Tuesday, April 29, 2008

1st Qtr 2008 Review and Atypical Markets


Courtesy of the credit mess and massive mispricing of risk that has built up in our system over the past decade, the first quarter of 2008 was for both the fixed income and equity markets one of the worst starts to a year in a rather long time.

The question now being asked, a little over a month after the global economy ‘whistled past’ the Bear Stearns’ run on the bank (which might of resulted in a systemic meltdown), is whether the Federal Reserve’s invocation of emergency powers was the right decision or wrong decision to make. This will remain into perpetuity an unanswered question, but on the morning of March 17th, Fed Chief Bernanke’s decision to finance $30 billion of illiquid Bear assets to secure its takeover by JPMorgan Chase & Co. came as a great relief to a market susceptible to another 1987.

Fortunately for our clients invested in the Diversified Options Strategy, we ended the 1st quarter with a solid 3.64% for the 1X program and 7.90% for the 2X program.

At the end of last year, our 2008 forecast called for continuing high volatility, strength in gold, and propositioned that the controversial idea of nationalizing losses was going to be put on the table in order to “save the markets.” In light of this framework, we traded the Diversified Options Strategy rather conservatively. The systemic risk was never this great and risk management was our main priority.

At the end of February, the odds of a systemic breakdown were, in our analysis, higher than ever and we constructed positions that would have withstood nicely such an event.

This prescience proved fortuitous, and even during the frightful hours around the Bear Stearns’ collapse and MF Global’s rout to a low of 3.64 from the previous day’s close of 17.35 (a 79% drop in price), our positions' volatility remained extremely low and the program was never at serious risk of loss.

Our Diversified Options Strategy’s risk-reward approach is validated by our Top 2 standing in BarclayHedge’s option strategy CTA ranking by Sharpe ratio.

Looking forward for the 2nd quarter, most studies based on sentiment indicators have been illustrating historical levels of negativity, especially when measured from the peak of October 2007 to the bottom of January 2008. This is in line with other recessionary periods. However, this negative sentiment often serves as a contrary indicator of where stock prices may go in the future.

Admittedly, the Damocles sword of additional credit market write-offs remains. This could eventually lead to a more pronounced credit contraction phase, resulting in more retrenchment by an overly leveraged consumer. But for the time being, mean reversion seems to be the leading factor driving the current retracement in stock prices.

For now, our outlook for the securities market in the second quarter of 2008 is more positive, at least in the near term. We expect the longer term will likely produce more disappointments, but the shorter term indicates a reversal to the mean type of action.

While on the subject of mean reversion, we would like to point out what we think are key differences between the capital markets versus the commodity markets. And in the process, also spend a few moments to provide a fresh analysis our trading in the Commodity Options Program.

Securities in general, and certainly stock market indexes, tend to be very mean reverting and therefore they offer numerous opportunities to play contrarian and volatility arbitrage strategies. On the other hand, the leveraged structure, speculative skew and liquidity constraints of commodity markets, as well as sudden changes in supply-demand dynamics, make commodities much more prone to reflexivity.

This state of affairs is due to a number of reasons, some clear cut and some more debatable. In any case, we do not believe one can routinely trade commodity options as you would normally trade stock index options.

Our underlying philosophy for the Commodity Options Program is to integrate income generation strategies with a significant number of directional bets. By definition such an approach will make the program performance more volatile and subject to a number of speculative market calls during the year.

That said, commodities in general have experienced record moves since the beginning of the year. This is a result of a combination of massive speculative inflows, and an inflationary monetary policy put forward by the Fed in response to the systemic risk posed by the credit crisis.

The convergence of these two factors overran our initial thesis that a global slowdown in the economy, and the need for a credit deleveraging, would force the commodity complex into a correction. The resulting situation put the Commodity Options Program into a difficult situation.

This specific program produces results based on a mix of mean reverting trades and directional bets (as opposed to the Diversified Options Strategy which is primarily mean reverting). Mean reversion—selling overbought and buying oversold assets—ended up having a poor risk-reward profile for commodities as three sigma moves became the norm. This was especially true in two markets where we were engaged: wheat and crude oil.

The historical trading anomalies of wheat were enough reason to cause an uproar from the farming industry as the futures-spot price convergence ceased to function properly. Crude has also started to pose valuation problems as it has begun to act more like an inverse dollar proxy than a commodity. In this environment even directional trades were not exhibiting positive risk profiles.

Notwithstanding the headwinds, the majority of our trades in this program were successful, but the poor risk-reward profile produced larger than expected losses in the wheat and oil contracts.

Going forward, we feel that the opportunities for a more rational trading may have finally developed for the Commodity Options Program after the entire commodity complex was hijacked by sheer speculation.


-Davide Accomazzo, Managing Director

We Need to Eliminate the Enron Loophole

Excerpt from my article: "The Mysterious Case of the Commodity Conundrum, Securitization of Commodities, and Systemic Concerns."

"The theories which I have expressed there, and which appear to you to be so chimerical, are really extremely practical—so practical that I depend upon them for my bread and cheese."

— Sherlock Holmes, A Study in Scarlet (1888)

The mysterious case of the commodity conundrum is sure to elicit passionate debate on either side of the equation—is the commodity boom due to speculation or fundamentals?

Rising prices and a widespread bull market in commodities should indicate that there is a growing scarcity of hard assets. However, traditional forces of supply and demand cannot fully account for recent prices.

To be precise, the normal price-inventory relationship has been altered. This is the assertion of an expanding list of bona fide hedgers, commodity professionals and economists. Specifically, dynamics have changed because securitized commodity-linked instruments are now considered an investment rather than risk management tools. Of late, this has caused a self-perpetuating feedback loop of ever higher prices.

In a statement to the CFTC, Tom Buis, president of National Farmers Union, testified, “If [farmers] can’t market their crops at these higher prices, we’ve got a train wreck coming that’s going to be greater than anything we’ve ever seen in agriculture.” Billy Dunavant, head of cotton merchant Dunavant Enterprises, was more blunt, “The market is broken, it’s out of whack—someone has to step in and give some relief.”

Even CFTC Commissioner Jill Sommers acknowledged charges that speculators are skewing the market, in an apparent turnaround from the CFTC statement of April 21st which implied that commodity markets are functioning properly. Nevertheless, the official CFTC stance is that speculative trading is not the primary culprit behind surging commodity prices, but other factors such as the declining dollar are contributors.

Yet, it is undeniable that the physical delivery markets for grains, which require that the actual commodity be delivered against expiring futures contracts, are no longer converging. This is probably just the tip of the proverbial iceberg—it is arguable other hard assets are priced “out of whack” for any number of reasons.

For example, public policy plays a role in pricing issues too. For example, continuous accumulation of strategic oil reserves by multiple governments implies rising support levels. In that sense, speculative pressures can expose “bad” application of otherwise well-intentioned government policies, such as subsidies for ethanol production or programs which pay farmers to take erosion-able lands out of production. All the same, governments’ counter-response to excessive speculation can be unhelpful, and shutdowns of free market activities are occurring.

The problem for the public is that theses issues can be complicated, and in a sound bite society which desires easy answers and easier solutions, the predominant view is currently biased to commodities as an investment hedge against inflation and speculators as an easy scapegoat for all the world’s commodity woes.

Unfortunately, this thinking is a self-fulfilling prophecy which ultimately may feed into a negative economic cycle where legitimate commercials are squeezed out of business thereby reducing supply, protectionism gains traction, trade breaks down, hoarding ensues, riots occur and wars erupt over access.

Fact is, the genie is out of the bottle and it is not going to be put back. But the financial services industry also needs to acknowledge the imbalances it has wrought in the commodity markets. The following sets the record straight...

Futures and forward contracts are intrinsically different instruments than securities which are derived from the capital markets (e.g., fixed income or equities). This is underappreciated.

Derivatives are risk management tools, a “zero-sum game,” fundamentally different from the “rising tide raises all ships” concept of the capital formation markets. While, there is an established theoretical basis and considerable empirical evidence that link investment in capital market assets to positive expected returns over time, notwithstanding the recent surge in commodity prices, a legacy of academic disagreement supports the claim that, on an inflation-adjusted basis, the same cannot be said about commodities.

As noted by Greer (1997), the inherent problem is that commodities are not capital assets but instead consumable, transformable and perishable assets with unique attributes. Hence, speculative trading, by definition any commodity trading facilitated for financial rather than commercial reasons, likely results in “zero systematic risk.”

The conundrum for financial “investors” is that for every buyer of a commodity futures contract there is a seller—sine qua non, there is no intrinsic value in futures/forward contracts—they are simply agreements which commit a seller to deliver an asset to a buyer at some place/point in time. Accordingly, the derivatives and securities markets require two different types of regulation. Why?

The percentage of open interest in futures contracts relative to crop size is out of proportion. For some crops, only 10,000 contracts are needed by bona fide hedgers. For comparison, the year-to-date volume of wheat contracts traded through March 2008 is 5.7 million contracts. Meanwhile, the CFTC requires hedgers to provide large trader reporting, but unregulated participants have no such requirements. Further, there are systemic issues with big moves happening overnight and taking place off-exchange.

This is explained in further detailed in more detail in the complete version of this article (to request a PDF version, email: info@cervinocapital.com).

As a CFTC registrant and participant in the managed futures industry, I am personally baffled at our lack of representation regarding the “closing the Enron loophole” issue. Managed futures represent a class of regulated speculators who have traditionally provided liquidity to the bona fide hedgers. Our role is indispensible to the proper balance to commodity trading because we go both long and short commodities. However, if we do not ensure our place at the table, we may lose our rights if not the viability of our industry.

In effect, the “securitization of commodities,” a difficult topic in itself to analyze given the proliferation of different types of securitized commodity instruments, has led to an undermining of the prime economic purpose of the commodity futures market. The primary benefit provided by futures markets is that it allows commercial producers, distributors and consumers of an underlying cash commodity to hedge.

Investors must recognize that risk management markets exist primarily for the benefit of bona fide hedgers. Securitized commodity products are not structured to serve that purpose. Rather, this innovation has allowed money flows to distort price discovery, while at the same time undermine the all-important hedging utility. Further, they are sold as investments, when in fact these products are speculative.

As discussed in detail in the complete version of this article, the “Enron loopholes” within the Commodity Futures Modernization Act have served to undermine the authority of the CFTC, and put the futures industry as well as the economy at risk. It is time to rein in excessive market speculation which is occurring on the “dark exchanges’ and support the transition of unregulated commodity speculation back into the domain of the regulated futures industry.

The Close the Enron Loophole Act (S.2058), introduced by Senator Carl Levin of Michigan, would rearm the CFTC with the tools needed to subject “dark markets” to the same oversight as traditional futures exchanges. Exempt commodity exchanges would be made subject to the same standards as traditional contract markets regarding position limits, large trader reporting and transparency requirements. The proposed Act would also require large-trader reporting for domestic trades on foreign exchanges.

If a facility for trading commodities looks like a futures exchange and acts like a futures exchange, then it should be regulated like a futures exchange.

At the same time, securitized commodity products should come under regulations similar to that which has been imposed on single-stock futures. Recent events reveal that long-bias commodity index funds and commodity-linked ETFs may systemically represent a form of market manipulation.

If investors are interested in investing in commodities on an unleveraged basis, then the futures exchanges should develop “fully-funded” non-leveraged instruments, similar to mini-futures, for investors to trade.

Further, Series 7 securities representatives should be disallowed from marketing commodity-related investment products without also having a Series 3 license and registration as associated persons.

Additionally, commodity-related securities products should be subject to NFA 4-29 marketing rules as is imposed on futures industry registrants. For example, hypothetical concepts such as the roll return should have attendant hypothetical disclosures as would be required of futures professionals.

As to the institutionalization of financial investments in long-biased commodity positions, index funds need to accordingly recognize their inherent responsibility in financing credit lines to utilities which facilitate physical deliveries of commodities. Admittedly, this may be difficult under current law.

These concerns raise a key question for the futures industry, managed futures, and bona fide hedgers. Why are securities professionals allowed to hold themselves out as commodity professionals? The debasing of this core rule has led to confusion in the public's mind and threatens the futures industry profession, thereby undermining the CFTC's authority as granted by the CEA.

Has there been an abrogation of responsibility by the CFTC? Is this regulatory body now beholden to interests other than the constituents it is suppose to serve and regulate?

A key responsibility of the CFTC is to ensure that prices on the futures market reflect the laws of supply and demand rather than manipulative practices or excessive speculation.

The 2006 U.S. Senate Staff Report by the Permanent Subcommittee on Investigations concludes as follows:

“It is critical for U.S. policy makers, analysts, regulators, investors and the public to understand the true reasons for skyrocketing energy prices. If price increases are due to supply and demand imbalances, economic policies can be developed to encourage investments in new energy sources and conservation of existing supplies. If price increases are due to geopolitical factors in producer countries, foreign policies can be developed to mitigate these factors. If price increases are due to hurricane damage, investment s to protect producing and refining facilities from natural disasters may become a priority. To the extent that energy prices are the result of market manipulation or excess speculation, a cop on the beat with both oversight and enforcement authority will be effective.”

Ironically, we’ve been here before... The Commodity Exchange Act of 1936 repeats the same in a more concise fashion, “Excessive speculation in any commodity under contracts of sale of such commodity for future delivery… causing sudden or unreasonable fluctuations or unwarranted changes in the price of such commodity, is an undue and unnecessary burden on interstate commerce in such commodity.”

The more things change, the more things stay the same. “Eliminate all other factors, and the one which remains must be the truth.” Perhaps, we can take heart from Sherlock Holmes in “His Last Bow.”

“Good old Watson! You are the one fixed point in a changing age. There's an east wind coming all the same, such a wind as never blew on England yet. It will be cold and bitter, Watson, and a good many of us may wither before its blast. But it's God's own wind none the less, and a cleaner, better, stronger land will lie in the sunshine when the storm has cleared. Start her up, Watson, for it’s time that we were on our way. I have a check for 500 pounds which should be cashed early, for the drawer is quite capable of stopping it if he

- Mack Frankfurter, Managing Director