Which Commodity is Wrong? Part II

In the previous blog post, Rick Vollaro brought to your attention an important divergence currently happening in the market -- the one between crude oil prices on one side and the CRB RIND (raw industrials) and copper on the other. These three indicators are typically regarded both as important global growth barometers and as highly correlated with the stock market. Figure 1 highlights the relative price action of these three series since 10/3/2011, when the S&P 500 formed a short term bottom. Since then, crude oil prices have risen more than 25% while the CRB RIND stayed flat and copper bounced around to end about 7% higher (though it seems to be in the process of rolling over). Meanwhile, the S&P 500 has been stuck in the middle, looking like it's not sure which commodity to follow.

We performed a historical analysis (weekly data available since 1988) to determine historically which, if any, of the above commodity series was most relevant for the stock market. In addition to coincident correlations (relation between movements in two variables at the same time) we also looked at leading correlations (relation between movements in one variable and movements in another variable at some point in the future) up to 8 weeks. Table 1 reports the results. Thanks to the heat map, we can clearly see that both copper and CRB RIND have historically been much more correlated to the S&P 500 than crude oil prices in coincident terms. Moreover, even when a lead is applied, the correlation of copper and CRB RIND to the S&P 500 remains elevated. Table 2 reports the T-statistics of the correlations in Table 1. In other words we are testing whether the results from Table 1 are statistically significant, using a 99% confidence level. When it comes to the T-stat, the higher the better -- specifically, we want it to be higher than a given threshold (the right-most column in Table 2) in order to achieve the desired level of statistical significance. While the T-stats on copper and the CRB RIND are very large and passed the test by an ample margin, only a few of the T-stats on crude oil passed the test and only by a tight margin. Based on these results, copper and the CRB RIND appear to be more reliable barometers of global growth and to correlate better with the stock market than crude oil prices.

Figure 1: Relative Price Action Since 10/3/2011

Table 1: Leading the S&P 500 weekly returns (correlations since 1988)

Table 2: Leading the S&P 500 weekly returns (T-stats since 1988)

Which Commodity is Wrong?

Right now we're watching some interesting divergences within the commodity complex. Sean wrote a recent post about oil's rise, and he mentioned that many analysts see this as a sign that the U.S. might avoid recession. What’s puzzling is that oil is currently diverging from other commodities that are typically seen as barometers of global growth, like the CRB Raw Industrial Spot Index (RIND), which tracks a basket of 15 economically sensitive commodities, excluding oil (see the chart below).

Some of the technicians we follow are screaming that the strong correlation between oil and equity markets indicates that oil will likely lead the markets higher. They may be correct, but we're currently investigating the potential correlations and lead times between oil, copper and the CRB RIND. Stay tuned for the results of Sauro Locatelli’s research on which commodity is more likely to be wrong... coming soon to a blog near you.

Commodity Rout Should Provide Relief for Consumers

As bad as it’s been in the equity markets lately, it’s been just brutal in the commodity pits. The Dow Jones/UBS Commodity Index is off -14% this month, while the S&P 500 is down -5%. Certain individual commodities like copper, gold, silver, etc. have been bludgeoned in recent days. Earlier this year, commodity prices were soaring -- gas prices touched $4/gallon back in May. That spike is still filtering through official inflation numbers, with the CPI reaching a post-recession high of 3.8% in August.

It seems that the Fed’s QE2 program launched late last year was successful only in squeezing consumers by bringing back some inflation. Gains in asset markets have largely vanished, and economic growth was hugely disappointing in the first half of this year. But the inflationary side effects linger. Now, with QE2 out of the way and investors unimpressed with the Fed’s latest scheme to extend the maturity of its portfolio, commodities are undergoing a major re-adjustment lower. The bad news is that we view the commodity rout as reflective of a weakening global economic backdrop, and we don’t think it’s fully run its course. But the silver lining is that it should help sow the seeds for an eventual turnaround by providing some relief for consumers.

Chart: iPath DJ/UBS Commodity Index ETN

The Strange Case of Two Unloved Secular Stories

I find it interesting that Pinnacle is currently underinvested in two long-term or secular themes. One is the China growth story and by extension, our investment in emerging market ETFs and funds. The second is the commodity bull market story. Notably both themes are related to the other in obvious ways since China is the world’s largest importer of commodities. Also notable is that we think both ideas are largely correct. China will be a leader of global economic growth for years to come and in a world of increasing scarcity commodity prices should continue higher over time. The reasons we are underweight are somewhat complicated.

China is currently fighting a battle with food and energy inflation as well as a real estate bubble. Chinese policymakers have been tightening monetary policy in order to slow the economy and prevent an asset bubble from harming the economy. We have been commenting that Chinese policy is out of sync with much more accommodative U.S. monetary policy with the result being that Chinese and other emerging markets are under performing the U.S. stock market this year. As China and other emerging markets tighten policy and slow economic growth, commodity prices will also have to adjust to slower growth. In addition, the U.S. Federal Reserve is due to stop buying Treasuries and complete their quantitative easing program this June. If less accommodative U.S. monetary policy results in slower U.S. growth that should be a headwind for commodity prices as well. If the Fed ends up raising interest rates early next year that could result in a stronger dollar which might also result in lower commodity prices. In fact, we believe the dollar is currently oversold so any short-term bounce could further weaken commodity prices adding to the devastating price declines last week.

As tactical investors we invest our portfolios in a time frame that is much shorter than the secular or long-term time horizons required for many investment themes to mature. No doubt we will soon find a way to reenter both the emerging markets and the commodity markets since it is clear that there is a long-term story for both that deserves to be invested. But for now, we seem to be content to watch both stories from the sidelines. We have established target prices to sell our commodity position. Hopefully commodity prices will rebound from last week’s disaster and we will get to sell at the top of our target range. We do participate in both themes (China and commodities) indirectly by owning gold, energy stocks, international funds that own companies that do business with China, and U.S. stocks that derive a large percentage of earnings from emerging markets generally and specifically China.

Out With Commodities?

Commodities have certainly been on the mind of investors as price gains have been astronomical since a big correction early in 2010. Agriculture stocks were up 70% since then to their recent highs, silver was up just shy of 100%, and even broad commodity indexes were up 37%. These are amazing price moves which have initiated talk of bubbles in the commodity space (which is certainly warranted regarding silver). And perhaps we have begun the inevitable bursting of the bubble as commodity prices have been plunging over the last few days. However, a look into the recent past may put this decline into context.

The chart below is a price chart of DJP (the DJ/UBS Commodity Index ETN) from 12/31/10 to 5/5/11. You can see at the far right that commodity prices have fallen 7.65% in just four trading days. This drop is definitely newsworthy, and could be the harbinger of things to come in commodity prices, but look to the left of the chart. As recently as March, commodities fell 8.09% in five trading days, and from that drop in price preceded to rally 12.02% over the next two months. So this correction is not out of the norm so far and could provide an opportunity to add to current commodity positions. At Pinnacle we are watching the commodity space intently, and having discussions regarding whether to make any adjustments to our commodity positions as I write this entry.

Anecdotally, in 2007, Blackstone Group issued their Initial Public Offering very close to the top of the buyout binge America craved in the 2002-07 bull market. Fast forward to today and Glencore could mark the top of the commodity craze that has led the market higher since 2009. Glencore is the leading integrated producer and marketer of commodities in the world. Only time will tell if the next bear market is about to begin but the similarity is eerie.

Buying a (Big) Dip

The old adage passed from generation to generation in the investment world is to “buy when there’s blood in the streets." This simple sentence perfectly sums up the investment philosophy known as contrarianism, which means doing the exact opposite of the herd. In other words, buy the dip, and the bigger the dip, the bigger the potential opportunity. Well, we found what we think is an intriguing dip to buy for clients in our Ultra Appreciation model, which is the most aggressive strategy that we offer. Uranium stocks plummeted by 30% in just two days, which led us to purchase the Global X Uranium ETF (URA). The terrible tragedy in Japan opened this investment opportunity as panic and uncertainty surrounded the nuclear industry.

An independent analyst that we read daily summed up the opportunity as a short term, technical opportunity as URA bounces to fill the gaps down it made yesterday and today. I have marked the gap with a yellow bracket in the chart below to help quantify the exact move. If the gap completely closed, the price of the ETF would rise 27% from the current $14.70 price (this does not include the 7% price rise today).

To be sure, there is plenty of risk associated with this position. There are already rumblings from politicians and environmentalists to halt nuclear energy expansion, and this will intensify if the situation in Japan deteriorates further. At the very least, this will result in increased regulation and higher costs associated with uranium production. As a result this position is expected to be highly volatile over the next few months and loaded with headline risk, meaning that in our judgment it’s only suitable for investors with a very high risk tolerance.

Dr. Copper

The commodity with a PhD in economics, Copper, is showing signs of slowing here. It is viewed as a fairly reliable leading economic indicator because so much of it is used in the production of industrial goods. Copper is used specifically in wiring, heating, plumbing, and many electronic goods. When there is less demand in these specific areas, the demand for copper falls and that is reflected in the price of the metal. The industrial metal is currently off almost 10% from its high in the beginning of February, as shown in the chart below. Additionally, it has fallen significantly below its 50-day moving average, and the average is starting to slope downwards.

We spoke with an independent technical analyst this afternoon who echoed our thoughts that there are many warning signs emerging at this time. He specifically mentioned copper, the CAC 40 Index (the benchmark stock index in France), and semiconductor stocks as areas issuing the same warning signals. The S&P 500 is currently at an indecision point reflected by the tight range in which it has traded over the last 2 weeks. We will be watching closely to see whether the bulls or the bears win this battle, but our “weight of the evidence” approach has turned cautious in the short term.

Stealth Climb

With tax legislation on the horizon and unemployment concerns lingering, it seems the minds of Americans are preoccupied. In the past, crude oil would have been on everyone’s mind as it crosses above the $90 per barrel level. Now, it’s hardly mentioned in the main stream media and rightly so as the other issues deserve more attention. But it will be interesting to see just how far the price of oil has to move until the country starts to take notice again. When will this stealth rise be known?

In the first chart below is the price of oil. Since the market bottom in August it has climbed 21% to hit $90 per barrel. At that rate, we will hit $100 oil by February. The second chart is the price of a gallon of regular gasoline. That price has already broken the cyclical high, and stands above $3 per gallon. If we hit $100 per barrel on crude, we could easily see $3.35 per gallon at the pump. This would certainly hurt consumers’ pocketbooks; maybe even enough to have us take notice.

Additionally, other commodities have posted staggering gains this year. Cotton is up 80%, wheat is up 20%, and sugar is up 40% to name a few soft assets, while gold is up over 20%. This asset class has been the beneficiary of Quantitative Easing policies in Developed nations and strong growth in Emerging nations, and is starting to stoke inflationary fears. With the recent fiscal and monetary policies enacted by our leaders asset inflation is expected to continue. I guess it is good the tax extensions will pass (if not this year then next session of Congress) so we can pay for the commodity inflation. Although now is the time to take notice before this negative feedback continues.

Ahead of the Press…Again

In the July 26th issue of Businessweek, the feature article titled “Amber Waves of Pain” attacks the commodity Exchange Traded Fund (ETF) market. They note that investors were “angry” about certain ETF investments that did not perform as expected including the U.S. Oil Fund (symbol: USO). This was mostly due to a condition in commodity futures markets known as “contango,” where longer dated futures contracts are more expensive than near term contracts for the same commodity. USO and other commodity ETFs are constructed to buy contracts that are closest to maturity, and continuously purchase new near term contracts when they are about to expire. This process effectively reduces profits when contango exists, since the ETF is forced to purchase the more expensive future contracts that lose money when they are about to expire, resulting in something called “negative roll yield.”

Additionally, many commodity index funds reinvest their contracts between the fifth and ninth business days of the month. Because this rebalancing is well known by other traders, who are not bound by specific roll dates, they game the system and make it more expensive to conduct these rolls. These traders buy and sell before the expected ETF roll which drives up the price of the next futures contract while driving down the price of the expiring contract. In the end, the purchasers of certain ETFs lose.

However, here at Pinnacle, this is old news. In March, we recognized the inherent problem in many commodity ETF products and pro-actively searched for alternative products. This search led us to the E-TRACS UBS/Bloomberg CMCI Index Exchange Traded Note (symbol: UCI) which we believe is the most attractive commodity index option available at this time. UCI is constructed in a fashion that staggers the purchase of futures contracts at different maturities ranging from 3 months to 5 years, rather than just buying the closest contract to maturity. This helps to reduce the negative roll yield effect when contango exists. Additionally, UCI is constructed to slowly rebalance small percentages of future contracts every day. This helps prevent other traders from manipulating the price of the futures contracts. UCI has outperformed our previous holding by 150 basis points (1.5%) since we purchased it. We expect the marketplace to continue to develop new approaches to manage negative roll yields. This is another instance in which Pinnacle was ahead of the press…again.

For a more in depth look at UCI, please see the following Article of Interest on our website.

http://www.pinnacleadvisory.com/pages/pinnacleArticleDetails.aspx?LinkID=97605&spid=100848