Thursday, June 22, 2017

Why Commodities Are Not An "Investment"

Gold has shot up in value fairly recently, after being stagnant for two decades.

A reader asks if commodities are a good long-term investment.  I think you need to look at the track record of commodities and understand what they are to figure this out.

For example, while the media hyped the snot out of gold after it went up in value, no one talked about it between 1982 and 2002 (20 years!!) when it stayed flat in value (see chart above) and if you adjust for inflation, lost value.   And I suspect gold might do this again, remaining around $1000 an ounce for many years to come.   But that's just my guess.   And guessing isn't the same as investing.

Sure, you can show huge "gains" with any commodity over time, and you can also show huge losses, depending on your start and end-points.   But overall, over time, commodities don't outperform equities, as even recent history shows.

As I noted in other postings, gold is no different than other metals, minerals, or commodities.   Gold-bugs chant "gold is different!" but it is no different than aluminum, zinc, or even ordinary dirt.   It is a commodity, plain and simple, whose "value" fluctuates based on supply and demand.   Commodities don't earn income but merely vary in price over time, upward or downward.

This is not investing, it is gambling.   You might as well buy Elvis Collector Plates - they are a commodity as well.

So why do people trade commodities?   Well the key word is trade.   People don't buy-and-hold physical objects hoping they make money over long periods of time.   They usually don't.   Whether it is collector cars or antiques or whatever, in most cases, these things rarely appreciate much faster than the rate of inflation.  Most people lose their shirts.

Like Bitcoin or indeed any currency, people often buy gold as a means of parking money or exchanging money (indeed the definition of currency).   But hanging on to it makes no sense at all, any more than hoarding dollar bills would make sense.

Investing means putting money to work at an enterprise where the money is invested and used to create wealth.   A factory is built, people are hired, raw materials are bought.  Manufactured goods are made, and they are worth more than the sum of the parts.   Profits are earned, dividends are paid.   It need not be a factory, it could be some other enterprise, a loan, a bond, or whatever.   The point is, the money earns money - it makes money.   Commodities just sit there earning nothing, their value changing only due to their perceived scarcity.

I used the example of aluminum before.   Before new processes were discovered to make aluminum cheaply, it was one of the most valuable metals on earth - far more valuable than platinum and gold.   Overnight, it became nearly worthless in comparison.  Indeed, we throw away aluminum cans by the side of the road today.   If you could travel back in time to 1850 with a six-pack of lite beer, you'd be a millionaire.   Or at least very rich, anyway.

Oil is another example, and right now we are seeing how its value has fluctuated just in a few short years.   I was told at GMI that by 2000 or so we'd run out of oil and it was scarce.  Then the Canadians started tar sands.  We started fracking.   Suddenly, the world is in an oil glut.   That is the nature of commodities - subject to the whims of supply and demand, in this case, a glut of supply.

Or take demand.  Another "virtual currency" crashed last night as someone tried to sell off a huge chunk of it on an "exchange".   Since the number of people wanting to buy the currency is limited, the price started to drop off as this huge sale went through.   And that can occur in a lot of markets - including stock.   Again, we like to say that Bill Gates is a "Billionaire" based on his Microsoft stock shares, multiplied by the current share price.   But what do you think would happen to the share price if this morning, he put it all up for sale at once?   This is why "market cap" is bullshit.

Anyway, eventually, demand caught up with supply and this "virtual currency" recovered somewhat.  But it illustrates how volatile commodities can be.   Whether it is gold, oil, bitcoin, pork bellies, soybean futures or whatever, prices can change dramatically.   And this makes "investing" in this stuff little more than gambling, for the ordinary middle-class investor.   Yes, a lot of people get rich buying and selling commodities, you are not going to be one of them.   Rather, you will be the one who loses his money so the smart guy makes money.   The way to get ahead in the world is not to try to out-smart the smart people, but to simply not play their game.

So why do people buy and sell commodities?   Well, as noted before, it can be a way of parking money (in gold) during economic upheaval.   It can be a way of transferring money (Bitcoin) usually for illegal transactions.    And it can be a way of hedging risk.   A farmer grows a crop and hopes to make money.   But he is at the mercy of weather, insects, plant disease, drought, and fickle markets.   He might actually beat all the former but fail at the latter.  He has a bumper crop of corn, but then again so does everyone else - the market is saturated and prices plummet, to the point he is losing money on each bushel sold.

He can sell off his crop before it is even harvested as a commodities future and let some gambler bet on whether crop prices will go up or down in the interim.   The farmer gets an assured price, the gambler might clean up in the market later on.   It is a tricky business and you have to know these markets intimately - have studied and traded in them for years and years.

Which is why it is so suspicious that Hillary got into commodities, made $100,000 in three months, trading on the advice of a former executive for Tyson's foods (who was trying to settle an environmental claim with the Arkansas governor, her husband) and then got out of commodities trading and never went back.   The odds are..... well, long, to say the least.   Maybe that's why she lost the election, in part.  But I digress....

Commodities are not for amateurs.   The financial media hypes things that go up in value suddenly, and amateurs figure, "Hey, it must be poised to go up further!" and lose their shirt.

Succeeding as an amateur investor means understanding that you are an amateur.   You are a little girl with a floaty, swimming in a shark tank.   Stay in the shallow end or get eaten alive.   No, you might not "make out like a bandit" but you can prosper and do well - and not end up broke, bitter, and depressed.    Small-time investors who think they can "strike it rich" are the types who end up living in a van and then railing against society.