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Monday, September 25, 2006

More On Commodities

By William Trent, CFA of Stock Market Beat

We recently wrote that an investor’s starting point for exposure to commodities should be their relative weight compared to all possible investments.

For example, if commodities are 5% of the investable universe, the average investor has to be at 5%. If all investors shifted to 10% it would simply bid the price up artificially.
On the other hand, it is reasonable to assert that investors have had too little exposure to commodities historically, and that the weight may still be too low to reflect the fact that the investing world has to play catch-up.

Morgan Stanley’s Stephen Roach sees the trend as having reached bubble proportions:
Virtually every major institutional investor I visit around the world — from pension funds and insurance companies to mutual fund complexes and hedge funds — has a large and growing commodity department. The same is true of foreign exchange reserve managers and corporate treasury departments of multinational corporations. One major Wall Street firm is now run by a former commodity executive, and another has turned over management of its global bond division to the architect of its thriving commodity business.

Of course, the same could have been said in the mid-1980’s regarding equity departments, when they still had a long run ahead of them. As you know, we are not shy about drawing comparisons between today’s commodity markets and the mid-1980’s equity market. Roach, too, has picked up on this.

A recent Ibbotson Associates study recommends that commodity weightings in a multi-asset balanced portfolio could be increased, under conservative return and risk-appetite assumptions, to a high of nearly 30%. That would be more than three times current weightings and greater than seven times the estimated $2 trillion value of current annual commodity production (see T.M. Idzorek, “Strategic Asset Allocation and Commodities,” March 2006, available on The Ibbotson analysis praises commodities for their consistent outperformance and negative correlations with other major asset classes — going so far as to praise commodities for actually providing the protection of “portfolio insurance.” It concludes by stressing “…there is little risk that commodities will dramatically underperform the other asset classes on a risk-adjusted basis over any reasonably long time period.” Laboring under the constant pressure of the asset-liability mismatch, yield-starved investors can hardly afford to ignore this enthusiastic advice.

As a result, with multi-asset portfolios likely to have ever-greater representation from commodities, the financial-market dimensions of the commodity trade are likely to become increasingly important.

It was in the early- to mid-1980’s that the “equities always outperform in the long run” thesis began to take hold. As with other super-cycles, there is a kind of first wave that earns investor awareness before everyone jumps on and begins talking about and investing in the fad du jour. Is the commodity cycle played out? We don’t know, but we’ll bet you heard lots of cocktail party chatter about Internet stocks in 1999 and investment homes in 2004. When is the last time you chatted up someone’s pork belly portfolio? But Roach isn’t buying that argument.

For my money, there is far too much talk about the globalization-led commodity super-cycle. It gives the false impression of a one-way market, where every dip is buying opportunity. Yet commodities as a financial asset are as bubble-prone as any other investment. As is always the case in every bubble I have lived through, denial is deepest when asset values go to excess.

Admittedly the circles Stephen Roach hangs out in are different from ours. Perhaps the pork belly portfolio is the topic du jour at his cocktail parties. (Now that we think about it, perhaps we’re grateful we hang out in different circles!) But our bet is that this is still perhaps the third inning of the stock/commodity reversal game. As soon as there is a Jim Cramer of commodity investing we’ll consider contrary opinions. In the meantime, we think investors are still too focused on stocks and not enough on commodities.

As Steve Saville puts it:
In any case, regardless of what happens over the next several months it’s important for investors to understand that the long-term bull markets in metals and the stocks of metal producers did not end earlier this year. Long-term bull markets don’t end when the major stocks in the bull-market sector have valuations that are less than half the broad market’s average valuation; they end after valuations in the bull-market sector reach huge premiums.

The author may hold a position in the securities discussed. A current list of the author's holdings is available here.

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