Value Added
The Case Against Commodities
Sold as a diversification tool, they failed badly last year -- and will fail to protect you again if the market turns south.
By Steven Goldberg, Contributing Columnist, Kiplinger.com
October 6, 2009
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Hordes of new players have transformed the commodities markets into a dangerous corner of the investing world. As a result, I feel strongly that you should stay away from commodities. These markets are in uncharted territory and are unlikely to offer you the diversification benefits they did in the past.
Numerous studies released over the past several years showed that commodities tended to hold up well during steep stock-market declines. David Swensen, the star manager of Yale’s endowment fund, was one of the first to extol their merits. Before long, virtually every endowment and pension plan bought the story. So did hedge funds and individual investors, via exchange-traded funds. All of these new buyers overwhelmed the normal dynamics of commodities markets.
A strategy of adding some commodities to your portfolio worked -- for a while. As stocks fell from the fall of 2007 through midsummer 2008, the price of oil, a leading constituent in any broad-based commodities index, surged. It shot through the $100-a-barrel level early last year and hit a record high of $147.27 on July 11, 2008.
But that was the end of the party. As stocks collapsed in the fall of 2008, oil and other commodities plunged just as far and just as fast. In mid February, oil bottomed at $34 a barrel, almost precisely as stocks were nearing their lows.
What went wrong? It was a classic case of too many people chasing the same good idea. Many investors put 5% to 10% of their assets into commodities to cushion their portfolios when stocks tumbled. But the weight of investor dollars eclipsed market fundamentals. And the patterns of most investors’ behavior in buying and selling commodities -- as opposed to those who use the markets to hedge -- followed the same rhythms they did in buying and selling stocks.
“It’s whole a new ballgame,” says Charles Ober, the veteran manager of T. Rowe Price New Era (symbol PRNEX), which invests in stocks of commodity companies. “A lot of the studies that justified investing in commodities were based on data through 2005. If you look at data through 2008, it turns those studies on their ear. Price movements of stocks and commodities were so correlated it was pathetic.”
Those who are in the commodities markets to hedge now represent a small fraction of all commodities investors. Hedging, of course, is the raison d’être for the commodities markets. They allow, for instance, an oil company to lock in a price on its production months or even years before it can bring the product to market. A farmer can sell futures on his crops to raise cash for planting. “Investors are now a multiple of the people who need a hedge,” Ober says. “I can’t tell you if it’s five times or ten times, but it’s a big number.”
Almost none of this has happened before -- not even in the 1970s, the last time the price of oil blasted off, even as stocks suffered through a horrid decade. The futures markets weren’t nearly as liquid then, and ETFs didn’t exist. So few people and institutions invested in commodities.
Despite last year’s disaster, investors are still flocking to commodities. “People now perceive them as the new gold,” Ober says. Global growth -- particularly in emerging markets such as China -- is leading to increased demand, especially for oil, while supplies are gradually being depleted. In the long run, there’s a compelling case to be made for commodities. But the short term has been so thoroughly distorted that it pays to look for other ways to invest in commodities -- and other ways to diversify your investments.
Ober thinks the price of oil will begin to rise again sometime next year. He has as good a record as anyone at making such calls. But the global economy remains weak, and I think people worried about a pickup in inflation accompanied by rising commodity prices are getting too far ahead of the fundamentals.
The broken case for stuff
The thesis behind commodities involves several parts. Over the long haul, prices of most commodities have merely kept pace with inflation. But when you invest in futures, you put up only a small percentage of your investment. The remainder can be held in Treasuries or other securities, which can earn a profit.
Investors in commodities, in essence, provide insurance to companies that need to lock in a commodity price in advance. As the seller of that insurance, you’re entitled to a premium. That’s why futures that don’t come due for many months generally trade for less than those coming due in a few weeks.
But the market doesn’t work that way these days. Instead, the market currently prices near-term futures at a lower price than those expiring months in the future. Light crude oil for November delivery closed at $70.32 on October 1, but the same barrel slated for delivery next July closed at $74.50. For investors, the insurance premium -- which constituted much of their returns -- has disappeared.
Many investors today look to commodities to protect themselves from a falling dollar. In the 1980s, Ober says, there was little or no correlation between any fall in the dollar and high oil prices. Today, the correlation is huge -- in other words, commodities tend to rise as the dollar weakens.
Whether you’re concerned about a falling stock market, a decline in the dollar or a pickup in inflation, I think you should look elsewhere to insulate your investments. T. Rowe Price New Era is one good choice. You’ll likely get as much diversification nowadays in stocks of commodities as in the commodities themselves. And a well-run company can make money even when commodity prices are flat.
Investing in foreign stock funds also provides protection against a declining greenback. Indeed, more than half the revenues of the companies in Standard & Poor’s 500-stock index come from abroad. A declining dollar will increase the value of their overseas sales. A foreign bond fund is another good option.
As for the commodity markets, I’d leave them to the speculators.
Steven T. Goldberg (bio) is an investment adviser.
Reader Comments (7)
Posted by: Rick Kahler at 10/06/2009 06:13:38 PM
Steven, you make a great point for the rising corrolation of commodities to equity markets, especially in the fourth quarter of 2008. I was a bit confused why you suggest dumping commodities and in their place use more equity funds (natural resource and international) that have an even higher corrolation to the S&P 500. This seems to me to compound the case you made against commodities. International bonds are certainly the better choice. For my money, I would also include commodities or a managed future fund in a portfolio.
Posted by: fbcx at 10/06/2009 07:11:15 PM
And that is the problem with all markets today...way too many dollars chasing the same investment. Whatever becomes popular becomes overpriced until the "next big thing". In reality, nothing has value any more because there are way too many dollars and yen and pounds and marks and yuan in circulation and too many "smart guys" angling against each other to play the edges until the edges become mainstream. How did we get to this point...too many MBA's on Wall St. looking for a fast buck instead of making something of value.
Posted by: telkontar at 10/08/2009 10:25:57 AM
The article is against commodity futures, but for commodity stocks. The headline and first paragraph should have been more clear. The author does mention increased demand for commodities, which implies commodity values will rise. (This is in addition to the issue of possible inflation caused by more dollars chasing those commodities). Commodity investments are still a good hedge, but should be made properly. That seems to be the main point.
Posted by: Jaywalker at 10/08/2009 02:51:46 PM
Would you would mind citing the source of your comment that "more than half of the revenues in the S&P 500 come from abroad," please? I've read similar figures elsewhere and they range from 15% to "more than half." It's an important distinction.
Posted by: Greg Retzloff at 10/12/2009 04:22:06 PM
Correlations between asset categories do change. The fact that commodity movements were in sync with stocks for the last few years but weren’t prior to that is evidence of this. A good strategy might be to split what would be the “commodity” portion of a portfolio between an ETN that tracks underlying commodities themselves (like the DJ AIG Commodity Index) and a good natural resource stock fund like T. Rowe Price New Era. You would get the advantages of both with more diversification. In any case, dismissing an entire important asset category based on a few years worth of data is probably not smart.
Posted by: DG at 10/19/2009 03:49:35 PM
Here is some info on Foreign revenus for the SP, apparently derived from 2006 data however. From MSN Money 4/7/2007: About 45% of the revenue of S&P 500 companies comes from outside the U.S., and that figure could hit 50% by the end of the year, according to Silverblatt, the S&P analyst. "It's like buying a global stock fund," Silverblatt said. "You do have a lot of direct and indirect foreign exposure." Business Week 7/20/2007: Thanks to increasing globalization, roughly 44% of the S&P 500's 2006 revenues came from international sources. This compares to only 32% in 2001. The energy sector has the largest international exposure with 55.9%, followed closely by information technology with 55.2%. Interestingly, the exposure for the influential financials sector is a mere 30.9%.
Posted by: DG at 10/19/2009 04:03:15 PM
SP Revenue from a July 2009 S&P Markets Attributes Report: GLOBAL SALES In 2008, S&P 500 foreign sales increased 8.5%, while domestic sales decreased 0.3%. However, half of the issues still do not report suffi cient information for a complete breakdown. Of the reporting issues, 47.9% of all sales were produced and sold outside of the United States, up from 45.8% in 2007 and 43.6% in 2006. European sales represented 27.7% of foreign sales, with 9.3% coming from Canada. Asian sales decreased to 13.2% from 16.8% in 2007. Foreign income taxes increased US$ 11.5 billion, or 9.3%, as U.S. federal income taxes declined US$ 43.9 billion, or 29.1%, with Financials paying 16 times more abroad than domestically. Taxes paid to the U.S. now represent a minority of income taxes paid by U.S. companies.