Wait, How Much In Commodities?
By Roger Nusbaum, AdvisorShares ETF Strategist
The annual Barron’s Roundtable was posted over the weekend and had a couple of good one-liners to explore a little further.
From Felix Zulauf: The U.S. stock market now is valued higher than it was 95% of the time in the past 100 years.
He goes on to use the word nosebleed to describe valuations and he notes that small caps are trading at 28 times earnings and midcaps at 24 times. While I don’t know whether he is precisely correct it should be obvious that equities are not cheap. Bespoke Investment group reported (last Friday) that the trailing PE for the S&P 500 was 21.26 and the forward PE was 17.51.
I agree with the idea that valuation matters but the predictive ability here is quite poor. Zulauf himself thinks the first half of the year could be pretty good for domestic equities despite the unfavorable valuation. This is a risk factor but I would not use this as a defensive strategy as markets can stay overvalued by this measure for years.
Jeff Gundlach: Portfolios need to diversify away from deflation-oriented trades, which worked for a long time.
He believes rates will head higher and that inflation is coming back after a long deflationary run. Before the financial crisis, commodities were a good hold for much of the 2000’s. Not so after the crisis until just a few months ago as industrial commodities have rallied hard. Commodities tend to not do well in deflationary environments but there is an argument for gold as a deflation hedge from the context of gold being a currency that goes up against deflating currencies. Gold of course did very well in the early days after the crisis into its peak in 2011 but has mostly struggled since. Arguably gold as a deflation hedge wasn’t put to the test as we did not have any sort of catastrophic, deflationary outcome, more like heavier deflationary pressure than we’d had in a long, long time.
If inflation is coming back then TIPS makes sense although the Roundtable participants said to keep maturities shorter. They also like floating rate issues and equities should do better than bonds based on the idea that rising inflation means rising interest rates.
Gundlach also weighed in on asset allocation with the following: I’d recommend about 30% in fixed income, but you need a fixed-income allocation that is unlike a bond index. I’d also recommend a higher allocation to real assets, maybe as much as 20%. You could buy a commodity fund. Then I’d put 50% in equities.
He was also cautious on US equities, versus foreign, due to valuation, citing the CAPE Shiller PE. Guessing as to whether 2017 will be the year that foreign again starts to outperform is just that, a guess, but if you think he guesses better than most folks you might want to increase foreign exposure.
His idea of 20% in real assets via a broad-based commodity fund could be difficult for a couple of reasons including what is captured on the chart below from Google Finance that compares the S&P 500 index in yellow and one of the larger broad-based commodity ETPs in blue.
They are capable for going down for an awfully long time. If Gundlach is correct then maybe they will go up for an awfully long time but being wrong with a 20% allocation would be difficult, all the more so if an investor is swapping a portion of their fixed income allocation to commodities.
The other issue with broad-based commodity funds is their makeup. They tend to be dominated by the energy sector. Looking at three of the larger broad-based commodity ETPs (naming names is tricky from a compliance standpoint) the energy weightings are 36%, 56% and 62%. Someone who buys into more infrastructure spending providing a tailwind to industrial metals owns a lot of other stuff besides industrial metals with a broad-based fund. In the right scenario, higher energy prices could hurt industrial metals, so you have exposures potentially working against each other.
I’m on board with commodity exposure but I think 20% is simply the wrong way to go for most investors.