domenica 25 ottobre 2009

How many risks behind commodities

Three are commonly recognized as the main reasons behind the recent uptrend in commodities. First, investors fear that the expansive monetary policy conducted by major international central banks might significantly boost inflation in the years ahead. Commodities, in fact, traditionally yield positive returns in periods of high inflation, just as in the 1970s. Second, there are widespread expectations that an economic recovery, mainly driven by emerging economies (Chinese GDP gained 8.9% in Q3), can lead to stronger demand for commodities going forward, also due to a sharp increase in money supply globally. Finally, the rise in commodity prices may have been caused by the US Dollar’s fall.
Furthermore, leading international institutional investors are reshuffling their portfolios, increasing the weight of commodities. Indeed, commodities are particularly popular with investors because of their greater capacity to ensure an excellent portfolio diversification without penalizing the overall performance. Several academic studies published in recent years have shown that commodities can optimize the risk-return profile of a business or financial investment portfolio. In the study "Facts and Fantasies about Commodities Futures" (2004), the economists Gorton and Rouwenhorst have offered evidence that in the period 1954/2004 the performance of a portfolio constructed using 34 equally-weighted commodity futures was in line with the stock market return but with lower volatility and little correlation with stock and bond markets. Nevertheless, the CRB performance (composed of 17 major futures) did not confirm this trend: the index compound annual growth rate between 1956 and 2009 was 1.6%.
Structural factors are also in favour of commodity investments. In a recent interview, Jim Rogers said that the outlook for raw materials will stay rosy for several years. Indeed Rogers said that a growing number of people in emerging markets are adopting western lifestyles, with a consequent increase in raw material consumption. By contrast, he also said that little has changed for production capacity over the past 10 years.
But there are several reasons for caution before investing in commodities. First, the correlation between commodity and stock markets has risen sharply in recent months. As the table below indicates, the correlation between the S&P500 and CRB indexes has increased from 0.2 in the last 15 years to 0.52 in the last two years to 0.8 in the last year. The correlation between the S&P500 and WTI is also rising, while there is a steadily weak correlation between the S&P500 and WTI.

Moreover, the recent uptick in commodities has reflected the US Dollar’s weakness and not a bullish demand, as clearly shown by WTI. Indeed oil prices have moved up despite an increase in oil inventory and even though refineries running below their historical average.
Investors willing to invest in commodities should also consider the structure of the market. Some academic studies, including "Momentum strategies in commodity futures markets" by Miffre and Rallis, have shown that investors are highly likely to gain positive returns with futures in backwardation than in contango.
Although the above-mentioned theory is not unanimously accepted (other studies have shown that the returns of the futures curve are uncorrelated from the curve slope), the fact that the whole of the 20 major commodity futures we considered, with the exception of those on precious metals (gold, silver, platinum and palladium), are in contango signals that obtaining positive returns is no easy task at this point in time. A study by Standard & Poor's is a clear example. It gives evidence that those who invested in the Natural Gas futures have seen the value of their investment drop from 100 in January 1994 to 2.63 in September 2009 notwithstanding the 125% increase in the futures in the same period because of the position roll-over. Even those who invested in oil futures have seen their earnings more than halved during 2009 in the face of a falling dollar (for European investors) and of the repercussions of the futures roll-over.
For these reasons, investments in commodities should be made by well diversified instruments as the ETFs that cover a general index, while single commodity futures should be used only for trading and not for investing.
Investing in securities in the Basic Resource sector index may represent a viable alternative to commodities. Indeed, although Gorton and Rouwenhorst have shown that commodity-producing companies have underperformed commodity futures, this could have been triggered by the sharp increase in inflation in the years 1970s to 1980s - which was clearly unfavourable to the stock market.
However, this trend has reversed since 1987, with the DJ Euro Stoxx Basic Resources index significantly outperforming the CRB. Since 1987 the Basic Resources index has gained 238%, compared to +38% of the CRB. We believe that this trend will persist into the coming months unless a sharper turn to the upside in inflation, which would damage the entire stock market, materializes.

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