Indexology^® Blog

Industrial Metals are historically the most economically sensitive sector besides energy. While Chinese oil demand growth is set at 3.6% in 2014 and HSBC’s Chinese Manufacturing Purchasing Managers’ Index (PMI) edged down to 50.8 in November, barely above the key 50-threshold delineating expansion from contraction, according to IEA’s OMR Report, nickel is the only commodity in petroleum and industrial metals to have positive performance in 2014, although it is up just 0.7% YTD (as of Jan 29 after losing 1.1% for the day.) 

Many who are unfamiliar with nickel may wonder what it is used for, besides to strengthen the silver of the Stanley Cup. According to the Nickel Institute:

“Nickel-containing materials play a major role in our everyday lives – food preparation equipment, mobile phones, medical equipment, transport, buildings, power generation – the list is almost endless. They are selected because – compared with other materials – they offer better corrosion resistance, better toughness, better strength at high and low temperatures, and a range of special magnetic and electronic properties.”

Although  the manufacturing numbers aren’t great, the reason nickel is the only commodity between energy and industrial metals that is performing well is because of its unique supply and demand model despite general macro factors.

According to Reuters, there is a ban on exports of key mineral ores from Indonesia unless they are processed in the country.  However, weaker economic conditions have caused the ban to be lifted to allow shipments of copper, zinc, lead, manganese and iron ore concentrate, leaving nickel and bauxite – key ingredients in making steel and aluminium – the main targets.

Further, as FT.com points out, unlike copper, iron ore, lead and zinc, where miners were given a few years to phase out exports, shipments of nickel ore were cut altogether as of January 12th.

As you can see in the chart below, nickel has had a lackluster history post the financial crisis despite its gain of 188.0% from March 2009 to Feb 2011.  Since Feb 2011, the S&P GSCI Nickel has given back more than half that gain, losing 53.5%.

Also since Feb 2011, there have only been 13 of 35 months where the returns were positive and on average the positive monthly return was only 5.3%. This is compared to the negative 8.3% on average in the down months, which has hindered nickel from bigger profits. See below for the table of positive months since Feb 2011:

Source: S&P Dow Jones Indices. Data from Jan 1993 to Jan 2014. 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.

Despite the relatively weak economic industrial growth data from China that showed only 6% yoy in Dec 2013 versus 9.6% yoy in Nov 2013, demand for industrial metals like nickel may be on the rise. This is since they are linked with emerging technologies and electronic devices, including health care and biotech devices. For instance, some industry estimates show that demand for smart devices will increase 7–8% in developed markets, and 17% in emerging markets between 2012 and 2017. This may impact the demand, which may drive a comeback in prices.

However, as consumers deplete the inventories from 2011, the balance may depend on how fast the producers can bring supply to the market and how the governments treat trading bans. The chart below depicts the cycle of inventories reflected by backwardation and contango as measure by the index. Notice there has not been a shortage since Dec 2011, and even then, it was small – adding only 3 bps. The question remains whether now could be the time of another cycle switch for a sustained period of shortage or backwardation in nickel, where front month investors may benefit.

Every conversation I’ve had today with people from Nashville to Toronto has started with how cold it is outside.  After the shock of the cold and when the heating bills come due, the conversation may turn to how expensive heat was in January.  That, of course, is at least for those who don’t invest in commodities to offset price spikes.

After natural gas posted the biggest one-day gain of 9.2% on Jan 24, 2014 since June 14, 2012, the S&P GSCI Natural Gas has gained 19.3% this year.  It has gained 25.9% in just 10 days since Jan. 9, 2014 and is also up 44.6% since it’s low for the prior year on Nov. 4, 2013.

In the history of the index since Jan 8, 1994, it has been calculated on 5,053 days and only 39 of 5,053 days have had a higher gain than the 9.2% seen on Friday  – that is only 0.77% of days. That puts Friday’s gain in the top 1% of big daily gains for the natural gas index.  See the table below for days gaining more than 9.2%:

Also, January 2014 MTD has posted the biggest monthly gain since September 2009.  Only 17 months of the 240 in the history of the index have seen bigger gains than 19.3%.  Although natural gas can be considered in a bull market from the bottom, many will watch to see if natural gas will earn the bull market stamp in January by breaking break the mark of a 20% gain for the month. Please see below for the table of natural gas bull market months:

Last, below is a chart of the index, where you can see the level is highest since Jan. 29, 2010.

Understanding a market’s dispersion provides important insights into its internal dynamics and the opportunities and pitfalls that might await both active and passive investors.  Dispersion measures the average difference between the return of an index and the return of each of the index’s components.  In times of high dispersion, the gap between the best performers and the worst performers is relatively wide; when dispersion is low, the performance gap narrows.

We recently updated our volatility and dispersion dashboard to reflect full calendar year 2013 results.  Dispersion is at or near its all-time low in every market we surveyed.  This has important implications for an investor who owns anything other than a broad market capitalization-weighted index fund.  Dispersion doesn’t tell us anything about what the market’s overall performance will be, nor does it tell us what strategies are likely to outperform or underperform.  What it can do, however, is to help us estimate how much over- or under-performance we are likely to experience.

For example, consider the historical performance of the S&P 500 Dividend Aristocrats index.  Since 1991, when the market has been in its least-disperse quartile, the average monthly deviation of the Aristocrats index relative to its parent S&P 500 has been 0.71%.  In the next least-disperse quartile, the average deviation rose to 0.95%, then to 1.36%, and finally, in the market’s  most-disperse quartile, to 3.31%.  Its average monthly deviation was 4.6 times larger in the most disperse quartile than in the least.

What is true for the Dividend Aristocrats is equally true for other strategy indices and emphatically also true for active managers.  When dispersion is low, there is less opportunity either to succeed or to fail.  With dispersion at its current levels, strategies that deviate from market cap weighting — whether active or indicized — should expect relatively low incremental returns.

Friday, January 24 was a rough day for the US equity markets with the Dow Jones Industrial Average shedding 318.24 points or 1.96%.  Driven by increasingly wide spread expectations of a market correction and slowing manufacturing in China, the Dow experienced its worst single day point drop since June 20^th of last year.  On that day, the markets gave back over 353 points after comments from former Fed Chairman Ben Bernanke fueled fears of an imminent stimulus taper.

Lowlights from today’s tape:

• Today’s drop leaves the DJIA down nearly 700 points or 4.21% on the year.  It’s a pretty arbitrary measurement, but that’s the worst 16 day start since 2009 when the DJIA lost over 7.50% over those early days.
• Visa (V), responsible for the loss of nearly 45 points, was the worst performer.  Boeing (BA) was responsible for taking off nearly 30 points and 3M (MMM) nearly 29.  Procter & Gamble (G), adding just over 6 points, was the best performer and one of only 3 Dow stocks up on the day.
• As a group, Financials were the worst performer today (-97.42 points) and year to date (-174.36).  None of the 9 industries represented in the DJIA were up today, nor are any up on the year.

Municipal bonds yields have come down at a faster pace than U.S. Treasury bond yields helping to push up bond prices. Equity and currency market volatility is helping to drive cash inflows for municipal bond funds and when combined with manageable new issue supply has helped foster a stronger muni bond market. The S&P National AMT-Free Municipal Bond Index tracking investment grade bonds has started 2014 with a positive total return of 2.34%. The average yield of bonds in the index has fallen by 36bps since year end out pacing the drop in yield of the 10 year US Treasury bond.

Puerto Rico municipal bonds stung the bond market in 2013 with the S&P Municipal Bond Puerto Rico Index falling over 20% during the year.  That index has seen a rally of 3.7% in January as the average yield of Puerto Rico bonds in that index has improved to 7.19% from 7.44% at year end. Possible new bond issuance from Puerto Rico will test the depth of market’s appetite for these bonds in coming weeks.

Tobacco settlement bonds have benefited from yields coming down. The S&P Municipal Bond Tobacco Index has seen a positive total return of 4.72% year to date as average yields of bonds in the index have dropped by 33bps in January.

Five year municipal bonds tracked in the S&P AMT-Free Municipal Series 2019 Index have seen yields come down by 33bps to end at 1.63%. The S&P AMT-Free Municipal Series 2023 Index have seen yields come down by 36bps to end at 2.88%. Out longer, 20 year bonds tracked in the S&P Municipal Bond 20 Year High Grade Rate Index have seen yields come down by 45bps to end at 4.1%.