Making the case for a long-term bull run in commodities

Market Beat

There are few worse feelings for investors than to suspect that they were the last ones into a red-hot market.

So it was with the dot-com stock mania of the late 1990s and the California housing bubble of the last decade. Many of the last entrants to those markets, if they weren't quick to jump, suffered catastrophic losses when the booms turned to bust.

This year, investors tempted by soaring commodity prices may have that same gnawing fear of being too late to the party.

This is, after all, the second big commodity bull run in three years. The first one, during the first half of 2008, collapsed with the financial-system crisis and recession. The Thomson Reuters/Jefferies CRB index of 19 major raw materials jumped 32% from Jan. 1, 2008, to its all-time high reached July 2 of that year — then dived in a spectacular crash that wiped out 58% of its value by early March 2009.

The CRB index has been on a tear again, rising 40% since August, led by commodities including oil, silver, aluminum, corn and hogs.

It has never been easier for individual investors to get a piece of the action in raw-materials markets via conventional mutual funds, exchange-traded funds, individual stocks and other options.

But should you?

Jeremy Grantham, one of Wall Street's best-known market strategists, makes the case that the long-term story in commodities has become extremely compelling. Investors, he says, may not appreciate just how significantly the supply-demand situation for commodities has been altered over the last decade as consumption by emerging-market economies has mushroomed and supplies of many materials have dwindled.

Grantham, a cofounder of money manager Grantham, Mayo, Van Otterloo in Boston, writes a quarterly letter to clients that is eagerly read in the financial world. In his latest letter, he described how prices of key commodities declined for most of the period from 1900 to 2002, interrupted by periodic but relatively short-lived spikes (during the two world wars, for example).

Although global demand rose in the period, supplies of many materials more than kept pace. In agriculture, for example, the "green revolution" beginning in the 1940s led to dramatic gains in crop production.

But the commodity-price story has changed drastically in the last 10 years, Grantham says, amid rocketing growth and wealth in the developing world. This is not a temporary turn, he says. The surge in prices since 2002, though interrupted by the 2008 plunge, "makes it very probable that the old trend has changed — that there is in fact a paradigm shift, perhaps the most important economic event since the Industrial Revolution," he wrote.

"From now on, price pressure and shortages of resources will be a permanent feature of our lives."

What's important to note here is that Grantham, 72, didn't build a $100-billion asset investment firm by chasing fleeting trends. He is known as a classic value investor and a contrarian, meaning he tends to avoid what is popular.

In 2007, Grantham warned that global stock market values had become dangerously frothy. Then, after the 2008 crash, he said early in 2009 that stocks were likely to soon rebound, which they did early that March.

Now, his view of commodities is that the reality of limited supplies and still-enormous demand will be "the greatest challenge facing our species." He adds: "Whether we rise to the occasion or not, there will be some great fortunes made along the way in finite resources and resource efficiency, and it would be sensible to participate."

That's his long-term forecast, but it comes with a caveat: It's better to wait to buy, he says, because commodity prices could suffer a steep interim pullback if one or both of two things happen this year.

One, not surprisingly, would be a significant economic slowdown in China. In his report, Grantham included a table showing 17 commodities and China's annual consumption of each as a percentage of total world demand. Everyone knows China uses a massive amount of raw materials, but the numbers are stunning when shown in one list.

China accounts for 53% of global cement consumption, for example, 48% of iron ore use and 47% of coal demand. It consumes 39% of the world's copper, 36% of the nickel and 25% of the soybeans.

"If China stumbled it would stop a lot of commodities in their tracks" for a time, Grantham said in an interview.

The second possible event that could trip commodity markets would be a vast improvement in global weather this year, after the ruinous floods and droughts that struck critical crop growing regions last year. Grantham, though a believer in climate change, figures there's a good chance weather trends will be better this year for crops, if only because 2010 was so overwhelmingly awful for farmers.

If he's right, he said, "We will drown, not in rain, but in grain, for everyone is planting every single acre they can till."

But any price plunge in raw materials would be a reason to jump in, not run away, Grantham said.

Psychologically, however, a second slump in commodity markets, on the heels of the 2008 dive, probably would demoralize most investors rather than excite them, Grantham concedes. The argument would be, "'There you are, it's business as usual. There are plenty of raw materials, so don't listen to the doomsayers,'" he said. "Because it will have broad backing, this argument will be hard to resist, but should be."

Couldn't science surprise the world with further advances that would lead to more efficient use of raw materials, or greater-than-expected production?

"Technology, of course, will come up with pleasant surprises here or there," Grantham allows.

Yet that can't change the fact that many metals, for example, now have to be extracted from more remote (and therefore costlier) places, he said.

Grantham also dismisses the popular idea that investors and speculators are in large part responsible for the commodity price boom since 2002.

Speculation plays a role, he said, particularly with commodities that can be stored indefinitely, such as silver. But he maintains that the bulk of the rise in prices stems from "a permanent shift in the underlying fundamentals" of consumption and supply.

For investors who believe that raw materials are in a long-term bull market, the question then is how best to buy in.

Few 401(k) retirement savings plans include a commodityoption. That means most investors will have to pick ideas on their own or rely on an advisor.

Other than trading commodity futures or buying physical commodities outright, there are three main choices: funds that track broad commodity-price indexes; funds that own a diversified mix of stocks of commodity-producing companies; and exchange-traded funds that target commodity niches, such as agriculture or metals, by owning either the materials themselves or stocks of companies involved with them.

Kathryn Young, an analyst at investment research firm Morningstar Inc. , favors commodity-price index funds as a one-stop way to add raw-materials diversification to a stock-and-bond portfolio. The funds don't own actual commodities but use "derivative" securities to try to replicate or beat the performance of baskets of commodities.

Newport Beach-based Pimco has become a big player in this niche, with its $27-billion-asset Pimco CommodityRealReturn Strategy fund. Young prefers a lower-cost alternative, Harbor Commodity Real Return Strategy, which is managed by the same Pimco manager, Mihir Worah. Both funds are up about 13% this year.

There also are commodity index ETFs, such as PowerShares DB Commodity Index Tracking fund, up 15.8% this year.

The concept has proved itself, but investors considering the funds should take a close look at their history, risks and tax issues.

Portfolios that own a mix of stocks of commodity companies can provide exposure to the sector, but you're betting on the fortunes of the firms rather than having a direct stake in the price of the materials they produce.

One of the biggest and oldest funds is T. Rowe Price New Era, which is up 10.4% this year. But like many such funds, it is heavily invested in energy stocks. Young prefers a newer portfolio, Fidelity Global Commodity Stock fund, which she said is less reliant on energy and more broadly diversified in areas such as mining, chemicals, steel and agriculture. The fund is up 8% this year.

Like Grantham, Young advised that investors looking to take a stake in commodities go slow, commit to staying aboard for the long haul and try not to pay attention to the inevitable short-term price swings.

"If you look at it too much, the volatility will kill you," she said.

tom.petruno@latimes.com

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