Wednesday, March 19, 2014

What the blog is About

Throughout my 30 years in the commodities trading industry, I've recognized that most everyone in the business thinks pretty short term. Why? Probably because a lot of people in it are juiced on the action. Also, most people in the market making and support functions have a vested interest in active trading.
But it’s at longer time frames that fundamentals really matter. As Benjamin Graham said, “In the short run the market is a voting machine; in the long run it’s a weighing machine.” This blog is about the weighing machine. It is aimed at people who want to make intelligent decisions about commodities as part of their portfolio.
The heart of the analysis are graphs that expand on my article in the October 2013 issue of Futures Magazine, “Taking a Long-Term View on Commodities.” In it I argue that commodity prices are mean reverting over ten year horizons, and that the reversion is strong enough to produce sizable profits. The basic analysis is a graph of commocity prices deflated by both the US CPI and the value of the US currency on the X-axis and forward ten-year real returns on the Y-axis. Here’s the graph for aluminum:

So for example, in January 2001, aluminum was $1,620 per MT. This is equivalent to $2,163 in 2013 dollars. At that price, we would have expected aluminum to return about 1.05 times in ten years (a 5% gain) excluding inflation. In fact aluminum returned 1.11 times. The red line is where we are now. So the model is saying that aluminum is undervalued. You can expect it to rise about 40% in ten years in inflation-adjusted terms. If inflation is 2% per year, the actual rise will be 70%.
I have done a lot of statistical work on these relationships, and they are very robust. The reason is probably the old “cobweb” price theory. High prices bring out more production and consumer cutbacks. These lead to low price which in turn bring production cutbacks and higher consumption.
There is an important caveat to this analysis. Sometimes, this time really is different. Every now and then major changes reset the cost curve for a product permanently. A recent example is the introduction of hydraulic fracturing for natural gas in the US. On the other side is the draining of many low-cost reserves
of crude oil and some minerals. So this analysis is really a starting point. To go further, you have to have some knowledge of the industry in question. I'll go into that in later posts.
To see all the graphs go to the page "Ten Year Forward Return Graphs".