Monday, July 6, 2009

2nd Qtr 2009 Review and Recovery Debate


The second quarter of 2009 is winding down and it is time for some retrospective analysis and a few forecasts. In the addition to the written commentary below, I've also recorded a video for MarketDNA, a blog which I maintain for the benefit of my Pepperdine University MBA students.

The S&P 500 rallied an additional 15% in Q2 with a practical absence of any meaningful pullbacks. Not unexpectedly this rally occurred alongside a weakening USD. This inverse correlation has proven almost necessary in the last few years to justify any meaningful increases in equity prices. In this particular circumstance, the weakening dollar reflected the so-called “reflation trade” when economic and monetary stimuli are injected massively into the economy improving demand but also creating inflation expectations.

Stocks and commodities as well tend to react favorably in this context and so they did. Inflationary expectations were not missed by bond traders who continued to unwind the overly aggressive long positions accumulated at the end of last year and in the face of growing government supply, yields started to increase.

The inflation/deflation debate is at the core of any economic forecast for the foreseeable future. We believe it is undeniable that some level of inflation will be the legacy of this dislocating economic period but we do not believe it is an issue at the moment.

The economic recovery seems very sloppy and certainly uneven. Unemployment rates are still growing (albeit normally a lagging indicator) and based on historical comparisons should continue to rise significantly. The most positive scenario would be a shift in the engines of growth from the US to the emerging markets, a move that would spur international economic growth and new found incentives to increase productivity. However, emerging markets, as exciting as they may be in the long term, just don’t have the critical mass or the proper balance between domestic demand and exporting policies, to be able to drive the rest of the world out of this malaise.

Economic numbers out of China seem foggy at best, manipulated at worst; Russia is completely dependent on energy prices and those are a function of global recovery (a circular relationship); Brazil and India could help but in due time and not in the short term. In terms of equity prices, emerging markets did outperform US stocks and for long term portfolios, I still think they represent a good bet and should be on everyone’s radar.

At this juncture, the problem is identifying whether equities in general are still undervalued and then identifying selective opportunities. The P/E ratio of the US market is now at best indicating fair value and not anymore any undervaluation; this is true of TTM ratios, forward looking ratios and CAPE ratios as well. Another negative seems to be the increased selling interest on the part of corporate insiders who were actually big buyers around the March lows. The stock/bond ratio also indicates overbought equities compared to bonds (even though such extreme was recently alleviated). Overall, the US market does not seem to be a compelling buy at the moment and that should skew investors’ attention toward more selective ideas and strategies.

MLPs continue to be high on the list for the income and the inflation protection built into their business model. Also the tax advantage may come in handy as this administration may move toward increases in dividend and capital gains taxes. Of course the increase in Treasuries yields reduces the competitiveness of MLPs distributions; however, the spread remains attractive.

Option trading was not as profitable as expected in Q2 as a persistent lower implied volatility versus statistical volatility made derivative arbitrage more difficult. Lower volume in options also increased the cost of trading and made this quarter a non-event. Looking forward we think an increase in volatility is likely and a more aggressive two-way trading environment may be developing which would be beneficial to our strategy.

One last comment on increasingly strange intraday trading dynamics; many professional players have noticed that while the financial system has returned to some level of stabilization, on an intraday level market dynamics feel strange and maneuvered. Many theories are circulating including the never ending conspiracy explanations. We are not sure concrete manipulations are indeed occurring but it is clear that many intraday moves are nonsensical; one possible explanation may be that in the absence of a coherent and general investment thesis as you would normally experience during normalized times, computer trading and quant based algorithms take over distorting logical intraday supply-demand relationships. The increase weight of institutional trading in dark pools and supplemental liquidity programs may be significantly distorting intraday internals. This is something for the regulators to investigate but in the meantime it is another new issue that has to be incorporated into any market analysis.

- Davide Accomazzo, Managing Director

Commodity “Roll Yield” a Fictional Return?

This article, originally published by Opalesque Futures Intelligence (Issue 5, April 7, 2009), is an extract from the paper, “Term Structure and Roll Yield: Not Your Father’s Backwardation.”

Half the lies they tell about me aren't true. --Yogi Berra

Term Structure and Roll Yield
Question: if something is stated repeatedly as fact, does that make it necessarily true? We no longer believe the sun circles the earth, but that idea was once conventional wisdom.

A similar issue faces investors who use passive commodity indexes. In a recent Financial Times story, “Steep ‘contango’ forces traders to adapt commodities plans”, we are told that investors in commodity index products “obtain a separate return, known as the roll yield, as they shift their positions each month from the expiring futures contract into the following month.” This idea is so commonly asserted that it is accepted as fact—but is it?

The problem is that empirical tests using a variety of models have produced inconsistent conclusions as to whether there is in fact positive expected returns from speculating in the futures market. This is vexing to financial institutions who sell products structured around commodity benchmarks such as the S&P GSCI or DJ-AIG, and who need to “market” a structural source of return in what is essentially a zero-sum game.

Notably, ten years ago mainstream thinking about commodities was largely negative. Thomas Schneeweis and Richard Spurgin in their 1996 paper, “Multi-Factor Models in Managed Futures”, stated that the low level of investment in managed futures was due to the fact that investors required both a theoretical basis and supporting empirical results. In other words, prevailing wisdom at the time was against speculation in commodities.

The industry’s marketing solution came in the form of a series of studies over the past decade of which the most cited is “Facts and Fantasies about Commodity Futures” written by Gary B. Gorton and K. Geert Rouwenhorst, two Yale University academics. After their paper was referenced by Jim Rogers in his book Hot Commodities, the concept and theory of the roll yield became well established in the investor mindset.

Our working paper “Is Managed Futures an Asset Class; The Search for the Beta of Commodity Futures” nonetheless, takes issue with Gorton and Rouwenhorst’s conclusions.

To begin with, the roll yield is derived from a simplified definition of backwardation and contango based on what Hilary Till, co-editor of Intelligent Commodity Investing, describes as the “term structure of the futures price curve.” Nowadays, backwardation is commonly defined as conditions when “the futures price is below the current spot price” and contango as conditions when “the futures price is above the current spot price.”

However, this paradigm is not in line with the original definition of normal backwardation as described by John Maynard Keynes (1923, 1930), and related phenomena identified by Nicholas Kaldor (1939) and Holbrook Working (1948, 1949). Classically, backwardation and contango correlate the futures price to the “expected future spot price,” which is an unknown, to be discovered in the future, at the time the futures converges with the spot.

This difference in assumptions is not insignificant. The conundrum is that for every buyer of a commodity futures contract there is a seller—sine qua non, there is no intrinsic value in forward contracts. They are simply agreements which commit delivery of an asset at some place/point in time. So how does rolling contracts yield positive expected returns?

Rolling the Futures Contract Backward
Futures and forward contracts, unlike securities, are instruments with a finite life and terminate on pre-specified dates when the futures contract converges with the spot price. At that point the spot price is discovered and delivery of the underlying cash commodity is made between commercial participants.

A wheat futures contract, for example, has delivery contracts for March, May, July, September and December. For this reason, and as a matter of practice, most speculators do not allow their positions to enter the delivery period, and a perpetual long futures position requires a trader to “roll the contract” from one contract month to the next.

A close look at the studies written by proponents of the roll yield reveals use of a model or algorithm that results in a fictional trade. Rather than rolling the futures contract forward, they in effect roll the futures contract backward to provide “proof” for their thesis. This is facilitated with the assumption that the “expected future spot price” is a pre-determined static constant, which it is not.

As a real world example, let’s assume that a trader goes long a March futures contract at $100. The trader subsequently rolls that contract in sixty days by selling it at $120, and simultaneously reenters the long position via a July futures contract at $121. Sixty days later the trader exits the position altogether by liquidating the July contract at $111.

The long March futures contract trade results in a $20 realized gain and the long July futures contract trade results in a $10 realized loss. Using a simple method for calculating rate-of-return of an investment, the net gain of $10 is divided into the original $100 March futures contract price, resulting in a 10% return. This is straightforward and logical.

By contrast, the model for calculating the roll yield is complicated and arguably illogical. The following example is based on formulas conventionally used by researchers to calculate roll yield as documented by Till (2007) in Intelligent Commodity Investing (chapter 3, pages 73-78).

Let’s assume a trader goes long a March futures contract at $100, and then sixty days later sells the March contract at $120. The net gain of $20 is then divided into the original investment of $100 resulting in a 20% return. This is referred to as the “spot return.”

Now at the time the trader purchased the March futures contract, assume that the July futures contract was trading at $90. The algorithm for calculating the roll yield then subtracts this $90 July futures contract price in the past from the current $120 March contract liquidation price. This is called “excess return” and the net gain of $30 is then divided into the $90 July contract price for a 33% return.[1]

The “arithmetic” roll yield is calculated by subtracting the spot return of 20% from the excess return of 33%, which results in a supposed 13% return to the investor. Obviously, this mathematical trick mixes up past and present prices, and creates roll yield out of an imaginary transaction that is impossible to duplicate in the real world.

Admittedly, models are an abstraction from reality. Expecting such models to be exactly right is unreasonable, and it is generally understood that neoclassical economic models have inherent limitations. Ergo, we must be careful not to follow models over a cliff.

As noted by Robert Greer in his paper What is an Asset Class, Anyway?, the inherent problem with investing in commodities as an “asset class” is that they are not capital assets but instead consumable, transformable [and perishable] assets with unique attributes.

By definition, any commodity trading facilitated for financial rather than commercial reasons is speculation. Further, derivatives are risk management tools, fundamentally different from the “rising tide raises all ships” concept of the capital formation markets.

Investors should recognize that commodity markets are more complex than what many proponents would have you believe. In truth, the “zero-sum conundrum” makes it impossible to isolate a persistent source of return without that source eventually slipping away.


* Spot Return - Gain or loss from changes in the underlying spot prices. When the spot price of the commodity rises, the value of the futures contract tends to rise.

* Collateral Return - Interest on the deposit required to trade derivatives.

* Strategy Return - Some analysts refer to a return derived from how one weights and rebalances the components of a commodity index.

* Roll Return (focus of article) - Generated by owning a futures contract for a time, and subsequently selling that contract and buying a longer dated contract on the same commodity.

[1] Hilary Till cites the following with respect to excess returns: “As explained by Shimko and Masters, the convention in calculating excess returns is to treat the futures investment as being fully collateralized based on the second-nearby price.” D. Shimko and B. Masters, 1994, “The JPMCI—A Commodity Benchmark.”

Keynes, John Maynard (1930). “A Treatise on Money, Volume II: The Applied Theory of Money” London: Macmillan, 1930, pp. 142-147.

Greer, Robert J. (1997). “What is an Asset Class, Anyway?” Journal of Portfolio Management, Winter, 86-91.

- Mack Frankfurter, Managing Director

Tuesday, May 12, 2009

1st Qtr 2009 Review and Shifting Outlooks


A continuation of the general volatility experienced last year has continued into the first and second quarter of 2009—this is unsurprising. Most markets continue to see large daily swings even though, as far as the S&P 500 is concerned, the intraday ranges seem to have abated since the very destabilizing days of October and November 2008.

Within this environment of ongoing economic and social instability, Cervino Capital’s Diversified Options Strategy managed to book positive performance for the first quarter.

That said, the markets have been frustrating these last few months. What started out as panic selling into March 9th has evolved into a V shaped rebound which has taken the S&P 500 up about 39% from the lows with practically no retracements. The Nasdaq did even better with a 50% run concentrated in its high betas representatives: AAPL, GOOG and RIMM.

In the interim, the US dollar is back on the forefront of the global economic debate as the Chinese are again making waves for the substitution of the greenback as the world reserve currency. The Chinese suggest the new global currency should be modeled after the IMF Special Drawing Rights. Such an idea does not seem to have a chance to become reality anytime soon and such a proposal looks to be more a veiled way by the Chinese to demand additional global policy power in general.

Nevertheless, this renewed debate brings up the future relative value of the dollar. As long as markets remain destabilized the dollar should retain a bid, yet an improving macro situation will ultimately hurt it. In that case, the dollar and commodities will reflect inverse correlation.

It is within this dollar context that commodities are indicating a potential global economic resurgence as crude, copper, aluminum and platinum have started to build a base and move higher. Yet at this juncture, I believe commodities are less relevant an economic indicator, as policy and time remain in my view the two main drivers of any future economic renaissance.

Meanwhile, credit spreads in the corporate bond world (where the Federal Reserve Bank has not intervened) are still historically high and provide competition to equities as an investment choice. LIBOR, commercial paper and other credit measures look better strictly due to the Federal Reserve intervention. In effect, the Federal Reserve is now producing prices for many asset classes and instruments: ABS, MBS, CP, mortgages, Treasuries and so on.

From a macro perspective, there is a case to be made that equity markets may have found a significant bottom—significant being defined as a multi-month trend change. Many analysts have been calling for the formation of a generational market bottom. And it is true that some of the long term valuation metrics have become much more attractive than in the last 20 years (eg, cyclically adjusted P/E ratio, gold/S&P 500 ratio). However, while the market may have looked attractive below 700 it is certainly not as exciting above 900. I believe that a long term bottom will be more function of future global policy (especially a rejection of protectionist forces) and necessary time for the deleveraging process to take its course.

Add to this a shift in the domestic political-economic environment, and that any potential recovery will be cobbled by many fundamental factors (consumer balance sheet repair, commercial real estate loan refinancing, shadow foreclosure inventory, etc.), there is a strong argument that the current situation is not conducive for multiples expansion in equities.

It is within this structural context that we have approached this market. We had expected choppiness and inconsistent price action. Unfortunately, we were recently met with a constant and relentless upside momentum move which we are managing.

The key aspect to recognize about our strategy is that it excels in choppy markets, not momentum markets. We continue to believe that the long-term fundamentals will evolve into a sideways and range-bound market which we can take full advantage of.

- Davide Accomazzo, Managing Director

Epilogue: In the Beginning There was Alpha

Hear then, o Economidae, nymphs of the streams
Of infinitely discussed yet discounted prophets,
Of the story which I sing: the epic of men
And women locked in the battle of egos and coherence,
Precision and relevance, the song for all ages
And peoples to hear and revere the great and poor
Deeds of this tribe of malcontents and heroes...
--The Walrasiad, Prologue

In the beginning, Man created the markets. The markets were without form and void, and darkness was over the faces of analysts. And Man said, “Let there be Alpha,” and there was Alpha. And Man saw that Alpha was skeptic. So Man created Beta from Alpha so that he may have faith. Thus it was that Beta evolved from the aggregate of individual Alpha decisions.

In time Man affirmed that Alpha is only a derivative of Beta and not unto itself. Thus it was Alpha’s fate to be banished to the farthest corners of the market where it thrived little noticed in the wilds of commodities and forex, and strange unknown strategies.

And so it came to be that Beta ruled the markets for many generations and organized itself around the concept of rational agents and equilibrium. And those who claimed to be Alpha were really leveraged Beta or Alpha corrupted by money flows into exotic Beta. And Man saw it was good.

But alas, Man was not happy in his greed and sought more leverage and converted evermore Alphas from the wilds with the trap of untold assets under management. And thus, Beta's down-fall did come about, as Man did not recognize that faith and greed is cause for disequilibrium. Soon the wisdom of crowds became the madness of crowds, and all was chaos in the markets.

This was the way of the markets when the few remaining Alphas, the true skeptics, whose only heresy was to saith that economic agents are irrational and the natural order of the markets is disequilibrium, returned from banishment and did cause great wealth for their kind.

Thus it was that “true” Alpha in its actions restored the equilibrium. From then on it was said by Man that Alpha seeks madness in the wisdom of crowds and wisdom in the madness of crowds.

Hence, price discovery is yin-yang, as is wave-particle duality. In truth, all Man's philosophies reveal this dichotomy as Man is trapped in the observer effect, prisoners of the box in which Schrodinger placed his cat. Ergo, the universe is akin to True Beta and just a huge mechanism for price discovery on a quantum level. And Man saw that creative destruction was good.

- Mack Frankfurter, Managing Director