The Striker Report

As we are in the camp that believes commodities are prone to a nice performance for years to come, and the sell off in the late 2008 was rather exaggerated, we were not surprised by the latest reports by IMF and USDA.

The International Monetary Fund (IMF) recently published its report World Economic Outlook for October 2010 and in it they talked about commodity demand from emerging countries. The report reads, "because their growth is more commodity-intensive than that of advanced economies, the rapid increase in demand for commodities over the past decade is set to continue...the current era of higher scarcity, rising metal price trends and a balance of price risks tilted toward the upside may continue for some time."

US department of Agricultural (USDA) drastically revised estimates downward for the US corn harvest - they slashed a record 6.7 bushels an acre off the national harvest figures. This after projecting a record corn harvest as recently as August.

With emerging economies such as China, India, Brazil, etc. continuing their unprecedented growth, the stronger demand for commodities is here to stay. This asset class should not be missing in any serious investor's portfolio. Why? Because commodities move differently in the economic cycle than financial assets, such as stocks and bonds, they provide an excellent diversification benefits to the investor. Anti-cyclical movement between commodities vs. bonds and financial assets was demonstrated for example in the work of Goldman Sachs "The Strategic Case for Using Commodities in Portfolio Diversification" (July 1996). While financial assets are anticipatory and they move in advance in expectation of firms’ profits and GDP growth, real assets like commodities move based on current state of supply and demand for them. Next, they serve an important function as an inflation hedge. In inflation environment, stocks and bonds might struggle with their performance. And with both monetary (think QE II) and fiscal massive expansions, we can witness stronger inflation growth pressures rather sooner than later.

While historically we can say they have different movement in the economic cycle and provide diversification opportunities, in 2008 they plunged (-57% mid 2008 till beginning of 2009, as measured by Dow Jones UBS Commodities index) the same way stocks did (-57% since end of 2007 till beginning of 2009, S&P 500 index) and correlation coefficient was almost 1 at that time. So how can we prevent situations like these when during times of economic panic most assets move in lockstep down? First, it is important to repeat that we think plunge of commodities in 2008 was not fully fundamentally justified, as main emerging economies were not hit by financial crisis so much – and this means, based on our opinion, commodities as a whole (index) are undervalued and can provide nice returns in the years to come. But as 2008 event taught us new lesson it is better to add something more to the portfolio and both practice and research tells us use managed futures that are doing usually very well during times of economic stress. Managed futures returned 14% in 2008 based on Barclay CTA (Commodity trading advisors) index so they proved again 25 year long study by Dr. Lintner, a Harvard professor, that they are extremely beneficial tool in investors' portfolios (Dr. Lintner: "The Potential Role of Managed Commodity – Financial Futures Accounts in Portfolios of Stocks and Bonds", Toronto, May 1983).

So, it may be a wise move to look for a commodity trading advisor (CTA) that combines long commodities strategy combined with so called "alpha" addition – basically investing in commodities (index, can be commodities futures index) plus managed futures strategies that are trying to add some percentages over index performance (alpha). In reality, which is interesting this strategy might not even require much in the form of an initial capital.