A Possible Alternative to Stocks and Bonds: Commodities?

By CONRAD DE AENLLE JULY 14, 2017

Making a case that the stock market isn’t expensive these days often means dragging
Tina into the conversation.

Tina is short for “There is no alternative.” It is a claim that after a decade of loose
monetary policy and low interest rates, bonds, the traditional alternative to stocks, are
no better a bargain than high-flying stocks.

Yet there may be one alternative to stocks. Commodities got cheaper through much of
the second quarter, adding to several years of mediocre-to-weak performance. Gold
and silver were hit hard. So were materials that work for a living, such as iron ore,
copper, oil (and substances refined from it), although some of them staged rebounds
late in the period, as did many agricultural products.

Ordinary investors can take positions in commodities through funds that hold them
directly or that own shares of companies that mine, grow or process them. But should
they? Prices have tumbled, but have they tumbled enough?

Investment advisers are divided on whether commodities are on the verge of reversing
their poor performance, compared with stocks, and some who do think so aren’t
especially enthusiastic about it. There is wider agreement that commodities or shares
of production companies are worth owning for the sake of broadening a portfolio and
reducing risk.

“The stock market as a whole looks expensive to us,” said Matt Kadnar, an asset
allocation specialist for GMO, “but commodity stocks look like they’re trading at a
bit of a discount, relative to where they have traded historically, and there’s a
diversification benefit.”

“Having some element of your portfolio in commodity-based equities makes sense,”

he said, “but it’s much harder to call them a strong buy, as you could have 15 months
ago when they were being taken to the cleaners.” That was around the time crude oil
was trading at multiyear lows, in the mid-$20s a barrel, roughly half of where it is
now. Agricultural products and industrial and precious metals were also near long-
term bottoms.

Krishna Memani, chief investment officer of OppenheimerFunds, agrees that

commodity producers’ stocks would have been a better buy then, but he still thinks
they are worthwhile now and likely to perform well in the second half as evidence
mounts of a broadening global economic recovery.
“As commodities have gone out of vogue, commodity-oriented companies are
probably cheap, although I would have said that with a lot more conviction in the first
quarter of 2016,” Mr. Memani said. “As the synchronized global growth picture
persists, the discount may disappear.”

One reason that Mr. Kadnar thinks shares of production companies have recovered
less than they should have is that there is a bias against them that actually creates
long-term value.

“One of the things we like about commodity equities is that managers tend to avoid
them,” he said.

Mr. Kadnar was hinting at a shortcoming inherent in investing in commodities: There

are no correct fundamental prices for them. Yardsticks like price-earnings ratios exist
to indicate whether stocks are reasonably valued, but commodities typically move,
often with violent swings, in response to ephemeral and often unpredictable
economic, industrial and even meteorological events.

Investors can work around those difficulties, said Scott E. Wolle, chief investment
officer for global asset allocation at Invesco, by comparing recent prices with their
very long-term averages (most commodities are trading well below their average
prices over the last 10 years, he noted) and choosing exposure to a broad range of
markets, seeking diversification into and within commodities.

“That’s a long-term measure of value that should put you on the right side of the
trade,” he said.

Exchange-traded funds with a diversified range of physical commodities include

iShares S&P GSCI Commodity-Indexed Trust, PowerShares DB Commodity Index
Tracking Fund and United States Commodity Index Fund. The first two are heavily
weighted toward energy commodities; the third has equal allocations of 14
commodities.

E.T.F.s for production-company stocks generally focus on narrower segments, like

SPDR S&P Metals & Mining, FlexShares Morningstar Global Upstream Natural
Resources Index Fund and VanEck Vectors Agribusiness.

Commodities are useful in hedging against inflation, Mr. Wolle said. He

acknowledged that inflation has been subdued worldwide for many years and that
commodity prices have suffered for it, but they remain “one of the few assets that can
protect you against that.”
Certain commodities, most notably gold, also serve as hedges against political
uncertainty and upheaval, Mr. Wolle said. There certainly has been some of that in the
last several months, and gold has rallied about 20 percent from its low in late 2015.

With global monetary policy still loose, he recommends exposure to precious metals
to guard against any uptick in inflation. The immediate outlook is also auspicious for
industrial metals and energy, in his view, as economic growth picks up in more parts
of the world, though he advises steering clear of agricultural commodities.

As for how to get exposure, Mr. Wolle favors the materials themselves, or funds that
own them directly, rather than commodity stocks. Some companies hedge their own
exposure by using derivative contracts that lock in a specific price for what they
produce, limiting the benefit of rising prices, he pointed out.

The Wells Fargo Investment Institute, by contrast, favors a none-of-the-above

approach when it comes to short-term allocations to commodities. It has been bearish
since the start of the year and predicts weakness into 2018, in line with its bullish
outlook on the dollar, which tends to move in the opposite direction from
commodities.

But John LaForge, head of real asset strategy at the institute, conceded in a recent
report that “the U.S. dollar could make us wrong should it become unexpectedly,
excessively weak.” Noting that gold, an alternative currency for thousands of years, is
more sensitive to movements in the dollar than other commodities, he added, “Gold is
where we could be really wrong.”

Even if commodities bounce back, they may not bounce that high, Mr. Memani of
OppenheimerFunds cautioned.

“Commodities are probably in a good place, relative to the supply/demand dynamic,”

but that “doesn’t mean prices are going back to the old highs” achieved around six
years ago.

“People imputed special value to commodities based on the growth spurt from 2000
to 2007 driven by an investment and construction boom in emerging markets, and
China in particular,” he said. “As that demand accelerated in a meaningful way, it
helped prices, but that in turn brought in new supply and depressed prices. Unless we
get a new boom, the chance of prices going back to that level is pretty small.”

It’s clear that commodities cost a lot less than they did several years ago and that
stocks cost a lot more. But given the variety of opinions about commodities, it’s less
clear they are the best of the alternatives that value-conscious investors look for, even
if the others aren’t so great, either. So investors should be careful when considering
what, how and why to buy.
“With commodities, like anything else, there are no easy answers,” Mr. Kadnar said.

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