Commodities for the People
Scott Wright
Zeal LLC
June 2, 2006
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
ZEAL
June 2, 2006
So how can you profit from this information?
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based on all the lessons we have learned in our market research.
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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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