By Jason Zweig | 3:18 pm ET Nov. 30, 2014
Photo Credit: “The first oil well,” retouched version of 1859 photograph, Library of Congress
Long before it referred to consumers storming through shopping malls, “Black Friday” stood for a dire day in the financial markets. On Friday, Sept. 24, 1869, an attempt by mogul Jay Gould and his cronies to corner the gold market failed and the price of gold fell 18% in 56 minutes—sending many speculators to their ruin.
At the end of last week, the commodities market had a Black Friday that harked back to that devastation of 145 years earlier.
The prices of U.S. crude oil fell 10.2%, silver 6.4%, natural gas 6.1% and copper 5.8%. The Alerian MLP Index—a basket of companies, organized as master limited partnerships, that handle and distribute oil and gas—fell 5.3%. Gold got off easy, losing a mere 1.8%.
There are lessons in this latest Black Friday for all investors, not just those who lost money on commodities. Here are some of the most salient.
Beware of extreme extrapolations. In 2008, as the price of oil brushed past $145 a barrel, analysts rushed to get out ahead of the “trend” with their predictions of where the price was headed. Goldman Sachs called for oil prices to hit $200; at least one veteran observer of the industry foresaw the price reaching $300.
Right on cue, oil went down, not up—divebombing 77% between July and December 2008 and bottoming barely above $30 a barrel. Analysts then hastened to reverse their projections, just in time for oil prices to go right back up.
Now that oil has fallen 38% in five months, you should expect a rash of predictions of apocalyptically low prices. If you own energy stocks or MLPs, it’s probably too late to sell them (unless you can use a tax loss to offset realized gains elsewhere in your portfolio). Instead, watch for the last optimists to be swept away by pessimism—at which point it will be an opportune time to add to your energy stocks or MLPs. We’re probably not there yet.
With any asset, be skeptical of anyone who forecasts either an epic boom after prices have risen or an even more catastrophic collapse after they have fallen hard.
When the consensus is strong, it’s wrong. Between Nov. 4 and 11, more than 900 institutional investors and traders participated in the latest Barclays Global Macro Survey, a poll among clients of the global bank. They predicted, on average, that energy would generate more than a 30% return by the end of March 2015. Barely 5% predicted that the price for Brent crude oil—then about $82 a barrel—would be below $70 at the end of the first quarter of 2015. One in six said it would be $90 to $100.
There’s still time for them to be proven right, of course, but Brent sank 3.5% to $70.02 on Black Friday.
By the same token, the consensus on 2015 stock returns—that they will be pallidly positive—is probably wrong, too. The outcome that is most widely expected is the one that is least likely to be realized.
Understand how you will make money before you risk losing it. A stock generates returns through dividends, earnings growth and any potential rise in price. A bond provides returns through interest payments and any capital gain. Real estate produces rental income and a possible gain on sale.
The return on commodities comes from different sources. First, the market, or “spot,” price can go higher than what you paid for it. Second, you earn a positive “roll return” if you can sell this month’s futures contract for more than it costs to buy next month’s. Finally, you earn interest on the collateral that secures your bet.
Historically, the roll return has accounted for about half the long-term performance of commodities, but it has been largely negative in recent years as the rising popularity of commodity funds distorted the market. And collateral return, which was significantly positive in the past, has been squeezed to almost nothing in today’s low-interest-rate world.
So two of the three sources of return have been impaired. When spot prices plunge, as they just did, there’s little else to support returns.
More than $69 billion in new money poured into commodity mutual funds and exchange-traded funds between 2009 and 2011, the year gold glittered above $1,800 an ounce. Asking your financial adviser to explain exactly where future returns would come from might have stopped him from steamrolling you into a strategy that you—and perhaps he—didn’t understand.
The future returns on stocks and bonds have been crimped, too, of course.
With the S&P 500’s dividend yield just under 2%, the long-term growth rate of dividends and earnings at about 4.5% (including inflation), and a haircut of 0.5% to 1% to account for today’s high stock prices, a sensible expectation for long-term annual stock returns is 5.5% to 6%, including inflation, says William Bernstein, an investment manager at Efficient Frontier Advisors in Eastford, Conn.
And with the Barclays U.S. Aggregate Bond Index yielding just over 2%, bond investors can’t earn much more than that without taking excessive risk.
The ultimate lesson: When assets are priced for perfection in an imperfect world, investors who don’t slash their expectations are apt to be disappointed at best and devastated at worst.
Source: The Wall Street Journal