Back in early 2011, the investment thinking around commodities centered on two big ideas. First, commodities would protect portfolios from the inflation that would eventually result from the U.S. government’s seemingly endless easy money policies. The second theory supported by well-respected strategist Jeremy Grantham held that limited supply and insatiable global demand combined would cause commodity prices to enter a period of long-term secular increase.
In reaction to these two compelling ideas, commodity prices gained over 50% between March of 2009 and March of 2011. Over the next four years, however, commodities as a group fell in price by approximately 40% with half of that decline coming in the last twelve months (see chart below). What happened?
A “perfect storm” of forces came together over the period to cause the price collapse. First, weaker economic growth in key European and especially Chinese markets put pressure on prices. At the same time, supply increases across a wide range of commodities, the result of shale oil exploration in the U.S., bumper agricultural crops and capacity increases, kicked in. Finally, a rising U.S. dollar didn’t help. Global commodities are priced in dollars and a stronger dollar means foreign buyers end up paying more for goods which, by itself, can depress demand.
Historically, the case for owning commodities rested on the idea that their prices did not move in lock step with stocks or bonds. Because their returns were not perfectly correlated, investors holding commodities experienced less volatility and, if purchased at reasonable prices, enhanced returns (see chart above). And while inflation may seem like a thing of the past, it is important to remember that historically commodities have served as a hedge against rising price levels.
Whether commodities are a good buy today is a more difficult question. Commodity prices are set by the supply and demand dynamics of their particular market. Further, these markets tend to be self-correcting, meaning that prices eventually adjust to bring supply and demand back into balance. But the adjustment process can lead to a good deal of volatility and getting the timing of price changes right is difficult at best. Investors tempted to try and jump into and out of commodity markets run the risk of abandoning ship just when prices are at their lowest.
We think a small allocation to commodities makes sense for most portfolios. To achieve this we prefer to focus on the prospects of individual producers, rather than buying a broad based commodity fund. During periods of depressed commodity prices, such as we are seeing today, we look for high quality firms whose balance sheets, market position and management capability will allow them to survive the downturn. Companies in the midst of restructuring can also offer interesting value provided they have the ability to weather the storm.
Whatever approach is taken, investors interested in benefiting from the long term rise in commodity prices and their diversification benefits should pay particular attention to valuation and be willing to hold for long periods of time so that the long term price trends “drown out” the short term noise associated with speculation and unforeseen events.
