Diversification is one of the main tenets of safe investing.
Since different asset classes are not supposed to correspond, diversifying your
portfolio should allow you to hedge against losses in one category or profit
from another.
According to two American finance professors, commodities over the period
between 1959 to 2004 were not correlated with the stock market.
Commodities did well when stocks did not and commodities did poorly when stock
markets were rising. Of course during the recent market collapse
diversification didn’t help, because all asset classes including commodities
and stock markets collapsed together. What happened? Two things: ETFs and
emerging markets.
Commodities markets all have a central problem, inflexibility of supply. In
rising stock markets when demand is high, companies do not seem to have
problems fulfilling the demand by issuing debt or stock. Governments can issue
mountains of debt and investment banks can issue derivatives with a few key
strokes.
This is not true of commodities. It can take years to drill a new well, develop
a new mine or plant new fields. So with supply being inelastic, even small
changes in demand can send the price soaring and detach it from underlying
economic projections.
One of the most recent changes to the commodities markets has been ETFs. ETF
solve some major problems with commodities investing. Before ETFs you had two
choices: options and commodities companies like an oil or mining company.
Each had problems. ETFs are not perfect, but they do offer good solutions to
these problems. So the money flowed in. Global commodity assets under
management increased to about $235 billion by late 2009 compared with a mere
$6-10 billion in 2000.
Commodities markets used to be the province of a few professional players.
These included commodities producers and consumers trying to hedge and a few
sophisticated speculators. Now it is a huge casino made up of every type of
investor.
The ETFs went from tracking the market to being the market. Gold ETFs own more
of the metal than China. Two ETFs have accumulated more than 100,000 ounces
each of platinum and palladium.
In a market of only about 6 million ounces a 100,000-ounce swing is big enough
to result in large price swings. So speculative frenzies driven by cognitive
biases can easily overwhelm economic realities.
The other change in the commodities has been emerging markets. It is not news
that many of the major commodities producers have been emerging markets. Now
many of the commodities consumers are also emerging markets. In time
commodities markets could probably adjust to this change in supply and demand
except for one thing. Both sides are heavily dominated by state owned
companies.
State owned companies are creatures of the state. Regardless of the country,
they all function for political reasons, not for profit. They are not, nor do
they have to be, transparent. They are usually powerful enough to write their
own laws. The result is a lack of timely, complete, or accurate information.
Often there is simply no information at all and they can change the rules at
any time.
China represents a particularly good example. Buying by Sinopec and PetroChina,
and China National Petroleum Corp, massive consumers, most likely caused the
oil price spike in spring of 2008. (see my column of February 9, Of Inflation Swing and Commodity
Prices)
Massive stock piling of copper by Chinese companies pushed up the price of
copper in 2009.
ExxonMobil is the largest private oil company in the world, but it only ranks
14th. The rest of the producers, many of which are also consumers, are state
owned. Chile’s state owned copper company might be required to sell more to pay
for earthquake reconstruction.
So not only are commodities markets being changed by ETFs and emerging
countries, now there is the combination of the two, which could potentially
lead to some real trouble.
Often emerging market countries have sovereign wealth funds (SWFs). Like many
other investors, they have come to realise that ETFs are a good and cheap way
to invest and diversify. For example, China's SWF, China Investment Corporation
(CIC), is the fourth-largest investor in the US Oil ETF and it recently also
took a 0.4 per cent stake in the SPDR Gold Trust, the largest physically backed
ETF.
CIC is worth an estimated $300 billion and its mere size could distort the
markets, but that is not the only problem. It is the connections between the
government as an investor and the government as a consumer and producer. Through
their control of large businesses, governments could and do create bubbles that
would also be very profitable for their investments in ETFs.
The general assumption of most investors is that commodities and the ETFs,
which are supposed to represent them, move according to general economic
trends.
Both the reality and information about the real reason for price movements in
this asset class could be quite different. This does not mean that commodities
are not a good investment.
Money can be made by taking advantage of the volatility. It does mean that
assumptions about economics and safe diversification may simply be untrue.
