How Do Commodities Impact Stock Prices?

Lets talk Diversification

At the club, we frequently talk about diversification and its importance within your portfolio. Good diversification goes beyond simply buying stocks in different sectors. A well-balanced portfolio also finds opportunities to realize gains and profits from real estate, cryptocurrency, assets, and commodities. It's important investors understand how commodities work as they tend to move in the opposite directions of equities especially during times of high volatility in the stock market.

 

What are Commodities?

In economics, a commodity is considered an economic good or resource. These resources are usually widely available, therefore differentiators like brand name can be less meaningful in the commodities space.

 

Hard Commodities

Commodities are frequently split into two categories, hard or soft commodities. Here are some examples of hard commodities you can trade as an investor:

• Gold
• Rubber
• Lumber
• Oil

 

Soft Commodities

Conversely, soft commodities are considered agricultural products such as livestock. Additionally, soft commodities are typically resources that are grown. Here are some examples of soft commodities you can trade as an investor:

• Corn
• Wheat
• Coffee
• Sugar
• Soybeans
• Pork

Generally, most commodities are considered raw materials. These materials include agricultural or mining products like iron ore, sugar, grain, wheat, or even rice. Energy can also be considered a commodity. This includes electric, gas, coal, and oil. Electricity is generally difficult to store, and therefore these commodities must be consumed as soon as they're produced.

 

Trading Commodities

When you invest or trade commodities, your trading assets (typically through future contracts) are based on the underlying price of the physical commodity. Similar to using contracts to trade stocks, investors may buy or sell commodity contracts based on the agreement that you believe an asset will go up or down in price over a timeframe. When trading commodities, an investor does not maintain the physical asset, however. With that said, when trading a precious metal such as gold or silver, a trader may own the physical commodity. Since commodity trading tends to be done through futures contracts, these trades can be higher risk and may be more short-term in nature.

 

When to Consider Commodity Trading

1. Playing Defense with Inflation

Another reason investors may consider adding commodities to their portfolios is to help hedge their assets. Hedging is a term that represents how you manage or limit your exposure to financial losses. Commodities allow you to make defensive investments to battle against concerns over things like inflation. Inflation can weaken the value of the dollar which may lead to price increases from some of your normal purchases.

 

2. Hedging the Market

As we noted, commodities tend to perform best when the economy is worried about inflation. Another reason this happens is that commodities tend to have a negative correlation to stocks and bonds. This means that commodities tend to perform best when there's uncertainty in the stock market.

 

3. Prices Hikes

Commodities also tend to perform best when prices are skyrocketing and hitting new highs. The reality with trading asset classes, most of the new money comes in after the commodity has already produced significant returns. Traders who invest at this point are trying to 'ride the wave' and profit off a perceived trend. Many of these trades end up being made at the top of the market.

 

Current Commodity Prices

It’s no surprise commodity prices are currently surging. Think about it:

• The economy is reopening, and the unemployment rate is beginning to drop.

• Numerous rounds of stimulus have been pumped into the market. This increases consumer spending and generates higher revenue for businesses.

• The real estate market is also on fire!

  1. The work-from-home economy has allowed Americans to choose where they want to live without the need to consider commuting times.
  2. Increased demand and limited supply. Don’t look now, but new home sales are also booming.
  3. Building a new home requires a lot of lumber. Did you know, the United States is currently experiencing a wood shortage?
  4. Limited resources equal higher prices for everyone.

 

Skyrocketing Commodity Prices

Below highlights a few of the resources that are currently seeing their prices surge:

 

Lumber and Wood

• As previously discussed, the pandemic allowed people to reevaluate their living arrangements. This caused people to move out of densely populated cities and into the suburbs. This is fueling one of the fiercest housing markets in recent memory. This has caused an explosion in new homes.

• What’s It Mean? Lumber is becoming an extremely important commodity! If wood becomes more expensive, that extra cost has got to come from somewhere. New home prices are averaging over 30K more based on the effects on the lumber shortage.

 

Oil and Gas

• You probably don’t need us to tell you that gas is expensive right now. If you drive a car, there’s a good chance you’re aware of this fact. But did you know that the price of oil has skyrocketed 75% since November!? As the economy reopens, more cars will hit the road and more planes will take to the sky.

• What’s It Mean? Over 40 states are charging more for gas now than they did a year ago. Economists are predicting a boom in travel over the coming months. Increased demand will always equal higher prices.

 

Copper

• In March, the Copper Monthly Metals Index ticked up 12.6% on the monthly reading. This comes off the back of fresh 10-year highs in cooper prices. Did you know, China is the leading consumer of copper?. As their economy reopens, the copper price is expected to continue its ascension upwards. The pandemic itself is also a leading reason cooper is currently so expensive. The lockdown affected copper mining and with increased demand, the supply just isn’t there.

• What’s It Mean? Copper trails only aluminum and steel in terms of its widespread use. Copper is used in construction, telecommunications, transportation, and many consumer items. Any cooper shortage could affect each of these sectors.

 

Steel

• Another powerful commodity seeing increased demand and higher prices. Steel is currently in short supply within the United States which is causing the price of steel to surge. Unfilled orders for steel purchases have hit their highest levels in over 5 years. The steel demand has been steadily increasing thanks to demand in cars, trucks, and other steel products. To meet the booming demand, many steel mills have extended their hours of operations to 7-days a week. Domestic steel prices have risen over 160% in the last 8 months.

• What’s It Mean? Steel is a vital commodity that has a wide range of uses. Thanks to supply chain issues caused by the pandemic, the supply of steel is becoming extremely limited. Logistical challenges caused by the shutdown are still being felt as steel imports have been noticeably lower as well.

 

Summary

As the world begins to reopen and the pandemic fears are beginning to subside, it appears we may be on the cusp of an economic boom! But it's important to remember the effects of the pandemic are widespread and many industries and businesses are still having supply chain issues.

Production shortages and increased demand are affecting businesses and commodities up and down the board. It's important to understand how this increased demand may lead to a price increase for many commodities and raw materials.

Commodity shortages can have a huge effect on stock prices given how prevalent they are used in everyday businesses. As the price to procure these resources skyrockets, consumers are sure to experience price increases on many of their favorite products, businesses, or consumables.