Commodity Stocks: Improving Returns With No Extra Volatility
US Global Investors
By Frank Holmes
September 28, 2012
Commodity Stocks: Improving Returns With No Extra Volatility
By Frank Holmes
CEO and Chief Investment Officer
U.S. Global Investors
Commodities are the necessary building blocks of the world. Glance around you—commodities are what the world needs to live and prosper and are everywhere you look. The world’s seven billion people need resources, and that’s why we recommend investors consistently allocate a portion of their portfolio to a natural resources investment.
Not every investment is the same, though. Even within the commodities space, when looking at measures such as correlation, performance and risk, two indexes can have very different effects on a portfolio’s results.
Take two popular commodity-related indices for example, the Dow Jones-UBS Commodity Index (DJUBS) and the Morgan Stanley Commodity Related Index (CRX).
The DJUBS is made of futures contracts on various physical commodities that represent major commodity sectors such as agriculture, energy, grains, metals, livestock and precious metals. Basically, futures are contracts between a buyer and seller, where the buyer agrees to purchase a specific commodity for a specific price and specific time in the future.
The CRX is comprised of stocks involved in commodity related industries, such as energy, non-ferrous metals, agriculture and forest products.
Yet, while both indices are diversified across various commodities, their correlations to the overall market differ.
Take a look at the matrix looking at 10 years of data. The table lists the S&P 500 Index, which represents the overall U.S. stock market, and the two commodity indices. When two asset classes or investments are perfectly correlated to each other, their performance moves are in sync and they have a correlation of 1; 0 means that the two investments have no correlation to each other.
Over the past decade through June 30, 2012, you can see the DJUBS and the S&P 500 have had a correlation of 0.80. The CRX and the S&P 500 had a correlation of 0.62. This means the CRX is less correlated to the overall market than the DJUBS.
And why is a low correlation beneficial? In a diversified portfolio, it can reduce an investor’s volatility.
In the article “Material World,” Financial Planning found that a low correlation is a “valuable feature” for natural resources mutual funds. When author Craig Israelsen compared the correlation to the overall market to the 10-year annualized returns of 18 natural resources funds with 10 years of performance records, “a clear pattern” emerged. “Natural resources funds with lower correlations (that is, closer to zero) had better performances during this span,” he says.
Over the past 10 years, this pattern was prevalent in the CRX, as commodity producers far outperformed the index of commodity futures.
How to Optimize Your Portfolio with Commodities
So how do correlations and long-term performance translate to your portfolio? One way to look at this would be to create an efficient frontier, which charts a range of allocations to commodities and the overall market to see which portfolio would be most efficient, i.e., which portfolio enhances returns without adding risk.
To find the optimal portfolio between commodities and the overall market, the efficient frontier plots different portfolios, ranging from a 100 percent allocation to an investment in the S&P 500 and gradually increasing the percentage of commodities. Each dot along the path of the efficient frontier represents an incremental increase toward a 100 percent allocation to commodities investment.
First, we chart the efficient frontier of the DJUBS and the S&P 500. A 100 percent allocation to the S&P 500 would result in a portfolio achieving a 5.9 percent return and 20.3 percent annualized volatility.
Assuming the portfolio was rebalanced each quarter, our research found that a portfolio holding 25 percent allocation to the commodities futures and 75 percent allocation to an investment in U.S. equities would decrease an investor’s return by about 0.17 percent while decreasing volatility by a little more than 3 percent. Simply, the addition of commodity futures yields less volatility for about the same return.
A different picture emerges when you chart an efficient frontier for a portfolio invested in commodity equities and the overall market. In a portfolio of 25 percent commodity equities and 75 percent U.S. stocks, an investor reduces their risk by almost 1 percent while increasing their return by nearly 1.5 percent.
How Resourceful Is Your Portfolio?
The charts above illustrate how the power of commodities enhances a portfolio, although a 25 percent allocation may be a little too aggressive. For reference, about 15 percent of the S&P 500 Index is made up of energy and materials companies.
The Global Resources Fund (PSPFX) uses the CRX as its benchmark, and we’re pleased to say that over the past 10 years, the four-star fund* has outperformed its benchmark, resulting in even greater returns for shareholders.
Put commodities to work in your portfolio today.
* The Global Resources Fund earned a 4-star Morningstar Overall Rating™ among 121 natural resources funds as of 8/31/2012. The Global Resources Fund earned a 3-star Morningstar Overall Rating™ among 124 natural resources funds as of 6/30/2012.
- The major market indices fell this week. The Dow Jones Industrial Average declined 1.05 percent. The S&P 500 Stock Index fell 1.33 percent, while the Nasdaq Composite lost 2.00 percent.
- Barra Value outperformed Barra Growth as Barra Value fell 1.23 percent while the Barra Growth index declined 1.42 percent for the week. The Russell 2000 small capitalization index closed the week with a loss of 2.11 percent.
- The Hang Seng Composite Index rose 0.63 percent; Taiwan fell 0.51 percent, while the KOSPI decreased 0.31 percent.
- The 10-year Treasury bond yield fell 12 basis points for the week, to 1.63 percent.
Domestic Equity Market
The S&P 500 Index declined 1.33 percent this week, as the market’s euphoria over the Federal Reserve’s decision to conduct open-ended quantitative easing via purchases of mortgage-backed securities and keep interest rates exceptionally low through mid-2015 to boost employment faded. The market continues to struggle with the uncertainty in Europe. Speculation about the Spanish bank stress test continued for much of the week until the results were released on Friday.
- The utility sector rose 0.93 percent and was the only positive sector this week. The utility sector has been the worst performer over the past month and quarter and is a classic defensive, “risk off” group. Risk off was in vogue this week and the sector benefitted from that.
- The health care sector registered the second best performance this week, but did decline 0.25 percent. Cerner Corp was the best performer within health care and rose nearly 4 percent on Friday as a competitor Allscripts Healthcare Solutions Inc. said it is exploring a sale or leveraged buyout. Amgen, Dentsply International and DaVita were also strong performers this week.
- Accenture Plc. was the best performing stock in the S&P 500 this week as the company rose by more than 7 percent. The company reported earnings and raised guidance after the close on Thursday, citing very strong outsourcing trends.
- After a strong run, cyclical sectors have underperformed for the last two weeks as technology, materials and financials were the worst performers this week.
- The technology sector experienced broad-based weakness as market leader Apple fell by more than 2 percent. Netapp, Advanced Micro Devices and Micron Technology were among the week’s worst performers in technology.
- Jabil Circuit was the worst performer this week in the S&P 500, falling by more than 13 percent as the company reported a mixed earnings report, and guidance for the upcoming quarter and 2013 disappointed, a weak global economy was the primary culprit.
- While debasing the value of their paper currencies in the long term, renewed money printing in the developed world may have the ability to send asset prices higher in the near term.
- The market will now shift to earnings preannouncements and the upcoming elections, which could cause some volatility.
The Economy and Bond Market
After rising for the past month treasury yields fell this week as the euphoria surrounding the recent central bank moves dissipated. Bond yields have risen during prior quantitative easing periods as expectations for economic growth pick up. However there are always fits and starts to the process and this week the market refocused on Spain’s continued troubles and some weak data points in the U.S. The chart below shows that durable goods orders for September plunged 13.2 percent, well below estimates. Much of the drop was attributable to aircraft orders but even ex-transportation orders fell 1.6 percent when expectations were for a small gain.
- Consumer confidence unexpectedly rose sharply in September hitting a seven-month high. Consumers were much more optimistic regarding the economic outlook than in August.
- Weekly initial jobless claims fell to a two-month low and are showing some modest improvement.
- The S&P/Case-Shiller’s seasonally adjusted 20-city home price index rose 0.4 percent in July.
- Durable goods orders in September plunged by 13.2 percent, the largest decline in over three years.
- The Business Roundtables’s third quarter CEO Economic Outlook plunged to 66 from 89.1 in the second quarter. CEO’s confidence is the weakest since the third quarter 2009 on concerns surrounding the “fiscal cliff’ and a weak global economy.
- There was considerable speculation about the prospects for government policy action that would support the economy or stock market. The Chinese markets will be closed next week for a holiday and this is often when the government announces policy changes.
- Interest rates are likely to remain very low for the foreseeable future.
- Europe remains a wildcard with the markets shifting focus on a weekly basis.
- China also remains somewhat of a wildcard as the economy has slowed and officials appear in no hurry to take decisive action.
- Brazil raised its inflation view and dimmed hope for additional rate cuts. Brazil was one of the first countries to cut interest rates around this time last year.
For the week, spot gold closed at $1,772.10 down $1.00 per ounce, or 0.06 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, lost 2.01 percent. The U.S. Trade-Weighted Dollar Index gained 0.76 percent for the week.
- Gold prices continued to remain firm over the last couple of weeks.
- Gold stocks, on average, lost a little ground over the past week but pretty much are at the same levels as two weeks ago. The important point is that the strong march upward was not followed by an equally strong reversal in prices.
- Central banks continue to buy gold to supplement their reserve base. Ross Norman, CEO of brokerage firm Sharps Pixley, noted that banks are clearly concerned about bolstering their reserves with asset classes that maintain their value in the long run.
- South African gold mining shares traded lower than their North American peers over the course of the week.
- Strikes at Gold Field and Anglogold shut down as much as 39 percent of the country’s capacity. Angolgold noted there were work stoppages at all of their operations. Harmony Gold remained unaffected by the strikes.
- Higher wages and strike-related downtime are likely to depress the margins for the South African gold miners.
- Klondex Mines reported a drill intercept which carried 2,910 gram/ton (85 ounces/ton) over a 1.5 meter at their high-grade Fire Creek project in Nevada over the past week.
- In addition, earlier this month Paul Andre Huet joined Klondex Mines as its new President and CEO. Huet brings 25 years of high-grade, narrow-vein gold mining experience to the table for Klondex. Previously Huet led the team which built and permitted the Hollister Mine and was Mine Manager at Newmont’s Midas mine, both of which are in Nevada.
- While North American gold producers have been reluctant to buy their junior peers at greatly reduced prices, the Chinese gold producers have been on a shopping spree. Zhongrun announced plans to buy a 42 percent stake in Noble Minerals which has a gold mine in Ghana that is expected to recapitalize the operations to produce 150,000 ounces per year. Shandong Gold also announced plans to buy a 51 percent stake in Australia’s Focus Minerals, Zinjin Mining bought Norton Gold Fields, and China National Gold is in talks to buy a stake in African Barrick.
- While we have had a strong move in the gold price, two things are missing – China and India. Gold demand in India has plunged due to a weaker currency, slower economic growth and higher taxes. Chinese demand in the second quarter was 145 tons, down 43 percent from the first quarter. The slide in the Shanghai Stock Exchange Composite Index continued into the third quarter with the index hitting three-year lows. The return of these two players to the market should give gold a meaningful lift in prices but we need to see an improvement in their growth prospects.
- South Africa remains challenged by the labor strife. Junior mining companies and new IPOs will likely be challenged to raise new funds to further their development in the near term.
- Earnings reporting season for the gold stocks will start in October but with the dip in prices early in the quarter and subsequent rebound, we may not see meaningful quarter-over-quarter growth metrics. In addition, with the completion of the third quarter and the rise in prices into the quarter end, we may see some profit taking in early October. Don’t get too bearish though, the governments around the world are just warming up the printing presses.
Energy and Natural Resources Market
- Natural gas jumped 14 percent this week to the highest level this year as concern eased that stockpiles will reach storage limits before winter weather boosts demand for the heating fuel. Weekly Department of Energy data showed inventories increased by 80 billion cubic feet to 3.576 trillion in the most recent week while peak working gas capacity is about 4.239 trillion, department data shows. The futures have rebounded 73 percent from a 10-year low in April as rising power-plant demand eroded the biggest supply glut in six years.
- U.S. farmers maintained their record pace of harvesting corn and soybeans during the past week but farmers were not fully running their combines due to some rainy weather.
- Dow Jones reported that Anglo American, the world’s third-largest producer of coking coal, plans to reduce coking coal output in the coming months as it reviews its existing operations and projects due to weak coal prices and high costs.
- Baoshan Iron & Steel Co., China’s largest listed steelmaker, suspended production at a plant after demand fell for slabs used to make ships and bridges. “A downturn in demand in the downstream slab market” prompted the stoppage, the company said in a statement to Shanghai’s stock exchange yesterday, without elaborating on when production may resume. Production was suspended “to avoid increasing our operating losses,” it said.
- The People’s Bank of China (PBOC) has injected a record amount of money into the financial system this week to alleviate short-term liquidity concerns. The PBOC issued Rmb365 billon of reverse repurchase agreements over the past three days, the largest weekly amount in history. The cash inflow was effective immediately, causing the seven-day repurchase rate to fall 100 basis points from the three-month high of 4.75 percent reached earlier in the week.
- The Financial Times reported that South Africa would allow “fracking” in what could potentially be the fifth-largest shale gas reserves in the world and provide a major boost for energy, jobs and reduced pressure on coal production. South Africa has lifted its two-year moratorium on fracking; now all it needs is to find the water for the process in the Karoo desert. European nations that host shale gas are perhaps hoping that successful development of South Africa 's gas will encourage work in their countries.
- The Financial Post reports that “When the Fukushima nuclear disaster unfolded in March last year, even the most optimistic investors knew the uranium market was in for a rough ride - they just didn't think it would last so long. Eighteen months after the incident, uranium prices continue to hit new lows. The spot price sunk 50 cents to $46.50 a pound this week, which is the lowest level since 2010, according to Ux Consulting. Investors briefly drove the spot price above $135 in 2007. The long-term price has also declined, though it is higher at $60, reflecting the fact buyers will pay more for material delivered mid-decade or later.”
- China’s official Xinhua News Agency released two very important announcements today. First, the Communist Party of China will hold its 18th congress on November 8, 2012. Second, China charged former Chongqing boss and leadership challenger, Mr. Bo Xilai, for crimes including corruptions and his responsibilities in the murder of a British national, Neil Heywood. This should put to rest speculation over the leadership transition and other political issues, therefore removing a political risk premium from the equity market in China and Hong Kong.
- The A-shares market rebounded for the last two days of the week after the Shanghai Composite Index reached a three-year low at the 2004 psychological level. The market saw domestic fund companies and government pension plans buy into cheapness.
- Philippine’s government reported a surprise budget surplus for August 2012, though through slower spending growth.
- Indonesia’s central bank still expects GDP growth at 6.4 percent for 2012, and to improve its current account deficit in 2013.
- The Czech central bank cut interest rates by 25 basis points this week in an effort to boost economic growth.
- Singapore’s August industrial production contracted 2.2 percent, below consensus. The contraction was led by transportation engineering (down 20 percent) and electronics (down 7.3 percent).
- Thailand announced August export was down 6.9 percent, versus consensus down 5.8 percent. Exports to all key market contracted, led by Europe (down 23 percent), ASEAN 5 (down16.8 percent), Japan (down 12 percent), and China (down 8.6 percent).
- Guangzhou city in Guangdong province limited pre-sales for some home projects that have “excessive high prices.”
- Driven by domestic construction and consumption, Thailand bank loans are growing more than 15 percent year-over-year.
- The tension between Japan and China caused Japanese vehicle sales to slow in China and cancellations of Chinese tourist bookings to Japan. In the event of a military conflict between the two countries, global trades and economic recovery will be affected.
- The Brazilian central bank raised its inflation forecast for 2012 to 5.2 percent from 4.7 percent, citing recent fiscal stimulus. Stimulative monetary policy action now appears unlikely.
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