As many investors realize there are very few places to run from depreciating money given the overall flattish yield curve and historically low interest rates, alternative investments are entering the spotlight. With a persistent inflation rate, money must travel in search of a yield to avoid withering away, yet the present lack of positive real interest rates has made this task near impossible. There is only one asset class that naturally benefits from this environment and this explains why it has outperformed all its competitors. The asset class in reference is precious commodities, and understanding why the competition is weak is key to understanding why rare commodity prices will remain strong and why its the only answer to where money should go at present.
Stocks are Overvalued
Despite very weak inflation adjusted returns over the last decade, stocks still remain a poor investment relative to key metrics. The best and most common measure of a stock’s value is its price to earnings ratio. This breaks down the price of a stock to the earnings one can hopefully expect per share unit, and this provides an objective way of comparing varying stocks or measuring the market as a whole.
At present the price to earning ratio, commonly called the p/e ratio, is about 23 to 1 for the S&P 500 stock index:
This means that for every $23 dollars you would need to spend to acquire a stock you’ll receive only $1 dollar in earnings per year. Effectively, the stock would need to keep pace with its current earnings for the next 23 years just to fundamentally justify the base purchase price today, book value aside. If current earnings are likely to decline on an inflation adjusted basis, this situation is much worse.
In many respects, the current p/e ratio indicates stocks are too expensive. For one, the historical mean p/e is 16.41 to 1 and the median ratio is 15.81 to 1. Stocks right now, then, are at least 40% more expensive than their historical average.
In addition, dividends from stocks do not even make up for inflation. The dividend yield of the entire S&P 500 index is 1.94% per year, which is about 1% below the current Consumer Price Index (CPI) annual increase. Therefore, dividends actually are producing negative real returns, destroying the purchasing power of investor’s funds.
Houses are Overvalued
The most recent complete data available is from 2010, but the factors involved do not appear to have changed much since then so the information is equally applicable to present conditions. Since all residents need to either rent or own a home, the best measure for tracking the affordability of house ownership is the rent to buy ratio. This ratio takes the median house price and divides it by the median 12 month rental cost. The resulting value is effectively how many years an owner would need to keep an active renter to justify the price spent on the house.
Houses presently cost 22 years of rental income, which is above the historical average of 15. This is calculated by taking the median gross rent from 2010, $855 (source: US Census Bureau), multiplying it by 12 and dividing it by the median sales price for houses at the end of 2010, $226,900 (source: US Department of Commerce). Its important to note that this measure assumes the house is bought outright, rental income will not fall, houses will pace with inflation and there are no maintenance costs. If financing, broker fees, drops in rental rates, property taxes and maintenance factors are included house values become even less attractive by a wide margin.
Cash, Bonds and Fixed Income are Overvalued
Bond yields on short-term investment grade instruments are close to zero and even longer term yields on government bonds do not exceed 3%, the present inflation rate, by a substantive margin.
Given these facts, no fixed income instrument is producing a positive real return when relative risks are adjusted out of the equation. With bond prices at multi-decade highs, and yields nearing the zero bound, prices are technically restrained from moving much higher. If the inflation outlook turns out to be worse than the Bureau of Labor Statistics (BLS) estimates in their CPI, and default risks spike up from their historical lows, bond values look even worse than the already gloomy outlook.
Commodities are the Only Answer
Competitive valuation is largely the reason commodities have outperformed all the above asset classes in recent times and given that all other assets remain heavily overvalued, commodities should continue to shine. Real assets have more going for them than just competitive returns as well, and will be sought after for safety, quasi-insurance, and protection in an unusually uncertain economic environment. Commodities are unique in that there is no counter-party risk and the strong liquidity is sought after while economic calamities plague the global financial environment and credit system.
To keep trade competitive, governments around the world are debasing their currencies in an attempt to cheapen their goods on the international market. Instruments that are tied to cash, therefore, are in constant danger of governmental manipulation cheapening their returns. In addition, many assets are presently driven by the credit environment and the sustainability of the credit system has never been in such disarray in modern history. Given these facts its not hard to see why the only assets which have no credit risk, cannot be debased, and have strong liquidity are outperforming the rest.
On a valuation perspective, commodities do not have traditional financial metrics since they do not produce cash flow, but there do exist contexts which provide a means for measurement. For one, on a historical basis, commodity prices still seem attractive, as many agricultural and metal commodities are trading below their nominal highs and almost all are trading below their inflation adjusted highs. Furthermore, gold, one of the most reserved commodities, only makes up less than 1% of global asset allocation which is about at a historical low.
Another major, under-appreciated reason to see commodities as undervalued is the presence of large outstanding naked shorts in the derivatives markets which imply a potential short squeeze effect continuing if price rises persist. All this said, and remaining powerfully true, the real valuation driver for commodities, however, is the deterioration of the currencies they are priced in. With the present intention of central banks to monetize the collapsing credit system, there is no visible end to the potential for commodity price rises then.
The notion that commodities are the only place to run is no longer unique to “gold bugs” like us either. The philosophy is starting to hit the mainstream as money managers find it increasingly difficult to find returns by traditional investment allocations. For example, the lack of real returns in bonds and stocks was recently pointed out by famed bond king Bill Gross in a Bloomberg interview:
In all, the commodity market is far from saturated and the fact remains that there are no other viable alternatives to park cash in at present. So far as this remains true, the commodity bull market will continue to roar forward.
