Archive for February 11th, 2009
James Montier: Listen to those who don’t agree with you
Wednesday, February 11th, 2009
James Montier, Global Strategist with SocGen in London, is renown for his expertise in the field of behavioural finance. In fact, he has written the books, Behavioural Finance: A User’s Guide
Leaving the trees could have been our first mistake. Our minds are suited for solving problems related to our survival, rather than being optimized for investment decisions. We all make mistakes when we make decisions. The list below gives a top ten list for avoiding the most common investment mental pitfalls.
- You know less than you think you do.
- Be less certain in your views, aim for timid forecasts and bold choices.
- Don’t get hung up on one technique, tool, approach or view - flexibility and pragmatism are the order of the day.
- Listen to those who don’t agree with you.
- You didn’t know it all along, you just think you did.
- Forget relative valuation, forget market price, work out what the stock is worth (use reverse DCFs).
- Don’t take information at face value, think carefully about how it was presented to you.
- Don’t confuse good firms with good investments, or good earnings growth with good returns.
- Vivid, easy to recall events are less likely than you think they are, subtle causes are underestimated.
- Sell your losers and ride your winners.
Download the whole report here.
Tags: Dresdner Kleinwort Wasserstein, Earnings Growth, Face Value, Finance Series, First Mistake, Flexibility, Global Strategist, Investment Decisions, James Montier, Losers, Monkey, Pitfalls, Practitioners Guide, Pragmatism, Relative Valuation, Renown, Shelf Life, SocGen, Solving Problems, Subtle Causes, Timeless Piece, Top Ten List, Wiley Finance
Posted in Markets | No Comments »
Treasury’s Financial Stability Plan: Will It Work?
Wednesday, February 11th, 2009
By RGE Monitor
On February 10 Treasury Secretary Timothy Geithner presented the administration’s Financial Stability Plan to deal with the financial system’s toxic asset overhang and ease, if not reverse, the ongoing decline in bank lending to households and corporations. Out of the three broad options available - including nationalization, ‘good / bad bank’, backstop guarantee on ring-fenced toxic assets - the administration plan offers elements of all three.
The first program involves a mandatory ‘stress test’ for all banks with $100bn-plus assets which should also shed some clarity on the individual banks exposures and valuations of toxic assets. The Treasury’s Capital Assistance Program stands ready with preferred shares / warrants injections where needed, only this time with clear lending requirements and strict limits on dividends, stock repurchases and acquisitions next to a $500,000 compensation cap.
Any capital investments made by Treasury under the CAP will be placed in the Financial Stability Trust. However, it is still unclear what the options are for institutions that are severely undercapitalized or that fail to attract public capital on a recurring basis (see e.g. Bank of America, Citigroup after the 2nd bailout.) The program aims at ensuring full transparency disclosing all relevant information on capital recipients: www.FinancialStability.gov.
The second program, the Public-Private Investment Fund (PPP), aims at setting up a new lending/guarantee facility by leveraging an initial private capital commitment with government funds to an initial scale of up to $500 billion (can be expanded to max. $1 trillion.) The aim is to involve private capital on a large scale that sits currently on the sidelines while also allowing private market forces to determine the price for currently troubled and illiquid assets.
A similar experiment was tried before with the private sector sponsored M-LEC vehicle that ultimately proved unviable due to asymmetric toxic asset exposures of participating banks and due to still unresolved asset valuation issues. Commentators agree that for a similar plan to work this time, the government will have to assume a potentially substantial downside in order to induce otherwise unwilling investors to participate in view of the size of potential losses.
As we noted before, the size of the entire shadow banking system lacking liquidity is $10 trillion of which $6 trillion are assets held in the U.S. Not all of these assets will turn bad but at RGE we expect total losses on these shadow banking assets plus traditional loan losses to reach $3.6 trillion (of which $1.8 trillion borne by U.S. banks.)
One practical example is the Federal Reserve’s Maiden Lane portfolio of toxic Bear Stearns assets. If that performance is any guide, the upside left in these toxic assets might in reality be more limited than previously assumed. Cumberland Advisors reports that this particular portfolio has lost over 10% of its value, and losses are mounting. Indeed, the authors see ‘no prospect for a profit on this portfolio.
Renowned distressed debt experts such as Edward Altman and Martin Fridson note that the best time to invest in distressed debt is when default rates peak. Mind that high-yield default rates are set to rise to 15-20% sometime in 2010 from currently 4-5% due to very bad credit quality at the outset of the cycle.
The third program put forth by Secretary Geithner is an expanded version of the previously $200bn Federal Reserve Term Asset Backed Securities Loan Facility (TALF) program aimed at unclogging the markets for auto, student and other consumer loans. That initiative may expand to as much as $1 trillion, using $100 billion from the Treasury’s rescue funds, and include aid for commercial real estate markets.
Geithner points out that securitization created about 40% of the demand for new loans extended to consumers, students, and auto buyers. The decline of securitized lending to the tune of $1.2 trillion between 2006 and 2008 leaves a hole that needs to be filled if a severe lending contraction should be prevented.
Nouriel Roubini argues that, ultimately, nationalization may be a more market friendly solution of a banking crisis: it creates the biggest hit for common and preferred shareholders of clearly insolvent institutions and - possibly - even the unsecured creditors in case the bank insolvency is too large; it provides a fair upside to the tax-payer. Moreover, it bypasses the asset valuation issue as any overpayment goes back into taxpayers pockets. “With the government starting stress tests to figure out which institutions are so massively undercapitalized that they need to be taken over by the FDIC the administration is putting in place the steps for the eventual and necessary takeover of the insolvent banks.” This might well explain some of the negative market reaction.
The Treasury has stressed that while the ongoing price correction will stimulate home demand, there is a need to reduce foreclosures, which otherwise adding to the excess overhang of homes pose the risk of price over-correction, pushing more homeowners into negative equity. The Treasury plans to announce a Housing Program in the next few weeks to help refinance mortgages and contain foreclosures by reducing monthly payments for homeowners.
The program will be financed by using $50 billion from the remaining TARP funds. To increase lender participation, the plan makes it compulsory for banks using government funds under the Financial Stability Plan to participate in foreclosure mitigation. In order to stimulate home demand and help the current homeowners refinance, the Treasury and Fed will continue with their November 2008 plans to use $600 billion to buy MBSs and debt of the GSEs using and reduce mortgage rates to the 4-4.5% range. More importantly, the plan will increase flexibility to modify loans under the Hope Now and FHA Programs started in 2007-08 to help increase participation and foreclosure prevention.
Efforts to stimulate demand reducing mortgage rates and offering tax incentives will be largely ineffective as they are a small factor in determining home demand relative to factors such as tighter lending standards, changing dynamics for households - job and income loss, wealth erosion, rising savings rate, and low expectations of income or asset appreciation. These factors will constrain home demand in the short run while potential buyers await further price correction and banks don’t see the viability in offering a mortgage for a house whose value is expected to fall.
As a result, the government needs to focus on the supply side of the market by refinancing at-risk mortgages and preventing foreclosures that will only add to the existing overhang of houses. Moreover, government’s loan modification program should reduce mortgage principal rather than just reducing the mortgage rate or extending the loan maturity, which has been the case in past government programs. Unless the problem of insolvency among a large number of households is addressed, default on modified mortgages will continue.
Also, given the large number of homeowners with negative home equity, the program will need much larger funds - over $600 billion to $1 trillion though the actual cost might be much less, since the government will receive a share from future home appreciation. Monetary incentives for servicers are also low and ineffective.
Even the number of homeowners the program plans to target, 1.5-2 million is a very small fraction of the over 12 million homeowners with negative equity. In fact, several Democrats are pushing a legislation to allow bankruptcy judges to change mortgage terms that would allow lenders to reduce the mortgage principal for primary homes and bring down monthly payments. To increase participation, they support offering monetary incentives for servicers while lenders will be entitled to a share if the homeowner sells the house and also have the government share any losses on the modified mortgage.
As we have argued before at RGE Monitor, looking at the shortcomings of past government programs such as the Hope Now, Housing Retention and FDIC programs, the new program should be mandatory for lenders in order to increase participation. The government will also need to share the cost of modifying the loan, by matching the principal or the interest rate cut in a proportionate or less than proportionate amount. By guaranteeing the loans, the government will be the senior debt holder. The new interest rate should be based on the risk assessment of the borrower and all three parties - homeowner, lenders and servicers, and the government should share the cost of modification. However, determining the extent of principal reduction based on the true value of the house, and dealing with second lien mortgages and the diverging interests of mortgage servicers will be challenging.
Under the new guidelines for compensation issued by the Treasury, firms receiving federal aid will be subject to shareholder say on pay and will be required to cap executive compensation at $500,000 with any additional compensation given out in restricted stocks which can be cashed only after the government has been repaid or the bank has satisfied repayment obligations, and met lending and stability standards. Moreover, bonuses and compensation for other top executives will also be reduced. The Treasury requires disclosure of the compensation structure and strategy, and expenditure on luxury items.
While government intervention is warranted, the compensation reform does little to align risks with rewards. Large shares of the compensation can and will still be given out in restricted stocks including compensation for several traders and funds managers who are not under the lenses of the current plan. Government measures also give a green signal to those who have already received large compensation and severance packages at the troubled banks.
More importantly, the measures might act a disincentive in attracting credible executive talent to these troubled institutions in the future who can help deal with the bank losses and overhaul. Wall Street compensation is determined in a competitive market with CEOs joining a firm offering the most attractive pay packages and perks. Many banks are already reluctant to seek capital injection from the Treasury or are contemplating to payback past borrowings in order to avoid government scrutiny over their compensation packages.
To reduce excessive risk-taking in the short-run, compensation, bonuses and even severance packages should be based on the long-term performance of the employee relative to the risk undertaken with large part of the payments given out in restricted stocks that can be redeemed over a longer period of time.
Source: RGE Monitor, February 11, 2009.
Tags: Administration Plan, Backstop, Bailout, Bank Of America, Capital Assistance Program, Capital Commitment, Capital Investments, Financial Stability, Government Funds, Illiquid Assets, Nationalization, Overhang, Preferred Shares, Private Capital, Private Investment Fund, Private Market, Stress Test, Strict Limits, Timothy Geithner, Treasury Secretary
Posted in Credit Markets, Markets | No Comments »
Finally, the plan…sort of
Wednesday, February 11th, 2009
I am spending the next few days in Europe on a short business trip. First stop is Dublin where the temperature is icy, the mood is dour, property prices are plunging, the queues for jobless claims are five hours long, the soon-to-be-unemployed are holding protest strikes, and the banks are on the edge of a financial precipice. Yes, it may be a movie with different actors, but the plot is the same as in many other countries.
Meanwhile in the US, Treasury Secretary Timothy Geithner yesterday disappointed the markets with the lack of detail on the administration’s Financial Stability Plan. After all, he did say a few days ago (paraphrasing): ” We are not going to put out the details of our plan until we get it right.” (Please click here for RGE Monitor’s discussion on whether the plan will work.)
The US stock market indices plunged as investors gave a thumbs-down to the announcement, with the S&P 500 Index losing 4.9% and the Dow Jones Industrial Index 4.6%. All market sectors were in the red with Financials (-10.9%) leading the sell-off, with trading volume on the NYSE the highest since mid-December and advances beating declines by seven to one.
According to Lowry’s reports, Friday was a 90% up-day, only to be followed yesterday by a 90% down-day. “Panic on the upside, then panic on the downside - this is one dangerous market,” said venerable Richard Russell (Dow Theory Letters)..
Bill King (The King Report) commented as follows on the bank rescue package: “Geithner and Team Obama have been furiously polling private equity and Street titans to gauge their interest and participation thresholds in various bailout plans. Geithner’s lame plan implicitly indicates that few people wanted to participate in the leaked/proposed plans.
“Private investors know toxic paper remains incalculable with open-ended liability. The market understands that no bank bailout has been announced because there is no plan, barring an outright gift, that will fly with private investors. And an outright gift will infuriate taxpayers. Geithner asserted, ‘We will have to try things we’ve never tried before.’ You mean like telling the truth about the quantity and quality of toxic assets?”
Back to the stock market, key resistance and support levels for the major US indices are shown in the table below. All the indices are trading below the 50-day moving averages and the Industrials and Transport have also breached the December 1 lows. The critical November 20 lows are now within close reach and must hold in order to prevent considerable technical damage.
Where to now? As pointed out before, the primary trend is still bearish. The chart below shows the long-term trend of the S&P 500 Index (green line) together with a simple 12-month rate of change (ROC) indicator (red line) and the RSI oscillator (brown line). Although monthly indicators are of little help when it comes to market timing, they do come in handy for defining the primary trend. An ROC line below zero depicts bear trends as experienced in 1990, 1994, 2000 to 2003, and again since December 2007. Having said that, the levels of both the ROC and RSI are massively oversold.
At this juncture, short-term movements are almost impossible to predict, although 90% down-days are usually followed by two- to seven-day bounces. Seven out of the eight most recent 90% down-days were followed by rallies, according to Richard Russell. Having said that, my belief is that traders will simply have to wait for Mr Market to show his hand, especially as far as the November 20 lows are concerned.
And while we wait, I am trying to capture a leprechaun and find the “hidden treasure” on the Emerald Isle.
Tags: Bank Bailout, Bill King, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Index, Dow Theory Letters, Financial Stability, Jobless Claims, Market Sectors, Obama, Outright Gift, Precipice, Private Investors, RGE Monitor, Richard Russell Dow Theory, Short Business, Stock Market Indices, Thresholds, Us Stock Market, Us Treasury Secretary
Posted in Markets, US Stocks | No Comments »
Investing in Crude Oil via ETFs & ETNs
Wednesday, February 11th, 2009
This comprehensive overview on investing in oil using ETFs and ETNs was contributed by MarketFolly.com.
‘tradefast‘ is the nickname of an independent equity trader who has more than 20 years of market experience at a major financial institution and 2 hedge funds. He now trades for a private investment fund, using a combination of both fundamentals and technicals. (He’s our kinda guy).
Last week, he sat down to explain how contango affects the crude oil ETF’s and ETN’s that many investors and traders usually play, including USO, OIL, & DBO. This next piece is a follow-up post to that topic. So, before beginning, make sure you check out: How Contango Affects Crude Oil ETFs & ETNs.
Next, he takes a look at how to play crude oil using those same ETFs & ETNs. He writes,
Objective
This article provides some straightforward insight as to how a retail trader/investor can implement a directional play on the price of crude oil. Included is a discussion of the manner in which the forward market for crude oil can cause crude oil ETF returns to deviate from spot market returns. This article is not intended to be authoritative, comprehensive, or highly technical. It is simply a compilation of previous discussions on the topic (with some added elbow grease and my version of common sense). Readers should be aware that much of the material in this article has been discussed previously here and here. Certain elements of this article are pulled directly from these sources.
Note:
When I first wrote about the effects of forward curves on crude oil ETFs, the crude market was in steep contango and the discussion attracted widespread attention. More recently, the crude curve has flattened somewhat and it may appear to some individuals that the curve shape has become less of an issue to retail speculators. I have a different view. I believe that sharp volatility in the shape of the curve makes it imperative that retail crude speculators understand how curve adjustments can affect their positions. This topic is not dying, but rather garnering added importance.
Introduction - Retail Investors Cannot Trade Spot Crude Oil
I have a friend with fairly extensive stock trading experience who generates most of his technical market analysis using the S&P 500 futures contract. When it comes time to transact, however, he will swing over to the cash market and trade an ETF such as SPY (S&P 500) or a leveraged ETF such as SSO (2x the S&P 500) or SDS (2x the inverse of the S&P 500 - a double short). Although he and I share the same trading objectives (to capture a directional movement in the S&P 500), I choose to generate my technical analysis using the precise instrument which I expect to trade. In my case, SPY (or SSO or SDS if I desire leverage). I am confident in my approach because I know the instrument I am trading exhibits an extremely tight relationship to movement in the S&P 500 cash market. Simply put, I trade SPY because is a highly dependable proxy for replicating the spot market of the S&P 500.
Unfortunately, traders or investors wishing to implement a directional play on crude oil lack access to a tradeable instrument which tracks spot crude oil in the same manner that SPY tracks the S&P 500. Instead, we must choose from an array of instruments which are structured with the intent of tracking crude prices, but with flaws relating to the fact that crude oil (unlike the S&P 500) is a physical commodity for which spot trading is limited to those who can transport, store, or produce crude oil.
Crude Oil Futures - The Curve
Fortunately, despite our lack of access to the crude oil spot market, there is a highly liquid market for futures contracts which reference crude oil. And, the price of these contracts exhibits volatility which generally resembles the movements in the spot market. Many traders transact directly in crude oil futures contracts, electronically or in the futures pit. These traders rely on the fact that they will never have to physically handle the commodity itself. They can simply close out their futures positions prior to expiration and net out the difference between their entry and exit price.
The fact is that trading in crude oil futures (which expire monthly) is spread out over several months, even years. And, the price of crude for delivery at future expiration often varies substantially from month to month. At times, prices in future delivery months are progressively higher than in the nearest delivery month (contango). And, more often than not, the opposite is true (backwardation). Many futures traders have specialized knowledge of the day-to-day shifts in supply and demand fundamentals and they are comfortable projecting price movements at specific points along the forward curve. The typical retail investors probably lacks the skill-set needed to profitably exploit forward curves in a sophisticated manner.
Introducing Crude Oil ETFs/ETNs
For the retail crude oil speculator who is incapable of trading crude oil futures, there are tradeable ETFs (Exchange Traded Funds) and ETNs (Exchange Traded Notes) which employ futures contracts in pursuit of the general objective of “tracking the price of crude oil”. A typical crude oil ETF will hold long positions in WTI (West Texas Intermediate) crude oil futures contracts. As with most futures traders, these funds employ leverage, putting up a small portion of the capital to buy the contracts. The rest of the fund’s assets are invested in money market instruments which generate a modest amount of interest income for the fund.
ETFs - The Roll
In theory, the existence of crude oil ETFs enable individuals to implement a single equity trade to express a view that crude oil prices will either rise or fall in the future. Unfortunately, this objective is compromised by the existence of a forward curve in the crude oil futures market.
Because of the forward Curve, any ETF referencing crude oil cannot simply rely on ownership of the existing front month (closest to expiration) futures contract. To remain invested at all times, it must periodically sell its existing futures holdings and roll its exposure to a futures contract expiring in a more distant month.
ETFs - Return Components
With crude oil ETFs, the technical result of utilizing crude oil futures for the NAV (net asset value) return is dependent on three variables: 1) changes in the spot price of crude oil, 2) interest earned on un-invested cash, and 3) the ‘roll yield’ - which is a function of the spread between the price of the contract being sold and the price of the contract being entered. In contango markets, the roll yield will be negative because the fund must pay up to enter the more distant contract, and the opposite is true in backwardated markets. Furthermore, the precise timing of the forward roll can have a material impact due to the propensity of the expiring contract to experience high volatility in the days immediately prior to expiration.
Roll Yield - ETF Return Illustration
Let us consider the case of a hypothetical crude oil ETF which provides exposure to the front month crude oil futures contract, with the exposures rolled forward as expiration approaches.
To illustrate the concept of the roll yield, assume that the 2009 spot return on crude oil is +20%. But, assume that persistent contango in the market results in a cumulative roll yield of -15 %. In these circumstances, the combined return of a crude oil based ETF might be in the ballpark of +5%, a far cry from the +20% return generated in the crude oil spot market.
As illustrated, contango in the crude oil market may cause ETF returns to lag spot market returns. Not surprisingly, a flat/stable forward curve would result in a minimal roll effect. On the other hand, a backwardated curve may cause the ETF to outperform the spot market.
Roll Yields - A Source of Tracking Error
The variability of roll yields coupled with the shifting slope of the forward curve should dispel any notion that the return on crude oil ETFs will track the spot market of crude oil in a predictable manner. The managers of the crude oil ETFs and ETNs are fully aware of this issue and they make no claims regarding their ability to replicate spot crude returns. They merely claim to attempt to track a return benchmark that is comprised of crude oil futures contracts, thereby providing traders/investors with some ability to participate in directional movements in the price of crude oil. (Note: This situation is analogous to an issue which exists with certain leveraged (non-oil) ETFs which have proven to be extremely deficient in terms of tracking their benchmark indices in volatile markets. These instruments have strictly adhered to their stated strategies and objectives, but have failed to achieve the imaginary objectives of many careless traders.)
ETFs/ETNs - Examining the Fine Print
Included below is some language directly out of the prospectuses of some of the more popular crude oil ETFs and ETNs. Notice that the managers willingly acknowledge the issues related to forward curvature and the roll yield impacts on returns. This segment of analysis will focus on the three most popular crude oil instruments in existence today: an ETN (OIL) and two ETFs (USO & DBO). Many of the issues raised herein are applicable to all crude oil ETFs and ETNs, although leveraged ETNs (such as DXO) involve complications which are not analyzed here.
ETF versus ETN - Counterparty Risk
No discussion of crude oil ETFs would be complete without some mention of the important difference between an ETF (Exchange Traded Fund) and an ETN (Exchange Traded Note). With an ETF, holders are secured by the assets of the fund, so the credit worthiness of the fund manager firm is not a relevant consideration. If the manager collapsed into insolvency, the ETF would be unaffected, except for the possibility of a change in management (which is not an important consideration in the case of a fund which is passively managed to match a specific benchmark). In contrast, owners of an ETN are unsecured creditors who receive a mere ‘promise to pay’ equivalent to the value of the underlying assets. Let’s simplify this distinction: If a given ETF and a given ETN have the same exact net asset value (NAV), it is conceivable that the ETN could be worth less than the ETF if the manager of the ETN asset pool experienced a level of financial distress which resulted in a material downgrade of the credit quality of the manager’s bonds. Given that most ETN managers are financial institutions with challenging balance sheets, this risk is worthy of consideration.
In a worst case scenario, the ETN manager could face an abrupt insolvency and default on the ETN. This risk, often referred to as counter party risk, is similar to the risk that credit default swap (CDS) holders faced when Lehman Brothers and AIG encountered insolvency. We, as rational individuals, do not buy insurance from high risk insurers. And, as such, we should think similarly about owning ETNs issued by high risk managers.
US Oil Fund (USO)
USO is a standard crude oil tracking ETF that utilizes a strategy resembling the hypothetical ETF analyzed earlier in this article. Accordingly, USO entails all of the risk factors related to the use of crude oil futures as a tracking mechanism for crude oil prices. As with all ETFs, the objectives, the portfolio structure, and the major risk factors are clearly disclosed in the prospectus.
From the ‘risk factors’ section of the USO prospectus,
“in the event of a crude oil futures market where near month contracts trade at a lower price than next month contracts, a situation described as ‘‘contango” in the futures market, then absent the impact of the overall movement in crude oil prices the value of the benchmark contract would tend to decline as it approaches expiration. As a result the total return of the Benchmark Oil Futures Contract would tend to track lower. When compared to total return of other price indices, such as the spot price of crude oil, the impact of backwardation and contango may lead the total return of USOF’s NAV to vary significantly. In the event of a prolonged period of contango, and absent the impact of rising or falling oil prices, this could have a significant negative impact on USOF’s NAV and total return.”
Notice how they warn that USO may experience a negative roll yield which may cause the NAV of USO to deviate significantly from the spot price of crude oil. Is there historical precedence for USO deviating from spot oil by a material amount? As it turns out, the answer is ‘yes.’
“During the past two years, including 2006, these markets have experienced contango. This has impacted the total return on an investment in USOF units during the past year relative to a hypothetical direct investment in crude oil. For example an investment made in USOF units on April 10 and held to December 31, 2006 decreased, based upon the changes in the closing market prices for USOF units on those days, by 23.03%, while the spot price of crude oil for immediate delivery during the same period decreased 11.18%.”
The only logical conclusion is that USO is not a direct play on the spot price of crude oil. It is, instead, a play on the spot price, forward prices, and the relationship between spot and forward (or, the slope of the futures curve).
Power Shares DB Oil Fund (DBO)
DBO is different from USO in that its managers utilize specialized strategies intended to mitigate the effect of roll yields on returns. As with USO, the prospectus for DBO directly addresses the issue of roll risk. In the case of DBO, however, the manager is not passive about accepting a negative roll yield in a contango market. In the words of the manager,
“Rather than select a new futures contract based on a predetermined schedule (e.g., monthly), each Index Commodity rolls to the futures contract which generates the best possible ‘implied roll yield.’… [The manager] is able to potentially maximize the roll benefits in backwardated markets and minimize the losses from rolling in contangoed markets.”
I think it is fair to point out that the active approach being utilized by DBO presents both opportunities and risks in relation to the more passive rule-based approach used by USO. It is certainly conceivable that, by employing their optimization model, DBO will exhibit improved roll yields and better returns than USO. But, as with all things financial, the DBO model may backfire due to faultiness of imbedded assumptions. If DBO’s approach were full-proof, it is probably fair to conclude that an arbitrage opportunity might exist whereby profits could be generated by pairing a long position in DBO with a short position in USO. At this juncture, I am extremely hesitant to advocate such a strategy. Advanced readers wishing to gain a better understanding of DBO’s optimization approach may benefit from this link.
iPath S&P GSCI Crude Total Return ETN (OIL)
OIL is structured as an ETN issued as an uncollateralized obligation by Barclays Bank PLC. It is a financial institution that can be regarded as vulnerable to rising default risk in the current environment. As with USO and DBO, OIL is managed with the objective of tracking WTI crude oil prices by trading in crude oil futures (rather than the physical commodity).
OIL uses a specific benchmark to guide its futures trading activity: a crude oil index devised by Goldman Sachs. As with most index funds, OIL’s objective is to minimize the performance tracking error in relation to the index. OIL is not intended to perform better or worse than the index. The composition of the index, by design, can include any of the crude oil futures contracts which expire within three months. At present, however, the only contract used to calculate the index is the front month contract (which expires three business days prior to the 25th of the next calendar month).
OIL’s roll strategy is formulated and it is unique from that of DBO and USO. But, the differences in relation to USO probably do not have a material economic effect. In particular, holdings of the front month futures contract are rolled over a five day period commencing on the fifth business day of the month. Essentially, this means that OIL will have completed its roll approximately two weeks before front month expiration. (Note: USO rolls two weeks prior to expiration).
In essence, OIL is more similar to USO because the roll strategy is formulaic, and not intended to minimize the effects of negative carry in a contango futures market (or maximize the benefits of backwardation). But, this similarity is also offset by the fact that OIL carries material counterparty risk since it is an ETN, while USO and DBO do not (since they are ETFs).
USO Versus DBO Versus OIL - Expenses and Liquidity
The volatility of these instruments is so high that expenses have a relatively minimal impact. But, for frugal and/or longer term investors, the following information may be relevant:
Annualized expense ratios:
•USO 0.86%
•DBO 0.54%
•OIL 0.75%
Empirical Data - Historical Price Returns
It is unwise to draw any specific conclusions from this information, but a quick examination of the recent market returns of USO, DBO, and OIL reveal the following facts:
Year-to-date price returns (thru 1/24/09):
•USO -2.9%
•DBO +1.1%
•OIL - 7.9%
Although inconclusive, the material disparity between the return of USO and OIL is potentially due to the fact that OIL is an ETN issued by Barclays - a Bank that has suffered from extensive credit quality impairment in recent days.
Returns, 2008 peak to current:
•USO -72%
•DBO -65%
•OIL -75%
Further assessment of the relative returns of these instruments can be found here.
Conclusion
Considering the following factors:
1.Counterparty risk
2.Futures roll strategy (and roll yield)
3.Liquidity and expenses
USO has no counterparty risk and no active management risk. DBO has no counterparty risk but has inherent risks and opportunity related to the active management of the roll. Lastly, OIL has material counterparty risk. I currently favor USO as the instrument to express my directional views on crude oil over the other two instruments DBO and OIL.
Thanks to ‘tradefast’ for the excellent in-depth overview of crude oil ETFs & ETNs. We think he has highlighted some excellent points that any trader or investor should know before using these vehicles to speculate on crude oil. If you haven’t already, make sure you check out: How Contango Affects Crude Oil ETFs & ETNs. For additional coverage on crude oil, check out the recent slide presentation: Cheap Oil = Over. Also, we’ve commented on cheap oil, and have covered energy trader Eric Bolling’s latest oil trades and thoughts here.Lastly, you can follow tradefast on Twitter, and catch his thoughts on his blog.
The above article was a contribution from MarketFolly.com.
Tags: Common Sense, Compilation, contango, Curve, Dbo, Elbow Grease, Equity Trader, ETF, ETFs, Etn, Forward Curves, Forward Market, Hedge Funds, Investing In Oil, Major Financial Institution, Market Experience, oil, Oil Etf, Price Of Crude Oil, Private Investment Fund, Speculators, Trader Investor, Volatility
Posted in Bonds, Credit Markets, Gold, Markets, Oil and Gas | No Comments »
Donald Coxe: Have Commodities Started to Outperform?
Wednesday, February 11th, 2009
Although we have anxiously awaited a new issue of Basic Points from Donald Coxe, since he announced his departure from BMO in December, he has continued to make himself available via conference calls. Among other things, Mr. Coxe did mention that there would be an issue this month. Here, however, is the full transcript of the February 6, 2009 conference call, that we have produced for your review:
Donald Coxe, February 6, 2009, 10:00 a.m. - Conference Call Transcript
The chart we sent out is the relative strength of the Reuters Jefferies CRB Index to the SP500.
The tagline was, “Have commodities started to outperform?”
There’s a lot in this chart and I want to take you through the story, where we’ve got just horrendous economic news. We’ve gone from the bad, to the terrible, to the scary, to the absolutely horrendous with both Canada and the US, announcing the worst job, losses either on record, or back to the middle of the 70s. And yet, we’ve got the stock market up, the TED spread narrowing, the VIX narrowing, and the BKX is strongly outperforming the S&P today.
So we’ve got very mixed numbers. if you’re looking at it from an economist’s standpoint, the world is just spiralling downward to disaster. But the commodity story is gradually changing, and remember as you can see from the chart, the relative strength off the CRB futures to the S&P was a terrific forecaster of what economic news was coming.
Commodities collapsed really before we had the collapse in the S&P, and one very brief spike, and then going down to a new low which was reached at the beginning of December. We’ve been just gradually working a little bit higher. Now you may say, well this is really struggling to find something good out there but theres much more than just this.
As you know, I’ve always put great strength on looking at Investors Business Daily Reports on their 197 stock groups that are traded in the US market. Now Remember, these aren’t just US stocks, these are stocks that trade on US stock exchanges, and over the years, I have found this to be one the most helpful tools in getting an idea of the way in which the market is dealing with its views of the future, as opposed to the economic numbers which basically reflect what is happening right now. When there’s a divergence between the two, quite often it turns out that the performance of the equity groups in the IBD was a better forecaster than any of the economic forecasts that were out there.
Now this isn’t a one hundred percenter, but its a very good indication and over the last few weeks, ie. since this new year began, there’s been a huge change in the makeup of the IBD list of 197 groups. As we look at it this morning, I recommend that you all use this: page B2 of the IBD, andif we look at it this morning, this is the relative ranks over the last 6 months, so therefore you don’t get an instant change. This is not an extremely short-term index; this shows you that over the last 6 months which stock groups have done best, and what’s really crucial is to see how they’ve changed their ranking because they show them, right now, three weeks ago, 6 weeks ago, and then way back; and what we see here is the number 1 ranked group in the whole group is metal ores, gold and silver, and they’ve got several stories in today’s IBD about various gold mining stocks and how well they’re doing.
That’s the number one group. Now, in the top twenty, and they always have a box around the top twenty group, we’ve had a big, big change in the last few weeks. We now have a total of 5 groups, which are commodity related which are ranked in the top twenty for performance over the last 6 months. #13; I’ve just come back from speaking to big group of grocery and wholesale conference in Nevada, and the #13 group is retail and wholesale food. #17 is oil and gas transports and pipelines; #18 is oil and gas refining and marketing; #21, just off the bottom of that, food, flour and grain; #23, food preparation; #26, oil and gas, international exploration and production; and, not doing as well, but not off the bottom of the chart, are Banks, North East, at #47; Banks, Southeast at #52, Finance, Savings and Loan #56, and moving up in just 3 weeks, from 165th rank to #66 is the fertilizer stocks. And, once again today, fertilizer stocks are strong, in fact, the agriculturals are very very strong today.
The importance from our standpoint of this is that the view out there within the commodity industries about the outlook is changing even while the economic numbers just get worse and worse and worse. And I’ve got to take you back to what happened back in the 70s, because this is almost eery as to how much this is the way things were in ‘74, ‘75, One of the statistics published about the unemployment numbers was that these were the worst unemployment numbers since 1975 in the US and Canada, they’re the worst on record. And Canada, of course, has great commodity orientation in its economy. The unemployment numbers tend to be coincident to lagging numbers, and the unemployment numbers will continue to get bad and worse.
Why is the stock market overall so strong? Well, this virtually guarantees that the stimulus package will get passed. Now I’m deeply disappointed in how the stimulus package has turned out. its turned out to be a grab bag of a whole bunch of liberal wishlist programs they figured they could never get passed through Congress under ordinary circumstances but by labelling them as stimulus ther’re going to be able to get them through.
Rahm Emanuel, who’s the head honcho, next to Obama, in the White House said, “It would be a shame to waste the worst financial crisis since the Great Depression.”
So, what we’ve got here is a wolf in sheep’s clothing, but at least we’ve got activity. And, the evidence on the financial side is that the massive re-liquifications that are being done by the Fed, and then the various bailout programs are having their effect, because the TED spread is way down at 92.50, and the VIX index is also way down. Either the stock market is dealing with a total unreality, or there’s already a change out there.
One of the surprises has been the strong performance of the base metals recently, and that’s because both China and Korea have announce that they’re going to be buying base metals to build into their national reserves. Korea is very frank about it because they want to protect margins of their industries against what they see is stronger demand later in the year.
Now this is a sort of a Sovereign Wealth Fund type deal, when commodity importing countries use their reserves to buy in cheap raw materials to protect their goods producing industries, but its interesting that it came on the same day this week. And this is a sign in the key Asian economies, that as bad as things are for them, their export numbers are terrible and all these things that we know about, and the Baltic Dry Index has doubled since being down 99%. Dennis Gartman remarks today in his great letter.
Does this just mean that we’re going down along with the economic numbers, or is the world changing? Its been out thesis that the commodities stocks would start to outperform before the stock market really had reached a recognizable bottom. And that was on the basis that they were the strongest groups going into the downturn, they were the group that led the downturn, and therefore what you want is to see whether that was that the whole story had changed, the whole story of commodities as an asset class, and that that was over. Or whether this was, as it was back in 1974 and 1975, a great pause in a much bigger trend. We, of course, are of the second view.
This is a pause, a dramatic pause, in a much bigger trend, and as you can also see from the chart, what happened with the commodities, was the real collapse occured as the banking crisis really got out of control, and we went to the low, where the CRB futures at the 1st of December, when the whole picture of the banking industry was really grim. This was a low on relative strength for them after the stock market had already reached its November low, so again, its a relative strength reading.
The fact that all commodity stock groups have been strong lately is in itself a really impressive sign of either, total un-reality out there, or that the market is sensing a big change in the wind. As I look at my screen here of all the commodity stocks, every single agricultural stock isi up except one. The oil stocks are somewhat mixed, although oil prices are down. The group is about flat. And of course the precious metals stocks notwithstanding that gold is pausing in here as a group are up, but the base metals stocks are all up, all up substantial amounts.
This again is like 1975, and I beleive that what we’re seeing here is a recognition that financial assets are going to have trouble doing as well as hard assets, because the sheer scale of the reflation, is so dramatic, far beyond anything that was done. Back in the 70s we had inflationary monetary policies which made things worse, but we didn’s have the derivatives there back then driving things. It was actually monetary growth which signalled to people that monetary growth was too much, and that we’re going to have more inflation. And Gold is giving the signal, coming off $38 on what was going to be its eventual run up to $825-850, much later.
For investors, this dramatic outperformance, a one-month date, its just been amazing to these stocks, the last month, I mean we’re talking of double digit returns for a great number of commodity stocks no matter which group you’re looking at. That’s why, of course, the IBD Stock Index shift. Because this is after all, you know, the stock market has been a really bad place to be, the worst January on record. The worst for the S&P on record and so the conventional strategists have gone back to the forecasting ability of the S&P in January and predicting that this could be a year as bad or worst than last year. I’m not going to make an overall stock market forecast here; that will come later. But when you look that while the stock market was going down, that all of a sudden the most beaten up group is starting to perform very strongly, what it is is a fundamental change, I believe, in direction, and therefore, our favourite group is going to continue to give good relative strength.
Now of course, relative strength can still be a negative if the stock market breaks through to new lows. I can’t talk right now about the alpha that you’ve got, but I can point out that despite all the problems we’ve had, we still have a gigantic contango in oil. Now this is being treated by most observers as a sign of weakness. Again, I go back to the 70s. What happened was oil swung into contango, and stayed there year after year. It hasn’t been in contango on a sustained basis, except during the period which ran for about 18 months earlier in this decade, when oil demand kept running ahead of supply, and gradually, people saw this happening, and bought out the futures curve farther, but we swung back into backwardation, and now we’re in this sustained contango. At meetings with clients in Las Vegas, the oil contango was for them, and this is the grocery industry, this is a big part of their costs, they kept saying, ” What does this mean? Why is it that oil prices even a few months out are way ahead, let alone, years out?”
My view is that this is an expression of the relative willingness of producers to sell forward, as against the willingness of consumers to lock in prices that they feel they can live with. And so we’ve got a gigantic rebalancing and hedging game going on here, and I don’t think much of this is speculative activity. I think the speculative activity got excreted from the system by the collapse of the hedge funds, and particularly after the collapse of Lehman, which locked in $65-billion of hedge fund assets, so that the big debate that we were having last spring was that oil breaking through a $100 was purely a speculative thing, and not reflecting reality. It turned out there was more speculation than even I understood. But, we certainly knocked that out because the big players have been decimated. This of course also spreads out into the valuations of the private equity companies which have been sort of the worst area of the financial market recently, apart from the Wall Street banks.
There’s these currents around here which indicate that there’s gradually a belief system that although China and India and Korea and these economies which were the drivers of the commodity bull market, are slowing down, and are having troubles. At the conference, the first speaker in the panel in the morning, who is a guy loaded with data; he’s from First Data. He was just back from China; he said that unemployment rate is skyrocketing over there, the government is desperate and they’re pulling out all the stops. What we know is this is a very responsive command and controlled economy and therefore they still have the liquid assets. Remember, they got a 40% savings rate in China, so those savings can be moved out into the economy. Where as opposed to the US, our savings rate has just finally crept above the zero rate.
If in fact then, these big economies are not going to collapse along with the OECD, then its a very clear cut case as to which asset class is going to do better than the other. That’s the hard asset class. Bbut what’s also fascinating is the change in the prices of the grains relative to other commodities. And, thats at a time when the USDA keeps increasing its estimates of the reserves on hand of the grains. i.e. we’re getting bearish news on the grains from the USDA, very disconcertingly bad news, in fact, as they’ve calculated that particularly in the case of corn, how much isi on hand, and it turns out to be more, and the reason for that is the bankruptcy of these ethanol companies, the Verasun’s of the world. So. of course, ethanol based consumption of corn has collapsed. But when you look out further out on the futures curve, what you see is strength, and then you come down on to the statistic that nobody wants to talk about, which is the sun spots and the weather.
Well, the weather data, you can pick your stories as you want. As I was flying out there, to Las Vegas, sitting watching CNN in the terminal, they had a great scene in Trafalgar Square, which was totally buried in snow, and they had kids rolling in the snow. The only other active people in the square other than the kids playing in the snow, were a group of war protesters. it was explained to us that they’re paid for being there. Once again another snow storm has hit England. Now this isn’t January, or December, its February.
The sunspots have still not come back. Right up to date, we’re still getting very low sunspot acivity. In another 6 weeks, my back of the envelope calculation works it out, if they don’t come back, we will have the longest sustained low sunspot activity, in about 2 centuries. At some point, this is going to start attracting attention from the people out there who are telling us that the only we have to fear is global warming and of course, naturally, in this collection of liberal wishlists that are going to get voted through the senate. There’s huge amounts of money to deal with Global Warming. And, this will another case I believe where the liberals’ agenda will be based on theories that are being exploded before our very eyes about the reality. If the correlations of past history work, then we’ve got a very late planting season coming up at the very least and so we start to count the time because if the sunspots haven’t returned by May, then based on correlations dating back to 1804 when the astronomer Royal, William Herschel, one of the greatest astronomers of all time, saw the correlation of sunspots and the price of wheat, then we’re going to have a shock to the global system, and I believe that that much history should be respected.
While I was on vacation, I read a History of Scotland, and one of the small stories was explaining why Scotland got taken over by Britain at the end of the 17th century. The biggest reason was 6 straight years of crop failure. Now this was the years of the ‘Maunder Minimum,’ in terms of sunspots, the lowest sunspot activity for which we have proven records, because they only, started keeping the sunspot data with the time of Galileo; and of course, Scotland is very far north, and the effect of cooling naturally is felt the further far north you are from the equator you are, because the tropical zones are such a huge percentage of the actual face of the Earth, because of the width of the Earth, the zones, that as you move further north, you get cooler temperatures, then the effect of any reduction of solar energy is felt much more powerfully. In other words the further north you are, the more damage is done from cooling on crop production.
That’s why it is that Brazil can continue to have terrific production of soybeans because they’re so close to the equator, in their main production zones. But what happened in Scotland, was that although crops were erratic, poor to marginally good at times in England, they were much better than in Scotland, because there, they had late Springs, and devastating frosts.
Now will all this repeat itself? The scientific community says ‘no.’ There’s a correlation that you can show, but they can’t show how it works. But as an historian, I have to tell you that I still believe this could prove to be one of the biggest stories of the year, but nobody’s talking about it.
Therefore, if you’re buying into the agricultural stocks, you don’t need to feel that you’re taking a bet on this, because the market is already taking a big bet on it; Not so. There’s just nobody out there except the Farmer’s Almanac, by the way, that said it was going to be a bad planting spring, because of sunspots. You may say, “Come on, you can’t cite the Farmer’s Almanac.” Well, the Farmer’s Almanac has managed to stay in business as long as it has by using the climatalogical data and they were quite candid about it, that it was because of sunspots, or the lack thereof. So that’s the only support there is at the moment that I’m aware of for our thesis.
So what you should do now, in terms of your overall equity exposure, the fact remains that the big stock indices are still weighted to the economy stocks and the financial stocks. The financials have a much lower weight than they had before, but within the financials, and that’s why I talked about these regional banks, I believe that what we’re going to see is continued great relative strength of the bank banks; the regional banks, those who actually know their customers, and do traditional banking, as opposed to the investment banks, and the glamorous Wall Street types who dissipated their stockholders’ equity by levering up with the colateralized debt obligations and all those other monstrous products that they didn’t understand. They ceased to be bankers, and became packagers of toxic waste which was re-labelled as great food.
So if we separate out from this the highly publicized banks which are on life support systems supplied by Washington, then I believe that there’s still enough relative strength being shown there that the economy is suffering, but just because Citibank and these other banks are down 80% or 90%, you shouldn’t say that that means the banking industry is down 80% or 90%.
So the economy is going to be a series of stories here and there, and I don’t believe we’re going to get economic numbers for some time, which are going to be the kind of things that are going to be stock market friendly, so I can’t make out at the moment a case for increased equity exposure. I can simply reiterate that within the equity group the signals that we’re getting are that the commodities selloff on relative strength is over, and that the fundamentals are that people are going to be starting to look further out. The stock market is supposed to be a forecasting tool. What they’re saying is that these reflations are eventually going to work enough so that the world will not go down the tubes, and there will be demand for hard assets. That’s the story of the 70s, and its going to come back in somewhat different form, its going to be a shock to the stock market, its going to be a shock, certainly to the intellectuals and the others in control of the media, but I do believe that this implies that the TSE will once again outperform the S&P this year and therefore, that the worst is over, that you pick your spots.
Now as far as weightings, we are coming out with an issue of Basic Points this month, and we will be publishing revised recommended weightings in the commodity groups. I’m at a bit of a disdavantage here, because I’ve got to; I know that the number of people on the call is a fraction of the number of people who read Basic Points, but I can simply tell you that I believe that we’re getting the signals already from what stock groups are doing as to where your emphasis should be. So I recommend that you check those out and that that be part of your guide as you’re figuring out you’re going to be allocating your capital or for those who are thinking of things like RRSP season in Canada, and haven’t given up the faith on stocks, which stocks it is you want to buy now to put in your RRSP. Not that you’re planning to go back and look at it 90 days from now to see how its done.
The fact remains that the billion people that we’ve added to the world’s consumption side, haven’t all turned poor, just because of all the unemployment in the US. So its still going to be a tough winter and a tough spring, but I think that the world of the future is starting to show itself and our job is to try to predict the future rather than getting to mired down in the gloom right now.
Remember the same economists were telling us things can only get worse. As recently as last June were predicting 2-3% economic growth. Now they’re saying there’s no hope, and I’m not ridiculing the economists, because there are a few of them like Nouriel Roubini, who correctly called it. David Rosenberg did a great job. But the economic consensus just suddenly changed and that’s why we had this V-shaped collapse which came as fast as the collapse came the last time in 1974. And at the worst in 1974, the multiple on the Dow got down to 6 (times). I don’t think that we’re going to see that this time, but it means that you’ve got to be cautious about having said that there’s definitely been a bottom in the S&P and the Dow. But I do believe we’ve seen the bottom for the commodity stocks as a group. That’s it.
Tags: Bkx, BMO, Canada, Collapse, Commodities, Conference Call, Crb Index, Donald Coxe, Economic News, Economist, Emerging Markets, Forecaster, Full Transcript, India, Investors Business Daily, Jefferies, Relative Strength, Reuters, S&P500, Standpoint, Stock Groups, Stock Market, Tagline
Posted in Canadian Stocks, Commodities, Economy, Gold, Markets, Oil and Gas, Outlook | 2 Comments »
