As the stock market nears all-time highs, a lot of investors are starting to look around for ways to diversify their portfolios in case the stock market reverses.
One asset class that has become increasingly popular for diversification is commodities. Though investing in commodities used to require using futures and trading on margin, with the introduction of new commodity-based exchange-traded funds and exchange-traded notes, buying and holding commodities has never been easier.
The question is … does buying commodities to add a layer of diversification and protection to your portfolio actually work?
Large pension and fund managers don’t seem to think so. In The Wall Street Journal, Ianthe Jeanne Dugan reported that many large funds — such as the California Public Employees’ Retirement System (Calpers) and the Teachers Retirement System of the State of Illinois — have been pulling money out of commodities because they haven’t provided the portfolio protection they expected.
So what’s happening?
In Macro-Driven Markets, All Correlations Move to 1
When the entire investing world starts to focus on the same large macroeconomic events and news announcements, traders tend to start making similar moves. Sure, contrarians are always out there who’ll take the opposite side of the current popular trade — that’s what makes the market possible. But when too many people start thinking alike, we tend to see higher levels of correlation between asset classes. This is happening in our current “risk on” vs. “risk off” market environment.
When investors the world over start shifting from risk on to risk off, they pull their money out of riskier, higher-yielding assets and put it into safer, lower-yielding assets. When these same investors start to regain their confidence, they reverse their positions and start moving out of the safer assets and back into the riskier assets.
This relatively coordinated movement causes asset classes that normally wouldn’t be related to each other to start moving in tandem. In short, it brings the correlation between various asset classes closer and closer to 1 — the point at which two assets move in lock-step with each other.
Click to Enlarge Here’s an example. In the past, commodity prices have moved independent of where the U.S. stock market has gone. After all, different economic forces were at work in each market.
However, now that it’s so easy for stock investors to gain access to the commodity market, that relationship has changed. In Figure 1, you can see the positive correlation the S&P 500 has had with the PowerShares DB Commodity Index Fund (NYSE:DBC), an ETF that tracks the DBC Commodity Index.
With a few exceptions, when stock prices have moved higher, commodity prices have moved higher, and when stock prices have moved lower, commodity prices have moved lower.
This pattern of correlated price movements doesn’t provide a lot of protection from a diversification standpoint. If you had 70% invested in stocks and 30% invested in commodities, you would see your account boom during the good times — and see it collapse during the bad times.
Click to EnlargeOf course, as you can see in Figure 2, a nice inverse correlation between stocks and longer-term U.S. Treasuries still exists.
When stocks are moving higher, Treasuries tend to move lower, and when stocks are moving lower, Treasuries tend to move higher.
This means you can still diversify your portfolio. However, you might not want to focus on commodities in the short term to provide a lot of downside protection if stocks move lower.
John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.