The 19th of October will be etched in traders' memories forever for two reasons. The first is the Crash of 1987; the second is an unusually lively -- what the diplomats might call "frank and useful" --
Columnist Conversation exchange on that date last week.
The question before the house is whether commodities are a good measure of inflation. At first blush, this might seem to be a riddle on the order of "Who is buried in Grant's Tomb?," but the answer is rather surprising.
The Long View
Let's take some very long histories of various cash commodities and deflate them by the producer price index, which I've presented in the chart below. I've used monthly averages of the cash market prices both to avoid single-day outliers and the contract roll problems associated with futures markets. All data presented in the chart below go back to 1946 except for coal (1984), aluminum (1951) and natural gas (1976). You may wish to keep in mind that the world's population has more than tripled since 1946.
Two indices, the Reuters/Jefferies Commodity Research Bureau (CRB, 1956), and the Journal of Commerce-Economic Cycle Research Institute (JOC-ECRI, 1971) are presented as well. As a rule, I do not like the entire
concept of commodity indices because they involve combining negatively correlated assets, but even these measures have not shown long-term uptrends. The CRB data since June 2005 are colored differently to note the change in index composition.
If we regress individual inflation-adjusted commodity prices against time, we should see positive coefficients for those commodities whose prices on average rose faster than the PPI and negative coefficients for those commodities whose prices failed to keep up with inflation.
On the chart below, the coefficients are color-coded into groups: Black for grains, brown for renewable industrials, gray for indices, light blue for industrial metals, green for livestock, red for energy and magenta for precious metals. Platinum is dual-coded to reflect its industrial and precious metal duality.
Source: CRB-Infotech CD-ROM, Howard Simons
The groupings in this chart tell a story in and of themselves. Renewable resources, whether they are grains, renewable industrials such as wool, cotton or rubber and livestock, all have fallen steadily over time. Rubber, addressed here in
August 2000, is particularly striking, inasmuch as the world's tire population has grown considerably since 1946, and modern radial tires require natural rubber. Even recyclable industrial metals such as steel scrap and copper have declined steadily over time. Other industrial metals, such as zinc, tin and aluminum, essentially have kept pace with inflation.
That leaves us with precious metals and energy. Both natural gas and crude oil are somewhat misleading because they were under price controls or cartel controls for much of the available history. Even gold, the most inflation-sensitive commodity, was under price controls until the mid-1970s. And silver's positive coefficient is an artifact of the Hunt brothers' 1979-1980 escapades, in which they created a silver bubble that soon popped.
Let's stipulate that conventional crude oil and natural gas, crude oil in particular, are rising in price faster than inflation. They are not renewable resources and they are not recyclable in any economic sense. Because we extract the cheapest resources first, we should expect to encounter higher marginal extraction costs and diminished returns on investment; this is the "peak oil" argument. But even here the laws of economics have not been repealed: The energy cost of producing a constant dollar of GDP has fallen steadily for three decades and shows no signs of slowing anytime soon. The current surge in prices provides increased incentives for energy productivity, so we should expect the decline in the chart to accelerate in the years ahead.
Productivity mandates declining real commodity prices over time. The chart below illustrates that this has proven true. Commodities are not financial assets, they are factor inputs to production. If their real price does not decline, they will lose market share to substitution and conservation. This is very different from, say, a stock, which can become more attractive at a higher price.
Source: Energy Information Administration
One of the great mysteries of economics is why analysts totally familiar with the historic volatility of the past are so willing to project smooth paths for the future. Markets do the same; let's take an expectation variable such as the Treasury inflation-protected securities market's implied rate of inflation for the next 10 years and map it against the Dow Jones-AIG index.
This expectation has matched the commodity index only for a brief time, between the stock market low of October 2002 and the bond market's acceptance of ever-tighter monetary policy in April 2005. Economic growth and monetary policy must coincide for expected inflation and commodity prices to correlate. At present, the two have diverged until the weight of the fed funds rate increases.
I am beginning to conclude that we are at a Potter Stewart moment, which takes its name from the late Supreme Court justice who famously knew obscenity when he saw it. We all believe that we know inflation when we see it, and suffice to say very few of us feel our individual costs of living are measured well by the government's price indices.
Inflation as a concept includes the length of each of our planning horizons and our perceived personal financial risks as well as the backward-looking measures employed in the price indices. It is a forward-looking market, a change in behavior. No thermometer can measure it, certainly not that of the commodities markets.
Howard L. Simons is president of Simons Research, a strategist for Bianco Research, a trading consultant and the author of
The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he appreciates your feedback;
to send him an email.
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