How to Survive a Recession

LESSON 21: Buy Commodities

During a recession trillions of dollars invested in the stock market must go somewhere, and a large portion flows into commodities. Commodities include precious metals such as gold and platinum, agricultural products such as sugar, wheat and soybeans, meat products such as cattle and pork, energy products like oil and natural gas, and basic materials like lumber and cement.

Why do commodities become attractive investments? Because commodities have intrinsic value. Commodities are the basic building blocks of life and the economy. Unlike stocks, which are intangible representations of future value that can fall to zero, a unit of any given commodity theoretically cannot drop below its intrinsic value.

A commodity has intrinsic value because it a) must be consumed by humans to survive, b) must be produced or extracted with expenditures of capital and labor, and c) is difficult or impossible to substitute.

For example, gold is necessary to make electronics and jewelry, required huge mining companies to extract and refine it, and it is difficult to find a substitute for it at the same price/benefit ratio. Silver and lead are often substituted for gold, but these too are commodities. The same goes for sugar, meat, lumber, oil, soybeans, and many other commodities.

The price “floor” of a commodity provides downside protection compared to a stock which has no price floor and can drop to zero. The intrinsic value of a commodity is set by supply and demand, which are influenced by the rate and cost of production. If a commodity’s price drops below the cost of production for an appreciable amount of time, producers will no longer extract, grow, or process that commodity. But human and industrial demand literally forces the production of these commodities because there are no acceptable substitutes. This causes commodities to have a built-in price “floor” roughly equal to the sum total costs of extracting or growing, refining, shipping, and storing the commodity.

Commodities are a refuge from poor economic decisions made by politically motivated governments. Commodities are internationally traded and retain economic value in a way that is separate from any single country's currency or economy. Currencies can go up and down due to economic policy decisions. Commodities, on the other hand, are more closely tied to pure supply and demand. In this sense, they provide a refuge during recessions when governments may intentionally devalue their currencies to stimulate the local economy.

Commodity prices often increase toward the end of recessions due to capacity constraints caused by lack of capital investment. When the economy is growing rapidly and major institutional capital is invested in the stock market, commodity prices can languish for long periods of time. If commodity prices (and thus sales margins) are low for long periods of time, commodity producers have little incentive to invest in new capacity. Major capital investments in machinery, mines, and processing facilities are delayed. This creates a setup for future price increases due to capacity constraints if demand increases. Commodity speculators and commercial hedgers know that new mines, oil fields, and refining facilities do not appear overnight. They drive commodity prices up in the belief that capacity limitations will persist and become worse as demand increases.