Wikinvest Wire

Changing the Way Investors Think

Thursday, July 27, 2006

Man is by nature a poor investor. He seeks comfort in the company of others, preferring to stay with the herd regardless of the consequences, rather than thinking independently and taking on the risk of being wrong alone.

Trends spanning years or decades go on much longer than many would imagine, simply because public opinion becomes entrenched - current conditions, despite their preposterous nature when viewed in hindsight, become accepted wisdom.

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Whether it's a multi-decade bull market in stocks or a half decade long housing boom, individual investors look around and see everyone else doing the same thing and figure if they join in, they will be doing no wrong. The performance of individual investors managing their 401k accounts is a good example of this herd behavior - most plan participants underperform the broad indexes simply by chasing last year's star performers.

It happens over and over, year after year, and is a truly worrisome aspect of today's ownership society where it seems individuals seeking a comfortable retirement must also become investment experts early on in life (see "I have some bad news for everyone in the room")

While life-cycle funds help make a bad situation slightly less so, they are not the panacea that many believe them to be.

Why?

The accepted wisdom may be wrong.

One look at the recent performance of broad equity markets reveals a big goose egg when gains are measured going all the way back to 1999. Near term prospects are not so rosy - with a softening economy, many are predicting more weakness in stocks directly ahead.

Though most people don't realize it, the last half decade and the two decades prior were just part of a larger pattern that has been repeating at roughly eighteen year intervals for well over a hundred years.

The 80s and 90s saw a bull market in equities while the new century ushered in a bull market in commodities - most people do not yet recognize the end of the familiar and the beginning of what is now unfamiliar.

In the chart below, from Hot Commodities by Jim Rogers, it is clear that there was a sea-change a few years back where commodities began to outperform stocks. While most investors are holding steady with last century's stocks for the long run approach, others have already moved on.


Click to enlarge

Since they started keeping records, long periods of stocks outperforming commodities have alternated with long periods of commodities outperforming stocks, and with one look at the chart above it should be clear to the most casual observer where we are in the current cycle.

But, ordinary investors pay little attention to current conditions, let alone multi-decade trends.

Just as in the late 1960s when nearly two decades of superior equity gains had come to an end, when the nifty fifty were peaking like dot coms did in 2000, most individuals didn't notice the emerging bull market in commodities that ran for the next fifteen years.

Similarly, when lines were forming outside coin shops in the early 1980s so everyone could buy gold or silver bullion, few realized that the beginning of the greatest bull market in stocks was dead ahead.

Investors must fundamentally change the way they think in order to do well in the years ahead - the tide has already turned, yet so few realize it.

The commodity story goes like this

Playing out over a period of three decades or more, the complete cycle begins with a period such as the 1980s where over-investment creates a glut in capacity that causes commodity prices to decline and stay low for many years as all the new capacity was absorbed. This ushers in an era of low inflation, as in the 1990s, and as a result, publicly traded companies become more profitable and equities rise.

Commodity producers then stop investing in infrastructure and exploration because it just isn't worth it at depressed prices and, after many years, demand increases to the point that commodity prices begin to again rise, as they did in the late 1990s. As is the case today, due to years of underinvestment, prices continue to rise, inflation once again climbs, and both corporate earnings and stock prices come under pressure.

As a result of rising commodity prices, more money is spent on infrastructure and exploration, but since it takes years for new mines and new oil fields to start producing, prices continue to rise as they are likely to do in the years ahead. After years of increased investment, supply surpasses demand, and commodity prices once again fall, some thirty years or more after the cycle began.

Based on historical precedent, we are now roughly one third into the current cycle favoring commodities.

The role of emerging economies around the world and the fact that, compared to previous decades, American companies are oriented more toward finance than manufacturing both change the dynamics a bit, but iron-ore is still iron-ore and oil is still oil.

So far, save for a global economic meltdown, the cycle seems destined to repeat as it has done many times before.

To be successful, particularly during a time when increasing responsibility is laid on the individual, investors must change the way they think. Investors must recognize how the passage of time changes where money can be made and where the herds dawdle.

Most will fail to see the new trend until it is firmly entrenched - until nearly all others around them are also convinced of its staying power. But, by that time, all the easy money will already have been made and what will be left is the dangerous blow-off phase where great gains are as easy to come by as great losses.

The new commodities bull market is already changing the way investors think, but there are many who will resist this change until it is almost too late.

13 comments:

Anonymous said...

The interesting thing at this time in history is that we may be approaching "peak everything." In other words, we may have taken more "stuff" out of the ground than is left to find, so basic commodities may become scarcer and scarcer for quite some time.

It's not just "peak oil" but "peak copper," "peak gold," etc. I believe there will eventually be a solution of sorts to the oil situation (maybe genetically engineered organisms that directly produce something that can be used as fuel from sunlight and basic nutrients), but you can't make basic metals. Until we have mining operations on other planets, we're stuck with what's left here on Earth.

That's going to make commodities awfully expensive for years and years.

- Pete

Steve Wilber said...
This comment has been removed by a blog administrator.
Steve Wilber said...

Tim, my apologies if you addressed this before..

I have a hard time reconciling how you can be bearish on the economy, but bullish on commodities. When the recession hits, wont "stuff" get cheaper due to less demand?

Anonymous said...

Peak everything,a . Just tell me when to invest in the landfill mine ETF's.

Tim said...

Steve,

I'm not sure what you mean by "bearish on the economy". If you mean "expecting a recession sometime in the next year or two", then I'd say that I'm bearish. Given that there will be weakness in commodities during a recession, the question becomes,"If you are overall bullish on commodities for the longer term, what do you do about an approaching recession?"

My view is that timing exit and reentry to try to avoid the recession is a fool's errand because you just don't know what's going to happen. If you remain invested through the duration of the bull market, maybe the next ten years, then you'll be much better off, especially if you get in early enough to ride through the tough times sitting on gains.

Remember that stocks took almost two years to recover from the setback in 1987 and almost a year to recover from the 1990-1991 recession. If you had been fully committed to stocks in the early-mid 1980s, riding out these rough periods would have been much easier to handle, both financially and emotionally.

Of course this logic fails in the global economic armageddon scenario.

TJandTheBear said...

Steve,

Even in a depression, a certain level of consumption is guaranteed. Factor in (a) the initial supply/demand imbalance combined with (b) the continued declining production of existing, aging facilities and (c) the long lead times to develop new production, and you have an extended boom. The tighter money in a recessionary environment can only exacerbate the problems of bringing new supplies on-line.

Rogers makes this case pretty well in his books.

john_law_the_II said...

(I have a hard time reconciling how you can be bearish on the economy, but bullish on commodities. When the recession hits, wont "stuff" get cheaper due to less demand?)

if that were true, there would never be a bull market in commodities because the price would cause a recession and drop demand for commodities. were the 70s times of good economic growth, because that's when commodities were roaring?

let's take the reverse of your argument. if a recession weakens commodity demand, then growth must push up commodity prices, no? that doesn't not explain how during the 80s and 90s we had growth but continuously falling.

the fact is during secular cycles, the economy grows BECAUSE commodities are in a bear market. this makes doing business cheaper and boosts profits.

as you can see from the charts, a commodity secular bull happened during the 30s. sure, commodities fell hard from 1929-1932, but I think that commodities fell far enough during the 80s and 90s for a repeat.

john_law_the_II said...

(Of course this logic fails in the global economic armageddon scenario.)

the response to a scenario would mean lower interests rates, more money and a flight into hard assets.

Anonymous said...

OK, so let's assume I'm convinced that commodities will out-perform stocks for the next 10 years, and I'm willing to stay invested for that long (I am).

So, is this commodities in general (including the foodstuffs), or just oil/gas, metals and the like? I know that oil is getting scarce, and I've always liked a little gold, but what's the best *way* to invest in these?

Mutual funds by sectors? Specific companies? Companies that produce/mine, or those that transport and/or invest in them?

I'm not looking for specific funds or companies, just the flavor...

Kerk93 said...

Anon,
Our country and world are based on faith in promises written on paper (or at least since 1971). Due to our monopoly as the world's reserve currency which has a lot to do with having to purchase oil in dollars, it has worked to our advantage immensely. We have been able to tax the rest of the world by having our currency be the reserve standard. No matter how hard anyone tries, our might has been too great, especially after the fall of the Soviets. By tax, I mean inflation of our money supply. It is a tax, no matter how you cut it. I think it is safe to say our free ride is coming to an end. The faith is being torn down. How anyone in our country honestly thought that deficits don't matter and you can make money by doing nothing is beyond me.

Now some folks in the world actually have savings vice debt. If you have actual savings, where are you going to put them to attempt to preserve what you have? I'm putting them in commodities. Do people need precious metals? Not in the consumption sense, but owning physical PMs requires faith in absolutely no one. It is about as honest as you can get. As that faith gets worse, that funny money will buy less and less of the hard assets. People will want more and more of the funny money since they know it can/is being created at alarming rates. That is my take on describing cycles in the economy without using fancy economic terms that those who create them don't fully believe.

One last note. I know folks will say we had boom bust cycles even while on a gold standard. Yes, we sure did. It's called creating dollars you can exchange for gold that doesn't exist to begin with (fractional reserve lending). People are still putting faith in the currency that there is actual gold (or whatever medium) backing it. As folks begin to lose faith that there is actual gold backing those dollars they are holding, you get the same result. If it weren't for dishonest people (which even I am not altuistic to believe will ever happen), I'm fairly confident that these cycles would disappear. Honestly, how could they not? Unfortunately, I don't see the day where there are no dishonest bankers or politicians, do you?

Tim said...

Anon 1:12,

All commodities, but with an emphasis on energy and precious metals - about equal amounts of commodities and related companies in the form of ETFs, mutual funds, and individual stocks - all available through any brokerage like ETRADE, Schwab, etc.

If you go here you can sign up for a free two week trial at the website, then go to the Portfolio page for details, and be sure to see the Guide For New Subscribers though you are under no obligation to purchase anything - all your questions will be answered.

Anonymous said...

Kerk93:

The US was only semi-on the gold standard from 1932-1971 anyway. Internationally, gold was still available on demand to settle the current account. But internally, US citizens were beholden to the inflationary dictates of the Fed.

There were silver and gold notes circulated variously until the 50s, IIRC, but being "real" promissary notes backed by precious metals, they were driven out of circulation much earlier than this and hence ceased to have any sort of common use (Gresham's law).

When you look at this in retrospect, it is obvious the US just didn't have the international cachet to swindle the global community early on; it could only bully around its own citizens until 1971. At that point the US was clearly the anti-communist/petrodollar superpower of the free world and could do basically whatever it wanted (including tax the entire globe through dollar inflation).

Anonymous said...

The commodities "boom" is a money thing called inflation. This is what it looks and feels like. It happens every time the fed lowers rates too far and holds them down too long.

The "peak" logic would have us believe we have crossed the threshold of "peak" housing. Same bubble.

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