Riding The Wave

September 01, 2005

WHY COMMODITIES?

Although the case for commodity investing has been made before, it is worth repeating. The argument for the inclusion of a commodity component in a balanced portfolio can be made on two primary foundations. The first is its role as an inflationary hedge. The second relates to the positive aspects that the inclusion of non-correlated assets such as commodities can bring to a traditional portfolio allocation model.

Inflation Protection

Simply stated, commodity prices are driven by global supply and demand. Commodities are priced at the margin, which is to say that all investors pay the market clearing price. Small changes in demand and supply are reflected immediately in the spot prices, which are disseminated instantly. This information is digested by traders and reflected almost immediately on various public futures exchanges around the world. Thus, investors have access to a wide range of relevant price data.

Figure 3


Source: RTM Management

Global commodity price inflation is a complex topic. Following a period of falling commodity prices, we have witnessed a significant increase in the price levels of a number of important commodity sectors. Demand and supply dynamics have combined with systemic factors to get us where we are today.

Global demand, especially from China (but let's not forget India, Russia and Brazil), has increased. As these economies develop further, their appetite for raw materials is expected to intensify. It is believed that global consumption of commodities will continue to escalate along with this transition.

At the same time, a number of other factors have held supplies in check. Because prices were low during the 1990s, producers were reluctant to commit capital to new production facilities. Producers reacted to low prices by concentrating on the lowest-hanging fruit-the most easily recovered (least expensive) deposits were the only ones that could be justified. One need only look at petroleum production or mining for examples of this. During the past 20 years, there has been virtually no new refining or mining capacity added in the United States.

Figure 4

Correlation

S&P 500 (TR)

Lehman

SPCI TR

GSCI

S&P 500 (TR)

1.0000

0.2278

0.1404

0.0917

Lehman

 

1.0000

0.0154

0.0731

SPCI TR

   

1.0000

0.8500

GSCI

     

1.0000

R-Squared

       

S&P 500 (TR)

100%

5%

2%

1%

Lehman

 

100%

0%

1%

SPCI TR

   

100%

72%

GSCI

     

100

Source:Standard& Poors

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