January 25, 2006
HOW FAR WILL COMMODITIES RUN?
Optimists like to say that there's always a bull market somewhere. The challenge is deciding where the aphorism applies, and where it doesn't. As always, there are doubts for each and every asset class. Inevitably, there is hope as well. Beauty and bull markets, in sum, remain in the eye of the beholder. Time is the final arbiter of who's right and who's wrong, but waiting ten years is about as practical letting your cat baby-sit the parrot.
Now that we've dispensed with the usual caveats, we're free to point out that commodities, broadly defined, appear to be caught up in a phenomenon that some might label a bull market. In fact, more than a few pundits are applying the term these days, and forecasting that more of the same is on tap. One of the early adopters of this theme has been the celebrated globe trotter/investor Jim Rogers, who jumped on the band wagon early by launching the Rogers Commodity Index in 1998, a contrarian move at the time, given the soaring equity market back then.
In 2006, commodities as an investment look decidedly less contrarian. Indeed, most broad-based commodity indices have done quite nicely in recent years. The Dow Jones-AIG Commodity Index, for instance, gained an annualized 18% a year for the three years through the end of 2005, comfortably above the S&P 500's 14.4%, for instance. And last year's performance showed that commodities' momentum was in particularly strong form, as the chart below reveals.
That strong run may be enough to turn some investors away. But that could be a mistake. In addition to being a hot tactical play at the moment, many studies note the strategic appeal as a permanent holding, albeit one deserving of a weighting adjustment from time to time depending on the outlook du jour. An academic study from last year, for instance, strongly suggests that commodities are no fair-weather friend for the enlightened asset allocation plan. “Facts and Fantasies About Commodity Futures" crunches data on more than 40 years of futures prices through December 2004 and concludes that raw materials are a potent agent for diversification over the long haul. “While the risk premium on commodity futures is essentially the same as equities, commodity futures’ returns are negatively correlated with equity returns and bond returns,” write finance professors Gary Gorton of the Wharton School at the University of Pennsylvania and K. Geert Rouwenhorst of Yale School of Management.
The inherent cycles that define commodities help explain why the asset class delivers so much value as a diversifying agent in an otherwise paper-laden portfolio of stocks and bonds. Commodities futures “perform well in the early stages of a recession, a time when stock returns generally disappoint,” Gorton and Rouwenhorst write in their study. “In later stages of recessions, commodity returns fall off, but this is generally a very good time for equities.”
Exposing a traditional investment portfolio to the price volatility of raw materials for the long haul, in other words, pays off. “Facts and Fantasies” notes that commodities’ negative correlation with equities and fixed-income tends to increase as the holding period lengthens. Meanwhile, the risk-return profile of commodities is comparable to equities for the 43 years through March 2004, the paper reports. Commodity futures returned about 11 percent annualized over that span, or roughly the same as equity returns, as measured by the S&P 500. As for risk, defined as the standard
deviation of returns, commodities scored slightly lower numbers: 12.1 percent versus 14.9 percent for the S&P 500.
There are a growing number of proxies for commodities beyond trying to assemble a mix of individual futures contracts. Reportedly, that includes soon-to-be-launched ETFs. Meanwhile, there are futures and options contracts on broad commodity indices, various limited partnerships, and a handful of mutual funds, such as the Oppenheimer Real Asset fund (QRAAX). It doesn't take a Ph.D. to figure out why investors have poured money into this and similar commodity-oriented funds in recent years. QRAAX is an index fund that tracks the Goldman Sachs Commodity Index, which, like its competing benchmarks, has run rings around most other asset classes of late. Indeed, Morningstar reports that QRAAX sports a 22.8% annualized total return for the three years through 2005's close, far above the 8.5% posted by the S&P 500.
But the past is gone, and the future is unclear, which brings us back to the question: What might commodities do as an asset class going forward? As you might expect, there is no shortage of opinion, a fair chunk of tending toward bullish. That includes the latest musings from Mr. Commodity, a.k.a. Jim Rogers, who tells BusinessWeek in a fresh interview dated today that the bull market for commodities still has long legs.
"If history is any guide, this bull market [in commodities] will last until sometime between 2014 and 2022," Rogers tells BW's Alex Halperin. The reason? Supply and demand remain "out of whack," Rogers explains. "There's been no major oil discovery anywhere in the world in over 35 years. All the oil fields in the world are in decline. All the mines in the world are in decline. There's been one lead mine opened in the last 25 years."
In fact, Rogers' prediction for a bull market extends beyond energy, which tends to be the dominant force in commodities indices. "I expect all commodities to do well. The supply-and-demand situation for nearly all of them is out of balance, and it takes a long time for those forces to change. That's why bull markets have lasted so long and likewise, why bear markets have lasted so long."
Rogers isn't alone in his bullish outlook. For example, Philip Richards, chief executive at RAB Capital, told Reuters yesterday that commodities will provide a handsome return for the next decade.
But lest anyone think commodities are sure thing, they might do well to remember that greed and fear remain the only perennial factors in the marketplace. Making the indelicate point with a touch more diplomacy, Richards cautions that "it would be a mistake to expect everything to go up in a straight line." The price of crude oil, to take the obvious example, has been strong lately, "but there is evidence of new supply coming to the market, which could quiet things down for a couple of years."
This might be a good point to remind that nothing is guaranteed, which is why the financial gods invented diversification. That said, perhaps the best argument for owning a strategic allocation in commodities is the fact that relatively few investors do so. Indeed, one only has to look at the world of mutual funds to gain some quick perspective. The overwhelming majority of funds target paper investments. By contrast, portfolios focused on commodities are but a tiny fraction of the mutual fund realm. By that measure, commodities are still a contrarian play. Nonetheless, even contrarians can get burned from time to time.
Posted by jp at January 25, 2006 10:25 AM
The upswing in commodity markets is well underway. There is talk of a new era of sustained high prices (the China effect etc). More ETFs are soon to be launched, giving smaller investors access to this overlooked asset class. The minimum equity hurdle to get in to commodity funds is getting lower.
As soon as I hear any of my non-investor friends mention commodities as an investment possibility, I will know that it is all over. I fear we are rapidly closing in on that point.
Posted by: Abobtrader at January 29, 2006 7:27 PM