Sunday, September 14

Week 167 - Have Commodity-Related Stocks Hedged Against the Lack of Real Growth in the S&P 500 Index?

Situation: The S&P 500 Index made its all-time inflation-adjusted high on 9/1/00. Fourteen years is a long time for the stock market to be in the tank, even though the main hedging tool (10-yr US Treasury Notes) has been effective. After adjusting for 2.4%/yr inflation since 9/1/00, the Vanguard Intermediate-Term Treasury Fund (VFITX) has returned 3.3%/yr vs. 1.3%/yr for the Vanguard 500 Index fund (VFINX) with dividends reinvested, as of 8/16/14. Robert Shiller maintains a long-term series for both 10-yr US Treasury Notes and the S&P 500 Index. After adjusting for inflation, returns were 1.5%/yr for 10-yr Notes vs. -0.2%/yr for the S&P 500 Index (1.6%/yr with dividends reinvested). Without adjusting for inflation, 10-yr T-Notes were up 3.9%/yr and the S&P 500 Index was up 2.1%/yr (4.0%/yr with dividends reinvested). 

The general explanation for this 14-yr period of low 2.4% inflation is that it results from the lack of real growth in economies around the world, and this lack of growth can be associated with two global recessions that have occurred. Most observers think that a growing reliance on borrowed funds has been a major contributor to those recessions, i.e., interest payments were shackling growth. This culminated in the credit crisis of 2007-08. The problem is slowly being corrected through deleveraging, including government action to reduce spending and raise taxes. 

When central banks lower interest rates to stimulate growth during a recession, the currency is said to be weakened or debased. (The official term is financial repression, see Week 76 and Week 79.) This will correct itself when the economy recovers, i.e., central bankers will reverse their policy by withdrawing the excess reserves that they had been pushing into the banking system. During the period of currency debasement, the prices paid for “hard assets” naturally drift upward. (Think of the “bubble” that formed in US housing prices when the Federal Reserve kept interest rates too low for too long after the “” recession (March 2001 through November 2001.) 

What does this information mean for readers of this blog? Do we need to protect our retirement savings during periods of “financial repression” by investing in real estate, gold, commodity-related stocks, or commodity futures? All of these have real economic utility and are therefore bound to go up in price when the value of the dollar is falling. These are also inherently volatile investments, so we need to think long and hard before making that leap. They’ll start to lose that pricing power when the Federal Reserve starts to wind down its policy of financial repression. (Look at what has happened to the price of gold. It fell 35% between the summer of 2011 and the summer of 2013.)  

Let’s take a closer look at how commodity-related stocks have responded. Those stocks typically pay dividends and are easily traded, which are advantages not shared by other hard assets. On 9/10/13, we published an index of 15 commodity-related stocks (see Week 115). It showed that commodity-related stocks did indeed enjoy pricing power between 1992 and 2013, returning 14.5%/yr while the return for gold bullion was 13.7%/yr, twice the return on Vanguard’s S&P 500 Index fund (VFINX). 

Now that another year has passed, let’s see how the unwinding of financial repression has impacted those results. The accompanying Table shows that both gold bullion and commodity-related stocks haven’t done as well as the S&P 500 Index fund (VFINX) over the past 5 yrs but are still ahead since 9/1/00. One of our benchmarks for this week is the T Rowe Price New Era Fund (PRNEX), a low-cost, low-risk natural resources mutual fund. Red highlights denote metrics that underperform our main benchmark, the Vanguard Balanced Index Fund (VBINX).

Bottom Line: Commodity-related stocks and gold bullion are volatile assets, but worth owning during periods of financial repression. You just need to think about switching to an S&P 500 Index fund the moment you think the Federal Reserve is starting to wind down its policy of “printing money” to “prime the pump.” Most financial professionals can’t time that trade correctly, so you’ll do better by simply owning shares in one or two of the highest quality commodity-related companies for the long term, taking care to pick companies with dividend growth that outpaces inflation (see Column H in the Table). Chevron (CVX), Exxon Mobil (XOM), Canadian National Railway (CNI), and Monsanto (MON) look like suitable candidates for long-term dollar-averaging. But there are others to consider (see Week 163), such as Archer Daniels Midland (ADM). 

Risk Rating for the 15 stocks in the Table: 7

Full Disclosure: I dollar-average into a DRIP for XOM, and also own shares of CVX, CNI, POT, BBL, DD and MON.

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