The stocks to commodities ratio measures the S&P 500 relative to the commodity market index PPI (Producer Price Index). When the ratio rises, stocks beat commodity returns - and when it falls, commotities beat stock returns. The chart's yAxis is logarithmic and over the long run stocks clearly outperform commodities.
According to Baran (2013) stocks and commodities are negatively correlated. The main reason is the fact that equities and commodities behave differently during the short term credit cycle. Stocks perform better in late recessions and early expansions while commodities overperform in late expansions and early recessions. Furthermore, Bannister and Forward (2002) found that equities and commodities alternate on leading the market on average every eighten years (18-year cycles), which also corresponds to deflationary and inflationary cycles. Periods of deflation are characterized by a boom in stocks and sound money (i.e. gold standard of 1879, Bretton Woods after WW2). These periods are followed by inflation, including inflationary events such as the Gold nationalization of 1934, the Nixon shock of 1971, and war (WW1, WW2, Vietnam, Iraq). Realizing their position in the cycle, in 2002 Bannister and Forward correctly predicted the outperformance of commodities over the following years and the risk of war in the middle east.
The chart above displays the 1-year rolling correlation coefficient between the S&P 500 and the Producer Price Index. A correlation coefficient of +1 indicates a perfect positive correlation, meaning that the two indices moved in the same direction during the specified time window. Conversely, a correlation coefficient of -1 indicates that they moved in opposite directions.
Diversification is the practice of spreading investments across different asset classes to reduce risk. In his book Principles, Ray Dalio called diversification the “Holy Grail of Investing”. He realized that with fifteen to twenty uncorrelated return streams, he could dramatically reduce the risks without reducing the expected returns.
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