Sold as a diversification tool, they failed badly last year -- and will fail to protect you again if the market turns south. By Steven Goldberg, Contributing Columnist October 6, 2009 Hordes of new players have transformed the commodities markets into a dangerous corner of the investing world. As a result, I feel strongly that you should stay away from commodities. These markets are in uncharted territory and are unlikely to offer you the diversification benefits they did in the past.Numerous studies released over the past several years showed that commodities tended to hold up well during steep stock-market declines. David Swensen, the star manager of Yale’s endowment fund, was one of the first to extol their merits. Before long, virtually every endowment and pension plan bought the story. So did hedge funds and individual investors, via exchange-traded funds. All of these new buyers overwhelmed the normal dynamics of commodities markets. A strategy of adding some commodities to your portfolio worked -- for a while. As stocks fell from the fall of 2007 through midsummer 2008, the price of oil, a leading constituent in any broad-based commodities index, surged. It shot through the $100-a-barrel level early last year and hit a record high of $147.27 on July 11, 2008. But that was the end of the party. As stocks collapsed in the fall of 2008, oil and other commodities plunged just as far and just as fast. In mid February, oil bottomed at $34 a barrel, almost precisely as stocks were nearing their lows. What went wrong? It was a classic case of too many people chasing the same good idea. Many investors put 5% to 10% of their assets into commodities to cushion their portfolios when stocks tumbled. But the weight of investor dollars eclipsed market fundamentals. And the patterns of most investors’ behavior in buying and selling commodities -- as opposed to those who use the markets to hedge -- followed the same rhythms they did in buying and selling stocks. Advertisement “It’s whole a new ballgame,” says Charles Ober, the veteran manager of T. Rowe Price New Era (symbol PRNEX), which invests in stocks of commodity companies. “A lot of the studies that justified investing in commodities were based on data through 2005. If you look at data through 2008, it turns those studies on their ear. Price movements of stocks and commodities were so correlated it was pathetic.” Those who are in the commodities markets to hedge now represent a small fraction of all commodities investors. Hedging, of course, is the raison d’être for the commodities markets. They allow, for instance, an oil company to lock in a price on its production months or even years before it can bring the product to market. A farmer can sell futures on his crops to raise cash for planting. “Investors are now a multiple of the people who need a hedge,” Ober says. “I can’t tell you if it’s five times or ten times, but it’s a big number.” Almost none of this has happened before -- not even in the 1970s, the last time the price of oil blasted off, even as stocks suffered through a horrid decade. The futures markets weren’t nearly as liquid then, and ETFs didn’t exist. So few people and institutions invested in commodities. Despite last year’s disaster, investors are still flocking to commodities. “People now perceive them as the new gold,” Ober says. Global growth -- particularly in emerging markets such as China -- is leading to increased demand, especially for oil, while supplies are gradually being depleted. In the long run, there’s a compelling case to be made for commodities. But the short term has been so thoroughly distorted that it pays to look for other ways to invest in commodities -- and other ways to diversify your investments. Advertisement Ober thinks the price of oil will begin to rise again sometime next year. He has as good a record as anyone at making such calls. But the global economy remains weak, and I think people worried about a pickup in inflation accompanied by rising commodity prices are getting too far ahead of the fundamentals. The broken case for stuff The thesis behind commodities involves several parts. Over the long haul, prices of most commodities have merely kept pace with inflation. But when you invest in futures, you put up only a small percentage of your investment. The remainder can be held in Treasuries or other securities, which can earn a profit. Investors in commodities, in essence, provide insurance to companies that need to lock in a commodity price in advance. As the seller of that insurance, you’re entitled to a premium. That’s why futures that don’t come due for many months generally trade for less than those coming due in a few weeks. But the market doesn’t work that way these days. Instead, the market currently prices near-term futures at a lower price than those expiring months in the future. Light crude oil for November delivery closed at $70.32 on October 1, but the same barrel slated for delivery next July closed at $74.50. For investors, the insurance premium -- which constituted much of their returns -- has disappeared. Advertisement Many investors today look to commodities to protect themselves from a falling dollar. In the 1980s, Ober says, there was little or no correlation between any fall in the dollar and high oil prices. Today, the correlation is huge -- in other words, commodities tend to rise as the dollar weakens. Whether you’re concerned about a falling stock market, a decline in the dollar or a pickup in inflation, I think you should look elsewhere to insulate your investments. T. Rowe Price New Era is one good choice. You’ll likely get as much diversification nowadays in stocks of commodities as in the commodities themselves. And a well-run company can make money even when commodity prices are flat. Investing in foreign stock funds also provides protection against a declining greenback. Indeed, more than half the revenues of the companies in Standard & Poor’s 500-stock index come from abroad. A declining dollar will increase the value of their overseas sales. A foreign bond fund is another good option. As for the commodity markets, I’d leave them to the speculators. Steven T. Goldberg (bio) is an investment adviser.