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The Global Recession/Recovery Trade
May 11, 2009
We’ve commented quite a bit over the last several months how stock and commodity markets have been uncharacteristically linked over the past 6+ months, essentially becoming one “market” which rises when traders believe we’re headed for a recovery in world economies, and falls when it seems there’s more global recession ahead.
Stocks and commodities are supposed to move independently of each other, because they are valued on entirely different premises. Commodities provide economic value through being consumed (Sugar in your coffee) or transformed (Crude Oil into Energy), while the value of stocks and bonds lies in the value of their future cash flows. They are truly two different animals, and investments in commodities do give exposure to a truly alternative asset class. In contrast, hedge funds are not a true alternative asset class as they often trade the very stocks and bonds you’re attempting to diversify away from.
Because commodity markets move in reaction to global supply and demand, not the future cash flow of corporations, they are not supposed to be at risk from stock price declines, liquidity issues, and credit problems which until now, nobody understood closely tie together hedge funds, stock, bond, and real estate investors.
But the past 7 months have thrown this concept of commodities having little to no correlation with the stock market on its head. That simply hasn’t been the case since the financial crisis began.
Consider that the average of the 30 day correlations between the Reuters/Jeffries CRB commodity index and S&P 500 stock index has been just .056 over the past 10 years; but has jumped nearly 8-fold to an average of .500 over the past 8 months. And that the three highest 30-day correlation readings between the CRB and S&P 500 in the past 10 years have all come in the past 6 months (November, February, and April).
[The Reuters/Jeffries CRB is a weighted commodity index which is somewhat skewed towards petroleum products, but includes everything from Heating Oil to Orange Juice. View the following link for more on the CRB index: http://www.jefferies.com/pdfs/RJCRB_Index_Materials.pdf]
And this isn’t just the overall commodity index or the energy commodities we’re talking about. Wheat, for example, has seen its 3 highest ever 30 day correlation with the S&P 500 readings in the past 6 months as well. The same holds true across the major physical commodities, with Soybeans, Corn, Sugar, Cotton, Copper, Hogs, and Cattle all seeing at least one of their 3 highest EVER correlation readings with the S&P 500 during the past 6 months.
A table showing the monthly correlations (30 day correlations on the last day of the months listed) over the past 12 months is below. With the help of the color coding reading as a temperature gauge of sorts with green negatively correlated, yellow-orange non correlated, and red positively correlated – you can quickly see that we’ve really heated up recently, with all of the red and orange at the bottom of the table (the recent months)
As a refresher, correlation is a statistical figure with values which range between -1.00 and +1.00, meant to show how inter-related two sets of data (in this case daily % returns) are. If they have a correlation of 1.00, they are perfectly correlated, meaning when one market rises 1%, the other will do the exact same, and when one loses -1%, so will the other. If they are at -1.00, they are exactly opposite; with one making the exact opposite amount the other loses each day, and vice versa. The ideal situation is to have the correlation be 0.00, which tells us they act independently of one another.
With some of the highest correlations happening just last month (April), you can see that this isn’t just a case of the correlations rising in a falling market. Correlations usually do rise in a falling market (read our old newsletter covering that by clicking here). The massive sell off in global equities and subsequent dumping of hard assets (commodities) is just half the story; as the correlations have remained high as the stock market has rallied the past two months.
This is truly a case of traders bidding up (or selling) everything from tech stocks to Cocoa based on where they think the global economy is heading. It is one big bet on the economic health of the world, with commodity traders having to pay closer and closer attention to what their friends at the stock exchanges are doing each day.
But is this just a result of the financial crisis, and subsequent recovery (not sure we can say we’ve recovered yet)? Or is something more happening here? Could it be that the interconnections of the global economy have caused stocks and commodities to be ever more closely correlated? The table below shows that perhaps something bigger is going on.
The table shows the daily correlation between each of the listed markets and the S&P 500 index over the listed time frames (1mo, 3mo, 1yr, 5yrs, and 10yrs). You can see from the table getting more orange and red as it moves down that correlations are rising across the different time frames, with things getting more correlated as we get closer to the present.
So what could the ‘something bigger’ be? If the notion of a more interconnected global economy causing higher correlations seems farfetched, consider that there are whole stock markets which are viewed as commodity-linked markets: Canada, Australia, Russia, and Brazil. Or that the largest market capitalization in the S&P 500 (twice as high as the 2nd place company) belongs to Exxon Mobil – a company closely linked to commodities and specifically the price of oil. In fact, the commodity producing sectors of the S&P 500 (Energy and Materials) are over 16% of the stock index. So we should expect at least 16% of the index to be correlated to commodity prices. [Source: http://www2.standardandpoors.com/spf/pdf/index/SP_500_Factsheet.pdf]
All of this begs the question for those invested with managers utilizing commodity markets - what does it mean for your portfolio of managed futures investments?
Managed Futures remain non correlated with stocks (and now commodities too)
While managed futures, as represented by the Barclay’s CTA Index, have shown their non correlation to the stock market over the past 9+months first rising as stocks fell between Sep and Dec, and now unfortunately falling while stocks have rallied (past performance is not necessarily indicative of future results); the interesting thing is that managed futures have shown an almost negative correlation to commodities over this time.
Managed futures as an asset class, generally speaking, rode the move down in commodities, but have been late to reverse course in the beginning of 2009 (suffering as commodities have rallied). All of this means we’ve seen a pattern of managed futures making money when commodities fall, and losing money when they rise.
This is a somewhat rare occurrence for managed futures as an asset class, because it is rare for most CTAs to be long or short ALL commodities. A more normal portfolio would see a manager long a few grains, for example, while short a soft commodity like Sugar. With offsetting positions, gains are driven by the moves of the individual markets, not commodity prices as a whole.
But with all of the markets moving in the same direction (highly correlated) at the same time, some managed futures programs are seeing issues. For example, in normal times a program may be long Crude Oil and short Soybeans at the same time, with the expectation that over time the one may move higher while the other moves lower. Over the past six months, the likelihood of making money in opposite positions in two markets such as these has been greatly reduced.
Thus the risk to some managed futures programs is that market diversification may not be enough in times like these. If that is your program’s main source of protection from sharp moves lower (losses in one sector will be offset by gains in other sectors, etc.), the fact that all the different markets are now moving together turns what is supposed to be a small amount of risk on several markets into a large amount of risk on effectively one market (or one trade tied to the global economy).
Programs which are susceptible to this include any CTA which uses market diversification as their primary risk tool, and trade the same model/strategy across many markets in many different sectors. Classic systematic trend followers fall into this category.
We continue to believe that the programs which are better situated to handle this highly correlated environment include discretionary trading programs and programs which use multiple strategy types as a source of diversification.
Discretionary traders have not backed us up on this call so far this year, with programs such as Mesirow, DMH, and Dighton having gone through losing periods as the ‘normal’ market relationships discretionary traders look for aren’t present (for example, grain markets can be trading off stock market indicators, not fundamental factors such as weather and crop reports).
But the recent swine flu scare and subsequent move in the Hog market gave us hope that things are returning to normal. For a few weeks, the Hog market actually did its own thing, ignoring what the stock market was doing and expectations for the world economy – and instead focusing on a perceived lack of demand for Hogs.
Similarly, outside of commodities, a poor US Govt. bond auction similarly saw that market trade on its own accord, not in reaction to stock prices.
As we move further from the March 9th stock market low, we believe there will be more and more examples of markets trading on their own market internals. This will create new price moves, which managed futures advisors will look to capitalize on. We wouldn’t be at all surprised to see several of the shorter time frame CTAs and discretionary traders figuring out these new moves just as this recent bear market rally runs out of steam and stocks head back to their lows. Because while correlations between commodities and stocks are proving to be quite high – the fact that managed futures programs can and will go either long or short both commodities and stock indices, puts them in position to remain non correlated with both no matter what happens.
IMPORTANT RISK DISCLOSURE
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Recent investor confidence experienced during the past few weeks was again validated with the U.S. Treasury Dept.’s release of its bank stress test results. The report indicated most institution were sound, although a few will be required to raise capital to meet all specifications of the test. The marketplace had been waiting for the results of the test for weeks in rally mode and the results seem to give market participants a stronger sense of the government’s ability to guide the economy out of the worst financial crisis since the Great Depression.
The overall attitude seemed to take foot in commodities as most sectors posted strong rallies on ideas that the worst might be in the rearview mirror and strong consumer demand may come to the forefront, especially with the large injection of equity that has been put into economies not only in the U.S., but abroad. The earnings announcement season which is nearing the end included another smattering of better than expected figures. U.S. economic reports continued to be constructive and aided to the furthering of investor confidence during the past week.
News from Europe was a bit more robust with the EC lowering their key lending rate to 1.00% along with indicating they will purchase up to €60 billion in covered bonds. They also termed inflation as subdued and saw limited risk for further deflation in Europe.
The best performing sector for the week was the energy sector as positive economic developments and news that the surplus supplies seem to ebbing after the most recent weekly supply report sparked a large rally sector-wide. For the week Natural Gas futures +21.57% lead the way followed by RBOB Gasoline futures +12.40%, Crude Oil futures +10.32% and Heating Oil futures +9.68%.
The precious metals sector posted strong rallies across the board garnering their support from the anticipation of stronger economic times ahead after the bevy of better headlines emanating not only from the U.S. government, but worldwide. Palladium +12.82% led the sector rally followed by Silver +11.64%, Copper +10.44%, Platinum +5.62% and Gold +3.01%.
The grain complex found support from planting worries in the U.S. due to the wet spring in the Corn Belt and news that exports remain at a strong pace in the soy sector. The Livestock trade posted a nice rally mostly due to the market anticipating the end of the “swine flu discount” the price structure had built in since the news first hit 10-days ago. Soft commodity price activity remained firm with the main feature stemming from ideas that the price structure still remains undervalued at current levels based off of an expected decline in production. Weekly changes in the grains saw Wheat rally +3.68%, Soybeans +1.83% and Corn +1.79%. The soft sector activity saw Cocoa +7.87% leading the way followed by OJ +7.83%, Coffee +5.23%, Cotton +4.63% and Sugar +1.46%. Livestock activity saw Lean Hogs +4.01% and Live Cattle +1.06%.
The Stock Index sector experienced another week of firm undertones from the Treasury Department’s stress test results. NASDAQ futures -0.64% were the lone weak sector as there was a 6% drop in the semiconductor index due to patent squabbles between a couple of large entities. For the week the S&P 500 futures rallied +5.55% followed by Russell 2000 futures +4.63%, Mid-Cap 400 futures +4.61% and Dow futures +4.09%.
Currency futures were active, especially after the action and announcements by the EU Central Bank which sparked a strong rally in the Continentals and in turn casted heavy weakness in the Greenback. For the week the Euro +2.76% led the way followed by the Swiss Franc +2.70%, British Pound +2.09% and Japanese Yen +0.71%. The U.S. Dollar index declined -2.61%. Activity in the rate sector was on the soft side as poor participation during a long-term bond auction in the U.S. led to higher yields and lower futures. 30-Year Bond futures fell -1.60% followed by 10-Year notes-0.11%.
Multi-Market trend following managers have had a rough start to 2009 as choppy market conditions (lack of trends) have prevented most from making money. The good news is that early returns in May are much better as the commodity markets have started to decouple from stocks and begun trending again. Markets on the move include the energies, meats and grains, which have all started into early trend -type moves. Plus, Coffee and Sugar are also on the move as floods have hampered growing conditions in these markets. Let’s hope these market moves are a sign of things to come for the rest of 2009!
It’s still early in May but several managers have jumped out to the head of the pack in multi-market trading. Futures Truth has had a great start to the month as both of their programs are up over 4% so far. The Futures Truth MS4 program is the leader at approximately +5.05%, while the Futures Truth SAM 101 program is at an estimated +4.16%.
Other managers with impressive estimated gains thus far include Robinson-Langley at +4.52% est., Dighton +3.04% est., Attain Portfolio Advisors Modified Program +1.93% est., Hoffman Asset Management +1.53% est., Clarke Global Basic +1.48% est., Clark Global Magnum +1.04% est., Integrated Managed Futures Global Concentrated +0.70% est., and the Attain Portfolio Advisors Strategic Diversification Program also at +0.70% est.
Managers at or near breakeven for the month include DMH futures at +0.13% est., Mesirow Financial Commodities Absolute Return Program 0.00% est., and Mesirow Financial Commodities Low Volatility Program 0.00% est. Meanwhile, Lone Wolf Investments LLC Diversified Program is the only program in the red in May at approximately -2.42%.
Index traders have had a slow start to the month with Paskewitz Asset Management 3X Contrarian down an estimated -1.21%, while MSLO is down approximately -1.00%.
After several months in the black, several Option Trading Mangers are off to a slow start so far in May. In particular, managers who focus on the popular S&P 500 futures options are struggling to adjust to the continued upward momentum of the stock market – remember, premium collection traders prefer the markets they trade to remain in a range vs. to have large and extended moves. Current estimates for May are as follows: Ace Investment Strategists -1.28%, Cervino Diversified -1.97%, Cervino Diversified 2x -4.38%, Crescent Bay PSI +0.18%, Crescent Bay BVP -1.78%, FCI OSS -3.51%, FCI CPP -1.19%, Raithel Investments -0.07%, and Zenith Index is flat.
As the Agriculture and Grain markets continue to pick up their momentum this will be a section to monitor more closely – so far in May the action has been mixed with NDX Abednego and Shadrach pushing ahead an estimated +0.45% and 0.90% respectively and Rosetta Capital falling back approximately 1%. Stay tuned…
Trading systems chugged along last week with moderate success across both the day and swing time frames. Monday’s rally provided the best opportunity for trading systems with equity markets closing on their highs but trading activity was significantly slower for the remainder of the week.
Beginning with the day trading systems, Compass SP bounced back last week up $2,525 after struggling in recent weeks. Compass started the week on the right foot with a large winning trade tallying $2,825 but followed it up with a small loss of $300 on Wednesday. Rayo Plus Dax had three trades last week, one losing trade on Tuesday surrounded by winning trades on Monday and Thursday for a net result of +€595. Waugh eRL didn’t miss a day of trading last week with five trades totaling +$153.10 while BetaCon 4/1 ESX had three trades totaling +€150. Rounding out the other day trading systems, ATB TrendyBalance v2 Dax came out of hiding but suffered a loss of €470 on two trades.
Transitioning over to the swing systems, bonds were lucrative with Jaws US 400 and Jaws US 60 closing out trades for +$1,982.70 and +$1,641.85 after getting in line with the bearish trend in the 30-Year Bonds early in the week. Both AG Mechwarrior ES and Strategic ES finished the week positive up $380 and $540 respectively. Finally, Ultramini ES had two trades for a net loss of $147.50 for the week.
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.