Indexology^® Blog

Headline news on Friday was that oil dropped below $40 per barrel, the lowest since March 3, 2009. It’s bad news for an oil investor to learn 6 1/2 years are wiped out – that is no gain since the bottom of the financial crisis.

Unfortunately, the reality is so much worse than that. The price per barrel of oil is an unrealistic measure for most investors since the oil needs to be stored and that can be costly. Futures contracts are priced to include the storage costs, so according to the theory of storage equation, one is indifferent between buying an oil futures contract or buying physical oil and storing it until the time of expiration of the contract. Needless to say, storing at least 1000 barrels of oil is inconvenient, so most investors prefer futures. Sometimes, returns of futures contracts are more profitable than the spot returns and at other times futures lose more than the spot market. Inventories drive the difference where excess inventory that is expensive to store is losing to a futures investor from a curve condition called contango. The opposite condition, called backwardation, is profitable and happens when there is a shortage so there is no value to storage, and a premium, called convenience yield, is put on owning the commodity immediately.

Obviously right now there is excess oil inventory, but how much is being lost from the term structure of futures as described by the theory of storage equation? It might be more than you think. The answer is shown graphically below where the S&P GSCI Crude Oil Total Return includes the term structure costs from rolling but the S&P GSCI Crude Oil does not. With a quick glance, it is clear that 10 additional years of returns are wiped out from these costs.

At Friday’s close, the S&P GSCI Crude Oil index was at 221.69, the lowest since 3/2/2009 when the level was at 220.05, and it fell 62.1% since its high on June 20, 2014. However, the S&P GSCI Crude Oil Total Return fell 66.3% from its June high to a level of 516.55, its lowest since Oct. 11, 1999 when the index was 508.38. Four percent may not seem like much, and although the difference is small from the backwardation that was present through Nov, 2014 (as shown in the chart below,) again, it is enough to erase an additional 10 years of returns.

Two things are interesting. One is that the current rolling costs are currently only about half of what was observed in the drawdown from July 14, 2008 to Feb. 18, 2009. The other interesting observation is that the huge negative rolling costs don’t exactly correlate with the timing of the drawdowns. It was really in Jan and Feb of 2009, that the roll cost spiked with a 33.5% loss in the total return versus a 10.0% loss in the spot return. It took the inventories over 4 years to deplete with no significant shortage for roughly 6 years as shown in the chart below:

It is difficult to predict how long this glut will last. However, It may be longer than expected if China decides to use some oil from its (unkown) strategic petroleum reserve as prices rise, and its devalued yuan makes it more expensive to import the oil.

To add to the turmoil, on average when oil is down, it drops 6.9% in a negative month. Historically, gas falls about the same amount, losing 7.0% in a negative oil month. This time unleaded gasoline has held its value relatively well, only dropping about 1/4 of the drop in oil, reducing the benefit to consumers.

From processing issues to labor costs, despite commodity drops, prices seem to be rising for consumers. Check out announcements from: Starbucks about raising prices despite a near 25% drop in coffee this year; the USDA announced rising beef and pork prices despite S&P GSCI Feeder Cattle,  Live Cattle and Lean Hogs losing 8.2%, 12.1% and 22.6%, respectively; some are even reporting bread price increases despite a drop of 14.5% and 21.4% in Chicago and Kansas Wheat. At least chocolate prices are increasing with a the rise in the cocoa commodity price – that is up 5.6% year-to-date. Maybe a little extra serotonin is helping the demand in this otherwise stressful market.

To end this on a sweeter note, many index innovations have been developed to better manage rolling costs from contango. The chart below shows an annualized 10-year comparison of an enhanced rolling strategy that is relatively simple but reduced the loss by half. It also compares a more sophisticated dynamic roll that has lost less than 3%. If diversification and inflation protection are goals, a smarter rolling strategy may be useful for a potentially prolonged term structure in contango.

As my S&P Capital IQ colleagues recently noted we have reached a golden age of investor activism. In the past five full years, activist engagements increased fourfold. The success of investor activism has helped these firms both attract more capital and deliver greater returns as their principals now regularly make news and headline events.

The S&P U.S. Activist Interest Index is designed to measure the performance of companies within the S&P U.S. BMI that have been targeted by an activist investor, as defined by S&P Capital IQ, within the last 24 months. The activist must have at least a 5% equity stake, determined through SEC Form 13D filings and the target company must have a minimum three-month average daily value traded of $20 million.

The index launched in April 2015 and as of July 2015 had 67 constituents. The index had 32% in consumer discretionary and 17% in industrials. Some consumer discretionary constituents included Interpublic Companies (IPG) and Crocs (CROX). 

S&P Capital IQ does a quarterly review of the activities of the top-10 hedge funds that collectively manage $200 billion in assets. During the second quarter, the consumer discretionary sector experienced the second most buying activity. The $2.4 billion for the sector was behind only the $7.2 billion for the health care sector.

According to my S&P Capital IQ colleague Pavle Sabic, who published the Hedge Fund Tracker research, among the top 10 top purchases, four companies were in the consumer discretionary sector. They were JD.com (JD), Netflix (NFLX), Amazon.com (AMZN) and Starwood Hotels & Resorts Worldwide (HOT). Meanwhile Rolls Royce (RYCEY) was the lone industrials sector constituent in the top 10.

There are a few ETFs that seek to replicate the holdings of hedge funds.

Please follow me @ToddSPCAPIQ to keep up with the latest ETF Trends

The FOMC released the minutes of its July 28-29 meeting earlier today.  While there was no discussion of raising the Fed funds target at the July meeting, all agreed that economic conditions are improving and that the labor market is getting stronger. The inflation rate is below the Fed’s 2% target and will be watched closely.  Most members felt that pressures keeping inflation where it is or pushing it lower are abating. No one expected a further sharp drop in oil and energy prices.   Comparing the members’ comments about the economy as it was when they met to more recent releases on GDP, industrial production and housing starts reveal an improving economy.  There appears to be a growing consensus for a move towards raising the fed funds rate.  One member of the committee noted that further increases after the initial move should gradual.

However, all the data aren’t in yet.  The next FOMC meeting is on September 17^th. Before then we will see another employment report, another personal income and spending release with the Fed’s preferred inflation indicator, the personal consumption deflator and several other data releases.  FOMC decisions will depend on the upcoming data.

The economy is improving, inflation isn’t falling, the Fed wants to begin normalizing monetary conditions and the policy tools are all in place.  It looks more and more like September will see the first move up 2006.

Those expecting the Fed to delay any move because of the rising US dollar, Greek debts or Chinese stocks were disappointed by the minutes – there were some comments but no suggestion that foreign developments would get top billing and sway Fed policy.

As the chart shows, Its been a long time…

Malaysian ringgit continued the plunge and hit a 17-year low.  The offshore holding of Malaysia local government debt also fell with the heightening FX volatility and declining FX reserves.  The S&P Malaysia Bond Index dropped 1.27% in August, bringing year-to-date (YTD) total return to 1.66%. Its broader benchmark, S&P Pan Asia Bond Index, aggregates the returns from 10 countries in Pan Asia and calculated in USD, dropped -0.56% YTD.

Nevertheless, Malaysia has better fundamentals comparing with other Asian countries.  Malaysia has been assigned solid credit ratings of A-/A3/A- . It also released better-than-expected 2Q15 real GDP growth at 4.9% y-o-y.

In fact, the Malaysian bond market almost doubled its size from 2007 to currently MYR 423 billion. Similar to other Asian bond markets, the corporate bond market expanded rapidly from a merely 5% to 15% of the overall market.   Among the corporates, over 90% of exposure belongs to financials sector, with popular names like Malayan Bank, CIMB Bank, Public Bank and RHB Bank.

Looking at the yield performance, the yield-to-maturity tracked by the S&P Malaysia Bond Index has widened 17bps YTD to 4.14%, as of August 18, 2015. The yields of the S&P Malaysia Government Bond Index and S&P Malaysia Corporate Bond Index currently stand at 4.02% and 4.78%, respectively.

Exhibit 1: Market Value

Exhibit 2: Yield-to-Maturity

“I don’t agree with you Jodie…..Gold is in a bear market….too early to put some money in the yellow metal….” is a comment from the article recently posted by the Economic Times asking the question, “Where do you see the gold prices making a bottom as every fundamental turns unfavorable for gold?” 

We love your comments expressing your opinions about where the market is and where it’s going, just as much as we love to share the history lessons told through our indices.

Let’s pretend today is sometime in the middle of 1981. President Reagan just established the Gold Commission that rejected returning the U.S. to a gold standard. The Fed raised rates to 20% and inflation fell. But that created a recession. Gold investors lost about half their asset values. They wondered, “Had gold reached its bottom?”

To understand the answer to this question, investors might consider the underpinnings of the prior bull run of over 400% that started when Nixon took the dollar off the gold standard in 1973. Inflation tripled, the dollar crashed, and after years of erratic monetary policy, investors piled into gold as a safe haven. The perfect environment for gold ended and investors wondered about the future of gold without these supports.

For the next 20 years, gold lived through mostly expansionary periods. Even as investors abandoned gold for stocks, gold didn’t fall much further.

Not until Sep. 11, 2001, did fear ripple through the market, triggering the flight to safety into gold again. The drivers of inflation and a weak dollar that supported gold through the 1970’s bull run were back. These factors plus the global financial crisis and worries about government reform led gold to a record high. Such forces in addition to the growing popularity of the gold ETF as a new way for investors to access gold sent gold soaring more than 600% over the next ten years, until Aug. 2011.

As worries eased, investors fled gold once again. However, many in this selloff have no memory of the 65% drop that happened in 1981-82. Currently, gold has only lost 45% since its peak four years ago, but the majority of the loss happened in 2013 when gold dropped 28%, the most since 1981.

It is difficult to predict where the bottom is but the last time gold dropped this much it took over 25 years to recover. It certainly diminishes the importance of identifying the bottom even if the bottom has been reached.

Gold would need to drop another 40% from current levels in order to match the 1981-82 drawdown, so it wouldn’t be surprising to see gold fall further. Investors need to look to underpinning fundamentals again to understand gold. Poor economic data from China, inflation under control, low interest rates plus gold’s diminished status of a safe haven are not promising. Investors continue to flee as evidenced by recent record outflows. If interest rates rise again that may help gold futures since the collateral return increases but there may be outflows in lieu of income producing securities.

Since most single factors like inflation, interest rates, jewelry demand, oil prices, geopolitics and U.S. dollar strength don’t alone move gold, they are unreliable indicators of gold’s prices. However, one statistic that is pretty solid through time is that gold is uncorrelated to the stock market. On average, the 12- month correlation is zero but even on short intervals of rolling 90 days the correlation doesn’t ever exceed 0.6.

Once again, timing gold doesn’t necessarily matter. Gold is not always owned for high returns but instead serves to protect against a drop in other assets like stocks. It has held up in times of inflation and may hedge against other risks like geopolitical risk that hurts stocks. Investors looking for diversification and capital preservation may use gold in a portfolio framework at any time.  Now is as good of a time as any to invest in gold given its recent drawdown and the strong stock market performance over the past several years.

Again, we’d love to hear your thoughts. Do you think now is the right time to buy gold? Or do you agree with the comment above that it’s too early to buy gold?