Agile Investing Takes Advantage of Commodities Selloff

Jan. 8.07 | About: iPath S&P (GSP)

The New Year got off to a rough start for commodities bulls. Commodity markets, which have been in a corrective mode for the past several weeks, took a nasty tumble in the first week of 2007. Crude oil dropped nearly $5 last week and closed at an 18-month low of $56, which is 30% below its peak of $80 in July and 13% blow its average price of $66 in 2006. Copper prices fell 11% last week and are 38% off their May 2006 peaks. Gold tumbled $28 last week to $607, its lowest level in two months.

The recent weakness in commodity prices has been attributed to various factors ranging from unseasonably warm weather to slowing global economic growth to diminished hopes for monetary easing from the Federal Reserve. Another factor not as frequently cited is the simple volatility inherent in today’s leveraged financial markets. Last week’s sharp losses in the commodity markets, not unlike similar precipitous declines in global equity markets last summer, is the most recent illustration of how quickly positions get unwound when leverage magnifies losses.

Commodities Tumble Presents Opportunity
We are going to take advantage of the recent sell-off in the commodity sector to re-establish a position in a diversified commodities fund. We held a position in a diversified commodities fund in our model portfolios in 2005 and the first four months of 2006, but exited the asset class on April 30, 2006. At the time, the commodities sector, particularly the energy and metals areas, had experienced a very sharp run-up and appeared over-extended and vulnerable to a lengthy period of correction and consolidation.

After exiting, we said we would look for an opportunity to re-enter the asset class at more attractive prices. With diversified commodity indexes now 10-20% lower (depending on their level of exposure to energy and industrial metals commodities, which have experienced the sharpest corrections), and with sentiment now quite nervous about the outlook and prospects for the asset class, we believe we have reached a point in time where it makes sense to re-establish a position in diversified commodities in our portfolios.

We believe that commodities are in a secular bull market that began in 2001 and will extend for several more years, due to a variety of bullish catalysts, principally including favorable supply/demand dynamics and paper currency depreciation/devaluation. Moreover, commodities are an attractive component of a diversified portfolio, due to their history of positive returns, their historic negative correlation with stocks and bonds, and the hedge against inflation they provide.

GSP: Energy-Intensive
The vehicle we are choosing to re-establish exposure to commodities is the iPath Goldman Sachs Commodity Index Exchange Traded Note (NYSEARCA:GSP). This security, which is managed by Barclay’s, tracks the Goldman Sachs Commodity Index, or GSCI, which is comprised of a diversified basket of 24 individual commodities, but has approximately a 75% weighting Diversified commoditiesin the energy complex (e.g. crude oil, natural gas, heating oil and gasoline). The balance of the index is diversified across a variety of other commodity sectors including industrial metals, agriculture, livestock and precious metals.

A detailed fact sheet for GSP can be viewed and downloaded here. To maximize tax efficiency, Barclay’s has structured this investment vehicle as an exchange-traded note rather than an exchange-traded fund, but for all intents and purposes it functions and is traded like other ETFs. The expense ratio of GSP is 0.75%.

The energy-intensive GSCI, which GSP tracks, sank 6% last week, and is trading very near its 52-week low. Needless to say, there are very few asset classes on offer today for prices at or near their 52-week lows. Market concerns pertaining to inflation, the Middle East, and oil cycle up and down. Currently, concerns about inflation and energy prices appear to be at low ebb, so this may be a favorable time to accumulate inflation hedges. Moreover, paper assets have dramatically outperformed hard assets since August, so this may be an opportune time to accumulate positions in hard assets.

Clearly, the situation in the Middle East remains an unpredictable wild card in the financial markets, with obvious implications for energy prices. Regardless of what one may think of the efficacy of the proposed "troop surge" in Iraq, the risk of instability and a disruptive geopolitical event in the Middle East remains a significant issue for the markets. A position in GSP, with its high weighting in energy, provides our portfolios a hedge against this risk.

GSP 7 month chart