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