An inflation rate of 7.5% shocked many investors and spooked the stock market. This happens because such an inflation rate leads both to economic and corporate profits uncertainty, and uncertainty about how fast and how much the Fed will tighten. This translates into stock market volatility. The question is: What can investors do to mitigate the impact of these on their portfolios?
“Diversify your investments” has always been one all-purpose recommendation. For most investors there are three diversifying “baskets:” stocks, bonds, and cash. However, should investors now consider a fourth? According to some thinking there is another – commodities – that should be considered.
Commodities are things like gold, silver, oil, and wheat. What are the pros and cons of investments in them, and how do they differ from investments in the traditional baskets?
The purpose of stocks and bonds is to raise money for the corporation. A bond can be valued by examining its interest rate and its probability of default. A stock can be valued on its forecasted future earnings and dividends. These are all uncertain and investors are paid to bear this uncertainty.
Commodities are different; investors usually don’t invest directly into commodities. They generally invest either directly or indirectly in commodity futures. These securities are a short-term wager on the future value of a commodity. Indirect investments in commodity futures are available through exchange-traded products and sector mutual funds.
Commodity futures are unlike stocks or bonds. Their purpose is to allow firms to obtain insurance against the future value of their commodity. There is nothing to value – no dividends or interest payments.
The key question: Is it worth doing? Certainly not for short-term investors. Over the recent past, based on commodity fund returns, they lost money in more years than they gained; for example, a $10,000 “investment” in the Bloomberg Commodity Index at year-end 2010 would be worth less than $5,000 at year-end 2018.
One study of 1959-2004 by Gary Gorton and K. Geert Rouwenhorst provides some insight into the possible very long-term value of an investment in commodities. They reported that an equally weighted index of commodity futures had similar returns to the S&P 500 with lower volatility, was negatively correlated with stocks and bonds, and positively correlated with inflation.
The research firm SummerHaven Investment Management built on this study. Their research also suggested that for investors with enough patience, commodities could offer promise. They studied commodity returns going back to 1871. They concluded that commodities outperformed cash by an annualized 5.2%. For context, U.S. stocks outperformed cash by an annualized 5.5% for the period 1900-2018.
While recent commodity funds returns have been good, five-year returns were minuscule and 10-year returns were negative. Thus, commodities are far from a sure thing. However, if an investor is convinced that high interest rates aren’t ephemeral, a small allocation to a commodity fund is not unreasonable. Understand, the role of commodities, due to their negative correlations, is to try to offset equity losses in a severe market downturn. For an allocation to commodities to be worthwhile, it could require an unusually severe downturn.
All data and forecasts are for illustrative purposes only and not an inducement to buy or sell any security. Past performance is not indicative of future results. If you have a financial issue that you would like to see discussed in this column or have other comments or questions, Robert Stepleman can be reached c/o Dow Wealth Management, 8205 Nature’s Way, Lakewood Ranch, FL 34202 or at firstname.lastname@example.org. He offers advisory services through Bolton Global Asset Management, an SEC-registered investment adviser and is associated Dow Wealth Management, LLC.
This article originally appeared on Sarasota Herald-Tribune: ROBERT STEPLEMAN: What are the pros and cons for commodity investing?