How the Japan Earthquake Is Hurting Commodities' Returns

Many investors in commodity funds have been wondering what happened to their investments after the Japan earthquake, asking why commodities were getting hit at the same time as their equity investments.

They were wondering, "What went wrong?" The answer is nothing. In fact, commodities have performed exactly as should have been expected if one could have forecasted the devastating impact of the Japan earthquake.

There are basically two different kinds of shocks to our economic system and stocks:

• A supply shock like the 1970s oil crisis, which can lead to dramatic increases in commodity prices with negative impacts on equities
• A demand shock such as what occurred in 2008, when demand falls and that is bad for both stocks and commodities

One of my favorite expressions is: The only thing you don't know about investing is the investment history you don't know. And that applies to the performance of commodities. As the table below shows, the S&P GSCI generally produced positive returns during years when the S&P 500 Index showed a loss, with gains in six of the nine years. However, the S&P GSCI produced even worse losses than the S&P 500 in the three remaining years. This is why I recommend taking an allocation to commodities from the equity portion of the portfolio, not the bond portion.

Now consider the performance of commodities during years of negative returns on long-term government bond returns. Since 1970, the S&P GSCI has produced a positive return every year that long-term government bonds have declined.

It's also important to note that in the three years when S&P 500 and the S&P GSCI both fell, long-term government bonds provided positive returns.

Since the evidence demonstrates that commodities hedge the risks of longer-term bonds very well, you should also consider adding more duration to your portfolio if you add commodities, earning the term premium (while your commodities allocation helps to hedge the greater risk of unexpected inflation that goes along with longer-term bonds).

While commodities have experienced losses since the Japan earthquake, so have stocks. At the same time, long-term Treasury bonds have rallied. Thus, if one had taken the commodity allocation from equities and added some duration to their bond allocation, the overall impact on the portfolio of adding a small allocation to commodities (such as 5-10 percent of the equity allocation) would have been minimal. And looking at the return of the entire portfolio, not its individual components, is the only right way to look at things.

More on MoneyWatch:
Japan Quake Shows That Thoughts Should Be on Those Affected, Not on Investment Plans How Commodities Affect a Portfolio 5 Reasons to Avoid Variable Annuities TIPS Update for March 2011 Quest for Alpha: What You Need to Consider When Handling Your Own Investments
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