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The Importance of the “Roll Return” in Commodity Futures Returns

(October 22, 2006)

Dear Subscribers and Readers,

I hope every one of our subscribers is having a great October so far.  The weather is still in the mid 70s over here in “sunny California,” although we did get a lot of fog this morning (we are in the west LA area).  Speaking of weather, Accuweather is now predicting a colder-than-normal winter for the country this year (which is at odds with an official government forecast from NOAA), especially in the Northeast.  But just like I (and our illustrious poster, rffrydr) had mentioned in our discussion forum, I still don't expect any of this to cause a sufficient enough drawdown in our natural gas supplies to cause any price spikes during this upcoming winter.  My position on natural gas is still the same: The secular bull market in commodities is still in place – but I still will not touch natural gas on the long side until we see more evidence of hedge fund or pension fund capitulation in the commodity or energy markets.  This may occur tomorrow (although it is highly unlikely) or it may come in the spring – so for now, readers please stayed tuned.  I anticipate a very profitable play in natural gas at some point but now is not the time (on either the long or the short side).  Most likely, we will not see any sustained uptrend in any commodities or commodity shares until we see a clear sign that the Fed will be cutting rates.

Speaking of October, this has definitely been one of the most uncommon Octobers in stock market history – as both the “October low” and the “four-year election cycle low” came two to three months early (depending on which index you were tracking).  I hope that none of our subscribers was caught the wrong way.  It is one thing to be out of the markets and in cash and it is another thing to be short.  While it may not be totally true that we should always “be bullish on America,” I have always made it my point to only short the broad market (as opposed to individual stocks) if we have a confluence of all three of the following factors: 1) high absolute valuations, 2) high relative valuations compared to other financial assets such as bonds, REITs, and international securities, 3) a hawkish Fed in the midst of a rate hike cycle.  While a good case can be made for both 1) and 3) over the past 12 months, 2) is definitely way off the mark – as exemplified by the still-benign readings of the Barnes Index, the relatively low amount of equity holdings as a percentage of total households' net worth, and other readings I have mentioned in our commentaries over the last six months.  At this point in time, U.S. equities (with the exception of cyclical industries) still remain one of the most attractive classes in relation to bonds, commodities, real estate, and emerging market securities.

Let us now do some “laundry work” before getting to the gist of our commentary.  On the afternoon of September 7th, we entered a 50% long position in our DJIA Timing System at a print of 11,385 – which is now 617.37 points in the black.  On the morning of September 25th, we entered an additional 50% long position in our DJIA Timing System at a print of 11,505.  That position is now 497.37 points in the black.  Real-time “special alert” emails were sent to our subscribers informing them of these changes.  Subscribers can refer to our DJIA Timing System page on our website for a complete history of our DJIA Timing System signals.

As of Sunday afternoon on October 22nd, we are still fully (100%) long in our DJIA Timing System and is still long-term bullish on the U.S. domestic, “brand name” large caps – names such as Wal-Mart (which is now making a serious effort in the Chinese market by acquiring Taiwanese-owned Trust-Mart and naming a more aggressive new head of operations in China), Home Depot, Microsoft, eBay, Intel (which is not only regaining the performance advantage over AMD, but is actually extending it), GE, American Express, Sysco (“Sysco – A Beneficiary of Lower Inflation”), etc.  We are also very bullish on good-quality, growth stocks – as these stocks collectively have underperformed the market since 2000 and which, I believe, will benefit from a change of leadership going forward (leadership which will transfer from energy, metals, and emerging market stocks to U.S. domestic large caps and growth stocks, in general).  At this point, the breadth of the market is still strong.  The lack of any significant correction in the stock market so far is a sign of strength, and not “irrational exuberance.”  Moreover, the underperformance of a stock like Caterpillar at this point of the cycle is actually normal and expected – as Caterpillar is a very cyclical company and has been a great beneficiary of the emerging markets and commodity booms of the last few years.  Since we are now arguably experiencing a deflationary boom, the underperformance of a stock like CAT and overperformance of stocks such as WMT, SYS, MSFT, HD, AXP, EBAY, AMZN, etc., are to be expected.

Again, while it may be tempting to take quick short-term profits here, I urge our readers not to get “cute” and to try to time this market on a short-term basis.  I assure you – no trader on the face of this Earth can do this successfully on a consistent basis – not Jesse Livermore, not Bernard Baruch, not George Soros, Stanley Druckenmiller, and not even Steve Cohen of SAC Capital – who have actually just recently sworn off short-term trading (effectively forever) in his fund.

Let us now get on with our commentary.  One of our most active posters, rffrydr, actually discussed the concept of the “roll return” in commodities in a post earlier this evening – and I just thought it will be appropriate for us now to shed some light on the historical significance of the “roll return” when it comes to investing in fully collateralized commodity futures, such as the Goldman Sachs Commodity Index or to a lesser extent, the United States Oil Fund.  First of all, what is a “roll return?” 

“Roll Return” is the difference between the current spot (what you pay if you “consume” the commodity today) and the futures contract price.  It is also the return a futures contract holder would earn if the spot price stays constant until the expiration of the futures contract – in which case the price of the futures contract would gradually converge to the spot price.  Assuming the spot price is held constant, a futures contract holder will earn a positive roll return if the price of the futures contract is lower than the spot price (this behavior is termed “backwardization”).  Conversely, a futures contract holder will experience a negative roll return if the price of the futures contract is higher than the spot price and is converging to it over time (this is termed “contango”).  According to a recent research paper from Gorton & Rouwenhorst (2005), adopting a positive roll return strategy would have netted an investor an additional 4.87% annual return in their equally-weighted index of commodity futures, while a negative roll return strategy would have resulted in a negative 5.17% annual deviation from the annual return of their index from July 1959 to December 2004.  This is based on an equally-weighted index of 36 nearby commodity futures contracts, rebalanced once a month.  The positive roll return strategy involves holding the 18 futures contracts that exhibit the steepest  backwardization behavior while the negative roll return strategy involves holding the 18 futures contract that exhibit the steepest contango behavior.

Moreover, this additional return of adopting a “positive roll return” strategy of holding 18 futures contracts with the steepest backwardization behavior comes on top of the 11.18% annual geometric average return of Gorton & Rouwenhorst's index over the last 45 years – or an annual return that is about the same for U.S. equities (and a higher Sharpe Ratio to boot!).  Following is a chart straight from their 2005 paper showing the inflation-adjusted performance of their commodity futures index vs. stocks and bonds over the last 45 years:

Stocks, Bonds, and Commodity Futures Inflation Adjusted Performance 1959/7-2004/12

Moreover, diversifying into commodity futures position such as the GSCI Total Returns Index would have been especially attractive, given its lack of correlation (which actually turns into a negative correlation over a period longer than three months) with both stocks and bonds.  And more importantly, while returns of U.S. stocks have negative skewness – commodity futures returns have historically had positive skewness – meaning that while stocks tend to usually surprise on the downside, the opposite is true for commodities.  This is probably obvious for folks who lived through the two OPEC embargos during 1973 and 1979.  With the exception of the early 1980s and the late 1990s, investing in commodity futures would have been a no-brainer – both as an investment to capture returns and as an investment for diversification purposes.  As always, however, the $64 million question is: Will this period of outperformance apply going forward?  Just like the early phases of the 1995 to 1998 Yen carry trade, this was as close to a free lunch in the financial markets as you can get.

Unfortunately, most commodity futures contracts are no longer exhibiting backwardization behavior.  In fact, as pointed out by the Economist article, “… the roll yield has now turned negative, so that investors in futures contracts are losing. In the year to date the roll yield has been minus 13.35%, and the annualised yield on the next two months' contracts is minus 38.4%.”  This is apparently to anyone that is trading crude oil futures, as shown in the following chart showing the contract price per barrel for selected futures contracts from November 2006 to December 2009 vs. open interest.  Note that the futures prices for crude oil are in contango until December 2009!

NYMEX Crude Oil Futures vs. Open Interest as of October 11, 2006 - Crude Oil futures prices effectively in contango until December 2009!

Today, there are is virtually no single commodity that is exhibiting backwardization behavior – except for possibly the frozen orange juice market – and we are only seeing this mainly because there are temporary shortages in Florida oranges.  As noted by William Bernstein (the author of ‘The Birth of Plenty” – not to be confused with Peter Bernstein) in his latest September remarks to the Gorton & Rouwenhorst paper:

How can you not own these things [commodities]? Easy. The planet described by Gorton and Rouwenhorst is not the one you and I live on. Let's fast forward forty-six years to the NYMEX crude pit in lower Manhattan today. It's a few minutes before 2 P.M. and what you see boggles the senses: a pullulating mass of huge guys elbowing each other and howling at the tops of their lungs in fits of greed. What you don't see is big offers coming from independent traders or even from brokers for the major oil companies. Now the largest offers are coming, ultimately, from folks with names like PIMCO and Goldman Sachs. And their clients are hardly scared stiff of deflation. Quite the opposite in fact—these big commodities funds and hedge funds are looking for insurance against inflation. How else does one explain $75 oil and a supply chain brimming with the stuff?

In a market whose major propelling force is the demand for insurance against inflation, those who supply it will demand a premium. Goodbye Keynesian normal backwardation, hello . . . . forwardation? (Your vocabulary word this day is "contango," which is not a dance performed in Buenos Aires, but rather the proper term for a condition where futures trade above, not below, the expected spot price.) And I wouldn't bet on the rebalancing bonus either; as my kids would say, "That's so 2005"; nothing makes a premium disappear faster than tout le monde chasing after it.

There's not a breath of this in the Gorton/Rouwenhorst working paper, but between this version and the article that finally appeared in the March-April Financial Analysts Journal, someone definitely got to them:

The Keynesian theory of normal backwardation . . . may fit the context of undiversified farmers during the 1930s, but it has less appeal in the context of modern multinational companies operating in global capital markets . . .

In other words, the next time someone tries to sell you a commodities fund based on the Goldman Sachs Commodities Index, smile and say, "Sorry, but I'm from Earth and you're from planet I Love Lucy. Let's revisit this discussion in an alternate universe."

In short, the character of the commodity markets has changed – especially given the entry of global investment banks, hedge funds, and pension funds.  Moreover, in the short to intermediate term, our MEM indicator is showing that speculators are still overstretched and overleveraged given the dismal growth of the St. Louis Adjusted Monetary Base and the hawkishness of not only the Fed, but the European Central Bank as well.

Okay Henry, just what is your MEM indicator?  Readers can refresh their memories on our MEM indicator by reading our October 23, 2005 commentary, but basically, here is the gist of it: Our MEM indicator is calculated by taking the difference of the 52-week growth rate of the St. Louis Adjusted Monetary Base and the 52-week growth rate of M-3 (both indicators smoothed using their ten-week moving averages).  The rationale for using this is two-fold:

  1. The St. Louis Adjusted Monetary Base (currency plus bank reserves) is the only monetary aggregate that is directly controlled by the Federal Reserve.  One can see whether the Fed intends to tighten or loosen monetary growth by directly observing the change in the adjusted monetary base.  By knowing what the Fed intends to do, we will know whether investors and speculators are "fighting the Fed" so to speak, and generally, fighting the Fed usually ends in tears more often than not.

  2. The St. Louis Adjusted Monetary Base inherently has very little turnover (i.e. low velocity).  On the contrary, the components of M-3 (outside of M-1) has higher turnover and is more risk-seeking.  If M-3 is growing at a faster rate than the adjusted monetary base, than it is very logical to assume that velocity of money is increasing.  Readers should note from their macro 101 class that the Federal Reserve has no direct control on M-3.  Instead, M-3 is directly affected by the ability and willingness of commercials banks to lend and by the willingness of the general population to take on risks or to speculate.

Since the Fed has just stopped publishing M-3 statistics, this author has now revised our MEM indicator accordingly.    Instead of using M-3, we are now choosing to use a monetary indicator that most closely resembles the usefulness of M-3 – that is, a measurement which tries to capture the monetary indicators which inherently have the highest turnover/velocity in our economy.  We went back and found one measurement which is very close – that of M-2 outside of M-1 plus Institutional Money Funds (the latter is a component of M-3 outside of M-2 which the Fed is still publishing on a weekly basis).  That is, we have replaced M-3 with M-2 outside of M-1 plus Institutional Money Funds in our new MEM indicator.  Following is a new weekly chart showing our new MEM indicator vs. the St. Louis Adjusted Monetary Base vs.  M-2 minus M-1 plus Institutional Money Funds from April 1985 to the present:

The MarketThoughts Excess M Indicator vs. Monetary Base. vs. M-2 outside of M-1 plus Institutional Money Funds (April 1985 to Present) - 1) Markets did well during 1995 to 1998 - despite a decline in the monetary base and immense speculation - primarily because of the Yen carry trade! But now, the BoJ is tightening as well... 2) Speculators continue to be aggressive in recent months despite the slowdown of the U.S. economy. Especially when it comes to *negative carry* speculations such as commodities or high yield corporate and emerging market debt, subscribers should continue to tread carefully here. Despite this, however, this indicator of speculation in the markets continues to be substantially more muted than where it was in early 2001.d

As can be seen in the above chart, our MEM indicator is still significantly in negative territory – meaning that the Fed has continued to more or less tighten (lack of growth in the St. Louis adjusted monetary base) even as speculators and investors alike continue to take on risks (increasing pseudo M-3).  That is, the Fed has not been loose at all – and in fact is now as hawkish as they were during early 2001.   Most of the recent monetary growth has come from commercial banks and the private financial sector – meaning that investors have again been “fighting against the Fed.”

In a liquidity-constrained environment – the most dangerous investments are “negative carry” assets – assets such as money-losing real estate or investments that don't give you any dividends or interest – such as gold.  Another class of dangerous investments is foreign currencies that have a lower yield than the U.S. dollar – such as the Canadian dollar, the Euro, and possibly the Japanese Yen (the only thing going for the Yen is that it is very undervalued on a purchasing power parity basis).  However – by far the most dangerous “investment” in a liquidity-constrained environment – are overvalued physical assets which not only don't provide the investor with any interest income, but which actually have a “negative roll return” – such that one is paying someone else to be holding the asset.  Today, many commodities are in such an environment – such as gold, crude oil, silver, copper, and even corn.  The fact that speculators are still fighting the Fed suggests that there is still more downside to come for commodity prices in general.  Again, I would not consider going long commodities here until we see more evidence that the Fed will start cutting the Fed Funds rate in the near future.

Getting back to the stock market, the most recent NYSE short interest data was just released.  Following is a monthly chart showing the NYSE short interest vs. the Dow Industrials from November 15, 2000 to October 13, 2006:

NYSE Short Interest vs. Dow Jones Industrials (November 15, 2000 to October 13, 2006) - For the month ending October 13, 2006, total short interest on the NYSE increased approximately 9 million shares to 9.75 billion shares - the fifth consecutive month that it has made a new all-time high and only 250 million shares short of a 10 billion share short interest. The 12-month rate of increase of 12.7% declined slightly from last month, but is still close to the greatest rate of increase since May 15, 2005 - suggesting that we should be seeing higher prices in the stock market going forward.

As mentioned on the above chart, the NYSE short interest increased approximately nine million shares to 9.75 billion shares for the month – the fifth consecutive month that it has made a new all-time high and only 250 million shares short of a 10 billion share short interest.  Given that the major market indices are still in solid up trends – this is a bullish development, as in a typical bull market, the short interest represents a source of “fuel” for a continuing uptrend.  Again, from last week's commentary, let me remind you (and myself) of one thing that I have said many times in our commentaries: Tops are inherently hard to call.  And by definition there can only be one top – and chances are that you are not going to be able to call it.  We are going to have to see much more investor optimism and divergences before I am even willing to hint of a top.  Again, while the U.S. market is short-term overbought and can correct any time, I would continue to hold the stocks that you fundamentally like as the intermediate trend definitely remains up for now.

Let us now discuss the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from October 1, 2003 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (October 1, 2003 to October 20, 2006) - For the week ending October 20, 2006, the Dow Industrials rose 42 points while the Dow Transports rose 48 points - marking the fourth consecutive week where both of the Dow indices have risen at the same time. More importantly, the Dow Transports again hit a multi-week high - as it hit a high of 4,728.007 last Monday and closing at 4,706.31 on Friday - the highest close since July 12, 2006. While the two popular indices are now ST overbought, readers who are long should continue to hold on for now - and not try to be *cute* in timing any subsequent corrections - even though they are probably inevitable over the next couple of weeks.

For the week ending October 20, 2006, the Dow Industrials rose 42 points while the Dow Transports rose 48 points – marking the fourth consecutive week where both of the Dow indices have risen at the same time.  While the Dow Industrials rose yet further above its prior all-time high made on January 14, 2000, the action in the Dow Transports continues to be very encouraging as well – as its high of 4,728.00 last Monday represented the highest close since July 12, 2006.  For the bears who had been pointing out to the weakness in the Dow Transports as “evidence” that this rally was not sustainable, the most recent strength of the Dow Transports is thus a red flag (and thus encouraging for the bulls).  However, more importantly, the Dow Jones Utility Index actually made a new all-time high last Friday, and since the Dow Utilities has tend to be a leading indicator (anywhere from three to 12 months) of most typical post World War II bull markets – this is another red flag for the bears.  Given the bullish signals in both the Dow Transports and the Dow Utilities, we remain 100% long in our DJIA Timing System.  The only exception is if the Dow Industrials rises to 12,500 over the next few days – in which case we will probably shift back to a 50% long position.  Readers please stay tuned.

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The latest four-week moving average of these sentiment indicators bounced from an extremely oversold level of 1.7% in late June to 24.0% for the week ending October 20, 2006.  Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending October 20, 2006, the four-week MA of the combined Bulls-Bears% Differentials rose from 22.1% to 24.0%. Given that the four-week MA has is still on an upward trend and given that it is not too overbought yet, readers may now want to look for higher prices here - but this indicator is now getting overbought and readers should be very careful about initiating new positions here.

With the exception of the week ending September 29, 2006, the four-week MA of this indicator has been rising relentlessly since early August – and is now very close to overbought territory.  Readers who have been looking to initiate new long positions in the stock market should probably wait until after this indicator or the stock market has experienced a correction in the upcoming weeks.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator for the stock market, and it has had a great track record so far according to the following Wall Street Journal article.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from October 28, 2002 to the present:

ISEE Sentiment vs. S&P 500 (October 28, 2002 to Present) - The 20 DMA hit its lowest reading since late October 2002 on September 15 and has since reversed and has even risen above the 50 DMA - suggesting that the market has bottomed and that the trend continues to be up.

As one can see from the above chart, the 20-day moving average of the ISE Sentiment reversed back to the upside a few weeks ago (from 101.5 to 108.2) and has risen further to 123.9 in the latest week.  Meanwhile the 50-day moving average also reversed on the upside from an extremely oversold level of 109.1 a couple of weeks ago to the current reading of 113.5.  The fact that the shorter-term moving average has reversed back to the upside and has now crossed above the 50-day MA suggests that the market has already bottomed and that the intermediate uptrend remains intact for now.

Conclusion: Even though the stock market is now overbought on a short-term basis and is subjected to a correction at any time, there is no doubt that the intermediate trend remains up for now.  As I have said over the last few months, investors should now overweight U.S. domestic large caps and growth stocks – as opposed to cyclical stocks and anything that has to do with commodities.  Again, we remain 100% long in our DJIA Timing System and has no intention of shifting to a less bullish stance anytime soon (unless we quickly hit DJIA 12,500 in the next five to ten trading days).

As for commodities, readers should definitely go back and read the Gorton & Rouwenhorst paper on collateralized commodity futures (which basically means an unleveraged position in commodity futures) – as well as the importance of the “roll return” when investing in commodities over the last 45 years.  Given that virtually all U.S. exchanged-traded commodity markets are no longer exhibiting backwardization behavior (that is really an understatement since the average annualized roll yield fro commodities this year is negative 13.35%!), investing in commodity futures (or a collateralized commodity futures index like the GSCI) today is most probably a sucker's game.

Signing off,

Henry To, CFA

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