Caution: High Correlation Between Commodities and Equities

One of the biggest draws to commodity investing has long been its low correlation to equities. Investors would add commodity exposure to their portfolios to help diversify returns, as the movement in commodity markets had long been independent from that of equities. But 2012 is doing its best to redefine the rules, as it seems that commodities have begun to show an increased correlation to major equity benchmarks [for more commodity news and analysis subscribe to our free newsletter].

“The S&P GSCI composite index of commodity sector returns only added 0.52% so far this year, compared to 11.99% for the S&P 500. During the same period, the weekly correlation between the S&P 500 and the S&P GSCI has been about 0.49, compared to an average of about 0.15 between January 1976 and December 2011″ wrote Thao Hua last month. All the while, the interest in commodities has been growing, as it was reported that U.S. defined benefit plans have increased their commodity holdings by roughly 13% over the past year.

Since the beginning of the year SPY and DBC, two of the most popular ETFs of their respective asset classes, have featured a correlation of 0.45. But playing around with dates and time ranges (minimum of 30 days) can yield correlations as high as 0.76 this summer, as it would appear that the correlation is only growing. As for the reasons why this phenomenon is developing, there is no smoking gun, though many have chose to blame inflation [see also Warning: John Hussman’s Model Shows the Worst Short Term S&P Risk-Reward in a Century].

What to Do?

In all likelihood this is a temporary phase that commodities are enduring, as history suggests that correlations should be much lower. But should this relationship continue to grow, commodity investing may be in a bit of a pickle. Long term investors will find little use for commodities if they are no longer diversifying their holdings. Instead, commodities would likely only be utilized by active traders who seek out these assets for their enticing volatility.

Assuming the correlational rut continues (again, a very unlikely scenario), commodity investors may want to look to both gold and silver. Most people consider these precious metals as alternative currencies, so their price drivers may be less tied to that of commodities. Thus far in 2012, GLD has featured a correlation of just 0.1 to SPY while SLV is sporting a 0.17, suggesting these two assets have been able to withstand the recent pattern of the overall commodity industry. It should also be noted that 2011 saw a period where both gold and silver were highly correlated to the S&P 500, but the streak was snapped this year, and the same will likely happen with overall commodities in time.

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Disclosure: No positions at time of writing.