The following article -- the lead feature from the fall 2014 issue of Changing Business, the research magazine of the Johns Hopkins Carey Business School -- examines Assistant Professor Jim Kyung-Soo Liew's finding that commodities, though often described as a reliable counter to inflation, actually fail to stack up in that role:
When the stock market hits record levels and bonds become vulnerable to rate hikes, many investors elect to keep significant amounts of their portfolios in cash. But because cash loses its value to inflation over time, financial advisors tout commodities as an effective hedge. The price of commodities, these advisors argue, stays ahead of inflation and makes them an attractive investment option.
Well, not really, concludes a paper co-authored by Assistant Professor Jim Kyung-Soo Liew of the Johns Hopkins Carey Business School and two members of the New York-based Investment Research Foundation, George Crawford and Andrew Marks. After poring over 53 years of data, the trio found that commodities do not offer a consistently reliable haven from inflation.
Commodities represent raw materials as opposed to finished goods. They include categories such as energy (oil, natural gas), metals (gold, silver, platinum), and food (soybeans, sugar, cocoa), among others. In their paper – “Spot Commodities as Inflation Protection,” published in the winter 2013 issue of The Journal of Wealth Management – the authors examine the “spot price” (current market price) of commodities and its historical relationship with inflation.
The standing theory has been that inflation is factored into the cost of these items, so owning them helps an investor ride out periods of high prices. Liew and his colleagues found that while commodities prices sometimes rose along with inflation, the prices plummeted as inflation cooled. And many commodities didn’t keep ahead of inflation over the necessary period.
Liew says those who recommend commodities as a hedge remember the rise in value – based on personal experience – but overlook the decline.
Liew, Crawford, and Marks reviewed the performances of 45 spot commodities and 13 commodity aggregates (groups of similar commodities) from 1960 to 2012. They found that not only did commodities fare worse than stocks and bonds, but just a third outpaced inflation. In most cases, Treasury bills performed better than commodities.
The one commodity area that routinely outpaced inflation in their review was energy. But energy could be volatile, too – dropping substantially in value during some periods. For a long-term investor, it would seem that energy would be a reasonable alternative. But Liew warns that energy is undergoing rapid technological transformation. Wind and solar technology may eventually push down the value of oil. Natural gas prices may drop as fracking becomes more common. On the other hand, the environmental dangers of fracking could limit its use and leave prices largely unchanged. Either way, technology’s effect on energy is unpredictable.
As with any examination of a broad financial topic, the rules have exceptions that invite debate about overall conclusions. For example, from 1972 to 1976, all commodities outperformed stocks, and gold provided impressive returns from 1978 to 1980, the research found. Proponents of commodities may point to those periods as evidence that commodities can be a smart move, as long as an investor gets into and out of that market in a timely fashion.
True enough, Liew says, except that it is exceedingly difficult to time such a market.
He says he understands why financial advisors are attracted to commodities. Investors are seeking an effective way to better diversify their portfolios. And while commodities offer the advantage of not correlating with the rise and fall of the stock market, they are hardly a set-it-and-forget-it option if the goal is to stay ahead of inflation.
If investors are tempted to take up a financial advisor’s offer to add commodities to their portfolios, says Liew, they should check to see how actively the advisor will monitor the commodities’ effectiveness as an inflation hedge. Unless the advisor can demonstrate a history of knowing when to buy and sell commodities – again, not an easy task – an investor is probably better off looking elsewhere for inflationary hedges.
– Michael Blumfield