&P 500 index) anyway (an average discount of about 28%). So we shouldn’t be fooled into thinking these stocks are cheap just because they look cheap relative to the rest of the market – they usually are.
However, by the end of the first quarter of 2020, the discount had widened to “almost 80%” – very cheap indeed. In fact, it hasn’t been seen before, with nearly a century’s worth of data to draw on.
In the long run we may have all of our energy needs produced by solar power and all our construction needs produced by solar-powered nano bots converting worthless raw matter into anything they want. But not in the next decade.
So pricing the sector for near extinction seems drastic, even for a forward-looking market. As GMO puts it: “the global economy couldn’t function without extractive industries. Furthermore, the world can’t transition from fossil fuels to clean energy without the materials that clean energy relies upon”.
What makes these stocks attractive now? Well, we’ve been in a bear market. So producers have grown miserly in terms of their spending. A combination of capital discipline and improving prices for their products would be very good news for share prices.
But even if commodity prices don’t rise, the sector looks cheap. As the GMO team says: “resource companies have had a rough go of it in recent years, but at these valuations, investors have a large margin of safety even with very conservative assumptions… we believe this will likely end up being an excellent entry point for long-term investors.”
Now that was a month ago, and prices have moved up since then – but only enough to suggest that GMO was onto something. I’d suggest that there’s still plenty of opportunity to get on board. Particularly if inflation really does take off after all this.
We’ve already covered several ways to invest in various parts of the resources sector, including uranium and base metals, and we’ll be covering them all in a lot more detail in future issues of MoneyWeek magazine. Do subscribe now if you haven’t already.
Oh and we’ve got a new MoneyWeek podcast up today with a very special guest. Merryn discusses radical uncertainty, Covid-19, and how to pay for all this with former Bank of England governor Mervyn King (a man who should know). Listen to it here now.