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(Chart updated on 30 November 2015 with ratio at 0.51)
The ratio of the price of gold to the S&P 500 shows two notable extremes that are clearly visible in the log-scale chart below. The first was a reading of 6.1 in January 1980 when gold spiked up to $850 per ounce and the S&P 500 was struggling to shake off the 1970s syndrome of “death of equities”, “misery index” and “malaise”. The second was 0.19 in July 1999 and subsequent months when gold hit a multi-decade low of $252.8 while the S&P 500 soared on the wings of the Nasdaq bubble.
A more recent high of 1.5 was in September 2011 when gold reached an all-time high of $1,895. The ratio has since retreated to 0.56 today which is a level not seen since the stock market highs of 2007.
It should be noted that the average for the ratio, since gold started trading freely in 1968, is 1.18, which means that it is now well below the average. Reversion to the mean here would mean the S&P 500 falling by half or gold doubling, or various combinations such as for example the S&P 500 falling by 35% while gold rises 35%.
There is no doubt that there is some exuberance in the stock market, but it does not necessarily follow that the ratio should quickly revert to its long-term average. After all, one may ask, why is this ratio even relevant? It is a question that is justified if you believe that gold should only reflect inflation expectations. Then it would rise or fall with inflation fears.
But in reality, there is more complexity in what drives the price of gold. Inflation numbers were similar in the 1990s and 2000s but gold fell in one decade and rose in the other. Therefore, inflation alone is not enough to explain its behavior.
What drives the price of gold will be the subject of another post. But here it is enough to say that it is driven in part by several factors which are the inverses of those that drive the S&P 500. It makes sense therefore to keep an eye on the ratio.
“It is really important to have ags in your portfolio. Most people have gold and most people have oil. The fact that they don’t have ags is actually quite a mystery.” Sal Gilbertie, President of Teucrium Funds.
TO HEAR THE PODCAST, CLICK HERE OR ON THE TIMELINE BELOW:
As Sal Gilbertie would have it, CORN is not only the king of agricultural commodities. It is also the ticker symbol for one of Teucrium Funds agricultural ETFs. In addition to CORN, Teucrium offers three other single-commodity ETFs: WEAT, SOYB, CANE, for wheat, soybean and sugar. Each of these ETFs invests in futures and is configured to “mitigate contango and backwardation” and to track the price of its underlying commodity. A fifth ETF, with ticker TAGS, tracks an equally-weighted basket of corn, wheat, soybean and sugar.
I recently had a conversation with Gilbertie who is President of Teucrium. Gilbertie cut his teeth in the 1980s as a commodities trader at Cargill and later at other large institutions. His case for investing in agricultural commodities is three-fold:
- the long-term: growth in demographic demand in emerging markets.
- the timeless: diversification away from the S&P 500 and from gold.
- the short-term: agricultural commodities are now significantly undervalued relative to gold.
1- Long-term Demand and Supply
Demand for agricultural commodities is expected to rise steadily in the decades ahead due to 1) the growth of the global population currently from 7 billion people to over 9 billion by 2050 and 2) the rise in living standards and concomitant improvement in diets in emerging markets.
The table below shows future population estimates per the United Nations’ medium variant estimates. It should be noted that this medium variant assumes a big decline in total fertility rates (TFRs, number of children per woman) in India and Sub-Saharan Africa. In the event that TFRs do not decline as fast as expected, the population growth in these countries would be even greater.
Asia and Sub-Saharan Africa will show the biggest jump in population and in demand for basic food stuffs. Note in the table that Sub-Saharan Africa is forecast to contribute half the population growth between today and 2050, and as much as 81% of the growth between today and 2100.
It is not difficult to conclude from these figures therefore that Sub-Saharan Africa will require more than a doubling of food supplies in the next 35 years, a significant challenge at a time when it is still trying to eliminate hunger in many countries.
Of course, supply is also growing but it is generally more volatile than demand due to periodic crop failures (from floods, droughts etc.) in one or another region of the world. Supply is also constrained by two factors: lower yields from farms in emerging markets and poor infrastructure in the regions of the world which have the largest unused acreages of arable land.
In 2012, the African Union Commission (AUC), the United Nations’ Food and Agriculture Organization (FAO) and the Brazil-based Lula Institute joined forces to “eradicate hunger” in Africa. At the time, the Chairperson of the AUC stated the following [my emphasis]:
“Food security is one of the key priorities of the African Union. Africa has the potential to increase its agricultural production given that almost 60 percent of the arable land in the continent is still not utilized. This enormous potential can make a real difference to improve our agricultural production and food security. It is time to move beyond subsistence agricultural production and consider ways of eventually embarking on agro-industrial production.”
More generally, looking at the global picture, Sub-Saharan Africa is believed to have the largest reserves of untapped arable land. As promising as this may be, massive investments in technology, infrastructure and logistics will be needed before new farm land can yield significant amounts of grain that can be delivered to consumers.
With regards to agricultural yields, an FAO report released in 2002 stated:
“Global cereal yields grew rapidly between 1961 and 1999, averaging 2.1 percent a year. Thanks to the green revolution, they grew even faster in developing countries, at an average rate of 2.5 percent a year. The fastest growth rates were achieved for wheat, rice and maize which, as the world’s most important food staples, have been the major focus of international breeding efforts. Yields of the major cash crops, soybean and cotton, also grew rapidly.”
For example, wheat yields in developing countries have nearly tripled from 1,000 kilograms per hectare in 1968 to over 2,600 now.
To sum up, supply will keep up with demand but only if yields improve at existing farms and if new infrastructure is put in place to service new arable land.
2- Timeless Diversification
Agricultural commodities are less correlated to the stock market than gold and should therefore be considered for diversification at any time. In recent decades, gold has drawn tens of billions in portfolio investments mainly because it was seen as a hedge against possible dislocation in financial markets.
Gold delivered on its promise as an effective diversification asset in 2008-2011, outperforming stock markets by a wide margin during the financial crisis and its aftermath. Although it has retreated from its 2011 highs in recent years, gold is still a significant outperformer of all leading stock indices in the decade and a half since it hit bottom in 1999. See chart above.
Of course, gold grossly underperformed stocks in the 1990s, but the subsequent decade proved that there can be prolonged periods of time when it beats the popular indices by a very significant margin, notwithstanding comments by some market participants who deride it as barbaric or uncivilized. The pragmatic reality is that, barbaric as it may be, gold sometimes outperforms stocks for ten or fifteen years.
Still, if we have shown that diversification into commodities is desirable, the chart above from Teucrium’s web page argues that agricultural commodities are even better diversifiers than gold because they have a lower historical correlation with the S&P 500 than gold does. Through the 20-year period 1995-2014, sugar, corn, wheat and soybean have all had a lower correlation to the S&P 500 than has gold.
3- Short-term Valuation
The ratio of gold to corn was in September 2014 at its highest level since gold started trading freely 38 years ago. It stands today at nearly twice its long-term average. Gilbertie says that, on average since 1976, an ounce of gold has purchased 165 bushels of corn. Last September, an ounce of gold could buy 377 bushels and today it can buy around 300 bushels, still nearly twice the long-term average.
The ratios of gold to the other grain commodities and to sugar tell a similar story.
Thank you for reading. My conversation with Gilbertie includes more original insights about the mechanics of trading futures and ETFs and about the supply and demand prospects for agricultural commodities.
You can listen to the full podcast here:
Disclosure: The author has no contractual agreement with Teucrium and receives no compensation from Teucrium. As of the date of this posting and for at least the following 72 hours, the author has no investments in the Teucrium Funds.
Disclaimer: This article represents the author’s best faith efforts at presenting true facts. Nonetheless, despite the author’s best diligence, the article may include unintentional errors. Do your own work, read more research and draw your own conclusions before you decide to trade.
Initially published at Seeking Alpha on Thursday, July 2, 2009.
The question about owning gold should not be ‘why’ but ‘how much’. At the very least, gold should be considered a form of insurance against either financial collapse or rising inflation. It is pointless therefore to ask ‘why’ if you generally believe in the merits of owning insurance on anything. You don’t buy insurance for your house as an investment, but as a hedge against the low-probability scenario of it burning down or being destroyed by a hurricane or flood.
The only caveat to this analogy is if you don’t believe gold is a suitable form of insurance. But then what is? One scenario where gold may fail the test would be a deflationary economy. However, considering the amount of pump-priming that central banks are engaged in, the likelihood of deflation has receded compared to six months ago. Furthermore, the scenario of a Japanese-style deflation is unlikely for the American economy because our financial system (unlike Japan’s) is hard-wired to domestic economic growth and any deflation would quickly result in renewed systemic stress which would in turn lead to more investors buying gold.
The market recovery since March has alleviated many concerns, but only the most optimistic analysts would say today that the economy is out of the woods. To the rest of us, the risks of either another bout of systemic distress or of accelerating inflation are very real. In light of the steps taken by the Obama administration and by the Fed, the greater of the two risks is now that of accelerating inflation. The economy will likely see rising prices brought about by the very large government budget deficits and by a weakening dollar.
Underlying this picture is the overall demographic picture of the United States. Starting in 2005, and for the first time in 30 years, the size of the most economically active population (the 30 to 60 year-old segment) is stagnant at around 121 million souls. Between 1975 and 2005, this segment grew every single year, from 87 million to 121 million, contributing to economic growth. Due to a decline of the birth rate in the past thirty years relative to the preceding thirty, we are now in the fourth year of a fifteen-year period (2005 to 2020) when this segment will flatline at 121 million. The last period which saw the size of this bracket stagnate was the 1970s when the 30-to-60 group remained at 89 million (dipping to 87 million in 1974-75).
(If we redefine the most active bracket as the 25 to 67 year olds (instead of 30 to 60), the size of that bracket will continue to grow until 2017, which is good news for a resumption of GDP growth. However, the weakening of the economy since 2007 suggests that the inflection point has already been passed and that we should focus on the narrower 30 to 60 bracket. Most people who are younger than 30 don’t have a lot of money to spend and most people over 60 cut back on their spending.)
This suggests that the assumptions of economic growth for 2010-11 and beyond made by the Fed and the Treasury will prove too optimistic if they are premised on a demographic context such as we have seen in the last three decades. Lower-than-expected growth will mean lower tax receipts and greater demand for subsidized services, making it difficult to reduce the budget deficit. The bond vigilantes are already back in action and we can expect long-term rates to rise, the dollar to weaken and inflation to accelerate. It is very likely that gold will break through its March 2008 high and that it will see a price of $1,500 or even $2,000 per ounce before the Presidential election of 2012.
While its overall effects on the economy are clearly negative, inflation has one benefit which is to reduce the burden of excessive debt. Rising wages mean that households with fixed-term debt (fixed-rate mortgages, credit-card debt, etc.) will service that debt more easily since monthly payments will be falling in real terms. And real estate prices would see a recovery, though probably only in nominal terms. The same is true at the national level with rising inflation reducing the debt and entitlements burdens borne by the Federal and state governments, but also damaging in the process many social services as well as our relationships with our country’s creditors.