COMMODITYINDICES
equity weakness and higher inflation,
particularly in recent months. Figure 6
Figure 6: 60-Day Rolling Correlations of WTI to the USD,
showshowWTIhasbeengenerallyneg-
S&P & 5-Year Break-even Inflation
ativelycorrelatedwiththedollar,uncor-
related with the S&P (save recently),
and positively correlated with 5-year
breakeveninflation, which is acommon
measure of future inflation expecta-
tions derived from the 5-year forward
USTIPSmarket.
However,thestrategicmotivationsfor
investing in commodities have become
increasingly blurred with tactical rea-
sons, as investors turned off by the dis-
mal recent performance of traditional Source: Bloomberg
asset classes such as equities have
sought higher performance elsewhere. cyclical nature of oil as opposed to the dynamic return of the S&P
Using our estimates of inflow, we can and the Dow Jones Index.
test to see whether the following fac- Aninvestmentintoacyclicalassetwithalong-runexpectedexcess
tors have positive explanatory power rate of return of zero such as commodities will always decrease a
forinflowstocommodities:weaknessin portfolio’s long-run expected excess return. However, the portfolio
the dollar, lower S&P returns, higher mayseeanimprovedSharperatioasthediversificationbenefitsand
inflationexpectations,higherVIXindex the reduction in the variance of the portfolio outweighs the loss in
(a common measure of market anxi- expected return.
ety), and finally, prior-week perform-
ance of the associated commodity
It is important to recognise the limitations
index. Econometric tests reveal that all inherent in commodities given their
of these factors have the correctly pre-
cyclicality and high volatility
dicted impact of flows, with dollar
returns, inflation expectations, and Strategic diversification into commodities should focus on finding
past performance having positive sta- theidealportfolioallocationbalancetomaximizetherisk-returnpro-
tistical significance. file, but should not focus solely on seeking returns on the basis of
The results above are in line with momentum from past historical returns. This is particularly the case
widely cited stories of the dollar and foramean-revertingfactorsuchascommodityprices,forwhichhigh-
inflation being drivers of financial erpastperformancepredictslowertonegativefutureperformance.
investment. The value of commodities In fact, we view momentum-trading as a key building block of a
as a hedge against economic down- speculativeassetbubble.Bubblesoccurwheninvestorslosesightof
turns, a falling dollar, and higher infla- thefundamentalinherentvalueofanasset,butmakelongpurchas-
tion is also consistent with a long-term es simply in anticipation of finding another investor who would be
strategic investment by large institu- willing to buy the position at an even higher price. Relying on the
tional investors in commodities. positive feedback of momentum-trading is a tactical investment
However, we stress that investment strategy inconsistent with a vision of commodities as a strategic
drivenbypastperformanceofthecom- asset class.
modity indices is not.
The momentum-chasing nature of Figure 7: Inflation Adjusted Oil, the S&P and the
index investment is a potentially worri- Dow Jones Index, 1861-2007
some finding. In the hullaballoo over
commodities, investors may be forget-
ting the obvious: commodities are
inherently static assets whose prices
fluctuate around some long-term (but
potentially changing) equilibrium level,
while equities are shares in the future
cash flow of dynamic firms providing
long-term returns from technological
progress. Adjustment to a higher equi-
librium price may mimic superior
returns in the short term, but it cannot
lastforever.Figure7showsthelong-run
Sources: BP, Bloomberg
46 SEPTEMBER 2008 COMMODITIES NOW
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