Unlike a stock or a bond, a commodity is not a producing asset, but rather it is a hard asset. A producing asset provides an investor with ownership in a company (stock) or a claim against the company's assets (bond). The fundamental value of the producing asset is tied to the company's current balance sheet as well as its future earning potential. Because the future earning potential is unknown, a producing asset can trade at over or under-valued levels to its true fundamental value.
Hard assets on the other hand do not have a fundamental value, defined the same way as producing assets. The value of a hard asset is whatever someone else is willing to pay you for that asset. For commodities this is usually based on the price of the finished good that is made from said commodity minus the cost to produce the good plus a profit for the producing company. Therefore in an "orderly economy" where there aren't any spikes in supply or demand, commodity spot prices should increase by somewhere close to the inflation rate over time. That being said, there are definitely periods of time when demand is growing faster than supply (e.g. Japan's real estate bubble in the late 80's, Dutch Tulip Mania in the 1600's, etc.) and vice versa.
It is during these periods of spiking supply or demand that one might consider a commodity to be over or under-valued. This is something we touched upon in a recent blog post. We use a metric that was developed in house called the Inflation Adjusted Commodity Index (IACI) to compare a current commodity price to a long-term average price adjusted upward for inflation. When commodity prices are X% above or below the IACI, we consider them to be over or under-valued. Defining whether commodities are under, over, or fairly valued is part of the Seasonal Model in MarketVANE. Ascertaining the fundamental state of the commodity market is a good first step, but it is incomplete if you let it completely drive your decision on whether on not to invest in them.
Season Investments, LLC
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This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.