R36, Pg. 54, V5: Under special risk characteristics, 1) Business cycle-related supply and demand. 3 points are given why commodity returns have been weakly correlated with stock and bond returns. Point No.1 - Agree with it Point No.2 - Ok. If you say so, can’t argue without any backing, but ok, that’s the general characteristic of a commodity Point No.3 - Commodity prices tend to decline during times of a weak economy. Doesn’t this directly contradict the second point? Bond and Stock prices also decline during times of a weak economy. So how are they weakly correlated?? Thx
Can you post what the 3 points are
- Commodities correlate positively with inflation whereas stocks and bonds are -vely correlated with inflation 2) Commodity prices and stock/bond prices react differently in different phases of the business cycle. Commodity future prices are more affected by short-term expectations, whereas stocks/bonds prices are affected by long-term expectations. 3) As mentioned above.
sparty419, I wish I can tell u whether there is a direct contradiction or not, but here’s my take: --Generally CFA materials try to state that alternative investment (including commodity) is a good diversification tool to the typical investment (stock & bond) in a broad sense because their return/risk are “weakly correlated”. --There are lots of flexibilities in the whole thing. First, stock and bond returnes may not correlate with each other. e.g. In a downturn, stocks perform poorly. However, fixed-rate bonds in your portfolio may perform well since the Fed continually cuts interest rate. Unless there is a credit crisis, most avg. and high quality bonds should do good in a downturn. This is probably the thing that threw you off because CFAI wraps the 2 separate asset classes as one here. --Commodity price are highly correlated with inflation. However, stocks performs well with low/moderate inflation but poorly in high inflation. --Correlation is a matter of “degree” in some circumstance. Zero and negative correlations are good for diversification. In addition, “low/weak” correlation can be used for diversification as well. In a upturn, commodity price usually goes up so does the equity price, but it may not be in a highly correlated way in every instance. CFAI just tries to say that commodity can be a good diversification tool for everyone’s portfolio usually containing a mix of stocks and bonds. If I got anything wrong, please let me know.
You will see this kind of discreprency (spelling?) in CFAI curriculum. Just remember that commodity (except agricultural products) provides good diversification (positive can be go up and down with other assets. It doesnt say negative correlation) and has low correlation with other asset classes. Isn’t bond price rise in weak economy (recession)?
Thanks for that. I guess the key words would be “low correlation” as opposed to “negative correlation”.