It is perhaps not surprising that investors would want a piece of the action--commodity stocks have delivered superior returns in recent years, riding a wave of higher oil prices, and few investors--particularly highly paid professionals-want to be left behind. To underweight the market's hottest sector and risk underperforming because of that decision is to take a serious career risk if you're a money manager. If you h
ave at least market-weight, however, and you're wrong, well then at least you had good company.
The (admittedly, highly simplified) prevailing case for energy stocks, even though they look historically expensive, runs as follows: demand is high and should continue to rise thanks to the rapid industrialisation of emerging economies such as China and India, whilst supply is constrained and may become more so if conflict in the Middle-East continues to escalate.
An Alternate View
Bill Miller, manager of the $20 billion Legg Mason Value Trust in the US, begs to differ in his just released first-quarter commentary. Miller isn't well known in the UK, but he's probably the most respected and best known fund manager in the U.S., having guided Value Trust to 15 straight years of S&P 500 beating returns--the longest such streak of any fund manager. Over the past decade, his fund has returned 14.1% per year, on average, outpacing the index by 5.2 percentage points on an annualised basis. A version of the fund is available in the UK.
Miller makes several key points against owning commodities at this juncture. He notes that few were interested in commodities before the rally, which would have been the correct time to buy them, and relates the current fascination with commodities to the fading tech boom in 2000. The obvious implication is that it's good to buy low and sell high, but usually a poor idea to buy after something has already had a massive rally: "The reason to own commodities may be that one believes they provide equity-like returns but with little correlation with equities. The time to own commodities is (or at least has been) when they are down, when everybody has lost money in them, and when they trade below the cost of production. That time is not now."
Miller also addresses more specifically the justifications for higher oil prices: He notes that commodity bulls assume demand will not be curtailed by higher prices, and questions whether this assumption is warranted. He points out, for example, that in the last bull market for commodities--the 1970s--the Fed monetised price inflation by pursuing an expansionist policy. Today, he says, "central banks are withdrawing liquidity, not adding it." He also argues that commodities appear to be priced at unsustainably high levels as their current prices greatly exceed their marginal cost of production, which should be their equilibrium price over time. Miller gives the example of Copper trading at $3.25 a pound, against a marginal production cost of $1.30 a pound.
Finally, Miller takes a look at the history of commodity prices movements, and notes that they tend to shows 20 plus years of "oscillation around zero . . . followed by very sharp moves up to a new equilibrium level that is about 3x the old level, then a few decades of stasis." That suggests again that the commodity move is nearing its end and that we are heading for another lengthy period of stasis.
What to do?
So, who's right? The fact of the matter is that it's hard to tell. So many variables impact commodity prices, that it's well nigh impossible to predict their direction with any degree of accuracy. This is perhaps even more true now, given that so much of the demand for commodities is being driven by emerging economies that tend to be more volatile than developed markets. Finally, we can't help but agree with the very basic idea that the time to buy something is whenit’s cheap rather than when its dear. Given the historically high level of commodity prices, the fact that they appear to be in substantial excess of the long-term equilibrium implied by the marginal cost of production, and the uncertainty surrounding the stability of future demand growth, adding commodities exposure at this juncture appears to be at the very least, a risky endeavour.
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