The economy is booming, and the stock market is falling, at least as of this moment. It may be time to think about adding commodities to clients' portfolios.
If putting commodities in a stock portfolio seems like adding coal to a tire fire, you have a point. The Dow Jones Industrial Average posted a 665-point loss Friday, sparked by fears of rising inflation. At this writing, Mr. Market is busily tacking on another hundred points or so to the Dow's Friday's carnage. But if you think stock prices can be volatile, try watching the commodities markets, where animal spirits are almost always present.
Nevertheless, academic research generally has pointed to commodities (typically in the form of actively managed pools) as beneficial to a stock portfolio. Harvard professor John Lintner wrote the first paper in May 1983 suggesting that commodities could improve the risk-adjusted returns of a stock portfolio.
But Mr. Lintner was looking back at an inflationary period when he wrote his paper.
The theory hasn't worked in practice during the current expansion, said Jim Paulsen, chief investment strategist for the Leuthold Group, in part because the Great Recession ushered in a period dominated by falling prices.
From their 2008 peak, commodities prices have cheapened 75% relative to stocks, he said. Since 2008, adding commodities to a stock portfolio has only reduced the portfolio's performance and increased volatility.
"Starting from 100% stocks, adding a 10% position in commodities significantly lowers the expected return of the portfolio while only modestly reducing return volatility, " Mr. Paulsen said in a note to clients. "And, for commodity allocations beyond 20%, the expected return of the portfolio is reduced while risk is increased."
While looking at the relative performance of stocks and commodities, however, Mr. Paulsen found that whenever nominal — not inflation-adjusted — gross domestic product was greater than the unemployment rate, commodities did indeed reduce volatility and increase performance. "One unique aspect of this recovery has been that during the entire recovery, the unemployment rate has been in excess of nominal GDP," Mr. Paulsen said in a phone interview.
As of the fourth quarter, however, that's no longer true. The most recent print of GDP puts nominal GDP growth at 4.4%, and the most recent unemployment rate is 4.1%.
During periods when nominal GDP is greater than unemployment, "the risk/return is as different as night and day," Mr. Paulsen said. "Since 1970, when GDP was greater than the unemployment rate, the average annualized return from commodities has been about 50% higher than the return achieved in the stock market."
Synchronized global growth may well lead to greater demand for commodities. Revving up supply, however, is not as easy: You can't wave a hand and open a copper mine. And rising global wages can lead to supply constraints. For example, Chile, the world's biggest copper-producing country, registered a 10% decline in production due to 43-day strike at Escondida, the world's largest copper mine.
Unlike the 1980s, when investors interested in commodities had to settle for a limited partnership, advisers have a number of broad-based commodities funds to choose from. Still, they need to look carefully at commodity ETFs to make sure they suit clients' needs.
For example, PowerShares DB Commodity Index Tracking Fund (DBC), the largest broad-based commodity ETF, invests in a range of commodities from crude oil to silver. It is heavy on energy, with a 56% stake in crude oil, gasoline and natural gas. The second-largest ETF, iShares S&P GSCI Commodity-Indexed Trust (GSG), is even more reliant on energy, with a 63% exposure.