Liam Pleven of the WSJ writes the following:
For much of the past decade, investing in raw materials has looked like a slam-dunk, as rising prices held out the prospect of big gains and the proliferation of exchange-traded funds made placing bets easier. The trend of rising commodity prices in recent years helped fuel a belief that is now common among financial advisers and pension managers: that ordinary investors should have some slice of their long-term money parked in commodities.
Where we differ from the consensus is that investors should have a slice of their long-term money parked in commodities. ”Parked” implies passive allocation. One of the potential problems with such an approach is the fact that individual commodities can fall out of favor. Consider the example of whale oil and rye:
Examples of commodities getting pushed aside aren’t hard to come by. Petroleum production, for example, killed off the 19th-century market for whale oil as lamp fuel; a long whaling voyage might yield 4,000 barrels, according to historians, but a well could pump out 3,000 barrels a day.
More recently, there’s the case of rye. As recently as 1986, rye was a widely grown grain and a featured component of the CRB commodity index, which measured inflationary pressures. But rising demand for other crops pushed rye aside, and global production has fallen by half in the past quarter-century, just as corn production nearly doubled. As prices for many crops soared in the past decade, rye rose, too. But while average U.S. corn prices nearly tripled between 2000 and 2010, rye prices barely doubled.
Or even consider the example of natural gas:
Perhaps the most persistent threat to commodities investors isn’t that a commodity will be pushed aside, but rather that better technology will make it possible to produce the same materials more cheaply or in greater volume, which could in turn slam prices.
One stark, recent example comes from the growing use of hydraulic fracturing to tap U.S. supplies of so-called shale gas—natural gas previously considered impractical to access. The potential environmental impact of the technique is controversial, but shale gas has transformed the domestic energy picture. U.S. government estimates of the nation’s technically recoverable natural-gas reserves have nearly doubled in just four years.
The sudden change from a looming shortage into a growing glut has sharply reduced the cost of natural gas. Futures prices have typically hovered around $4 per million British thermal units this year, after averaging nearly $7 in the years before the practice became widespread.
Rather than a passive allocation to commodities, I would suggest taking a tactical approach to commodity exposure. There are stretches of time when it makes sense to have exposure to commodities (i.e. when they have strong relative strength) and there are times to be completely out. Relative strength can provide the means of making those tactical decisions.
