The Commodity Investment World Conference-Some Observations on Commodities as a Diversifier

For two days last week, it was my privilege to attend the Commodity Investment World conference through the courtesy of Seeking Alpha. A broad spectrum of commodities markets, their economics and approaches to these markets were discussed.

Commodities conferences historically have been the denizens of inflation hawks. Theories of Malthusian catastrophes as population and consumption growth outpace agricultural production have always suggested dwindling supplies with the development of shortages and hence,higher prices for commodities.

Beyond the Club of Rome disaster scenarios, come monetary arguments for inflation. If currencies have value because of scarcity, central banks around the world have spent the last several months creating fiat money by decree-simply put, when money becomes too plentiful, it loses its value. Even Ben Franklin observed some 230 years ago:

"The currency, as we manage it, is a wonderful machine. It performs its office when we issue it: it pays and clothes troops and provides victuals and ammunition, and when we are obliged to issue a quantity excessive, it pays itself off by depreciation."

Many commodities historically have functioned to offset the depreciation in the currency that Franklin described and have been storehouses of value and hence, inflation hedges.

This conference was much more realistic in its tone. Commodities, which generally serve portfolios as tremendous diversifiers because of their low or negative correlations to equities have unfortunately demonstrated near perfect positive correlation with equities recently. The English translation of this statistical notion is straightforward...stocks have been declining- and so have all commodities.

So why bother even thinking about commodities in what appears to be a deflationary environment? Two reasons:

1. As Marc Faber of GloomBoomDoom fame has cited, when the investment community is fascinated by a major theme (deflation), outstanding opportunities arise elsewhere. "The greater the mania in one sector of a market or in one stock market, the more likely that neglected asset classes elsewhere offer huge appreciation potential." I believe that commodities, as several panelists at the conference indicated, may bottom within a few quarters.
2. The sources of return for commodities relate not only to issues of supply and demand and economic fundamentals but also to the possible returns from long/short active management as well as what are termed, "roll yield" and "collateral yield."
   

Roll yields occur when the price of a commodity is higher for shorter delivery dates. The investor earns a positive roll yield by buying, waiting for the price to appreciate as the delivery date approaches, then selling and using the proceeds to reinvest at a cheaper price at a longer term future delivery date. Collateral yield is the return earned by margin held against a futures position (generally T-bills.) The significance of roll returns should not be ignored...for the 15 years between 1989-2004, crude oil returns averaged about 20% per annum of which 6% per annum consisted of pure spot price returns and 9% consisted of roll returns.

Under more normal circumstances, if any of us can remember what normal is anymore, commodities can be a terrific portfolio diversifier. Why?

1. Commodities tend to correlate positively with inflation whereas stocks and bonds tend to negatively correlate with inflation. In an article that Warren Buffett authored in Fortune in 1977, he explained the deterioration of securities under inflationary conditions.
2. Commodity prices and stock and bond prices react differently under different phases of the business cycle. As business cools, treasury bonds tend to rally, whereas stocks and commodities tend to skid. As business expands, stocks and commodities tend to be pro-cyclical whereas bonds will decline.
3. Commodity prices tend to be more affected by short-term expectations whereas stocks and bond prices tend to be more affected by long-term expectations...not necessarily true at the moment, but at least a "normal" expectation.

Hence, commodities can be very potent portfolio risk diversifiers.

Here are a few links which you may find useful:
The Benefits of Commodity Investment

Alpha, Beta, and Commodities: Can A commodities Investment be Both a High Risk-Adjusted Return Source and a Portfolio Hedge?

Perhaps, one of the most interesting presentations at the conference was Dan Sternoff of Medley Global Advisors whose primary research focus is China. Though much of the commodity boom prior to July related to a silly notion that Chinese and Asian economies had decoupled from North America, the slowing of the Chinese economy has become quite evident.

Disturbingly, the deceleration is more rapid than even the Chinese government had anticipated no doubt precipitating China's biggest interest-rate cut in 11 years with the 108 basis point cut in one-year lending rates. However, according to Sternoff, the slowdown so far has been domestically led and not yet linked to the global cycle, more a consequence of China's slowing property sector affecting industries such as cement, steel, cars, appliances, and furniture.

Residential construction represents a significant 12% of Chinese GDP. Though not a real estate bust per se, (there are no Mortgage backed securities or other forms of securitization and housing is purchased with 25-30% down payments) property prices are down probably 5-10% nationwide with higher end apartments in larger cities down markedly more. Real estate transaction volume has fallen off a cliff.

Though Sternof expects Chinese GDP growth of about 7-8% next year, the composition of Chinese GDP growth is shifting away from resource intensive activities. He expects that state owned enterprises may well become acquisitive overseas as global valuations provide opportunities.

Other presenters had rather bleak views of Europe suggesting that most European authorities did not have a pro-active view of stimulus programs and that no governments had the skills of a Larry Summers or Paul Volcker in handling crises. Their conclusion in short, it is wrong to think that despite the steepness of the price waterfall, it is wrong to think that commodities have bottomed.

Roger Kubarych of UniCredit and a former associate of Henry Kaufman suggested that a reasonable fiscal stimulus plan of perhaps $400 Billion for the new Obama regime could include 4 segments:

1. Low to middle income tax benefits
2. A business investment tax credit or R&D tax credit
3. A program to stop foreclosures or a plan to help states and municipal governments buy foreclosed properties
4. An infrastructure building plan

It seems that many commodity traders are perplexed by the rather tight correlation of commodities to one another, not just their price movement relative to securities. It is unusual for industrial commodities such as base metals or energy which are clearly sensitive to economic activity to correlate this well with agricultural products that generally have little sensitivity to the economy.

As well, most commodities tend to bottom at their marginal cost of production, yet many instances were cited where producers, starved for working capital in the credit crunch, are willing to produce under their full cost of production merely to access cash flow.

Another interesting presentation addressed timber as an uncorrelated commodity asset whose value creation is largely attributable to biological growth rather than inflation. Basically, value increases as tree diameter grows and if current prices for small diameter trees don't work for you, a tree will grow about 7% every year, so greater value should accrue over time.

A very broad spectrum of commodity topics was considered. My only complaint about the conference relates to no-shows-there were numerous no-shows among presenters who were scheduled to appear for some topic panels. Despite this annoyance, in my view, the conference was worth attending.

Historically, portfolio construction meant a split between stocks, bonds and cash. I believe that going forward, commodities will also be an important component for portfolio construction.

Opportunities exist for not only portfolio hedging because of their usual uncorrelated returns, but also for active management strategies that take advantage of unusual backwardation. Like capital markets, commodity markets are in disarray and bathed in horrible sentiment. Though highly volatile in physical or futures formats, structured products and commodity ETFs may offer individual investors better opportunities to participate. It is too important a market with too many unique characteristics to ignore.