Correlations in commodity markets
Commodities are so common and present in every facet of our life- starting from our food, passing through our cars and ending with smart phones. You must understand commodities if you invest in stocks or bonds. You really cannot be a successful investor in other markets without understanding them. Investing in commodities can be a hedge against a bear market in stocks, rampant inflation, even a major downturn in the economy.
In this article I will present the relationship between commodities market and the stock market. We will also take a look at their connection with the US dollar.
Commodities market in recent years
The CRB Index gives a picture of the commodities market in recent years.
The index is comprised of 19 commodities including agriculture (like corn, soybeans, live cattle) energy (like crude oil, natural gas, heating oil), precious metals (silver and gold) and industrial metals (like copper, aluminium, nickel). I did not mention all of them but it is enough to understand that this index presents a wide picture of the commodities market.
Notice, that we are facing a very clear bear market. Since 2011 it has been decreasing from year to year. Prices reached new historical lows at the break of 2016/2017. Since January 2017 we have observed a price relief. Sentiment for those markets is very negative, we can clearly notice that investors turned away from commodities.
Usually, the market sentiment is very negative when we are close to the market bottom. So, negative market sentiment is a good signal for potential buyers according to the primary lesson of investing – buy value on the cheap.
Commodities and stock market
Two scientists, Barry B. Banister and Paul Forward carefully examined the relation between the commodities market and the stock market. They concluded that there is a negative correlation between these markets. The conclusion derived from their research provides even more surprising results: “stocks and commodities markets have alternated leadership in regular cycles averaging 18 years.”
Historical Relationship between Stocks and Commodity Prices
Source: Adapted from Bannister and Forward, 2002
Results from this research show that over the study period, stock and commodity prices had a negative correlation (-0.71). A high negative correlation existed between stock and commodity prices over the past 140 years. Why the negative correlation? There are few theories. One theory suggests that when prices of commodities grow the cost of the companies are bigger and they generate smaller profits which translates to worse results.
When we consider a prolonged bull market in the U.S. stocks in terms of stocks and commodities correlation, the conclusion is that the stock market now offers potential smaller returns than the commodity market. Check my report about best investment occasions in 2017 (Download here).
Commodities prices and US dollar
The correlation between CRB Index and the US dollar is presented in the following graph. The blue line represents CRB Index and the green one represents the US dollar.
As you clearly see when the US dollar goes up in price, then commodities go down. In 2008 when the dollar index fell to 72 the CRB Index reached its peak. Since the beginning of 2009 to the middle of 2011 we were dealing with a price relief on the commodities market. At the same time the US Dollar remained weak. Notice what happened later. Between 2011 and 2016 we observed a bear market for commodities and strengthening dollar prices. This behavior confirms a negative correlation between commodities and the US dollar.
From the beginning of 2017 we faced an unusual situation. Commodities and the US dollar decline together. When we consider a long term relationship between these two markets, which has existed for decades, this situation will not last for a long time. A similar situation occurred on the market in May 2006, nevertheless after a few months the market got back to its normal cycle and in January 2007 we could see again a negative correlation between commodities and the US dollar.
Commodities are negatively correlated with the stock market and the US dollar. This means that high stock prices translate into low commodities prices and when the value of the dollar weakens against other major currencies, the prices of commodities generally move higher. When building your investment portfolio you should take into consideration those correlations. It is extremely important to understand processes which occur on the market. I believe that investing in commodities will represent an enormous opportunity for the next decade or so, but only a conscious investor will gain an advantage from it.