Indexology^® Blog

Sorry, grains and meats, you are not one of the four main food groups.

Since this is the case, eating may have just become more expensive, especially for the high-end chocolate lover. Not me of course… but once again, as a commodity lady, when I consume goods (or goodies) and notice that prices are increasing or decreasing I think about the prices of the raw materials and how the indices are impacted.  I have noticed the price of chocolate increasing, so decided a deeper dive into the softs might be interesting.

So far in September, sugar, coffee and cocoa are hot. While the S&P GSCI Sugar and the S&P GSCI Coffee are up 5.1% and 3.2%, respectively, MTD through Sept 13, 2013, both are coming off of bear market draw-downs. From Jan 31, 2013- Aug 30, 2013 the S&P GSCI Coffee lost 26.5% and going back to its high in April 2011 the index lost 68.2%. The S&P GSCI Sugar lost 31.8% since July 31, 2012.

The story for the S&P GSCI Cocoa looks a bit different, and rather than a rebound from a bear market, it looks more like a bull.  From its low on June 27, 2013, the S&P GSCI Cocoa is up 20.1%.

There have been strong fundamentals supporting the price, both on the supply and demand sides.

Producers have cut capacity because when the cocoa beans are ground, roughly equal parts of cocoa butter and cocoa powder are produced, but consumers have demanded butter over powder, leaving producers with excess powder. The uneven demand profile can be blamed on greater high-end consumer demand, which requires more cocoa butter than powder.  Normally, as the cocoa butter-to-powder ratio increases, cocoa futures drop and the production evens out; however, this time is different since there are worries about a global bean shortage, especially from the Ivory Coast, one of the world’s top producers.

The FOMC, the Fed’s policy makers, meet Tuesday and Wednesday this week.  For investors the key agenda items are tapering and the future of QE3. Interest rate policy is almost forgotten as everyone prepares to scan the announcement expected at 2 PM Wednesday and then rush to either buy, or sell, bonds.  Market pundits seem roughly split with a slight tilt towards expecting some cut back in bond buying and QE3.

Paul Krugman, in today’s New York Times, argues for continuing QE3 at its current level. His concern is that starting to wind down QE3 would be seen as a signal that there is little room for additional job growth and that efforts  to create jobs and increase economic growth should be abandoned.  Krugman acknowledges that there is a lot of uncertainty about how strong the economy is and how much room there is for more QE3 – he wants to err on the side of encouraging growth.

As we have been reminded in the fifth anniversary of financial crisis reviews, the US economy recently came through the worst, and most confusing, period since the Great Depression of the 1930s.  Back then it was clear to Franklin Roosevelt and his economics team that there was a lot they didn’t know about the economy.  Their approach was to try a lot of things in the hope that something would work and that the rest wouldn’t do much damage.  Despite some 75 years of advances in economics, the Fed is still trying things to see what works.  QE3 is one thing the Fed tried. While no one knows for sure if it works, the economy is better off than a year or two ago and most agree that low interest rates and easy credit deserve some credit for the gains.   With interest rates up from last May, leaving QE3 fully in place a little longer would be reasonable.

MIT’s Technology Review pitches an argument by Richard N Foster, well known consultant, which uses exits from the S&P 500 to show that companies suffer shorter lifespans these days and are dropping off indices faster than they used to.  Foster includes a chart showing a seven year moving average of corporate lifespans including a forecast beyond the year 2025. He blames the increasing pace of technology and the need for rapid innovation for the losses.

Changes to the S&P 500, the Dow and other indices report shifts in the corporate world and rather than causing them. However, there is more going on here than the speed of innovation and technology.  About two-thirds of all exits from the S&P 500 are caused by M&A; and, more often than not, both the acquirer and the target are in the S&P 500.  When a company is acquired, it may drop off the index but its activities, products, revenues and (hopefully) profits remain – and stay in the index if the acquirer is in the index.  Sometimes a company is acquired specifically because it has great technology.  The better measure of lifespan might be to look at the handful of companies that leave the S&P 500 because they have shrunken or filed for bankruptcy.  Any measure of corporate senility must be balanced against the list of companies that have been in the S&P 500 since it became 500 stocks in 1957 or since it began as a 90 stock index in 1926.  There are some long lived entities still going strong.

Next week the Federal Open Market Committee, meeting for the first time since July, is widely expected to announce the tapering of its quantitative easing program.  Whether the Fed begins to reduce its bond purchases now or later this year, most observers recognize its inevitability.  Indeed, as we’ve noted before, even the anticipation of tapering has caused an increase in interest rates.

Should this disturb equity investors?  We all learn early on that, other things equal, rising interest rates are bad for stock prices.  Difficulties arise when we consider that other things may not be equal.  For example, if a strong economy increases both demand for credit and corporate profits, interest rates and stocks prices might both increase, and the reverse is equally possible.

Indeed, the last 15 years illustrate the point:

Since 1998, in months when 10 year Treasury rates declined, the average return on the S&P 500 has been -0.38%.  When the 10 year rose, the S&P 500 rose by an average of 1.81%.  This counterintuitive behavior suggests that interest rates were not driving stock prices, but rather that both rates and stock values were both being driven by exogenous factors.

Arguably, the Fed’s future behavior will depend on its assessment of the economy — the stronger the economy looks, the more likely a taper becomes.  But a strong economy should also be good for the stock market.  It’s arguable that the variables that will lead the Fed to increase rates will also support higher equity prices.

If you believe the S&P 500, which is market cap weighted, is considered the U.S. stock market beta, then the S&P GSCI, which is world-production weighted (analogous to market cap weighted), is the logical choice for commodity beta.  Typically, using an index, namely the S&P 500, as the benchmark for beta is standard practice in trying to describe the behavior of a single stock compared to the market. For example, a healthcare company, say WellPoint WLP, has a beta of .61, and a technology company, say Facebook FB, has a beta of 1.9 (according to Yahoo Finance).  What this means is that when the stock market index moves, WLP moves less than the market and FB moves more than the market.

In general, the following rules apply:http://en.wikipedia.org/wiki/Beta_(finance)

While we know generally tech stocks have higher beta than healthcare stocks, not many study the beta of commodity sectors and singles.  When examining monthly returns from Aug 2002 – Aug 2013, as one might expect, the beta of the energy sector is greater than 1.0 at 1.25. A less expected observation is that the beta of silver and nickel equal each other at 0.59, yet gold’s beta is only 0.27.  Not only were the betas of nickel and silver the same but surprisingly relatively high (ranked 8 and 9 of 24) for the very low weights in the index, only about 40 basis points each.  Another surprise was that natural gas, despite its low weight in the S&P GSCI of about 2.5%, had a beta greater than 1.0 of 1.1, and also no single commodity outside of energy had a beta greater than 1.0.  

While the S&P GSCI may be the best representation of the commodity futures landscape by its world-production weight, when investors measure beta of a single commodity or sector, they may use the Dow Jones-UBS Commodity Index, also a market leading benchmark. The DJ-UBS CI does use liquidity and production in its weighting scheme; however, it imposes limits on single commodities, groups and sectors since diversification is one of its key principles of construction. Learn more about the differences between the S&P GSCI and DJ-UBS CI.  

Using the DJ-UBS CI as a benchmark, it was no surprise the beta of energy was a bit higher at 1.39 than for the S&P GSCI at 1.25 since energy comprises more of the latter index. What was less expected was despite the relatively equal weights of commodities in the DJ-UBS CI as compared to the S&P GSCI, only 4 of 17 commodities outside of energy had a beta of greater than 1.0. Copper, Silver, Nickel and Corn had respective betas of 1.14, 1.14, 1.10 and 1.01. The other surprise was despite a high weight of almost 10% in the DJ-UBS CI, gold only had a beta of 0.55.

Please see the table below for the betas of commodity sectors and singles.

Source: S&P Dow Jones Indices. Data from Aug 2002 to Aug 2013. Past performance is not an indication of future results. This chart reflects hypothetical historical performance. Please see the Performance Disclosure at the end of this document for more information regarding the inherent limitations associated with backtested performance