Commodities and Equities: Think Before You Link

Consider the following exchange from the 1967 classic film Cool Hand Luke when Paul Newman's character gets locked in a detention box following his mother's death:

Boss Kean: Ah'm jus' doin' mah job, Luke. You gotta appreciate that.

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Luke: Boss, when you do somethin' to me you better do it because you got to or want to ... but not because it's your damn job.

Have the world's fund managers become the equivalent of the chain-gang guard, so mindlessly caught up in the fashion of the moment they forget that somewhere in their distant past lay a shred of humanity?

Let's answer this rhetorical question with a strong "yes" -- at least when it comes to the inanity of using investors' money to trade commodity-linked equities as substitutes for the underlying commodities themselves.

The tactic of attempting to duplicate the instantaneous market-clearing price of an inert asset with the discounted cash flows from a long-term corporate operation is so ungrounded in financial theory it should get the Wolfgang Pauli Lifetime Achievement Award after the late physicist's putdown, "It's not even wrong!"

In a January column, I asserted and demonstrated that the inflow of funds into everything related to commodities had distorted the relationship between commodity-linked equities as measured by the Goldman Sachs Resource index and commodity prices as measured by the Goldman Sachs Commodity index. What had been random prior to the Federal Reserve's so-far successful war on deflation launched on May 6, 2003, had now become linear. If you are keeping score at home, the total return on GSCI year to date has been -13.54%. Nice bull market, guys.

Case Studies

But as I have stressed since May 2004, there is really no such thing as "commodities," merely a collection of unrelated markets linked by virtue of being both tangible and exchange-traded. It is a market of commodities, not a commodities market. Let's use the occasion of Phelps Dodge's (PD - commentary - Cramer's Take) impending disappearance as an independent firm to run a set of case studies of the relative performance of various commodity producers to the broad market as a function of their underlying commodity price.

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Howard L. Simons is president of Simons Research, a strategist for Bianco Research, a trading consultant and the author of The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.

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