Indexology^® Blog

Both the surprisingly strong 2013 US stock market performance and the surging rebound in US home prices are sparking fears of another round bursting bubbles among many investors and market pundits.  While we don’t know the chances that either stocks or home prices will plunge in 2014, the collateral damage from either will be less than it was in 2008 because the underlying leverage in the economy is substantially smaller today than it was back then.

The financial crisis was a two-step (or double dive) event.  First home prices collapsed, wiping out about a third of the value of American homes. Second, a lot of the mortgage debt collateralized by those homes failed creating a cascade of defaults, foreclosures and worse.  The higher the loan to value ratio on a home with a mortgage, the smaller the price drop needed to put the mortgage under water.  The chart shows the loan to value ratio for all owner-occupied housing in the United States, including homes owned without mortgages or with mortgages before the boom times of no money down mortgages.  From about the beginning of 2006 to the beginning of 2009 it rose by half from 40% to 60%.  When home prices plunged, homeowners and their mortgages were vulnerable.  Today conditions are improved – the economy-wide loan to value ratio is down to 49%, not as comfortable as ten years ago, but better and safer for the economy than in the financial crisis.

This change did not just happen. Rather, the appetite for borrowing and debt is much less today than seven years ago. The total growth in mortgage debt in the 12 quarters ended with the 3^rd quarter of 2013 was -7.2% — mortgage debt fell. Compare this to the increase in the 12 quarters ending with the 2007 4^th quarter: 35.6%.  The same story, with somewhat different numbers is true across most of the economy. Growth in debt outstanding in the last 12 quarters to 2013:3 for the entire economy was 12.7% versus 29.3% for the 12 quarters ended in 2007:4.  The only sector where debt rose more quickly in the recent period was the Federal government, largely due to supporting the economy.  Even with the federal government, debt is under more control with the deficit as a percentage of GDP down by more than half to 4.1% currently from 10% during the financial crisis.

The lower leverage and debt overhang will not prevent a bubble from bursting, doesn’t mean stock prices or home values can’t slide and doesn’t mean we shouldn’t be concerned that some markets may be over-valued.  But, less debt and leverage means less damage if markets fall. That alone should ease some fears as we start a new year with higher prices on houses and stocks.

Since the S&P Municipal Bond Index was launched in 2000 it never has had two years in a row of negative returns.  However, a new year begins with all the uncertainty and expectations of any other year.  Municipal bond funds are entering 2014 following a long string of monthly cash outflows indicating that retail investors remain skeptical of the short term prospects of the muni market.

Helping to drive investor sentiment are:

• Puerto Rico: The S&P Municipal Bond Puerto Rico Index was down over 20% in total return in 2013.  Puerto Rico bonds hang on a precipice of a down grade by Moody’s, S&P or Fitch to below investment grade.  A downgrade by any one of those ratings providers would most likely continue to foster the junk bond trading environment that these bonds face today and make it more difficult and costly for the Territory to borrow in the future.  On average, bonds in the S&P Municipal Bond Puerto Rico Index trade at higher yields than corporate bonds in the BB rated category.  Who is hurt the most?  Investors in bond funds with high exposure to triple tax-exempt Puerto Rico bonds.

• High profile defaults:  The City of Detroit bankruptcy filing in 2013 followed other headline making defaults in 2012.  While representing a very small fraction of the municipal bond market, these defaults have been powerful reminders that buying bonds is simply lending money in anticipation of being repaid on time and in full.   In reality, new monetary defaults, as tracked by the S&P Municipal Bond Index totaled 19 bonds so far in 2013, down from 30 bond defaults in 2012. 

• Tapering and rising risk free rates:  Bonds in general, particularly long term bonds, are impacted negatively by rising interest rates.  Investor rotation to shorter duration bonds in anticipation of rising rates began in 2013. The prices of shorter term bonds simply move less given a change in interest rates then do longer term bonds.  A possible increase in demand for short term bonds can be expected in a rising interest rate environment. Rising interest rates should negatively impact the demand for longer term municipal bonds. 

• New issue supply:  Municipalities have decreased their new issue borrowing in 2013.  Supply of new issues is difficult to predict but an increase in supply without a parallel demand increase would potentially weigh heavily on the municipal bond market.

• Transaction costs: It is not easy to buy bonds as the transaction costs of buying individual bonds can be hard to figure out. This cost can erode the returns of holding individual bonds.  According to our statistical studies, the transaction cost for high grade bonds in the S&P National AMT-Free Municipal Bond Index has been approximately 170bps each way (buy and sell) for bond trades of $100,000 par value and lower.  In the past, during down markets, we have seen that transaction cost rise.  If the market gets weaker in the future, the possibility of higher transaction costs for retail positions can be expected.

If current trends continue, 2014 will herald a significant milestone for the ETF and hedge fund industries, as the total amount of capital invested in the former threatens to overtake the latter.

Hedge funds search relentlessly to deliver on a promise of alpha while their privileged investors – supplying notoriously high fees and the tactical burden of illiquidity – hope to gain advantage from partnering with the 21^st century’s investment titans. Once the darlings of the asset management industry, hedge funds are seeing their pre-eminent status challenged by a diametrically opposite segment of the investment spectrum, as the cheap, liquid and transparent value proposition of ETFs continues to attract substantial investment from across the globe.

Appropriately perhaps for an infamously opaque industry, official estimates of total hedge fund assets vary wildly. So it is hard to say conclusively how much money exactly is invested over all. Taking the numbers from BarclayHedge (who provide one of the highest recent estimates and freely provide data back to 2000) it looks as if total ETF assets are on course to break above total hedge fund assets early in the New Year. Indeed, as these numbers are somewhat delayed in any case, they may have already done so.

ETF total assets as of November 2013 (Source: Blackrock); Hedge Fund total assets as of 2013 Q3 end (Source: BarclayHedge)

Of course, that is not to say that the role of hedge funds is fundamentally challenged. Indeed, in aggregate they continue to attract new investor capital. But with the search for alpha becoming ever harder, it’s only surprising that it has taken so long for ETFs to gain the larger share of the pie.

Despite another year of flat performance from the S&P GSCI, it was a roller-coaster year with energy holding up the broad index while gold had its worst year since 1981.  Below are the top 13 stories from 2013:

13.  Risky Assets, Safe Havens or Lost Identities?   All commodities in the S&P GSCI and the DJ-UBS CI crashed on June 20, 2013, losing 3.1% and 3.0%, respectively, after the Fed declared the U.S. economy was expanding strongly enough for the central bank to begin slowing the pace of its bond-buying stimulus later this year.  This is generally bad news for commodities since historically as the U.S dollar strengthens, goods priced in dollars become more expensive for other currencies. The historical negative relationship between the U.S. dollar Read more […]

12.  S&P GSCI Precious Metals Hits Lowest Since October 2010 On April 15, 2013 the S&P GSCI Precious Metals dropped 9.6% in one day, entering a bear market from the 2013 high occurring on January 23. Since then, the index has fallen further to hit its lowest level of 1733.52 since October 1, 2010 when it was at 1717.53.  The precious metals index is down 20.1% YTD, and is off  21.3% from its 2013 peak of 2202.41. Uncertainty ahead of the Federal Reserve meeting may be causing gold investors to fear whether the Fed will signal the end or a reduction Read more […]

11.  Strong as Steel: Impacts of New Futures This morning I was interviewed for CCTV2 on the impact of new futures markets with a focus on iron ore. Although Iron ore is not in the major indices, the DJ-UBS and S&P GSCI, it is an economically significant commodity that is the main input for steel. I thought you might be interested in the questions and answers, 1. What can we take-away from the launch of China’s Dalian Commodity Exchange’s new futures market? It is exciting when there is a new futures market launch.  Generally, Read more […]

10.  Paying Too Much at the Pump?! Why are gas prices so high? I know I’m not alone as “a commodity lady” wondering this as I pull out my credit card to pay at the pump. (Which is not often since I ride my bicycle to work most days) Gasoline prices typically rise in the summer because more people travel to take vacations. However, this July, the S&P GSCI Unleaded Gasoline  gained 12.0%, which was the 4th highest increase in July in the history of the index (since 1988,) and the biggest rise in July since 2005 when the Read more […]

9.  Ready to Roll or Need to Weight? In the past few years a number of indices have been launched with a goal of minimizing the impact of contango.  The first indices launched with this goal were the simple (1-5 month) forward indices and the relatively static S&P GSCI Enhanced. In the time period from Aug 2004-May 2011, mentioned in my prior post, these indices did the job of outperforming the front month contracts in the S&P GSCI by reducing the negative impact from contango as shown in the chart below. However, Read more […]

8.  Fear Gauge Spikes: Let’s Play Hot Potato For what risk does the commodity investor get paid? At what point is the fear gauge so high the risk gets passed like a hot potato? The answers to these questions will help explain why post the global financial crisis there has been a link between VIX spikes and commodity losses. Let’s address the first question of what risk the commodity investor takes to be compensated. While there are five fundamental sources that drive the commodity asset class returns, the insurance risk premium is a major Read more […]

7.  Stanley Cup Index: What happened to the holy grail? Congratulations to the Chicago Blackhawks on their awesome win last night! I must admit I was very excited watching the most amazing finish I have ever seen in hockey, but as a commodity lady my first thought was about the metal in the Stanley Cup and what is it worth, especially given the current environment of a strengthening U.S. dollar and rising U.S. bond yields. From the economic backdrop, silver and nickel, the two metals that form the cup, are the worst performing metals in their respective Read more […]

6.  Not ALL Weights are EQUAL: Why Brent isn’t Heavier than WTI 2014 is just around the corner now and the new weights for both the DJ-UBS CI and S&P GSCI have been announced. While the index weightings follow the methodologies, there are questions around the weights of two particular commodities, Brent crude oil and WTI crude oil. The interest comes from the fact that they are the most heavily weighted commodities across the two indices and there has historically been a popular spread trade between the two, since theoretically they should trade similarly Read more […]

5.  Skipping Dessert?! Coffee, Sugar, Cocoa OR Bear, Bear, Bull 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 Read more […]

4.  Where’s the Beef? While I was eating at a well-known restaurant chain, I saw this sign in the front window: So of course as a commodity lady my mind doesn’t think about choices like chicken or veggies, but I wonder what happened to the price of beef in the shortage and why is there a shortage?   The S&P GSCI All Cattle, which includes both the S&P GSCI Feeder Cattle and Live Cattle, has gained 4.4% since the end of May, after losing 8.6% from the beginning of the year. See the monthly returns in Read more […]

3.  Commodities Crystal Ball: What do the FUTURES hold? What strategies will be the most profitable over the next 12 months?  Which spread will have the greatest opportunity? These are just a few questions we asked the audience at our S&P Dow Jones Indices 7th Annual Commodities Seminar, and we thought you may be interested in their answers. As I mentioned in a recent CNBC interview, the three main factors influencing commodities currently are quantitative easing, Chinese demand growth and geopolitical tensions.  This backdrop has been characterized Read more […]

2.  Index Rehab: Is Backwardation Back In-Style? My colleague, David Blitzer, is discussing index construction in his blog series “Inside the S&P 500″, and so far has reviewed selecting stocks and the float adjustment. While the index construction principles of transparency, liquidity, and systematic rules-based methodologies are widely similar between equities, commodities and other asset classes, there are details that distinguish the asset classes. For example, market capitalization and style like growth or value may be associated with Read more […]

1.  Keeping Up With Contango’s Twist As mentioned in an article today in the Wall Street Journal, there may be a shift taking place in the commodities markets. In simple terms, there may be more predominant shortages of commodities. Generally as inventories are abundant, there are higher storage costs, which reduce returns from a condition called contango where the longer-dated contracts are more expensive than near contracts.  As the inventories deplete, shortages may prevail, giving no value to storage for commercial consumers Read more […]

The most popular commodities post from an external contributor:

US Energy Production & Its Growth Dividend The substantial increase in the supply of energy from the United States is providing the US with an economic growth dividend. Since 2005, which we use as our base year since it roughly represents the year before the energy revolution in the US started, crude oil production in the US has increased 29% and natural gas production has grown 33%. The numbers are impressive and they continue to grow. Quantifying the US energy boom’s contribution to economic growth is not easy, even though it is Read more […]

The charts show the twin concerns of the Fed: inflation and unemployment.  Despite fears that easy money would send inflation surging, it is quietly fading away.  The real worry is unemployment. While declining, at 7% recently it remains above any estimate of full employment.  Low inflation and low unemployment can be in conflict with one-another.  Cutting unemployment requires a stronger, faster growing economy while keeping inflation low can be helped by economic slack, minimal wage growth and a soft job market.  To add to the challenge of meeting two opposing targets, the Fed’s current policy tools — the Fed funds rate and buying bonds – are tightly linked and can’t easily target two conflicting goals.

In 2014 the Fed is expected to keep interest rates low with the Fed Funds rate targeted at zero to 25 basis points, essentially the zero lower bound (ZLB).  First, they have said so on numerous occasions, second with inflation at one percent and falling there is little justification for raising rates and third, many more analysts and investors argue about bond buying than about interest rates.  The bond buying, better known as quantitative easing or QE 1-2-3, will be cut back and probably extinguished completely in 2014.  The Fed began the shrinking process in December after a couple of false starts, markets surprisingly welcomed the change with a rally in both stocks and bonds and there does seem to be a limit to the size of the Fed’s balance sheet.  The chief fear engendered by bond buying was that massive increases money would turn into much higher inflation. That hasn’t happened. QE 1-2-3 generated a lot of hot air but no inflation.

What if the inflation fears aren’t misplaced?  Should prices begin to rise, the Fed would drop the ZLB target for Fed funds, interest rates would rise and any remaining bond buying would vanish.  Given the last few years of ZLB and QE 1-2-2, this doesn’t look very scary.  If unemployment doesn’t drop further, will there be a QE 4? While this is a harder question to answer, the response is no.  After three rounds of quantitative easing, the search would probably be on for other ways to boost the economy.  One side effect of QE 1-2-3 has been rapidly rising asset prices for both stocks and houses, fast enough to make some that whisper bubbles are here again.  The best alternative policies are outside the Fed’s domain: increased fiscal stimulus and a higher minimum wage. However, both attract politicians and 2014 is a Congressional election year and also the preliminary bout for 2016.  So the more exciting action may shift from the central bank back to the legislature after four or five years when the Fed seemed to be the only serious economic player.