Commodities: The Missing Third Leg Of The Stool
“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure, that just ain’t so” is a quote attributed to Mark Twain. On writing this piece I wanted to be sure of that so I did some “research”. The irony, discovering that there is no evidence to that effect and the quote has also been attributed to a variety of people, including Josh Billings, Artemus Ward, Kin Hubbard, Will Rogers, and Edwin Howard Armstrong. Despite its uncertain origins, the quote is a wise one. It is a reminder that we should always be open to new information and willing to question our assumptions. We should also be careful not to overestimate our own knowledge, as this can lead us to make mistakes.
Commodities are portrayed as short term trading instruments, and not long term investments. Maybe it is because they are cyclical in nature, but business itself also has cycles, yet stocks and bonds are invested in with a long term outlook. The fact that when financial advisors speak about portfolio construction, they typically focus on getting you invested in stocks and bonds, says a lot about commodity investing not being seen as the third leg on the stool. In all the debate about the 60:40 portfolio (60% stocks and 40% bonds), I am still struck by how Commodities are being overlooked as an asset class. Commodities in the long run, can be just as boring in a portfolio as stocks and bonds, whilst still generating returns.
The primary reason that most will argue in favour of stocks and bonds, is that stocks and bonds generate a cashflow. Stocks will pay out a dividend and bonds will pay out interest. Well, for those arguing that, Amazon, Alphabet (Google parent company), Tesla, Meta Platforms (Facebook parent company), Berkshire Hathaway (Warren Buffett and Charlie Munger) are all in the Top 10 companies by market value (in the S&P 500) and do not pay a dividend. The list does not end with them. As for bonds, Real Interest rate yields on the U.S. 5 Year Treasury have averaged -0.07% over the last five years as yields were so low and inflation higher than the interest yield.
If I asked you to think of a movie about the markets and investment bankers, you would throw out names like The Wolf Of Wall Street, Margin Call, Boiler Room, The Big Short, and the original Michael Douglas character, Gordon Gecko from Wall Street without giving it much thought. These however, only allude to stocks or bonds. As for movies that center on commodities, I can only think of the movie Trading Places, starring Eddie Murphy, Dan Ackroyd and Jamie Lee Curtis. Depending on your age, you are possibly having to get on your search browser to figure out what on earth Trading Places is about. My point is, even Hollywood has a multitude of options on movies centred on stocks and bonds but hardly any about commodities.
I say commodities are the third leg on a stool as for me they complete the balance in this Balanced Portfolio we speak of. The good news is, even as retail investors, we don’t have to get lost in trading commodities on the futures exchange. Anyone can get exposure to commodities via an ETF. There are quite an extensive amount to choose from that are simply a proxy for an underlying commodity. One can own an ETF linked to a single commodity or basket of commodities.
Investing is supposed to be boring, and while individual stocks are exciting to own, picking stocks that will outperform the overall market over a ten year plus marathon is more difficult than it looks. Average returns are anything but average, given that the majority of portfolio managers do not achieve them (the average returns). I remember trying to explain to my financial advisor in 2017 why I did not want bonds in my portfolio and believed that stocks in the long run would outperform them. Our compromise was a portfolio that was 80:20 and not the 70:30 he was suggesting. The worry at the time was valuations on the stock market being too rich and a correction being highly likely.
Today, the worry most investors will have is not one of a mere correction, but heavier losses as a result of a recession, or stagflation. Despite bond prices being a “falling knife”, I can understand and respect the importance of a portfolio that is not 100% stocks. It’s been a bull market for stocks, that has gone from strength to strength, evidence in the S&P 500 being up a compounded 8.34% per annum over the last five years, despite falling more than 20% in 2018, more than 35% in 2020 and more than 27% in 2022. What happens when one of these days, the recovery is not as swift from stocks falling, or they stay in a range going up and down for years?
The U.S. economy has been resilient, for reasons unknown to even the smartest minds working at The Fed. Despite the rapid rise in interest rates in a short amount of time, inflation is still above the The Fed’s target, and they are determined to do whatever it takes to get it back below the 2% level (last reading was 3.67%). The markets seem to only now be coming to grips with what The Fed has been saying all along, and that is that interest rates will stay higher for longer. Have stocks stopped falling? Do Bonds continue to fall? Have commodities stopped falling?
Only time will tell, but looking forward, I would not put my investment in one asset class, as the fact is you can’t take it for granted that the next ten years will yield the same performance from each asset class relative to each other as the last ten years. Since November 2021, when The Fed first indicated that they are going to start increasing rates, the S&P 500 is down 6%, the U.S. 10 Year Treasury Note (Bond Price) is down 19% and the Bloomberg Commodities Index is up 7%. The missing third leg of the stool, commodities, that nobody talks about is the reason most model portfolios are on the floor.