Indexology^® Blog

The universal complaint heard today is the “Arctic Vortex” and freezing temperatures across much of the US including financial centers in New York, Chicago and Boston. Are the cold and the weather just something to complain about or do they really affect people and the stock market?  There are various academic studies about how the weather might affect the market covering the US using New York City weather data, Australia and even Thailand.  The results for cold and stock prices are mixed: some find some weak connection between daily temperatures and stock price movements, some find no result at all.  However, a number of studies find a connection between sunshine or clouds and stock prices – if the morning is sunny, the market is more likely to advance.  While one day is clearly an insufficient sample, the sun is out in New York (despite the five degree temperature) and the market is up.  Clouds, overcast and rain seem to be associated with mixed to poor markets, probably another case of psychology and (ir)rationality driving stocks.

Cold does make one large, unfortunate difference: extreme cold, or hot, weather increases mortality rates. Cold is far more damaging than hot weather, so much so that one study found that people migrating to the southern states in the US is contributing to increasing life expectancy in the statistics.

“A rose by any other name would smell as sweet” Juliet says to Romeo when trying to illustrate it is the essence of a something which is important, not what it’s called.  If Shakespeare were alive today, and Juliet were an investor, would he have her say the same things about an ETF?  Would she tell her beloved Romeo that an ETF by any other acronym would still invest in an index and be transparent?  Should 2014 turn out to be the year of the actively managed “ETF”, the answer is probably no because the essence of what had defined ETFs may completely change.

If it is the essence or function of something that matters, like the sweetness of a rose, then the acronym “ETF” could become misleading.   A simple google search of “ETF” in 2013 yields Wikipedia as the very 1st link. In the first paragraph on ETFs Wikipedia states “Most ETFs track an index, such as a stock index or bond index. ETFs may be attractive as investments because of their low costs, tax efficiency, and stock-like features”.[1]  In the 2^nd link, Investopedia defines an ETF as a “A security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange.”[2]

Thus the average investor would probably conclude the function (or essence) of an ETF is to track an index, therefore you know what you are purchasing.  It’s fair to assume they might also deduce that ETFs are good alternatives to many mutual funds because ETFs are said to be “cheap” and “transparent”.  Since their inception till 2013 ETFs have been synonymous with passive investing, just as roses have always been deemed to smell sweet.  This has arguably been a key driver to the success and growth of ETF industry and a boon to investors.

In 2014 we may see the beginning of an unraveling in the commonly assumed (and generally accurate) definition of ETFs because “actively managed ETFs that would be permitted to report their portfolio holdings quarterly” [3] may become typical for many new “ETF” launches. “That would put their reporting requirements on par with traditional mutual funds.”[4]  Thus if one uses the acronym “ETF” to describe both active and passively managed strategies a contradiction ensues, unless of course Wikipedia, Investopedia and countless others totally change their understanding of an ETFs essence.

2013 is the first year commodities have been in backwardation since 2003.  For those of you who need a refresher on the definition of backwardation, you are not alone, so here it is: “When a near-month futures contract is trading at a premium to more distant contracts, we say that a commodity futures curve is in “backwardation” or that the commodity is “backwardated.” This occurs when inventories of commodities are tight so market participants are willing to pay a premium to buy the immediate deliverable commodity. Theoretically there is no value to carrying costs such as storage, insurance and interest costs since there is a scarcity of the commodities.”

Also, for illustrative purposes, this graph may help:

The measurement of the historical backwardation (and contango, which is the converse of backwardation) shown in the chart below calculates the annual roll yield by taking the annual return of the S&P GSCI Excess Return (which measures the price return plus the roll return) less the annual returns of the S&P GSCI Spot Return (which measures the price return only). Backwardation was implied by a positive result, whereas contango was implied by a negative result. Notice 2013 had the first positive result since 2003.

The implication of this, as mentioned in a paper titled “Identifying Return Opportunities In A Demand-Driven World Economy” published by Marya Alsati-Morad, Peter Tsui and me, is that when commodities are backwardated, indices like the S&P GSCI and DJ-UBS that hold the near-month commodity futures contracts may earn a positive return from rolling into a cheaper contract before expiry.

For extra valuable insight on the impacts of contango and backwardation, please watch this special interview with Bob Greer, Executive Vice President & Manager of Real Return Products, PIMCO and Boris Shrayer, (former) Managing Director & Global Head of Commodities Marketing, Morgan Stanley.

For more on the environment and the index development and rolling versus weighting please see the links aforementioned.

Last but not least, something that is particularly interesting is that the last long streak of backwardation happened in 1984-1991, following a precipitous drop in gold of 48% from 1980-84.  During this the time of backwardation, the S&P GSCI returned positive every year between 1984-1990 for a total of 221%.

A steadily improving economy and no small amount of performance-enhancing stimulus from the Fed re-enthused equity investors in 2013, leading the Dow Jones Industrial Average to finish in record territory.

Let’s go to the tape:

• Impressive Climb – The DJIA finished the year at 16,576.66, up 3,472.52 or 26.50%.  That performance leaves us with the latest in a series of record closes, the best annual percentage gain since 1995 and the largest annual point gain in history.
• Leader & Laggard – Boeing (BA) was the standout contributor of the Dow, adding 444.47 points in 2013.  IBM subtracted 27.48 points to finish as the biggest detractor.
• Industry Performance – All industries added to the DJIA’s advance in 2013 – Industrials led, followed by Financials and Consumer Services.
• The Good – The biggest single day point gain – up 323.09 or +2.18% – was posted on October 10.  Despite finding themselves on Day 8 of the US government shutdown, investors were heartened by indications that House Republicans would offer a deal to raise the debt ceiling.
• The Bad – The biggest single day point loss – down 353.87 or -2.34% – was June 20 when the market had an – ahem – adverse reaction to Bernanke’s comments about tapering of the Fed’s bond buying program.
• Changes – There were three additions/deletions in 2013:  Hewlett Packard (HPQ), Alcoa (AA) and Bank of America (BAC) were removed after the close on September 20 and Goldman Sachs (GS), Visa (V) and Nike (NKE) were added for the opening of trading on September 23.
• Dividends – All 33 stocks that were components in 2013 paid cash dividends, with nearly $124 billion paid.  Exxon paid out the most with nearly $11 billion distributed to shareholders.
• Volatility – at 9.40, the DJIA’s realized annual volatility continued a downward trend from a peak of over 26 seen during 2009.
• Potpourri – there were 52 record closes in 2013, the most since 1995; as of the close of 2013, the DJIA is up 153.19% from its financial crisis low of 6,547.05 hit on March 9, 2009; and, we experienced two major milestones in 2013 with the DJIA eclipsing both 15,000 and 16,000 about 6.5 months apart

The hint in the title is GOLD and the answer is the year 1981.  In 1981, a Superbowl ad was $275,000, 750 MILLION people watched Prince Charles and Lady Di get married and GOLD lost 32.8%.  In 2013, the cost of a Superbowl ad was $4 million, Prince William and Kate Middleton welcomed Prince George, and GOLD lost 28.3%, the most since 1981.

If history repeats itself, Superbowl ads may get more costly, the royal family may have more babies, and gold may be doomed for a long recovery period. In fact, the recovery period for gold after the 1981 loss lasted 25 years – that is 10 years longer than the marriage of Prince Charles and Princess Diana.

Given the severity of the loss of 28.3% in 2013 for both the S&P GSCI and DJ-UBS Gold, many questions have been asked by the media today about the future of gold.  Here are some of the most popular questions:

1.  After the large gold selloff in 2013, do you believe gold can still be viewed as a safe-haven? The idea of gold as a safe haven doesn’t mean it is always a profitable investment – it just means investors are comfortable with gold as a store of value in uncertain economic times. In fact, in 2013 it was the safe-haven concept that drove gold down the most since 1981. Investors feared the fed tapering all year long, which might indicate a stronger economy.

2. Do you believe investors are no longer comfortable with gold as a store of value?  Gold as a store of value can be defined by the framework of super asset classes where capital assets, such as stocks, bonds and real estate, provide an ongoing source of value that can be measured using the present value of future cash flows technique.  Consumable or transformable assets, like commodities, only provide a single cash flow. Store of value assets such as currency and fine art are not consumed and do not generate income but do have a monetary value. Gold is a unique commodity that has a dual purpose of currency and whether investors are comfortable with gold as a store of value may depend on their view of the relative value to the U.S. dollar, where a stronger dollar is generally bearish for gold.

3. Anything that might replace gold as a store of value that investors might turn to in the new year? The most likely substitutes for gold as a store of value are other currencies or assets like artwork that have a value but no cash flows.  It is more logical to replace gold with an asset like the U.S. dollar than with an industrial metal that is consumed/transformed, though cases have been made for using other precious metals like silver or platinum.

4.  Besides the fed tapering, what else may drive gold down for 2014?  A stronger dollar, low inflation and an increase in producer hedging may be bearish for gold.  Higher producer hedging is especially important as an indicator since it is evidence of negative sentiment by the companies that are at most risk from a gold price drop.

5.  Are there any bullish factors for gold in 2014?  Strong Chinese demand growth may be better for copper than gold, given its economic sensitivity. However, the physical demand growth for jewelry in China has been strong (18% yoy q3 2013 according to the World Gold Council) and Indian consumption may rebound after the government crackdown on imports. Also, it is possible the fear of the slowdown in quantitative easing has been priced into gold already.

6.  What do you see going forward for gold? In 2013, the S&P GSCI and DJ-UBS Gold fell 28.3%. The last time gold fell this much was in 1981 when it lost 32.8% and it took 25 years to recover its drawdown.  Although in 1982, gold rebounded 12.5%, it lost another 32% in the next 2 years. If history repeats itself, it could take a long time for gold to recover but it could be viewed as a bump in the road of the long bull trend that has gained over 700% in the prior 12 years.

7. Do you have a bullish outlook on any other metals for 2014?  There may be a bullish case for industrial metals if Chinese demand growth is strong.  Copper is most economically sensitive, though palladium is particularly responsive to the automobile market.  However, after the financial crisis, the surplus of inventories has largely depleted in metals like aluminum, lead, nickel and zinc that make them more sensitive to supply shocks and demand increases to support their prices. 2014 may hold the turning point for the inventories from excess to shortage, which is generally profitable.