The Distance From New York To Chicago
Commodities and stocks have taken parallel paths

Over the last few years, commodities were "discovered" by institutional equity investors and pension funds. The commodity price boom of 2007 and the first half of 2008 was the icing on the cake; now, in any vote for the best uncorrelated investment, commodities would be the overwhelming winner. This newfound love of commodities ignores a long and colorful history; several revolutions of equity investing, which originated with commodities; and some ongoing debates about their investment properties.


As Old As The Hills
Commodities are older than equities: The grain trade began in ancient times, while modern corporations—or joint-stock companies as they were once called—began more or less with the Italian renaissance and then the Dutch and English East India Companies. One of the oft-cited legends of market bubbles is the tale of trading tulip bulbs in Holland in 1637. Tulip bulbs, an agricultural commodity, were traded largely through forward contracts on more-or-less organized exchanges. Closer to home, and to modern times, the commodity exchanges in the U.S. began in the middle of the 19th century and handled a wide range of agricultural and industrial products. By the end of the 19th century, listed futures contracts based on standardized commodities with clearing and settlement were well established. Chicago became the dominant center for commodities just as New York became the central focus for equities. However, both centers faced substantial competition from regional exchanges in many other cities. While regional equity exchanges tended to list local companies, regional commodity exchanges reflected local products and regional delivery points.

The worlds of equities and commodities grew in parallel, but with relatively little interactivity, through much of the 19th and roughly the first three-quarters of the 20th century. Not only were the geographic centers different, so were the regulatory regimes. Separate regulators arose with different defining moments and events. The industries, political groups and lobbyists also differed. Certainly each was aware of the other and some traders were active in both kinds of markets or occasionally moved from one market to the other, but the idea that institutional investors should routinely hold positions in equities and commodities was rare.

Quite possibly there are commodities traders and investors who look at the pension funds and institutions which have just discovered commodities and wonder what took them so long. For the equities world, two events of the last 25 or so years should stand out as moments when stock investors should have discovered commodities. The first, in 1982, was the beginning of stock index futures on the Value Line index on the Kansas City Board of Trade and on the S&P 500 on the Chicago Mercantile Exchange. While the Value Line contract came first, the S&P 500 contract is the one that succeeded and today dominates stock index futures on a global basis. These were not the first financial futures, though they were the first forays into equities. Treasury bond futures began a decade earlier on the Chicago Board of Trade.¹ The second event came a decade later with the introduction of exchange-traded funds, with the S&P 500 underlying the first such product, the SPDR S&P 500 ETF (AMEX: SPY). There is no question that ETFs are equity-based securities; however, their creation by Nate Most, then head of product development at the American Stock Exchange, was based on the idea of trading warehouse receipts as done in commodity markets.

Correlation And All That
The attraction of commodities for equity or fixed-income investors is twofold: 1) recent high returns as prices have surged, and 2) low correlation to the equity and bond markets.

While fully recognizing the importance of correlation in strategic asset allocation and the advances in financial economics, the commodities boom is really all about the money. As is generally the case in financial markets, the price boom accounts for most of the excitement and attraction to commodities.

There is little agreement, however, about what long-run returns may be found in commodities or how to find them. Cash market prices of most agricultural or industrial commodities have long-run, inflation-adjusted returns close to zero. Even oil, despite its recent lofty price, has seen huge swings and almost as much money lost as made. While stocks exhibit long-run, positive returns as seen in the history of the S&P 500—especially if dividends are reinvested—the same cannot be said of commodities in the cash market.

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