Commodities to Equity Ratio Trading Strategy – (Rules, Backtest, Performance, Results)

Last Updated on August 26, 2023

Commodities, being closely tied to weather patterns and economic activity, exhibit high cyclical characteristics. Similarly, stocks also display cyclical tendencies. Given this, is there an opportunity to capitalize on their optimal performance?

The commodities to equity ratio tries to do exactly that by telling us which asset class is performing better. But can we develop a profitable trading strategy using it? 

In this article, we are going to look at what the commodities to equity ratio is, create a trading strategy, perform the backtest and show you the results.

Related reading: – Looking for a trading strategy? (You find hundreds by clicking on the link)

What is the commodities to equity ratio?

The commodities to equity ratio is simply a division between the S&P Goldman Sachs Commodity Index (GSCI) and the S&P 500. Of course, you can also use another commodity index, but Goldman Sachs’ is widely used.

The ratio indicates whether commodities outperform or underperforming stocks by comparing the two indices. If the ratio is increasing, it suggests that commodities are performing better than stocks, indicating potential strength in the commodity market. Conversely, a decreasing ratio implies that stocks are outperforming commodities.

Here is a look at how the ratio has evolved over the last years:

The pattern observed is that equities demonstrated superior performance compared to commodities in the 1990s. However, the tables turned in the 2000s as commodities took the lead.

Subsequently, in the 2010s, equities regained their strength and outperformed commodities once again. But right now it looks like commodities may be poised to outperform equities once again.

Commodities to equity ratio historical average

The average ratio over the past 50 years hovers around 1.1 times.

In the 1970s commodity bull market, the ratio reached its highest point, surpassing 3 times. At present, the ratio sits at a historically low level of approximately 0.2 times, similar to the low point observed during the 2000 tech bust. As for whether the ratio will undergo a shift in the near future, it remains uncertain and difficult to predict with certainty (of course).

What is the correlation between commodities and stocks?

Commodities tend to bear a low to negative correlation to traditional asset classes like stocks and bonds.

Thus, any commodity trading strategy might be complementary to traditional stocks and bonds strategies. For example, Turtle Trading Strategies might offer diversification.

Why is the commodities to equity ratio important?

The commodities to equity ratio is important because it provides insight into the relative performance and valuation of two key asset classes: commodities and equities. This ratio compares the prices or values of commodities to the prices or values of equities in the market.

Here are a few reasons why the commodities to equity ratio is significant:

1. Economic Indicator: Changes in the commodities to equity ratio can serve as an economic indicator, reflecting the state of the overall economy. When the ratio is high, it may suggest that commodity prices are outperforming equity prices, indicating inflationary pressures or strong demand for raw materials, which can be associated with economic growth. Conversely, a low ratio may indicate weaker commodity prices relative to equities, potentially signaling a slowdown in economic activity.
2. Risk Perception: The ratio can also provide insights into market sentiment and risk perception. During times of economic uncertainty or market volatility, investors may turn to commodities as a safe haven or hedge against inflation, driving up the ratio. Conversely, when confidence in the economy and equity markets is high, the ratio may decline as investors favor stocks over commodities.
3. Sector Performance: The ratio can help gauge the relative performance of commodity-related sectors (such as energy, mining, or agriculture) compared to the broader equity market. A rising ratio may suggest strong performance in commodity sectors, while a declining ratio may indicate better performance in non-commodity sectors.
4. Diversification and Portfolio Allocation: The commodities to equity ratio can aid investors in diversifying their portfolios. Commodities and equities often have different risk-return characteristics, and maintaining an appropriate balance between the two can help manage risk and enhance portfolio performance. Monitoring the ratio allows investors to assess whether their allocation to commodities or equities is in line with their investment objectives and risk tolerance.

Commodities to equity ratio trading strategy – trading rules

Using the ratio we just calculated we are going to develop a trading strategy with specific trading rules and settings.

Apart from the ratio, we will have to calculate the 21-day simple moving average of the ratio. Now, the trading rules of the strategy we are going to backtest are pretty simple:

• We buy the S&P when the ratio is over the SMA;
• We sell the S&P and buy commodities when the ratio is under the SMA.

The idea is to take advantage of the asset class performing better at any given time.

Commodities to Equity Ratio trading strategy – backtest

We backtest the trading strategy using the SPX and the S&P Goldman Sachs Commodity Index. The data is not adjusted for dividends and splits. Here is the equity curve:

The strategy has performed well, but with huge drawdowns. Here are some performance metrics and statistics about the strategy:

• CAGR is 8.96% (SPX buy and hold is 7.81%)
• Standard deviation is 21.11 (18.57)
• Maximum drawdown is -58.09% (-56.78%)
• % of positive days is 53.07% (53.72%)

The strategy is invested 51.77% of the time in commodities and 48.22% of the time in the S&P 500. The only major difference with the S&P 500 apart from the performance is that the strategy is a little more volatile, given that it has a higher standard deviation. 

Commodities to Equity Ratio trading strategy – optimization

We choose to backtest the strategy using the 21-day SMA, but how does it compare to other SMAs in terms of performance?

As you can see below, as the SMA increases, the CAGR of the strategy diminishes. The strategy exhibits superior results when paired with faster SMAs compared to slower ones. Therefore, if you are considering implementing this trading strategy, we highly recommend using a fast SMA.

Commodities to Equity Ratio trading strategy – conclusion

To sum up, today you learn what the commodities to equity ratio is and we backtested a trading strategy to see whether the performance was great or not. As the results show, it may be wise to consider implementing this ratio in a trading strategy.