Reader Question: Should I Get Out of Commodities?

A couple of days ago I received an e-mail question from a good friend and regular reader. Here is the full text of the question:

"Hi Shadox,

A year ago, I put about 20% of my assets into commodity related stocks as a hedge for the blazing US and APAC economy: Metal and mining ETF; Mining companies; Brazil ETF (since their economy is based on commodities); Oil company stock. Since then, most of my portfolio has shrunk while this part has exploded.

It is now about 40% of my portfolio. Now, there is talk about a commodity bubble. I have some free money and I was thinking about putting it into a commodity hedge, but I don't know what that is? Cash? Bonds? Technology? What do I do?

Also, my gut tells me Oil is peaking (my gut told me that at $80 too so I am not sure using my intestinal system is a good idea). What is an Anti-Oil hedge? You could use this for a Blog post since I am sure anyone with commodities in his portfolio is thinking the same things...."

I have been wrestling with the same question in reverse, namely, is it too late to invest in commodities? About two months ago I have come to the (apparently premature) conclusion that hell yeah, it's too late. We are not currently invested in commodities. I recently rolled over my 401K which had a 10% commodities position into an IRA which does not include such a position. However, I do understand the benefit of diversifying into commodities and have written about this in the past (too bad that I did not actually take my own advice at the time).

When I think about diversification into commodities, I am thinking about a position equal to about 10% of your portfolio. However, the reader finds himself with about 40% of his portfolio dedicated to what is potentially a very risky asset class. Let me take the reader's questions one at a time.

First things first: we need to talk about portfolio re-balancing. If you are shrewed, wise or lucky enough to make a small investment whose value explodes, you should probably think about re-balancing your portfolio such that your investments in the various asset classes come back into line with your original plan. There are many reasons to do so, but let me name the most important one: regression to the mean.
Here's the idea - each asset class has certain typical historical returns. If the return on such an asset class in the short run is dramatically higher or lower than the historical average, there is a tendency for prices to return to their historical trend through a price correction (up or down). We are living through one such example right now. In recent years real estate prices have skyrocketed and returns on real-estate assets have significantly outpaced their historical levels. No more. Returns are now regressing to the mean by way of a sharp decline in house values. Tech stocks in the beginning of this decade went through the same process, and I believe that we may be in for a similar ride on the commodities side. If your portfolio is out of whack due to massive returns, take some money off the table to reduce your exposure to that asset class and re-balance your positions.

True, this is psychologically difficult to do because essentially I am suggesting investors should sell their winners rather than their losers... but, believe it or not, that's probably a winning strategy.

Let me address the second part of the question: what is a good hedge for commodity prices? Put in other words, if commodity prices go down, which asset classes would be unaffected or even benefit from this decline? The technical term from what reader is looking for is negatively correlated assets, or at least uncorrelated assets. The following asset classes have historically been negatively correlated with natural resources: U.S. Bonds (-0.14 correlation); cash (-0.12 correlation); high-yield bonds (-0.04 correlation). If you think about it, this makes perfect sense. Commodities tend to rise at times when the economy is strong, inflation is rising and interest rates are consequently being increased. These are exactly the times when bonds tend to do worse, and vice-versa. Stocks, especially large cap stocks, are also very loosely correlated with commodity prices (0.0 for large caps; and 0.01 for the S&P 500). A correlation close to zero indicates that the asset classes tend to act independently from each other: they are just as likely to move in tandem as they are to move in opposite directions. In fact, natural resources are very loosely correlated with pretty much all traditional asset classes. This makes them a very interesting diversifier, but not at 40% of your portfolio...

To read more about asset class correlations, take a look at this excellent article, which I have previously written about.