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How would Commodity Bubble Bursting affect CTA performance:
June 16, 2008
With more and more talk recently about the possibility of a commodity bubble either having already formed or in the process of forming – sophisticated investors have been asking Attain if we believe there is a commodity bubble, and if so – what could that mean for commodity based investments in CTA programs.
Are we in a commodity bubble?
Before we answer whether we think there is a commodity bubble, let’s first back up and explain what a bubble is, and why it is worrisome. Many people think a bubble is when the price of something rallies significantly over a short period of time. And while a big price spike is associated with a bubble, the price spike is the result of the bubble, not the bubble itself.
When economists warn of bubbles, they are really talking about a phenomenon in which prices for a certain good (or collection of goods) are well beyond what would be considered the true economic value of the good due to furious speculative buying of the good. This leads to unsustainable price action, according to economists; as there must be ever more speculative buying to fuel the ever increasing prices. As it is often put, you must find an even greater fool to pay a higher price than you did. Eventually, the world runs out of fools, and prices quickly fall back to earth.
A great example of a bubble are the internet stocks of the Dot.Com bubble. Stocks of companies which had never made a dollar in profits were trading at valuations above those of companies which had long histories of profits. The reasoning for not needing profits were because it was a new economy, based off the internet. But in the end, the Nasdaq lost over 75% of its gains as people stopped buying into the myth.
The case for a commodity bubble is made by many through simply pointing at the gains in several markets as laid out below (from Michael Master’s congressional testimony)
Commodity Futures Price Increases March 2003 - March 2008
Cocoa +34%, Coffee +167%, Corn +134%, Cotton +40%, Soybean Oil +199%, Soybeans +143%, Sugar +69%, Wheat +314%, Wheat KC +276%
Feed Cattle +34%, Lean Hogs +10%, Live Cattle +23%
Brent Crude Oil +213%, WTI Crude Oil +191%, Gasoil +192%, Heating Oil +192%, Gasoline +145%, Natural Gas +71%,
Aluminum +120%, Lead +564%, Nickel +282%, Zinc +225%, Copper +413%
Gold +183%, Silver +331%
Source: Bloomberg Financial Data
The table above sure makes it seem like we are in a bubble, with several commodities (especially metals, energies, and grains) up well over 100% in the past 5 years.
But consider the now well publicized Dot.com bubble, which saw Nasdaq stocks rise over 500% from 1994 to 2000 (just 6 years). By that measure, we’re no where close to a bubble yet in commodity prices, and would have to see them double again to get close.
So, while prices of commodities have increased dramatically over the past five years (more than doubling on average) – they haven’t increased as much as some other bubble periods, and it is under debate whether that qualifies as unreasonable price action driven purely by speculative buying. It is under debate whether it actually qualifies as a bubble.
While it may seem like semantics arguing over whether we’re in a bubble or not, it is actually very important because if the increased prices aren’t caused by a bubble, then they won’t come crashing down as a burst bubble would.
Assuming it is a bubble:
But let’s assume for a second that it is a bubble in commodity prices, and that a bursting of that bubble is on the near term horizon. What does that mean for investors in Commodity Trading Advisors who specialize in….you guessed it – commodity markets?
By the sound of it, commodity advisor and commodity bubble sure don’t sound like a good mix. And many investors have been scared off of commodity trading advisors (CTAs) by this association.
But unlike an internet stock fund in 2001 or a real estate investor during the past year – a commodity trading advisor isn’t only BUYING commodities. They sell commodity futures too, and trade options on them, and do delta neutral spreads, and all sorts of other methods.
That means CTAs, on the whole, are not likely to tank if 1. there is a commodity bubble, and 2. It bursts. The statistics back this up, with the monthly correlation coefficient of the CRB commodity index prices and Tremont Managed Futures index only 0.17. A correlation of 1.00 would be worrisome, as that would portend a bursting bubble would mean a bursting of CTA returns as well.
In fact, many are likely to benefit from a bursting commodity bubble. The table below shows the 20 largest losing months of the CRB Index since 1994, and the corresponding gain or loss in the Tremont Managed Futures Index during that time. The averages may surprise you. Across 20 losing months with an average loss of -4.30% for the commodity index – the CTA index averaged a gain, of +0.28%. A gain!
Now, how individual managers would fare during a commodity bubble burst depends on their strategy type. Multi-market trend followers are at the greatest risk, as their models are no doubt long most commodities currently, and would have to adjust to the falling prices, and exit their long positions eventually. This would lead to a month or two of losses, most likely, with a period of back and forth performance as prices moved from an up-trend, to consoldiaiton period, to down-trend.
But even trend followers have protection against a bubble bursting, in the form of market diversification, and low risks per individual trade. A trend follower is likely also in bond markets, foreign currencies, and markets like Sugar which have actually been down over the past year.
Shorter term traders would not suffer as much, being a little more nimble, generally speaking, and likely to exit their longs earlier and enter short positions earlier. And then there are discretionary managers like Dighton Capital and Rosetta, which may very well place bets on the exact thing we’re talking about – a bursting of the commodity bubble. Dighton already showed signs of this when they went long the US Dollar earlier in the year as the whole world seemed to be selling US dollars.
Finally – portfolio diversification is another way CTA investments are protected against a commodity bubble bursting, as a portfolio could include index option selling CTAs such as Crescent Bay and Cervino which don’t have any exposure to commodities.
At the end of the day, most of us at Attain do not believe that we are in a commodity bubble, thinking instead that there is a whole lot of demand for the commodities which have seen the largest gains, and not a whole lot of production to keep up with that demand.
But we also think that even if we are wrong and are in a bubble which will burst imminently, it is not going to be catastrophic to CTA investments, and instead either be a non-event or a good chance of being beneficial to CTA investments.
IMPORTANT RISK DISCLOSURE
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The grains and oilseed sector started their mid-summer season about a month early last week as severe flooding in key corn producing states in the U.S. Midwest (read Iowa/Wisconsin) prompted record buying in most grain contracts. Corn led the way with gains of +10.17% for the week as major crop damage was noted in several top producing states with no time left to replant. Early indications are that about 4% of expected acres to be planted in corn will be lost for this growing season. Wheat +8.15% and Soybeans +6.71% followed along, although these two sectors could be subject to near-term corrections as soybean acreage could increase due to the corn losses as there is still time to plant and wheat harvest is nearing full swing with the crop expected to be very large as planted acres versus a year ago were up substantially.
The Soft commodity sector found upside momentum from the grain rally as inflationary pressure from the current rally in most foodstuffs made this complex an attractive arena for investors. Cotton +6.34% and Sugar +6.16% benefitted the most as their link to the alternative fuel sector sparked strong support. The livestock sector was mixed as Live Cattle rallied +2.13% on ideas higher corn prices would keep cost of production inputs higher for some time, although Lean Hogs ended -.95% as they continue to stumble due to heavier than expected production. In other food sectors Cocoa futures gained +4.73% on strong demand.
Energy futures ended the week with a lower tone as news that Saudi Arabia will hold a special meeting among top energy officials in the near future seemed to cap and early week rally that was sparked by the weekly stocks report that showed bigger than expected draw downs for U.S. crude stocks. Crude ended the week -2.76% with heating oil -3.56% and RBOB -2.51% following suit.
Activity in the metals for the week was mostly lower as negative energy prices and ideas of slowing demand from developing countries kept pressure on the sector. Silver -4.97% led the way down followed by gold -2.99% and platinum-1.98%.
Currency and bond trading saw gains by the U.S. Dollar +2.31% as the main feature. Euro Currency -2.54% and Swiss Franc -2.77% found added pressure from a less hawkish attitude from the EU central bank a week after the statements they would take necessary measure to curb ongoing inflationary pressure in Europe. In bond trading the benchmark US 10 Year Note futures finished the week -2.69%, and the US 30 Year Bond futures were down -2.62% as comments from several Fed governors seemed to indicate inflationary pressures were on their minds.
U.S. equity markets spent last week basically sideways after steep losses the week before. Consolidation seemed to set in after some economic reports showed signs of improvement not to mention statements by several key figures involved in the credit crisis indicating that just maybe the end was near. For the week Dow futures ended near steady, SP futures were down a slight -.22%, and NASDAQ futures shed -1.26%. The small-cap sector was also a tad lower as the Russell down -.30% and the Mid-Cap lost -.86%.
What a difference a week makes for option trading mangers. Following a spike up of over 26% in the CBOE Volatility index on June 6th, last week saw volatility levels drop 10% - effectively moving most Index Options managers back into the black for the month. Leading the pack for the month to date is LJM Partners which is ahead an estimated +2.2%. Through May, LJM is ahead 19.14% for the year despite falling -12.39% in January. The program is up over 61% in the past 12 months, which is a very impressive number considering the advisor manages over $200 million in client assets. Other month to date estimates are as follows; Ace Investment Strategists +0.41%, Cervino Diversified +0.4%, Cervino Diversified 2x +0.67%, Cervino COP +1.24%, Crescent Bay PSI +1.71%, Crescent Bay BVP +0.17%, Diamond Capital +0.35%, FCI +0.10%, Rathiel +0.09%, Zenith Index +0.04%, Zenith Diversified +0.11%, Zephyr Aggressive +0.67%, Zephyr Moderate -1.14%.
Agriculture markets continued their excitement last week giving way to even more opportunity for the NDX program suite - NDX Shadrach is now ahead approximately 11.69% for June and Abednego is ahead approximately +5.29% as the front vs. back month spreads continue to widen in the Lean Hog and Live Cattle markets. Through May, Shadrach was ahead 12.66% for the year, including a drawdown of -3.35% in January, and better by 26.18% for the past 12 months. Elsewhere, for the month to date, Chicago Capital is down approximately -1.78% and Rosetta is down an estimated -1.39%.
In FX trading, Devrim was down aprox 15% as of June 6th but is now only down -6.17% for the month. Despite Devrim not posting any losing months since inception, historically, we have seen a -17% intra month drawdown.
High crop prices along with rising fuel prices continue to buoy trend following CTA’s in June. Horrible floods across the Midwest have caused immeasurable damage to crops resulting in record high grain prices. Markets like Soybeans, Soymeal, Corn and Wheat are all trading at or near record highs.
The top performing multi market manager thus far in June is Hoffman Asset Management. Hoffman has seen gains in grains, metals, treasuries, and meats for estimated returns of +5.25% this month. Next in line is the Attain Portfolio Advisors Modified Program with returns of approximately +4.87%. APA Modified has also been holding long in grains and energies over the last 2 weeks. The APA Strategic Diversification program has also done well so far in June and is up approximately +2.52% for the month thus far.
Other profitable managers include Dighton USA which has been holding long in both cotton and coffee for estimated returns of 1.55% in June; the Long Term Trading Navigator program is up approximately +1.42% and Robinson Langley Capital Management is up +0.37%.
Mangers in the red include Optimus Capital at approximately -1.59% and Northside Trading at approximately -7.00%.
With commodity prices continuing their volatile ways, it was no surprise to see stocks under selling pressure at several times throughout the week. Under normal trading conditions, it is unusual to see such an inverse relationship between the price of oil and the direction of the stock market. However, until we see some type of relief in energy prices the stock market is likely to have all eyes on the price of oil – rallying as oil falls, and selling off as oil rallies.
Beginning with day trading systems, Rayo Plus Dax was the top performer +$5,577.13 on a pair of trades. Trading on the same exchange (Eurex), BetaCon 4/1 ESX had four trades for +$441.39. Waugh eRL lost -$70 on two trades for the week while Compass SP lost -$350 on three trades. Finally, BounceMOC eMD lost -$701.11 on Friday.
Moving on to the swing systems, Ultramini ES reached its target on a long trade for +$670. Tzar NQ reversed long near the weekly lows and made +$2,129 on the closed out trade. Tzar ES was stopped out of its long trade for a loss of -$2,333.53 while the eRL entered long on Monday and held its position. Bounce eMD lost -$701.11 similar to the day trading program.
Systems that trade bonds generally struggled last week with Mesa Notes closing out a losing long trade for -$2,143.75, Signum EBL reversing long near the highs of the week and losing -$9,150 in open trade equity and Signum TY losing -$5,750 in open trade equity. Jaws programs fared better with the US Daily program +$138.05 while the US 60 was down -$533. Both Jaws programs were stopped out of their short positions just before bonds continued to move lower for the rest of the week.
Long term systems were quiet but there were some trend reversals and Cotton, Sugar and Coffee which were all up sharply towards the end of the week. Look for short exits in these markets over the next week if they continue to rebound.
IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.
Past performance is not necessarily indicative of future results. The performance data for the various Commodity Trading Advisor ("CTA") and Managed Forex programs listed above are compiled from various sources, including Barclay Hedge, Attain Capital Management, LLC's ("Attain") own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.
The dollar based performance data for the various trading systems listed above represent the actual profits and losses achieved on a single contract basis in client accounts, and are inclusive of a $50 per round turn commission ($30 per e-mini contracts). Except where noted, the gains/losses are for closed out trades. The actual percentage gains/losses experienced by investors will vary depending on many factors, including, but not limited to: starting account balances, market behavior, the duration and extent of investor's participation (whether or not all signals are taken) in the specified system and money management techniques. Because of this, actual percentage gains/losses experienced by investors may be materially different than the percentage gains/losses as presented on this website.
Please read carefully the CFTC required disclaimer regarding hypothetical results below.
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.