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.|
This content may not be reproduced in any form, or referred to in any other publication, without acknowledgment that it was produced by Sprott Asset Management LP and a reference to www.sprott.com. The opinions, estimates and projections (“information”) contained within this content are solely those of Sprott Asset Management LP (“SAM LP”) and are subject to change without notice. SAM LP makes every effort to ensure that the information has been derived from sources believed to be reliable and accurate. However, SAM LP assumes no responsibility for any losses or damages, whether direct or indirect, which arise out of the use of this information. SAM LP is not under any obligation to update or keep current the information contained herein. The information should not be regarded by recipients as a substitute for the exercise of their own judgment. Please contact your own personal advisor on your particular circumstances. Views expressed regarding a particular company, security, industry or market sector should not be considered an indication of trading intent of any investment funds managed by Sprott Asset Management LP. These views are not to be considered as investment advice nor should they be considered a recommendation to buy or sell. SAM LP and/or its affiliates may collectively beneficially own/control 1% or more of any class of the equity securities of the issuers mentioned in this report. SAM LP and/or its affiliates may hold short position in any class of the equity securities of the issuers mentioned in this report. During the preceding 12 months, SAM LP and/or its affiliates may have received remuneration other than normal course investment advisory or trade execution services from the issuers mentioned in this report.
SAM LP is the investment manager to the Sprott Physical Bullion Trusts (the “Trusts”). Important information about the Trusts, including the investment objectives and strategies, purchase options, applicable management fees, and expenses, is contained in the prospectus. Please read the document carefully before investing. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated. This communication does not constitute an offer to sell or solicitation to purchase securities of the Trusts.
The risks associated with investing in a Trust depend on the securities and assets in which the Trust invests, based upon the Trust’s particular objectives. There is no assurance that any Trust will achieve its investment objective, and its net asset value, yield and investment return will fluctuate from time to time with market conditions. There is no guarantee that the full amount of your original investment in a Trust will be returned to you. The Trusts are not insured by the Canada Deposit Insurance Corporation or any other government deposit insurer. Please read a Trust’s prospectus before investing.
The information contained herein does not constitute an offer or solicitation to anyone in the United States or in any other jurisdiction in which such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such an offer or solicitation. Prospective investors who are not resident in Canada or the United States should contact their financial advisor to determine whether securities of the Funds may be lawfully sold in their jurisdiction.
The information provided is general in nature and is provided with the understanding that it may not be relied upon as, nor considered to be, the rendering or tax, legal, accounting or professional advice. Readers should consult with their own accountants and/or lawyers for advice on the specific circumstances before taking any action.
You are now leaving Sprott.com and entering a linked website. Sprott has partnered with ALPS in offering Sprott ETFs. For fact sheets, marketing materials, prospectuses, performance, expense information and other details about the ETFs, you will be directed to the ALPS/Sprott website at SprottETFs.com.Continue to Sprott Exchange Traded Funds
You are now leaving Sprott.com and entering a linked website. Sprott Asset Management is a sub-advisor for several mutual funds on behalf of Ninepoint Partners. For details on these funds, you will be directed to the Ninepoint Partners website at ninepoint.com.Continue to Ninepoint Partners