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Want to Invest in Commodities? Be a Proactive Economist

Moti Levi

For the most part, economists are not good at making predictions -- even as a crowd. They're often asked to make short-term predictions about their macro ("big picture")-economic research, which is a fundamentally difficult task. So why should you "be an economist" to invest in commodities ?

Because when it comes to your portfolio, we're discussing long-term investments, not short-term ones.

Another good hat to wear, when investing in commodities: behavioral psychologist. Why? Because no less important than understanding economic factors and trends, is the ability to understand how people and markets react to them.

As with all investments, there are two distinct ways to invest in commodities: for the short term or for the long term. Trading in commodities for the short term is pretty much gambling, which I don't recommend as an investment approach, but some find it profitable (and enjoyable). The only time you are not gambling is when you are doing an arbitrage , which is buying below current market value , and not buying below "future" market value, which is often mistakenly called arbitrage as well. Hedge funds make these market moves all the time, but they use a lot of resources to be able to do so.

So the question is: How do you invest in commodities for the long term?

In the context of commodities, the "long term" might not be as long as you would think. In "Why Mixing Bonds and CDs With Stocks Actually Increases Your Risk," I talked about 20 to 30 years as the "long" term. With commodities -- depending on the specific commodity -- long term can be three to five years.

Three to Five Years?!

Commodities, such as oil and corn, are affected by business cycles and economic trends. This is similar to how currencies like the U.S. dollar, the euro or the Japanese yen are affected by their countries' respective economic cycles, as well as other geopolitical factors.

An energy company, such as Exxon Mobil (XOM Quote) (an "oil play"), or a company benefiting from higher demand for corn, such as DuPont (DD Quote) (a "fertilizer play"), can hedge its bets in the relevant sector and benefit whether prices go up or down, or sustain lower profits in a "down" cycle, knowing it would make huge profits in the "upturn."

You, on the other hand, cannot really hedge in the same way that an Exxon Mobil or a DuPont can.

Therefore, you have to understand economic trends, both local and global. If you understand these, you are on the first step to making money from commodities. But it is only the first step, however, because the market's reaction and your reaction to those trends are critical.

Unfortunately, we are poor at evaluating and acting on trends. Here's why: it takes several data points to understand a trend exists. Of course, you could "see it" coming if you analyze underlying factors, but that would make you an economist, right?

As I teach my students, there are two ways to forecast. The first is by "the numbers" or "the technicals" (Wall Street lingo: see quantitative analysis and technical analysis ). While you can benefit tremendously by using this method and exploiting consistent patterns, it only allows you to react to existing patterns.

The second method -- the economist's one -- is to understand how underlying factors affect prices. While more complicated, and requiring more data and fundamental understanding, it allows you to be proactive, and therefore exploit trends before the "crowd"can.

A Look (Back) at Oil

Three years ago it was already clear that oil prices would start to go up. Clear how? Recall the relatively fixed supply (refineries' capacity being the real bottleneck) and increasing global demand due to the rapid industrialization and growth of China, India and other emerging markets.

Three years later, oil has reached a record level. And it should still continue to climb over the next several years, unless the world falls into a severe global recession . Along the way, oil had, and will continue have ups and down (or volatility ), but the macro-economic uptrends are firmly in place.

However, to act on those trends three years ago, you had to take the economist's perspective plus not wait for the trends to fully materialize. That is, if you could do so. This is where the "behavioral" element comes into play.

We are notoriously slow to react to trends, and even slower to act on them. Our brains -- due to evolutionary reasons, I suspect -- seem to not be "wired" to react to emerging changes. We like stability. Only when the change is "constant" for a while, do we seem to act on it. Back to oil: if you would have taken an economist's wide and diverse perspective, and correctly read the underlying factors mentioned above, and you made yourself act on that analysis (the most difficult step), you would have bought (for example) an oil-focused investment product, such as an ETF like the SPDR S&P Oil & Gas Exploration & Production (XOP Quote) or an ETN like the iPath S&P GSCI Crude Oil Total Return Index ETN (OIL Quote).

Now is oil still a good long-term bet today, at close to $100 a barrel? Probably, but not as good a bet as it was even two years ago, when there wasn't much of a downside. However, unless radical global changes happen, the price of oil should continue to climb over the next several years.

Trendwatch: The Next Three Years

Today, you might consider investing in corn before prices (which have significantly increased already) rise so much that they reflect anticipated future increases.

Similarly, consider soy (although last year would have been an even better time to consider it). Here's why: when corn prices go up as corn is sold for ethanol, soy prices have to follow (as they are already doing), due to the shortage in basic, cheap, mass-produced, flexible food ingredients.

Plus, if you look into the new nonfood ways that soy is used, you'll discover its growing demand in the production of pharmacy staples. So unless new medical research finds that soy is quite harmful to your health (and this is unlikely to happen), then soy prices should continue to go up -- probably more so than corn, which has had much stronger price increases in the last two years.

A potential way to "play" these commodities: iPath Dow Jones AIG-Grains Total Return Sub-Index ETN (JJG Quote).