Time to Ditch Commodities?

Commodities are the market's equivalent of a good-time Charlie: They go up when the economy is booming, but they don't provide much diversification during times of stress.

Sure, commodities have been among the hottest asset classes of the past few years, spurred by hot performance and the belief that they will buffer portfolios from stock-market losses. Assets in commodity exchange-traded funds have grown by more than 50% during the year ended Aug. 31, according to Investment Company Institute data, while SPDR Gold Shares briefly became the largest ETF by assets in August, surpassing SPDR S&P 500.

Commodities often are touted for their lack of correlation with the stock market and their ability to add ballast to a portfolio during a market slump. But as they have gained in popularity, they have started trading much more like stocks.

The Standard & Poor's GSCI commodities index dropped 22.8% from April 29, when the stock market peaked, to the market's low on Oct. 3, almost mirroring the S&P 500-stock index's 19.4% drop. The six-month correlation between the two indexes—a measure of their propensity to move in tandem—reached 0.82 on Oct. 11, the highest since May. A correlation of 1.0 means two assets move in perfect lockstep.
Increasing Risk

The upshot: Commodities may be increasing investor risk, not reducing it. "Commodities are already in equity performance," says Mark Matson, chief executive of Cincinnati-based investment adviser Matson Money. "You don't need to double down."

The correlation between commodities and stocks has been slowly creeping up over the past five to 10 years, but more so in the last three, says K. Geert Rouwenhorst, a professor at the Yale School of Management's International Center for Finance.

In a 2006 study, Mr. Rouwenhorst and fellow Yale finance professor Gary Gorton found that from 1959 through 2004, commodities generally moved independently of the broader stock market. The long-term average correlation was close to zero between 1959 and 2004; zero would mean they are completely uncorrelated. During the past three years, however, the average increased to about 0.7 or 0.8.

Now some advisers are reducing their clients' exposure to commodities. Richard Kahler, president of Kahler Financial Group, a fee-only adviser in Rapid City, S.D., says that when commodities began tracking stocks more closely a few years ago, he started looking elsewhere for uncorrelated investments. Commodities, which previously would have been 10% of a client's portfolio, now make up just 4%, he says. He now has 9% of client assets in managed futures, which place bets on commodities and other assets rising or falling.
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Commodities haven't done much to protect against stock-market losses this year, with one notable exception: gold.

Gold might be one exception to the trend. It has a correlation of minus-0.79 to stocks over the past six months—meaning the two generally have moved in the opposite direction. Even after its recent 11% decline, gold is still up 15.8% over that period, compared with the S&P 500's 8.1% drop.

"Gold is a very good hedge against periods of dramatic financial instability," says Alex Godwin, global head of asset allocation at Citi Private Bank.

Jeffrey Seymour, an adviser at Cary, N.C.-based Triangle Wealth Management, says he had 10% of his clients' portfolios invested in broad commodity exchange-traded funds, but cut the exposure to about 5% in the middle of 2010 and to zero early this year. Because of the increasing correlation, he has moved them out of other commodities and into gold. He currently has about 9% of client assets in the iShares Gold Trust ETF.

Right now, gold is looking particularly attractive. The speculative rush that sent it up close to $1,900 an ounce has eased, with hedge funds and others trimming their positions, says Dean Popplewell, head analyst at currency-trading firm Oanda in Toronto. And with problems in Europe still unresolved, gold could have more upside. "After the purge, it's the only asset trading on an even keel," Mr. Popplewell says.
Trading at a Discount

While most commodities look increasingly speculative, commodity producers may be worth owning. They often trade at a discount to the underlying price of the commodity itself: At $82 a barrel, for example, oil is priced for moderate global growth, says Pierre Lapointe, a Montreal-based strategist at brokerage firm Brockhouse Cooper, while oil stocks are priced for a recession. Whether or not a recession is in the cards, he believes that makes stocks a better bet.

The ratio between the price of Brent oil and the S&P 1200 Global Energy index this month has reached its highest level in 15 years. Gold-mining stocks, too, are underpriced relative to gold: The ratio between the two now is near its highest level since 2008, though Mr. Lapointe says he expects gold to fall and the price of the stocks to level out.

Buying commodities is essentially placing a bet that the world won't produce enough of them to fill demand, Mr. Lapointe says, and that bet is priced into the market already.

That means investors may be better off buying an ETF such as Energy Select Sector SPDR or Market Vectors Gold Miners rather than the commodities themselves, especially if they believe the stock market has seen the worst of its declines.