Introduction to Commodities Investing

Module 3: Protect Your Investment and Profit from a Crisis

Learning Objectives:

• Learn how to better protect your buying power during periods of high inflation.

• Understand how to profit from very adverse market conditions.

• Become aware of how commodities have historically performed versus stocks.

Investing during Inflation: Commodities, Stocks and Bonds

One of the main appeals of commodities is the ability of this asset class to both smooth overall portfolio volatility and hedge (protect) against certain undesirable economic events, such as inflation.

Inflation refers to the general increase in prices of goods and services in an economy. As prices rise, consumers experience a decrease in the buying power of their money – one unit of the currency buys less than before the inflation.

During periods of high or increasing inflation, central banks may increase interest rates in order to try keep inflation under control.

High and increasing interest rates can be expected to have a negative effect on the prices of stocks. As borrowing becomes more expensive, and the cost of doing business increases due to inflation, it is reasonable to expect that companies will not perform as profitability as in low-interest rate, low-inflationary environments. Additionally, as borrowing money becomes more expensive, investors and speculators may find it more difficult to fund their purchases of the stocks of businesses, resulting in decreased demand and lower prices of stocks in general.

Two major reasons why inflation is very negative for bonds are as follows: 1) The future fixed interest payments (coupons) received by bondholders become less attractive as the buying power of these coupon payments decreases with increased inflation. 2) As interest rates rise, the fixed interest payments of older bonds become less desirable as new bonds become available with higher interest payments. Therefore, the older bonds with lower interest payments begin to sell at lower prices. There is an inverse relationship between the prices of existing bonds and interest rates.

When increasing prices of commodities, such as oil, timber and wheat cause the inflation, being invested in such commodities will automatically provide the investor with some protection. However, inflation is not always caused by an increase in the price of commodities. Whether or not commodities are the cause of inflation, many investors perceive commodities, such as gold, to be a source of safety during periods of high inflation.

In the seminal study, Facts and Fantasies about Commodity Futures (2004), Gary Gorton and K. Geert Rouwenhorst concluded that fully collateralised commodity futures have historically offered the same return and Sharpe ratio (a risk/volatility measure) as equities, while exhibiting negative correlations to stocks and bonds.

Gold and Gold Mining Stocks

In financial crises, many investors have historically sought the safe haven of precious metals, such as gold. During the 2008 financial crisis, gold initially dropped from about $1,000 per ounce to just above $700 per ounce in the space of 8 months. Then, over the next three years, it climbed to a high of over $1,900 per ounce.

Gold can be a rather polarising investment topic. It has been valued by civilisations for thousands of years and can be viewed as a form of wealth insurance. Many, though, criticise its general inability to produce cash flow for investors – stocks provide dividends, and bonds make coupon payments.

The prices of gold mining stocks, especially those of smaller mines, are typically more volatile than the price of gold itself. The potential rewards of investing into gold mining stocks over physical gold are generally higher, but the risks are higher too. Before investing into gold mining stocks, the investor should consider the business risks of a gold mining operation, such as those associated with labour, safety and management.

Diversification

Depending on your investment goals, varying degrees of diversification are recommended by financial advisers. It may indeed help reduce portfolio volatility. However, there are arguments against diversification.

Legendary commodities investor, Jim Rogers, has said that diversification will not make you rich. He has endorsed putting all your eggs in one basket (or at least very few baskets) and then watching that basket very closely. He is very quick to mention, though, that if you get this choice of basket wrong, you can expect to lose everything! He stresses that you must only invest in what you understand. Markets do not move in a smooth fashion, and a lack of understanding may cause confusion and panic when your investment does not perform as expected.

Market Crashes

Many investors love the opportunities that market corrections or crashes present. Warren Buffett has a famous quote: “Be fearful when others are greedy, and greedy only when others are fearful.” Stock market corrections and crashes can provide wonderful investing opportunities. But in order to successfully take advantage of these opportunities, you need knowledge and understanding. You also need the ability to not let your emotions overpower your brain’s logic and common sense!

There are many publications and articles explaining how the four primary markets (stocks, bonds, commodities, and currencies) tend to function in cycles. However, it is very important to understand the fundamental reasons behind price movements. Always do your homework!

Take Action

Continuing with your commodity from Module 1, research and become familiar with its historical price movements. Pay special attention to how it performed during market downturns, such as the 2008 ‘great recession’ and the 2000 ‘bursting of the dot-com bubble’. Where you see rallies or declines in the price, investigate how the stock market as a whole was performing during that period, and understand the reasons behind your commodity’s price movement.

Which countries are the biggest producers of your commodity? And how were their economies performing during these price movements? At the very least, investigate the level of their stock market, property valuations, unemployment level, and currency strength. The goal here is to begin identifying the various ways in which you can take advantage of commodity price movements.