Kenton Ralph Toews is an Investment Executive with Sprott Asset Management USA.
This story has been gaining significant traction lately: Commodities, relative to equities, are at their most undervalued in decades. Making the rounds are variations of this chart depicting the ratio of the S&P GSCI Total Return Index (SPGSCITR),1 a basket of commodities, to the S&P 500 Index (SPX).2 It paints a compelling picture of where commodity prices are in relation to U.S. equities. The long-term median of this ratio is 4.1. The ratio today hovers near 1.0.
This may translate into a significant investment opportunity in commodities given reversion to the mean.
S&P GSCI Total Return Index (SPGSCITR) vs. S&P 500 Index (SPX): 1970-2018
Source: Dr. Torsten Dennin, Incrementum AG; Bloomberg Monthly Last Price, Kenton Ralph Toews, Date: March 30, 2018.
But it is worth taking a deeper look at this chart when discussing relative value. Notice the SPGSCITR is a "total return" index and the S&P 500 (SPX) is a price return index. Hence, the chart above compares a total return index with a price return index. A total return index reflects price appreciation and the reinvestment of cash distributions and dividends (compounding over time). By contrast, a price return index does not reflect the reinvestment of cash distributions and dividends, ignoring the effects of compounding.
Over time, a total return index will outperform its corresponding price return index, given the added effects of income compounding.
You may be thinking to yourself that commodities do not pay dividends and so what income is there to compound in a total return index? The S&P GSCI is an index based on commodity futures contracts. Since a futures contract needs to be paid only at its maturity, cash collateral is set aside in anticipation of meeting the payout at expiration of the contract, and this cash earns interest for that time period. The S&P GSCI Total Return Index takes into account the interest earned on the cash collateral and reinvests it.
A price-to-price return comparison of the S&P GSCI and S&P 500 paints a much different picture than the original, widely publicized, chart above. The revised chart below suggests that commodities, relative to general equities, are even cheaper than reported. Furthermore, the commodity bull market of the 2000s barely registers a blip on this chart — it was nothing compared to the commodities bull market of the 1970s.
S&P GSCI - Price Index vs. S&P 500 (SPX) - Price Index: 1970-2018
Source: Bloomberg Monthly Last Price, Kenton Ralph Toews, Date: March 30, 2018.
Looking at the breakdown of the S&P GSCITR Index, energy is by far the largest component at 58% followed by agriculture at 26%; together, the two represent 84% of the Index. By contrast, precious and base metals, Sprott's specialty, only comprise 16% of the Index. Given the Index's weightings, it is most appropriate to deduce that energy and agricultural commodities relative to general equities are the cheapest they have been in the last several decades.
S&P GSCI Index Composition
Source: S&P GSCI Index Methodology, Kenton Ralph Toews, Date: February 2018.
How inexpensive is gold relative to U.S. equities right now?
Ratio of Gold Price to S&P 500 Index
Source: Spot gold price vs. SPX. Bloomberg Monthly Last Price, Kenton Ralph Toews, Date: March 30, 2018.
Right now, the Gold/S&P 500 ratio is approximately 0.5, which means one ounce of gold will buy half a unit of the S&P 500.
Over the last 90 years, the average Gold/S&P 500 price ratio has been 1.4.
Seventy-seven percent of the time, the Gold/S&P 500 ratio has been above 0.5. Fifty percent of the time, the ratio has been above 1.0. To keep the math simple and to be conservative, let us assume mean regression will take that ratio to 1.0 at some point.
As I write, gold is $1,335 a troy ounce and the S&P 500 is 2,685. To achieve a Gold/S&P 500 ratio of 1.0 at the current S&P 500 level, the price of gold would have to double to $2,670. On the other hand, if gold stays constant at $1,335, the ratio implies an S&P 500 at half its current level.
Ultimately, it does not matter whether the S&P 500 goes up or down. If history is a guide, and the ratio trends upward, gold will outperform general equities from a relative point of view.
We are now 10 years into the current economic recovery that has followed the 2008 global financial crisis (GFC). Historically, equities tend to outperform during the early stages of a recovery, while commodities tend to take the lead when the economy is overheating and inflationary pressures are rising. Are we there yet?
|1||The S&P GSCI (SPGSCI) is a benchmark Index for investment in the commodity markets. The S&P GSCI is calculated primarily on a world production weighted basis and comprises the principal physical commodities that are the subject of active, liquid futures markets. The S&P GSCI Total Return Index (SPGSCITR) reflects the performance of a total return investment in commodities.|
|2||The S&P 500 Index (SPX) is an index of 505 stocks issued by 500 large U.S. companies with market capitalizations of at least $6.1 billion.|
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