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Where can you invest during the current market crisis?

September 29, 2008

 

For those who haven’t seen the news yet, global markets in everything from bio-tech stocks to Malaysian palm oil futures were hammered lower today (Monday) as investors aggressively sold any and every asset class they could (except Gold and US Treasury bills). Especially hard hit were US stocks, which sold off as much as 7% to 9%.

It can be daunting enough to see red numbers (negative performance) across the board for stocks and commodities on a single day – but just take a look at what all of these different asset classes have done for the entire year.  It hasn’t been just bank stocks getting hit in 2008, with all major asset classes except cash and managed futures down for the year.

Past Performance is not necessarily indicative of future performance 

Asset Class

YTD Performance

Managed Futures

+5.80%

Cash

+0.85%

Bonds

-1.15%

Commodities

-4.01%

Hedge Funds

-5.05%

Real Estate

-19.73%

US Stocks

-26.24%

World Stocks

-29.50% 

Key: All results estimates as of 9/29/08 - Managed Futures = Credit Suisse/Tremont Managed Futures Index, Cash = 3 mo T-Bill rate, Bonds = Vanguard Total Bond Market ETF, Hedge Funds = Credit Suisse/Tremont Hedge Index, Commodities – Reuters/CRB Commodity Index, Real Estate = Dow Jones Wilshire Real Estate Securities Index, World Stocks = MCSI World Index, US Stocks = S&P 500 Index

Shouldn’t all of these different investment types perform differently over the course of a year? Doesn’t the conventional wisdom tell us that different asset classes are non-correlated, and that alternative investments in things like hedge funds and real estate are supposed to be able to have positive returns when stocks are selling off or the economy is in trouble?

These suppositions have certainly been made by many, but the logic behind them is proving increasingly false as we get deeper and deeper into the credit crisis which has been called the worst financial mess since the Great Depression.

When you look at what stocks did today in tandem with real estate’s losing record so far this year, hedge funds negative performance, and the issues we’ve seen lately with supposedly safe money market and bond funds - one starts to wonder if there are any viable investments which can actually do well in this environment.

We can start to whittle down to what is capable of doing well in this environment by first looking at what isn’t doing well, and why. At the top of the list has to be your stock only mutual funds or outright stock investments were likely negative on the year coming into today, and much more so after today’s -8% swoon. And sure enough, they are at the bottom of our list above showing 2008 year to date performance, at -26% for US Stocks and nearly -30% for global equities.

Are you truly diversified?

Many people are willing to diversify, and even attempt to do so. But are you truly diversified? Many investors who start out in stocks are told to diversify their funds across stock sectors, and indeed even geographical regions. But when you consider that small caps are down just like big caps, technology is down right along with energy plays, and world equity markets have performed worse than US stocks so far this year, it hardly seems like diversification into different stocks or stock markets is the answer.

So what about diversifying away from stocks? People have long thought it advisable to diversify into bond funds, or even money markets for the ultra conservative, using the old school logic that investors will rotate out of stocks and into bonds in times of trouble. But the money market rate is now down to less than 1% in areas (and adjusting for inflation is negative)  and the largest bond fund of all – Pimco’s Total Return Fund - suffered it’s worst single day loss in over 3 years last week as the credit crunch and resulting market gyrations affected them to the tune of -1.40% in a day, and down -2.53% on the year. (PTTRX)

What about alternative investments? Alternative investments in areas such as real estate, hedge funds, and managed futures are supposed to do well during times like these, and not need a strong economy or rising stock market to do well. And indeed the history supports that, especially in managed futures. But perhaps the supporting history behind some of those non correlated returns in hedge funds and real estate is only because the stock market has generally only gone up the past 30 or so years?

Let’s look at what those invested in hedge funds have seen for performance thus far in 2008 to see if they are diversified.  Hedge funds are supposed to be the ultimate absolute return vehicle, capable of doing basically whatever they want to make money. And there are many fine funds which have been able to navigate this current crisis. But on the whole, as measured by the Credit Suisse/Tremont Hedge Fund Index, hedge fund performance is down the past two months coming into September, and after what we’ve seen in September, is likely to be down an estimated -5% on the year. This is surely better than the stock market, but again – these absolute return vehicles are supposed to earn positive returns regardless of the market environment, not lose money because of it.

The reason hedge funds have seen losses, on average, is because the grand majority of hedge funds do not offer true asset class diversification, and are really just diversifying the way they trade versus the what they trade. Venture capital, private equity, and many hedge funds (convertible arbitrage, long/short, dedicated short, emerging markets, & event driven funds) are actually an extension of the equity class (stocks), not an alternate asset class altogether. Just look at what many hedge funds do to generate their absolute returns (Hedge Funds explained)

Worse yet, many hedge funds rely on ultra cheap financing to place their leveraged bets. When that financing dries up, say in global credit squeeze, they can’t leverage up their trades, and their returns become tied to the credit cycles of the economy they are supposed to be independent of.

As a quick aside, stock index option selling managed futures programs are technically alternative investments, but similarly they are not true diversifiers away from the stock market due to their investing in the same asset class (stock indices). Thus, while they may be non correlated and provide absolute returns 90% of the time – 10% of the time they may be highly correlated with a down market move, and suffer losses at the same time as a big sell off in stock caused stock market losses. See the CTA section of the week in review below for the proof of this.

What about real estate? Well, we can’t argue that real estate is not a separate asset class, but when the excess and over supply in that asset class is causing the losses in the stock class – they become a lot more correlated than we would previously have thought when compiling a diversified portfolio.  And while there may be some opportunities to get in at good prices here and there, many believe we are nowhere near the bottom in housing prices, for one; and are at risk of the commercial market collapsing next.   

And finally, what about commodities? They must be a truly different asset class, and thus offer true diversification? The answer is yes to that one, for sure; as commodities derive their economic value through being consumed or transformed - not on the basis of future cash flows like stocks and bonds. But…

Many had thought that long only commodity investing would provide diversification, and it has to a certain extent with commodities down just about 4% on the year, versus 6 times that for US stocks. But during the past few weeks, and especially today, with Crude Oil down 8% and Soybeans down 6% as US stocks were down nearly 8% - there is a global demand aspect to commodities. And if there is perceived to be a global recession (or worse, depression) as signaled by a plummeting US stock market – then commodities can begin to trade in lockstep with global equity markets, falling when they fall and rising when they rise. That sure doesn’t sound like diversification, and is one of the main problems with a long only commodity investment. It technically does diversify you away from the stock market, but does not necessarily protect your portfolio from a weak economy or recession. In a recession, both stocks and commodity prices can fall.

Managed Futures

So how is it that the managed futures asset class is sitting heads and shoulders above every other asset class so far this year (the Credit Suisse/Tremont Managed Futures Index ahead by more than 5% while every other asset class besides cash is down for the year.)

Managed futures describe investments into futures accounts managed by professional Commodity Trading Advisors (CTAs). And as you would expect with their title including commodities, CTAs can provide diversification into a true alternative asset class through exposure to commodity markets. But didn’t we just point out that commodity exposure won’t necessarily protect you from a weak economy/recession environment?

I’m glad you are paying attention. Here’s the important part and difference between investing in managed futures which trade commodities and investing in outright commodities -  managed futures don’t just provide long only exposure to commodity markets. That is, they don’t just rely on commodity prices going up, up, and away, like the long only commodity indexes and ETFs which everyone was running to get into earlier this year.

In addition, because there are now futures markets on things which aren’t really commodities at all, like stock indices, bonds, currencies, and even weather – managed futures programs can give exposure to bear markets (and rallies) in these financials. The rally in the US Dollar, for example, was behind most of the +30% gains for the Clarke Global Basic managed futures program in August (-29% all time Max DD), and the gains of over 100% in 2008 thus far for the Pere Trading Group have been achieved trading S&P 500 futures (-30% all time Max DD). Past Performance is not necessarily indicative of future results.

But beyond these examples, the true diversification power of managed futures does come from its exposure to the commodity markets. And in times like these, if you are looking to reduce your stock market exposure, or exposure to a recession or possible depression, it pays to concentrate on those managed futures programs which operate mainly on the commodity markets. At that point, you can eliminate market plunges from your worries, and know that performance will be tied to the manager’s skill, not a strong economy or rising stock market.

This independent performance of managed futures during periods of market stress outlined in our newsletter two weeks ago bears repeating.

Futures based investments are often viewed as a way to generate oversized returns due to the leverage built into futures contracts and potential for large moves, but it is their low correlation with traditional markets which causes managed futures investments to be volatility reducers and portfolio diversifies during the bad times.

To this point, we looked at how the asset class managed futures (using the Credit/Suisse Managed Futures Index) reacts to different stress periods as compared with the stock market (as measured by the S&P 500 index). History shows us that managed futures are the place to be during bear markets and crisis situations. You’ll notice the last one is the current crisis we’re in, the credit crisis.

1. 1994 - the surprise Fed rate hike in February 1994 sent stocks reeling, and caused the S&L crisis, Orange County bankruptcy, and Mexican Peso devaluation. (Mgd fut = +11.95%, S&P 500 = +1.32%)

2. 1998 - This year saw post-Communist Russia default on its debt, causing widening credit spreads across the globe. The widening spreads caused severe losses for several hedge funds, including Long Term Capital Management, which was eventually bailed out by a consortium of banks fearing a LTCM default would result in a severe shock to financial markets. (Mgd fut = +20.64%, S&P 500 = +28.58%)

3. 2000, 2001, 2002 - The much ballyhooed Internet bubble burst - tech crash, which began in March of 2000, and depending on who you speak to either ended in 2002 or remains unfinished. (Mgd fut = +8.16%, S&P 500 = -14.36%)

4. September 2001 - The 9/11 tragedy saw US markets closed several days, with major liquidity and backup fears realized instantly, sending global markets to fresh lows once markets reopened. (Mgd fut = +3.65%, S&P 500 = -8.08%)

5. October 2007 to present - Credit Crunch, Liquidity Crisis – The current market crisis brought on by a dip in housing prices and collapse in the sub prime mortgage market, has seen hedge fund failures, bank collapses, unprecendented action by the US Fed, and a global stock sell off. (Mgd fut = +9.40%, S&P 500 = -20.50%)

The lowly correlated managed futures index performed very well during periods of overall market stress, showing positive performance in all five incidences, and averaging over 11% higher performance than the S&P 500 stock index across those periods. (and nearly 20% higher if removing the 1998 period)

- Jeff Malec

IMPORTANT RISK DISCLOSURE


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Feature | Week In Review: Stocks and commodities plunge today | Chart of the Week

***Overview***

Today’s market activity makes what happened last week nearly obsolete, and as such we wanted to share some of the numbers from today (Monday) with you.  It was a massive sell off today in everything but Gold and government bonds, as US lawmakers did not approve the so called bailout bill which was to have solved this financial crisis.

S&P

-7.86%

 

Crude Oil

-6.96%

Nasdaq

-9.60%

 

RBOB Gasoline

-6.08%

Dow

-5.98%

 

Natural Gas

-5.22%

 

 

 

 

 

Corn

-5.52%

 

Cotton

-4.97%

Soybeans

-6.01%

 

Sugar

-4.35%

Wheat

-6.42%

 

Coffee

-3.62%

 

 

 

 

 

30 yr Bonds

2.02%

 

Gold

2.24%

10 yr Notes

1.85%

 

Dollar Index

1.92%

Euro Dollars

0.07%

 

Euro Currency

-0.90%

 

Last Week:

Market concerns over the solvency of not only the U.S. financial system, but economies worldwide continued to keep all investment sectors unnerved last week, although a bailout plan considered by the U.S. Congress did spark optimism and give the markets some hope and support at the end of the week. The brunt of the worries was reflected in the stock market sector the most with the Dow futures -3.88% leading the way down with the NASDAQ futures shedding -3.84% and the S&P futures -3.22%. The small caps fared even worse as the Russell lost -6.45% and the MidCap shed -6.29%.

Money momentum again continued to help hard asset backed investments such as precious metals on safe haven buying. The Silver again attracted heavy support with gains of +7.72% with Gold adding +2.78%. The industrial metals were another story as worries of a slowdown in the world economies left them ailing. Palladium led the way down losing -4.92%, Copper lost-3.32% and Platinum finished -3.07%.  

The Energy sector also found some support on safe haven buying along with ideas that the recent gulf coast refineries shutdown might take longer to come online than previously thought. Crude futures gained +3.98%, Heating Oil added +3.42% and RBOB Gas were up +2.81%. Natural Gas fell -2.91% hampered by heavy supply which was later confirmed by the weekly production and storage data released late week.     

The U.S. Dollar index -1.26% continued to find pressure from the financial turmoil in the U.S. investment banking sector as foreign investment remained intent to head back to European based currencies. For the week Swiss Franc added +1.48%, Euro was up +1.22% and the British Pound posted slight gains.             

The Grain and Soft sectors were mixed again last week, although the tone seemed to improve in some sectors on ideas an approval by the U.S. Congress on a financial bail-out plan might spark inflationary buying. Soybeans gained 2.02% with the rest of the sector ending just better than steady. The livestock sector was mixed as Lean Hogs +2.14% were supported by strong end user support and Live Cattle were steady despite light weakness in the cash market from heavy production. The soft markets posted mixed results with Sugar +5.91%, Cocoa +1.94%. The Cotton lost -3.53% with the balance of the market ending near steady levels.        

***CTAs***

We know many of you may be curious, nervous, or both about how many managers performed today, and we've taken a quick look around at the various managers and what activity we could see of them today, to get a very rough estimate of how they fared today and/or how they are faring for the month after today.

First, the good news. Many multi-market, discretionary managers were either unaffected by today’s wild activity, or profited from it.  The APA Modified program was able to add nearly 15% today alone to bring its monthly performance close to 25%, while its older brother – the APA Strategic Diversification program was also able to profit from the day’s activity with gains of close to 4%, bringing it near 10% gains for September with one day of the month to go.

Elsewhere, the Rosetta program tacked on about 5% today, while Clarke Capital and the NDX programs also enjoyed the day’s price moves, seeing moderate gains. Sitting on the sidelines and neither benefitting nor suffering from the day’s action (which really seems more like a win) were discretionary traders Dighton and DMH.

It was a much different story in the option selling space, as those managers are essentially betting against just the sort of event we saw (a large one day move). Here are some very rough estimates based on positions coming into the day - please note that if an advisor took action or placed additional trades,  they may not be reflected in these estimates, resulting in much higher or lower numbers. In alphabetical order: Ace Investment Strategist -20%, Ascendant -10%, Cervino Diversified Options was down less than 1%, Crescent Bay -6%, Crescent Bay BVP -4%, FCI -4%, LJM - 15%, Raithel -4%, Zenith -2%, Zephyr flat.

***Trading Systems***

Volatility crept back up to new recent highs last week with the VIX index approaching the 40.00 level again. Swing trading systems generally outperformed the day trading programs during the week, while long-term multi-market programs continue to shine as volatility, and therefore opportunity, appears to be filtering into nearly all market sectors.

Beginning with the swing trading programs, Tzar eRL and Tzar NQ both added some open trade equity to their current positions. Mesa Notes has been holding long and got some relief on the current long position after almost getting stopped out earlier in the week. Signum EBL too a little heat on its short position (two units) and will reverse its position to long if the Bund continues to trend higher. Signum TY is also holding short two units and roughly break-even on the current position.

Moving on to the day trading systems, Waugh eRL was the only profitable system +$766 for the week on three trades. BounceMOC eRL had one long trade on Friday that lost -$178.18. Rayo Plus and Compass SP both had losing trades on Tues and Thurs for weekly losses of -$1,419.41 and -$3,396.15 respectively.

In long-term trading, metals markets came roaring back as investors shifted funds from equities into the safe haven of precious metals. The gains in the gold market triggered short exits for many of the long term programs as well as some new long entries. Most other commodities have been heading south as the worry of a global recession has traders betting on a drop in demand for physical commodities.

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.