A recent article in the Financial Times highlights why, in part, the steam has gone out of the commodity markets. Judging the super cycle to be at an end, investors have exited the market en masse in the belief that no money is to be made from a falling market. After making 7% returns in the first half of the year from simply tracking the Bloomberg (formerly Dow Jones) Commodity Index, the third quarter has seen prices fall across the board.
According to the FT, figures compiled by Citigroup show net withdrawals from exchange-traded and commodity-linked funds totaled $8.2 billion in the 3 months to the end of September, canceling out inflows of $7.5 billion in the first half of the year. Prices have slumped by some 10% and there appears little confidence the trend will reverse anytime soon, draining investor appetite for the sector.
Quite rightly, the article identifies that passive investment in commodity indices, while they have generated good returns in the past, will likely not do so in the future. While we would never advocate passive investment in any class, the time for active management has never been more important or more valuable.
The article makes a good point in that we are in a bearish commodity market and that passively putting your money into commodity indices is not a good strategy for individual investors. Some people would argue that you’d be better off putting some money into commodities at any time for diversification purposes.
However, I would disagree.
As one of the best investors of all time once said: “Diversification is a protection against ignorance. It makes little sense if you know what you are doing.”
By using a trend-following strategy, investors would have realized that there was no point in keeping your money in the commodity market from the time it started breaking down in 2011. Especially when you had an up-trending stock market to put your money in.
Understanding the current state of the market is probably the most critical thing that investors need to do. At the end of the day, it all comes down to probabilities. In a bear stock market, almost every stock (regardless of how well the company is doing) will sink as the general market is heading down. The commodities market is no different. By going long on any individual commodity while the commodity market is falling, you are decreasing your probability of success. It’s like trying to sail when the wind is blowing against you.
3 Things Investors Can Do
- Investors can make great returns by investing in commodity indices as long as they get out of the market in bearish periods. Indeed, this is not hard to do as it’s easy to spot when the trend is changing. Moreover, individual investors have flexibility to quickly close their positions, protecting their gains during difficult periods. Investors can quickly find the current market trend in our monthly trend-following report.
- Investors can also strongly enhance their performance by selecting the strongest commodities when the general market is healthy. Although most commodities will follow the direction of the general market, some of them will break out or break down before or after the general market. Understanding when is the correct time to buy and to sell is also key to investment success. Investors can also find the performance of the sector and of each individual industrial metal in our monthly trend-following report, as well as the proper points to buy and sell.
- Investors can also use this to short the weaker commodities in a falling market. Although shorting needs more proficiency and most individual investors might be better off just cashing out in falling markets and waiting for better opportunities to come. Needless to say, no individual commodity should be shorted in a rising market.
Contrary to what the article says, we don’t recommend being long and short in relative value. In bullish markets, be long in what is showing relative strength. In bearish markets, cash out or short the weaker commodities at the right time. There is no need to complicate things by buying and shorting at the same time.
Finally, despite the bad performance of commodities since 2011, investors shouldn’t be discouraged. The next bull market in commodities could happen any time and the good thing is that you don’t need to waste your time making predictions. You just need understand when the market is changing and be ready when the next bull market is unfolding.
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