commodities running a marathon or sprint?

13 Jan

Commodities have been on a spectacular run since August. The Wall Street Journal’s front page story this morning specifically addresses agricultural commodities, including wheat, soybeans and corn. Along with precious metals, agriculture has led commodities’ price rise and helped incite continued inflows into these markets over the past several years. Traders cite on the ground reasons that prices have gone up so far so fast – including increasing consumption from China, multi-decade low reserves and higher corn ethanol production. Also, backwardation (future prices less than spot prices) in one-third of the GSCI commodities boosts the case for tight supply/demand conditions. But these supply/demand theses are valid regardless of price. (As with all non-income generating “assets,” pricing is an elusive exercise.)

Regardless of the specifically-cited reasons today, what I question is whether this is a modern incarnation of Gresham’s law, bad money driving out good. A hundred years ago, on a bi-metallic standard in countries that accepted other countries’ currencies as legal tender, the most “fine” or pure currency would be hoarded and the less pure (“bad” money) would be spent. Thus, as the debased money was used to buy the stronger currency, its relative price decreased and became even less valuable. The market saw to it that the worse currency was worth the least and the “good” money fell from circulation. Of course, this generally occurred in a system of fixed exchange rates and (mostly) convertible currencies. Today’s free-floating currencies are a relatively new development in monetary history.

Today, it looks like (“good”) physical assets are driving out (“bad”) fiat currency. Stated in terms of the dollar (because that’s how we measure them), commodities are clearly on the rise. Gold, silver, and copper, which as recently as a hundred years ago were used as a medium of exchange, were up 29%, 82% and 30%, respectively. Cotton and coffee gained 92% and 77%. As Standard & Poor’s observes, “2010 year can be broken down into two distinct periods – one extending from January through August and another covering the remainder of the year. The announcement of quantitative easing from the U.S. Federal Reserve has helped provide a bid for most commodities.” On one hand, it looks to me like the market is saying that fiat currencies are less valuable and/or are being debased. Or, we could have a speculative almost-bubble on our hands.

Bolstering the case for the latter is that ten years ago about $6 billion was invested in commodities. Today, it’s nearly $300 billion. Money flows tend to drive prices higher, all things equal, and it appears to be the same today. And where the money is flowing isn’t necessarily in the right direction. This Businessweek article elucidates some good points about commodity exposure. As someone smarter than me said, there is no asset class that enough money can’t spoil.

Whether these price increases are well-founded or not is open to debate, but there is a clear correlation between the announcement of “QE2” and the snapback in financial markets, including equities (correlation of commodities with stocks is near all-time highs). But not all commodities are moving higher – one that has bucked the trend is natural gas, which is abundant and experiencing low demand. Its price fell 40% last year. If the behavior Gresham discussed was occurring, we shouldn’t expect its price to languish for long.

Still, we can’t ignore the “hot money” going into commodities. For these, Wal-Mart may have said it best: “Watch for falling prices.” What the wise man does in the beginning, the fool does in the end.

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