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Correlation of Commodities and stocks: Converging or Diverging?
The lackluster performance of commodities over the past couple of years has raised questions about the end of the commodity super-cycle that lasted this decade. While the growth drivers of various classes of commodities vary significantly, commodities as an asset class delivered abysmal and predominantly negative returns since 2011. In 2013 alone gold has incurred a loss of 27%, and an investment in a basket of precious metals would have lost around 25% on an average. During the same period, agricultural commodities like wheat, coffee, soybean delivered -22.2%,-20.5% and -21% respectively. However, S&P delivered a price return of 29.6% during the same period driven largely by the stable economic conditions and as speculation on tapering by the US Federal Reserve caused assets to flow out of emerging markets and into the US.
Commodities vs Stock Correlations:
Traditional asset allocation theory suggests investing in commodities to not only protect against inflation, but also to diversify risk given their historical low correlation with equities. The statistics, however, paint a different picture. In recent years, correlations between stocks and different commodity categories has been converging, raising concerns about their effectiveness as a portfolio hedge.
Table 1: Correlation of daily returns between S&P 500 and various commodity indices
In addition to the macroeconomic scenario and the supply-demand gaps, studies have shown that business cycles play a predominant role in the consumption patterns of commodities. In addition, a few recent studies have shown that a weak correlation exists between various commodity based instruments and the actual price performance of these commodities.
A closer look at agricultural commodities such as wheat, corn, coffee and soybeans also shows some interesting patterns in terms of correlations. These commodities have traditionally been viewed as good indicators of inflation given their regular consumption patterns and lack of seasonal demand variability. Hence historically they had very low correlations to the equity markets in general and could serve as valuable diversifying assets. For example, from January 1970 - December 2013, the correlation between the S&P GSCI Agriculture Index and the S&P 500 was a very low 0.104. While bear markets and recessions would temporarily cause these correlations to rise, the spikes in correlations were more often due to higher inflation than anything else as these commodities were not particularly influenced by business cycles.
However, since the early 21st century, the correlation between agricultural commodities and the equity markets started rising, reaching a peak of 0.262 in 2007. As an example of this, from December 2007 - June 2009, the S&P 500 fell by -37% and the S&P GSCI Agriculture Index fell by -32.5%. In addition, from 2009-2013, lower interest rates and stable economic growth (especially since 2011) would ordinarily have led to a drop in correlations. Yet this has not been the case, and correlations have continued to be a quite high (by historical standards) 0.254 since December 2009. Staple commodities such as soybean oil (0.28), cotton (0.20) and wheat (0.19) contributed towards this elevated correlation.
Fig.2: Performance of Agriculture Index vis-à-vis S&P 500
Again, this is contrary to what was observed historically, where the correlations would rise temporarily during a recession and then drop soon after. As an example, during the early 1980s the Agriculture Index dropped quite strongly during the recession from July 1981-November 1982, but regained all its value within 8 months and exhibited a correlation of 0.083 until December 1989.
The industrial commodities category offers a contrary perspective. Industrials including base metals and oil are heavily influenced by the business cycles as their consumption varies based on industrial activity. Since 1970, the correlation between industrials and equities has proved to be the highest among the different classes of commodities. In the equity bull market ranging from the start of 2002 to the end of 2007, S&P Industrial metals index yielded a cumulative return of 273% (30% annualized), while the S&P GSCI Energy index delivered 210% total return (25% annualized). Investments in crude oil alone would have produced 355% overall returns in this period as compared to the 27% returns of S&P 500. Among other commodities, agriculture generated 40% total returns while precious metals yielded 194% returns in the same period. Industrials exhibited a higher volatility led by crude oil with 34.7% standard deviation in this period, followed by industrial metals with 22.6% while S&P 500 exhibited 16% volatility. Over the decade, the correlation patterns between equities and industrials kept on rising showing the pro-cyclical nature of the category.
Fig 3: Performance of various commodity classes since 1977
Precious metals on the other hand are considered as safe haven investments during periods of market contractions. Investments in gold in the recent gold bull period starting in 2008 to 2012 led to aggregate returns of 87% as S&P 500 delivered only 22% total returns. As the precious metals like platinum, silver and palladium have an industrial usage, a mild influence of business cycle is observed in the performance of this category. With limited industrial use and discovery of substitutable resources, the prices of precious metals are chiefly driven by the macroeconomic conditions and market sentiments. In a steady business environment, the performance and volatility of precious metals falls in between agriculture and industrials. In the long run, the correlation between equities and precious metals has been the lowest since 1970.
So far, commodity based products in the market provide exposure to all commodities and consider them to be the same asset class despite their contrasting dynamics. Most products award weights on the basis of world economic production thus overweighing a class of commodities over the rest. S&P GSCI for instance follows a production based weighting methodology thus overweighing on energy sector over the rest of the commodity classes. Such products would contradict the purpose of providing diversification and protection against equity downside in the long run. Instead the time is ripe for a tactical strategy that provides exposure to commodities based on business cycles and other relevant macroeconomic criteria.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.