Due to a bull run that has now lasted for over a year and taken the S&P 500 to new heights, stock prices are beginning to look untenable to many investors.
Talk of an AI-driven market bubble has become widespread, and comparisons to the dot-com bubble of the 1990s are increasingly used to describe today’s stock landscape.
Commodities, by contrast, have become cheaper over the last couple of years. From 2022 to 2023, the World Bank reports that commodity prices overall fell by about 40%. Much of this was due to an easing of supply constraints associated from the 2020-21 era.
Prices are, however, expected to level off and begin rising again over the coming year, so is now the time to buy commodities, and how can you go about adding commodity holdings to your portfolio?
The Investment Case for Commodities
A strong case for commodities is their comparatively low volatility, especially at times when inflation is running hot. While stocks shift on a daily basis, physical commodities follow more predictable supply and demand patterns.
Though commodity busts certainly do occur, they usually aren’t as sudden as stock market crashes. Investing in commodities is also seen as a useful hedge against inflation, since the price of physical goods rises with inflation while companies may become less profitable due to higher input costs.
Classical economics holds that commodities have an inverse relationship to stocks and bonds, as higher commodity prices typically result in lower earnings and therefore lower stock returns. For this reason, commodities can act as a decent hedge against stock downturns.
Interestingly enough, over long time periods, there is a close proven connection between the returns of stocks and those of commodities.
A 2020 research paper examining extensive datasets going back 400 years in three key commercial markets found that high returns on commodities predicted lower stock returns in a majority of cases.
When narrowed to agricultural, food and energy commodities, the correlation became even stronger. It’s especially interesting to note that these correlations held true in both periods of recession and expansion.
On a more day-to-day investment level, commodities can offer crucial diversification when included in a portfolio. Like real estate, commodities are less likely to respond to the everyday volatility of the stock market. As a result, they can produce steady returns during choppy market periods.
The final piece of the case for commodities is their own ability to generate high returns under circumstances when demand outweighs supply.
A classic example of this is Warren Buffett’s famous position in silver in the late 1990s. Seeing stockpiles dwindling and prices remaining low, the noted investor bought about 3,500 tons of silver, resulting in a $97 million profit when prices eventually rebounded.
While such mismatches between prices and market dynamics are rare in commodities, they can occur from time to time and open up the possibility for high returns.
How to Invest in Commodities
For most investors, the simplest way to add commodities to a portfolio is by buying commodity ETFs. These publicly traded funds are meant to track the value of different commodities and deliver returns correlated to them.
It’s very important for investors to understand, though, that there are several different types of commodity ETFs. The variety that will most closely track the price of a given commodity is a physical commodity ETF, which must actually hold the commodity as a guarantee of value.
In other cases, ETFs may invest in companies that produce the commodity or futures contracts, both of which can be more volatile.
Investors who are comfortable dealing with complex financial products may also choose to buy and sell commodities futures contracts on their own.
Futures trading requires a decent amount of experience because price fluctuations can cause an investor to lose money. The upside, however, is that they can be quite profitable for those willing to take on large financial risks.
A final option is to hold the commodity physically. For most bulk commodities, this isn’t a practical option for retail investors.
Precious metals, however, can be an exception to this rule. Buying physical gold, silver, platinum or palladium is often viewed as a practical way to store value. The major issue with this approach is liquidity because it’s necessary to find a buyer for the physical metal when you’re ready to sell.
Is Now the Time to Buy Commodities?
Right now, moving money out of stocks and into commodities may very well risk leaving returns on the table. The current bull market for stocks is relatively young and it could continue for multiple years if technological innovations keep productivity rising and earnings growing.
Given that the forward P/E ratio for the S&P 500 as a whole is 21.9, it’s difficult to argue that the stock market overall is substantially overvalued at the moment.
Commodities, by contrast, may not see particularly strong returns. Take copper and aluminum, two key metal commodities. In the coming year, the World Bank expects their prices to rise by 5% and 2%, respectively. This is well below the average historical return of the S&P 500, and the current bull market could keep stock returns higher even than that.
That isn’t to say, however, that commodities don’t have their place in a portfolio during times of strong stock market performance.
As mentioned earlier, owning commodities can be a good way to diversify a portfolio and protect against unexpected future downturns. Even though markets appear solid for the moment, buying commodities may be a good way to protect portfolio value over the long run.
Another good argument in favor of buying commodities is their ability to generate returns from geopolitical tensions. When wars or other conflicts affect production and supply chains, commodity prices tend to rise.
Due to ongoing wars in Ukraine and the Middle East, though, there’s already a risk premium priced into affected commodities. Barring another unexpected geopolitical disaster, the current situation appears more likely to support prices at their current level than actively drive them up.
Ultimately, the case for buying commodities now seems to come down more to diversification than potentially high returns.
Even though stocks are likely to outperform commodities for the foreseeable future, adding commodity ETFs to a broader base of investments could provide protection from eventual market corrections or unexpected geopolitical shocks.
A common and long-held market rule of thumb is to keep 5-10% of an investment portfolio in commodities, and that basic concept seems to make good sense in today’s market.
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