This article was originally published on TheStreet.com on April 24th, 2014 at 6:30am EST
Before there were alternative investments (“alts”) or hedge funds, having some exposure to commodities served as a good way to diversify a portfolio against stock market volatility. Historical correlations to the stock market are rather low, or at least sporadic, and owning commodities can also be seen as a hedge against inflation (higher costs of raw goods).
However, since the price of crude oil cratered from $150 per barrel all the way down to $40 back in 2008, the commodities asset class as a whole has been more or less shunned. Despite the price of oil having somewhat recovered — it currently trades around $100 — and with the stock market at all-time highs, now might be a good time to “un-shun…”
Below is a chart reflecting the PowerShares DB Commodity Index (DBC) over the past five years, including 20-, 50- and 200-day moving averages. If moving averages aren’t part of your regular analysis, just keep in mind that a shorter-term moving average crossing a longer-term moving average to the upside is a bullish signal.
Following technicals alone is sometimes sufficient for a trader, but let’s look a little deeper at the fundamental argument for commodities…
An important piece of information that gets too little attention (if it gets any at all) is that, almost without exception, commodities around the globe are priced in U.S. dollars. This means that their price per unit — in addition to supply and demand factors — depends largely on the strength, or weakness, of the greenback. If the dollar is weaker or weakening, it takes more of them to buy the same amount of goods. That means the price, in dollars, for said goods should go up.
An inverse correlation is defined as: “A contrary relationship between two variables such that they move in opposite directions.” Meaning, if items A and B are inversely correlated, when A moves up, B moves down by roughly the same percentage. And vice versa.
Below is a chart of the U.S. dollar over the past five years, as tracked by the PowerShares DB U.S. Dollar Index (UUP):
While many in the financial media have been calling for the U.S. dollar’s precipitous decline to worthlessness thanks to the Federal Reserve’s quantitative easing, clearly that has not been the case. But we have seen a slow and steady weakening which is evident in the chart above. The simple argument only makes sense, then, for dollar-denominated commodities to cost more (in dollar terms) in the world of a weakening dollar.
What’s inverse correlation got to do with me?
As I mentioned here a few weeks ago, fears about slowing global growth may well be overstated.
From the supply/demand side of the argument, this fear is a big part of the reason DBC is inexpensive right now. Take advantage of this and get a favorable entry point to an asset class that belongs in your portfolio anyway.
Have a great evening!
Adam B. Scott
Argyle Capital Partners, LLC
10100 Santa Monica Blvd, #300
Los Angeles, CA 90067
Adam Scott’s profile on TheStreet.com can be found here.