Why Commodities May Be Better Bet Than Stocks Now

Despite the recent pullback in commodities prices, the recovery in the global economy and eventual threat of inflation could make commodities a steadier bet than stocks in the coming months.

Cash and gold
Lilli Day | Photodisc | Getty Images
Cash and gold

The reasons go beyond conventional wisdom during times of inflation, when stocks usually falter as escalating prices erode buying power and discourages investors from the risk of stocks.

Instead, commodity backers believe the rise of emerging market economies such as China and Brazil will boost demand even further and put to rest fears that surging commodity prices are creating a bubble.

"There's a significant portion of the world that is emerging from third-world country status," says Rick Bensignor, chief market strategist at Dahlman Rose in New York. "Look at emerging market nations and pent-up demand for raw goods across the commodity spectrum, and the growth potential in emerging markets. There is huge upside for commodities for years to come."

Investors traditionally used futures and spot contracts to buy commodities but now can do so through a variety of exchange-traded funds and notes. Many of the hottest new ETFs in 2010, in fact, were commodity-based.

The CRB Commodity Index has picked up nearly 12 percent since its most recent low on Nov. 23, and has been trading well clear of its 50-day and 200-day moving averages since. It has easily beaten the nearly 8 percent return in the same period for the Standard & Poor's 500 . The CRB has traded flat this week after reaching its highest point since September 2008.

Market pros suspect commodities, from metals to agriculture to energy, could experience a modest pullback over the near term. But that likely would only create a buying opportunity.

"The best bull move is not something that goes from point A to point B in a straight line," Bensignor says. "It's step-like—rally, pullback, rally pullback. You want your peaks higher than the previous peaks and troughs to be higher than previous troughs. That's the basic definition of an uptrend."

The growing trend in commodity investing has spawned a host of ETFs and ETNs to play the market while hoping to avoid the volatility associated with options and futures.

Nicholas Colas, chief investment strategist at BNY ConvergEx in New York, isolated 17 ETFs launched in 2010 that are "earning their keep," which he defines as accumulating more than $100 million in assets under management. Several are commodity-based.

"The clearest message from the 17 funds that have managed to top $100 million is that exposure to commodities and emerging markets is still a hot investment theme," Colas wrote in a note to clients. "Nine of this group are tied either directly to metals/commodities or to the public companies that exploit such resources. Six funds track emerging markets, either on a country-specific basis or as a broad asset class."

Some commodities funds Colas mentions:


Investors have been hungry for diversification after watching the assorted asset classes across the capital markets move largely in lockstep for most of 2010.

Should inflation such as that which China and other developing countries are beginning to experience start spreading to the US, commodities would provide investors with a way to brace against volatility in the stock market.

"If the commodity story bleeds into higher inflation and wage inflation, that might hurt stocks but it will continue to help commodities," says James Paulsen, chief market strategist at Wells Capital Management in Minneapolis. "There's a diversifying property. If the 10-year Treasury keeps going up that might hurt stocks but commodities might continue to go up with it. They have different drivers."

Commodities benefit in times of weak US currency because most are denominated in dollars. That means they can be purchased less expensively with foreign currencies.

With the Federal Reserve likely to continue policies that keep interest rates low, commodities also will benefit from the weak-dollar play.

Conversely, some market pros worry that the stock market could become more volatile when the Fed begins its exit strategy, or if rates begin to rise despite the central bank's policies.

"The US currency is in real trouble," says Al Korelin, market analyst at AB Korelin in Renton, Wash. "Commodities are more fundamentally valued right now. I don't think the stock market today is necessarily based on sound business fundamentals."

To be sure, commodities have their doubters, fueled particularly by a very recent pullback among grains and metals. Hedge fund manager Dennis Gartman, author of The Gartman Letter, told CNBC this week that commodities could experience "a reversal of some consequence."

"With the Fed essentially spewing money it's hard to know exactly where that money is going to go, which markets will get affected," says Bob Gelfond, CEO at MQS Asset Management, a hedge fund based in New York. "It's like putting on a giant fire hose. You can't really control it that well."

Despite any short-term gyrations, however, few are willing to declare commodities a bubble ready to pop.

"Usually I associate bubbles with almost straight upward increases in prices. What we're seeing is a normal cyclical reaction of commodity prices to growing GDP," says Brian Gendreau, market strategist with El Segundo, Calif.-based Financial Network. "Materials are generally one of the more cyclical sectors. They're doing well and I don't see any reason why they shouldn't continue to do well."