A Soft Sell on Hard Commodity Assets

If we replace the energy-laden GSCI with the more balanced Dow Jones-AIG commodity index and display the GSR not on absolute terms but as a relative performance to the Russell 3000 index (RAY), we see the short put option profit profile expected of a firm such as Phelps Dodge. The GSR is not capturing the broad commodity rally completely.

Commodity-Linked Equities Underperform Commodities

Source: Bloomberg

Currency Effects

We should expect the GSR to get an alpha lift from dollar weakness; one implication of a weaker dollar is that more of them are needed to claim a given quantity of physical assets. This indeed has been the case so far, but it is a double-edged sword. Unless the dollar continues to weaken -- and my opinion is that it will strengthen on the back of a European rate cut -- this effect has run its course.

Commodity-Linked Equities and the Dollar

Source: Bloomberg

Playing the Trend

The current commodity rally has further to go, on the basis of present supply/demand imbalances alone. However, and briefly, please be mindful of the risks: First, much of the rally has been propelled by China's growth surge, and given the history of previous booms and their 50% or so ratio of nonperforming bank loans, they are due for some instability soon. The effects of the 1997-98 Asian and Russian cries on commodity prices were both quick and considerable.

Second and debatably, inflation has not yet materialized, despite the central banks' best efforts. The great commodity rally of the 1970s reflected inflation; it did not produce the inflation, and until inflation actually arrives, any commodity rally will, as noted above, be self-correcting.

Third, if you want to trade commodities, trade commodities. Do not mess around with proxy variables such as the ETF based on the GSR. You can trade futures on the Dow Jones-AIG index, the CRB index and on the GSCI index at the Chicago Board of Trade, the New York Board of Trade and the Chicago Mercantile Exchange, respectively. Pimco's Commodity Real Return Strategy Fund (PCRIX) and Oppenheimer's Real Asset Fund (QRAAX) offer exposure to commodity prices. The former combines derivatives on the Dow Jones-AIG index with TIPS; the latter takes a more eclectic approach involving assets as diverse as corporate bonds.

The comparative performance since July 2002, when all three assets became available, is telling. The annualized total return on the IGE has been 12.25%. The Oppenheimer fund has seen a 28.31% annualized return, while the Dow Jones-AIG index-linked Pimco fund has enjoyed a 42.25% annualized return.