Gold is a great hedge against inflation, but what if you want to hedge against the entire stock market? A commodities investment may be the best way to do that.
Updated Feb 27, 2023
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Commodities & Gold
Oil
Global Markets
When it comes down to it, we buy a lot of things without thinking. If we go back in the supply chain for every purchase we made, it all traces back to a handful of commodities. For instance, a chocolate bar is so cheap because the manufacturer scoured the earth for the best deals on ingredients like sugar, cocoa, milk, and corn. It made its way to you with the use of energy commodities like oil.
Commodities can make great investments for anyone interested in diversifying their portfolio to protect against inflation and reduce volatility. The best commodities to invest in are constantly changing according to global circumstances, so it's wise to invest in a diversity of both hard and soft commodities like the ones below.
Pros
Hedge against the market—correlates negatively with stocks
Hedge against inflation—investors benefit from higher market prices
Many ways to invest—buy commodities directly, buy futures contracts, buy shares of ETFs or mutual funds, or buy stakes in companies that produce commodities
Cons
Market factors—subject to supply, demand, and inflation
Geopolitical factors—subject to civil unrest, political events, and wars
Extraneous factors—subject to factors like weather and technological disruption
Investing in commodities means gaining exposure to the market forces of supply and demand. Commodities tend to be uncorrelated assets, meaning their prices tend to go up when the stock market is down. Additionally, commodities become more expensive when there is inflation because the buying power of consumers is weakened. Commodities are certainly a hedge against inflation and the stock market because they perform well when supply isn't meeting demand.
When there's minimal inflation, low market demand, a supply surplus, or a healthy stock market uptrend, commodities investments tend to perform poorly. It is important to carefully read the market and use precise models when generating forecasts to help inform your commodities investment.
Additionally, both soft and hard commodities are subject to extraneous factors like weather events, civil unrest, political events, technological disruption, and military actions that have the potential to wipe out your investment. While supply and demand are the primary concern of commodities investors, the probability of certain events bears equal weight in the decision to invest in any commodity.
Energy is the bedrock of industrialized society and humans have been exponentially more productive since we began exploiting fossil fuels like coal, oil, and gas. The use of fossil fuels produces carbon emissions that harm the environment and, while the adoption of cleaner energy sources is increasing, fossil fuels are nevertheless a primary fuel source. However, the need for sustainable energy storage could cause other hard commodities to eat into fossil fuel demand.
Oil and, by extension, natural gas, are the world's biggest investment commodities. They are both considered fossil fuels and have largely the same applications: the production of energy and plastics. Fossil fuels are hard commodities that saw increased volatility during the most uncertain periods of the pandemic. Investors should know the major distinctions between natural gas and crude oil before adding exposure to either one.
Natural gas is cheaper than crude oil and is getting cheaper to produce because new technological innovations like fracking have enabled cheap access to shale oil that was previously inaccessible. Fracking has been highly criticized for irreversibly damaging surrounding ecosystems, which has caused hesitation among retail investors as well as corporations that are intentionally distancing themselves from environmentally unsustainable practices.
Nonetheless, the demand for fossil fuels is growing and oil is getting more expensive, so the choice becomes choosing between cheap fuel in the form of natural gas or adopting sustainable alternatives like solar and wind. While so-called renewable energy sources are significantly better for the environment, they can't often produce enough energy to power an entire country, let alone the world. This has made the demand for energy storage solutions all the greater.
Lithium is an element used in the production of rechargeable lithium-ion batteries. Lithium batteries are important for portable devices like smartphones and laptops, but automakers' shift in focus to electric vehicles (EV) means lithium is in high demand. This trend is set to continue as drivers begin choosing EVs and the demand for lithium-ion batteries rises, making it an all-around hot commodity in tech manufacturing.
Car batteries require a lot of lithium to be produced, so as more cars go electric, there will be a shorter supply of lithium and batteries. Higher demand for lithium means other consumer devices become more expensive, making it an ideal commodity to invest in. Factoring in the implications of carbon emissions, toxic runoff, and child labor involved in South American lithium mining may dampen the ethical outlook on this investment, but nevertheless, it is a lucrative opportunity.
Moving to the other side of the periodic table, metals have historically been a foundational store of value. While some precious metals can be a somewhat impractical investment, demand for metals with technological utility is rising. However, all metals are hard commodities that must be extracted, which makes the metals market highly impacted by disruptions in the mining industry.
Gold has been used as a medium of exchange and store of value since ancient times because it is ductile, malleable, virtually indestructible, and very pretty. Even after the United States abandoned the gold standard, gold maintained its popularity as a store of value in the form of jewelry or bullions (gold bricks). Today gold is seen as less practical than other mediums of exchange, but its decoupling from fiat currencies has made it a popular hedge against inflation.
When it comes to investing in gold, your two best options are buying physical gold or 'paper' gold. Physical gold is exactly what it sounds like: It has some utility but is largely impractical and often accrues significant storage costs. The other option is paper or 'spot' gold, which implies investing in the commodity through an ETF or mutual fund. Spot gold is preferred by retail investors because all the extraneous costs of extracting and storing gold are factored in, meaning they pay for the convenience of investing in the underlying asset. Gold has underperformed the S&P 500 over the past decade, but the pandemic showed us its incredible resilience during bearish markets.
Silver is often associated with gold since they're both considered precious metals and share a history as currencies, but silver has a closer resemblance to copper. These two metals share a spot on this list because their price correlation serves as an important market indicator. Copper and silver investments saw nearly identical price performance over the past decade, but a recent divergence points to a nearing macroeconomic shift.
Silver has a dual identity as both a precious and industrial metal, offering more practical utility than gold but a better store of value than copper. However, challenges in the supply chain following the pandemic have led to a global copper deficit, causing copper prices to outperform silver in 2021. High inflation and economic growth are indicative of an overall bullish sentiment on copper—illustrated by a 25% spike in copper futures—with a lesser emphasis on precious metals.
Palladium is a lesser-known industrial metal that has risen in popularity among investors after a sharp price spike in 2019. Palladium is used in many sectors like medicine, water treatment, air purification, consumer computer chips, and more, but its main application is the primary material used to construct exhaust systems. The automotive industry uses 80% of the world's palladium, but a worldwide chip shortage has increased demand and led it to outperform gold and platinum. Automakers are cutting the production of palladium-heavy vehicles in favor of EVs, but it is uncertain if this will have an impact on palladium's upward trend.
Though all hard commodities investments are risky, palladium mining and—by extension—the price of palladium are acutely impacted by particular risks. Macroeconomic and ecological factors aside, palladium is a scarce metal that is mined mostly in geopolitically intense regions like Russia and South Africa. Recent military tensions between Russia and Ukraine prompted market fear that caused a temporary spike in the prices of metals, especially Palladium. While this reverses course upon de-escalation, it still shows that geopolitical events are an important factor for commodities investors to take into consideration.
Common commodities like milk and soybeans are important across the globe but aren't very popular as appreciative retail investments. This is because soft commodities are subject to different factors than hard commodities which make them more volatile and, hence, riskier as an investment. However, one soft commodity that could buck the trend is industrial hemp—medical marijuana's presentable cousin.
Hemp is a product of plants in the cannabis family and was federally legalized in the United States with the 2018 Farm Bill. While hemp does come from the same plants that produce marijuana, the bill only considers plants above a certain level of THC—the active intoxicating ingredient of weed—to be federally illegal. However, this regulatory structure has opened the door to realize hemp's industrial and pharmaceutical applications in the U.S., and investing in cannabis is becoming more popular because of that.
The epicenter of the hemp industry is the production of CBD, a non-psychoactive byproduct of cannabis that provides pharmacological relief for people suffering from arthritis, insomnia, anxiety, and addiction among other ailments. Hemp is an emerging carbon-free alternative to plastics and is used in the production of textiles, paper, insulation, cars, and personal care products. Such a versatile commodity could increase in demand as the emphasis on environmental responsibility increases.
Coffee is an ancient beverage that has become the most popular one in the world since being discovered in East Africa. The two billion people who drink coffee daily do so mostly because of the wakeful benefits (and addictive traits) of caffeine, but studies have shown that it can also reduce the risks of stroke, heart failure, colon cancer, Parkinson's disease, Alzheimer's disease, and more if consumed properly. Coffee consumption increases year over year in the U.S., with more emphasis than ever on 'gourmet' options.
Gourmet refers to coffee brewed from premium beans, which means consumption of espresso-based beverages like lattes and cappuccinos is on the rise. Coffee consumption is growing faster in Asia than in other regions, but overall consumption has more than doubled worldwide over the past two decades. Meanwhile, the amount of land suitable for cultivating Arabica coffee is decreasing in South American countries like Columbia and Brazil. If increased demand continues to trend upward, reduced areas for cultivation could drive up the price of gourmet coffee like Arabica.
Other than the obvious way of buying the commodity directly, investors can gain exposure to commodities through a variety of derivatives. Derivatives (like futures and options contracts) represent an investment in an underlying asset and are the most easily accessible to retail investors. The most common commodities derivative is the futures contract.
Futures contracts are agreements where a buyer agrees to purchase a commodity at a certain price by a certain date regardless of what the actual price will be. Although futures are actual binding contracts, they are often used as an instrument to speculate on the commodity's price movement until the set expiration date.
Futures are also high leverage positions, so investors must have enough capital on standby to cover the full cost of the contract. Futures are mostly reserved for seasoned investors, so those who lack investment experience and want to curtail risk can gain exposure to commodities through stocks, ETFs, and mutual funds.
There are several derivatives for investors who are more interested in gaining direct exposure to hard commodities. Investors can buy stock in a mining or drilling company, for instance, but their performance relies on uninterrupted production rather than the commodity's value appreciating as an asset. Gaining direct exposure to hard commodities has become more easily accessible than ever with platforms like Vaulted and OneGold allowing for direct retail investments in gold bullions.
Gold
If you're looking for something a little out of the box, FarmTogether turns farmland into the underlying asset and allows investors to profit from both the appreciation of land value as well as the production of soft commodities on that land. Even fossil fuels are now fair-game for retail investors with platforms like EnergyFunders enabling you to gain exposure to a diversity of oil and gas drilling projects. These are just two platforms investors can use to gain exposure to commodities without purchasing the underlying asset outright.
Oil
Stocks are the most straightforward commodities investment since they are no different than non-commodities stocks. A commodities stock investment is an investment in a company that produces a commodity, and there are also publicly-traded agricultural REITs investors can buy shares in. But these don't necessarily have to be publicly traded companies. For instance, Harvest Returns is a platform that gives users the opportunity to invest in private agribusiness.
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Farmland
The final option is to buy shares in an exchange-traded fund (ETF) or mutual fund. Both ETFs and mutual funds are investments into a pool of underlying assets and are traded similarly to stocks. The most notable distinction is that they are not companies, but are rather entities that only manage the underlying assets. The value of ETFs more closely adheres to the underlying assets because they're passively managed, so there are minimal fees and administrative costs. There are plenty of popular precious metals ETFs, energy ETFs, and agricultural ETFs. Mutual funds, on the other hand, are more actively managed to optimize the fund's portfolio, but this means higher costs can cut into the share price and cause a divergence from the underlying assets' value.