Commodities for the People

By: Scott Wright | Fri, Jun 2, 2006
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Investors are finally just starting to heed the cry of the watchmen. The commodities bull hath cometh, the commodities bull hath cometh! As a long-time proselytizer of the Great Commodities Bull, I'm sure having fun watching commodities storm the streets while gaining increasing exposure from the mainstream financial media. And in this process drawing in more and more capital on the investment and speculation front.

Though still likely in the first half of a secular bull run that will eventually capture everybody's attention as it matures, commodities are becoming a growing part of portfolios of all types from individual to institutional. And as the performances of most commodities blaze higher, it is hard not to do a double-take when looking at their beautiful charts.

And it is simple fundamentals that drive these secular price movements. More and more people are starting to recognize that it will likely take a decade for the economic imbalances commodities are experiencing to come to center. So in an environment where rising prices are near imminent, why not ride the trend and make some money on it?

But up until recently in order to invest directly in commodities, other than taking physical possession of them, you had to either be a sophisticated and risk-tolerant futures trader or take part in a handful of funds that tracked various futures-based indexes. And even though individual-stock picking continues to provide the best leverage and opportunities to multiply one's capital, the risks are deemed simply too high and not yet justified for many of the newly inducted commodities faithful that are cautiously but optimistically increasing their exposure in this sector.

Indirect investment into commodities as mentioned above can be achieved by investing and speculating in the stock market in the companies that explore, develop, service and produce commodities. We have been doing this for many years at Zeal with great success.

But for the average investor who is not yet up to the task of investing into individual companies, is not interested in futures, is not connected or does not want to pay to get into exclusive funds and does not have the capacity or capital to store say one contract of aluminum (44,000 pounds) or one contract of corn (5,000 bushels) in their back yard, how else does one broadly, directly and easily invest in the commodities market?

In comes the almighty ETF. Exchange Traded Funds have hit the floor running in recent years and are now giving investors and speculators the opportunity to "buy the market" in a multitude of sectors. Hundreds of billions of dollars of assets are now housed within ETFs and capital is flooding into them today at a much faster rate than the conventional and much-loved mutual funds.

Even though the first successful ETF originated in Canada on the Toronto Stock Exchange, Spiders (SPY), Diamonds (DIA) and Cubes (QQQQ) brought ETFs to widespread popularity in America as they gave investors and speculators the opportunity to easily bet for or against the Big Three of the general markets.

And because of this popularity, hundreds of ETFs have since come to market with hundreds more on the way. It is fair to say there is somewhat of an ETF craze happening today as new markets continue to open up for the average stock investor. There are countless benefits to ETFs that I can't cover today, but perhaps most important to consider is the fact that investors can now build a truly diversified portfolio solely from ETFs.

And some newer ETFs are actually starting to cater to the non-conventional stock-market investors. One of the most popular and fastest-growing ETFs today is the Euro Currency Trust (FXE). FXE is a popular choice among American investors who not only use it for income distribution to take advantage of euro currency rates, but use it as a hedge against the weakening dollar.

FXE doesn't have much to do with commodities per se, but I think it's amazing that the average stock investor is essentially now able to take part in the currency markets with each FXE share representing €100. Currency trading has the reputation of being one of the most complicated, difficult and risky markets to trade right up there with commodities futures. And outside of one's important gold investment to hedge the growing risk of weakening fiat, now investors who wish to protect the cash portion of their investments from the bleeding dollar might perhaps find a place of refuge in the FXE.

Also growing popular, especially from a contrarian perspective, are the single-country ETFs that invest in a foreign stock market or a basket of foreign stocks. These can serve as not only a foreign or emerging market investment, but also as a dollar hedge because the funds are calculated in the local currency and then converted back to the dollar. And for the fearless ones that want to take part in the growing real estate bubble, REIT ETFs are also on the menu.

Now with commodities gaining popularity, new-to-the-market commodities-specific ETFs are attracting crowds. The introduction of these ETFs has opened up a whole new dimension of investing and provides the average investor an opportunity to easily take part in various sectors of this secular bull market in commodities.

Some of these ETFs focus on tracking specific commodities, such as the streetTRACKS Gold Trust Shares (GLD), the iShares Silver Trust (SLV) and the U.S. Oil Fund (USO). Each of these ETFs is designed to track the performance of the underlying commodity it represents giving investors a measurably easy way to take advantage of the secular uptrend of certain major commodities. And all this without having to open a futures trading account.

Commodities ETFs have come to market with much praise, and of course some scrutiny, for a variety of reasons. But regardless of how vocal the yeas and nays are in tussling this out, the result is not only better exposure for commodities, but an easy way for mainstream investors to diversify their portfolios into the natural resources that keep the global economy moving. And the simplicity of these ETFs is just magical. Adding an ETF to one's portfolio requires the same trivial effort as purchasing any other stock in your trading account. All you have to know is the symbol and you are golden.

But the commodities ETFs mentioned above still did not solve the greater dilemma. How can the average stock investor take part in the broad commodities sector? Investors that do not have the time, resources or wherewithal to focus on individual commodities were still finding it difficult to access this type of investment vehicle.

At Zeal one of our favorite commodities indexes that serves this purpose is the venerable CRB Commodities Index. The CRB is an excellent proxy for the commodities markets as a whole and we've written many times about its fundamental and technical usefulness. But it's not easy to directly invest in the CRB if you are not a futures trader. Wouldn't it be neat if you could just buy the CRB like any other stock or ETF in your brokerage account?

The CRB happens to be one of about half-a-dozen commodities indexes out there. Commodities indexes are based on futures prices for the given commodities in which they are invested and have become very popular in recent years as institutional dollars have diversified away from stocks and bonds. Because of the popularity of these indexes, the futures markets have become more liquid as the indexes constantly invest incoming capital and continually roll over near-term futures contracts.

Most of these indexes weight their portfolios across many different commodities classes in order to reduce risk and gain broad exposure. And the CRB, as with these other indexes, has performed very well in this bull market. Its gains in recent years compared to other sectors have been outstanding. The CRB has doubled since 2001 and investors ranging from retail mutual funds to giant pensions are jumping aboard hoping to ride the secular nature of this bull.

Though these indexes have been popular, the average individual investor has still been somewhat left out, until just recently. One of these elite commodities indexes is the Deutsche Bank Liquid Commodity Index. In February the American Stock Exchange listed a tracking fund to mirror this index bringing a whole new style to ETFs. Under the symbol DBC, this ETF is designed to reflect the performance of the Deutsche Bank Liquid Commodity Index.

DBC provides excellent exposure to commodities and is the first of its kind to be traded in the American stock markets. Most ETFs track a specific stock or bond index. And the gold and silver ETFs give investors a different look by actually backing the funds' capital with the storage of the physical metal. But DBC is actually based on futures contracts for the basket of commodities that comprise it. It is designed so investors can have cheap and convenient investment access to a broad selection of commodities futures.

This is a dream come true for many investors and speculators who have always been leery of opening up a futures trading account. Futures trading is very intimidating for the average investor and comes with its share of risks. With DBC anybody can now access, of course indirectly, the commodities futures markets. And they can do it with the ease, flexibility and comfort of trading in the stock market.

DBC is managed like the elite commodities indexes mentioned above. The fund is backed by futures contracts that are continually rolled to longer-dated contracts so it never has to take delivery on a commodity. DBC is a little more complicated than your typical ETF that tracks stocks or bonds though as it is quite the task flipping futures contracts and obtaining the best roll yield. When futures prices are lower than spot, backwardation occurs and positive roll yields are achieved. But when futures prices are higher than spot a negative roll yield, also called contango, occurs. So the fund managers really need to stay on top of this type of ETF in order to maximize the benefits it provides.

Now one of the reasons we like the CRB so much is because of its broad mix of commodities. In this secular commodities bull market, other than some of the government-subsidized grains, all commodities should thrive. And as mentioned previously, the CRB serves as an excellent proxy for the progress and health of the general commodities bull.

Though I would have much rather seen a CRB-mirrored ETF hit the markets, DBC will likely serve us fine for now. But to make sure of this why not compare the two visually and compare their makeup. As a commodities investor who has long trusted the history and performance of the CRB, let's see how the DBC stacks up against it.

As is apparent in this chart, the brief history the DBC ETF provides shows there to indeed be a strong correlation between the CRB and the Deutsche Bank Liquid Commodity Index. Even the minor technical noise visually appears to be closely correlated. Since the inception of the DBC, it has had a strong correlation with the CRB of 0.967 with an r-square of 94%. So 94% of the daily behavior of the DBC can be statistically explained or predicted by the CRB, not bad.

Now since the CRB and DBC have such a strong correlation, their composition should be similar right? Well, even though they are both indexes that are comprised of a basket of commodities futures contracts designed to reflect the greater commodities markets, there are actually quite a few differences.

The Deutsche Bank Liquid Commodity Index is annually rebalanced to reflect its composition of only 6 commodities. The index is heavily weighted in energy with crude oil comprising 35% and heating oil 20%. Metals bring its hard commodity weight to a hefty 77.5% with aluminum at 12.5% and gold at 10%. Corn and wheat round out this index, each weighted at 11.25%.

Meanwhile the CRB index is comprised of more than three times as many commodities as the DBC. The pie charts below show these commodities and their weightings for each respective index. And as you can see the CRB provides a wide assortment of commodities ranging from orange juice to hogs to nickel. In looking at the CRB it is apparent that it provides a broad range of commodities that seem to capture the essence of the general commodities markets.

With an initial glance it may seem surprising that with the composition of these two indexes seemingly so different that their correlation can be so close. Yet the correlation starts to make sense when you take a closer look at the top-heavy commodities in each index. Both are very heavy in energy and metals.

It is no wonder why these seemingly lopsided weightings exist. Energy and metals have indeed been the driving force of this commodities bull thus far. The vast difference in fundamentals between finite hard commodities and non-finite soft commodities has caused supply-starved energy and metals to greatly soar. And because of the increasing importance they play in the global economy, energy and metals heavily weight the CRB comprising 59% of its index while the DBC has a massive 77.5% weighted towards these sectors.

At the announcement of the DBC launch, the Global Head of Commodities at Deutsche Bank stated, "DBC is designed for investors seeking portfolio diversification and exposure to global commodity returns, which have one of the lowest correlations to US equities and bonds. This platform will provide investors with systematic exposure to global commodities without the complication and difficulty of investing directly in futures contracts or in the commodities themselves."

These comments provide legitimate and reasonable arguments for any investor to add commodities to their portfolio. But to me it lacks a certain bullish exuberance I believe is warranted due to the incredible opportunities for growth a secular bull market in commodities has to offer.

When people look back on today's markets in the future, commodities will likely have been the stalwart of the entire global financial markets earning their investors fortunes. Don't be fooled by the fading cry of the other watchmen. Commodities are not just an inflation hedge as mainstream analysts will have you believe.

And though commodities are a good hedge to underperforming stocks and bonds right now, it is important for investors to understand that there is a bigger picture involved in the push toward this "alternate" asset class. In a time where the general markets are likely to be stuck in at least another decade of sideways trading at best, the fundamentals of once-underperforming and unloved commodities will likely continue to propel them in this glorious bull market that should last at least another decade.

The structural supply deficit especially in the energy and metals commodities cannot be quickly remedied. And other than increasing supply to meet fast growing demand, rising prices are ultimately the economic force that will close the gap of this imbalance. So with commodities looking to be the asset class most likely to make investors money in the coming years, DBC provides excellent exposure on this front and can be an important stepping stone for a massive influx of new commodities investors in the years to come.

Ultimately exchange traded funds are simple and easy-to-use tools for investors to perform index investing, or buying the market. And thanks to DBC and various other commodity-specific ETFs, commodities are becoming more accessible for the next group of investors and speculators that will pour their capital into the still-lesser-known-but-growing commodities markets.

And as new investors get more comfortable trading commodities, simple diversification will not be enough. Market gyrations can be profitable and fun to trade even in ETFs, especially since margin and options are allowed. But the best and most exciting positive leverage to rising commodities still lies in stock picking. This is where the legendary gains have and will be made in a secular bull market.

The stocks of the companies that are involved in the life cycle of a given commodity are primed to make incredible profits as their underlying commodities thrive in the markets. Though this only includes hard commodities as farmers are typically not publicly traded, the hards are what drive the markets, so this is just fine.

Gold is a prime example of this situation. The actual metal traded in the futures markets is up an excellent 183% as of its recent bull-to-date high, yet the venerable HUI gold-stock index, which is comprised of the best of the best publicly traded gold producers, is up nearly 1,000% in this same period of time. This should tell you a couple of things. First, commodities, in particular gold, are hot and where the excitement is happening. And second, the amazing gains are won in the individual stocks of the companies that bring it to market.

At Zeal we focus on such leveraged investment and speculation as mentioned above and look for the best of the best companies that mine, drill and explore for these increasingly valuable commodities. These companies not only have the potential to provide excellent long-term growth, but if played correctly can serve as highly profitable near-term tactical speculations.

Within a strategic upward trend, tactical movements indeed provide exciting opportunities for speculators. Each commodity class may show strength at various times, and if you can catch the interim swings in the right direction, exceptional gains can be made. We have been trading the precious metals, base metals and energy swings with excellent realized gains and are always excited for the next opportunity to further deploy as our research and technicals dictate.

Our renowned Zeal Intelligence and Zeal Speculator newsletters disseminate this cutting-edge technical analysis and time leveraged commodities-stock and option trades for our subscribers. In addition to this we also publish occasional supplemental Reports of our favorite stocks in a given sector that are primed to thrive with their underlying commodities. Join us today as we ride the bull higher.

The bottom line is commodities are starting to gain the necessary exposure they are due as this bull gathers strength for its run even higher. The ever-powerful ETFs are allowing investors and speculators to ease into the commodities front and diversify their typical stock and bond portfolios. And it's the exciting ETFs coming to market including the brand new DBC index tracking fund and the GDX gold-miners index paving the way.

This exposure will continue to lift commodities as a sector as more and more capital flows into this asset class which will in turn thrust the bull even higher. Legendary gains should continue to be won by investing and speculating in the stocks of the companies with the best leverage to profit from the rise in commodities prices.

 


 

Scott Wright

Author: Scott Wright

Scott Wright
Zeal LLC.com

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Thoughts, comments, or flames? Fire away at scottq@zealllc.com. Depending on the volume of feedback I may not have time to respond personally, but I will read all messages. Thanks!

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