Stock market indices have been somewhat volatile of late, and there appears to have been a rotation out of growth stocks and into value stocks. While some of this will inevitably come down to normal fluctuations, there's definitely a concern that rising interest rates could pressure stock valuations. So how can investors protect themselves from a potential stock market sell-off? I think oil major ExxonMobil (XOM 0.90%), copper miner Freeport-McMoRan (FCX 0.47%), and the Invesco DB Commodity Index Tracking Fund (DBC -0.44%) can help. Here's why.
What happened in 2021
Rising commodity prices tend to create inflationary pressures and that can lead to higher interest rates. Without getting into the weeds of commonly accepted financial matters, higher interest rates often put pressure on stock prices.
Let's put it this way, why put your money in a stock with a dividend yield of, say 1%, when you can put your money in a bond or even in the bank and earn more yield on it?
To demonstrate these factors and their impact on the real world here's a chart which I hope you will find useful. It shows how the price of oil and metals and minerals price has risen in 2021. The rise in inflation expectations is shown by the 10 Year Treasury Inflation-Protected Securities (TIPS)/Treasury Breakeven rate. The way to read this is that the bond markets are now pricing in 2.3% inflation over the next decade. Finally, the 10-year treasury rate represents the rate the U.S. Government borrows at, which in turn impacts mortgage rates.
The evidence is clear. All of these measures have been rising, and rising rates could put pressure on stock markets.
Data by YCharts
How to protect against a stock market fall
If the equity markets could come under pressure from rising rates, and rates are being driven higher as the market prices in inflation, then it follows that investors could benefit from investing in companies that benefit from the cause of the inflation.In this case, commodities.
Unfortunately, it's very difficult to know if the increase in prices for commodities like oil, copper, soybeans, and aluminum is going to be part of a multi-year expansion or merely a short-term phenomenon. That said, if you are worried by the prospect of rising commodity costs, then it makes sense to hedge the risk in your equity portfolio by buying some stocks with direct exposure to commodities.
Invesco DB Commodity Index Tracking Fund
The first option is simply to buy an ETF with broad-based exposure, such as the Invesco DB Commodity Index Tracking Fund. The ETF is invested in a range of commodities futures, with the current composition shown below.
The attractive thing about buying into a commodity ETF is it will give you broad-based exposure to commodities so you don't have to pick a winner within the group. In addition, it's a cost-effective to gain exposure.
Data source: Invesco website.
Freeport-McMoRan
Alternatively, investors could focus on stocks with direct exposure to the reflation theme, and copper miners such as Freeport-McMoran. Not only is copper seen as the most economically sensitive metal, but it has a long-term growth opportunity from the so-called "energy transition."
Switching from fossil fuels to renewable energy as a source of electricity generation implies a significant ramp in demand for copper, as wind and solar farms require copper for storage and transmission. Similarly, battery electric vehicles require up to four times the amount of copper wiring that internal combustion engines do.
Freeport-McMoran is particularly attractive because of its heavy exposure to copper. Management estimates that a $0.10 per pound change in the price of copper will result in a $425 million change in earnings before interest, taxation, depreciation, and amortization (EBITDA) in 2022/2023. For reference, adjusted EBITDA was $4.2 billion in 2020 and the current price of copper is around $4.12 per pound.
Image source: Getty Images.
Indeed, a combination of a rising copper price, an improving economy, and long-term demand from the energy transition has led to investors buying into Freeport-McMoRan in 2021.
Exxon Mobil
Meanwhile, investors have also been buying into the reflation trade, and the increase in the price of oil, by buying stock in ExxonMobil. It also doesn't hurt that ExxonMobil currently sports a 5.6% dividend yield and its management is committed to raising its dividend payout. It remains a great option for investors looking for exposure to oil.
The chart below shows how ExxonMobil's revenue tends to lag changes in the price of oil. So, it's a safe bet that ExxonMobil's stock price will appreciate given an increase in the price of oil.
Data by YCharts
Finally, for investors looking for exposure to farming commodities, meanwhile, Deere and/or Corteva might fit the bill.
Stocks to buy?
There's no guarantee that commodity prices will continue to rise, but if they do, inflation and/or inflation perceptions are likely to rise too. And if that happens, interest rates will rise and stock markets could come under pressure. In this context, it makes sense to buy some protection in your portfolio, and the names discussed above are good places to start.
