Indexology^® Blog

Barcode symbologies are mappings which allow humans and computers to communicate by simplifying the language into a code of bars and spaces that scanners can read.  If complex information can be depicted so simply that a computer can read it, why not use a barcode to better understand oil? If you see the pattern below, congratulations – you might be a computer (or an oil analyst.) If you don’t see the pattern, then don’t worry – you’re human.

Let’s walk though the symbology that maps the above barcode to its underlying message.  The first step in decoding the barcode is to show the labels of the chart.

The chart is simple. It’s just binary; 0 for backwardation and 1 for contango, where a black bar represents a month of contango. (As a refresher, contango describes the shape of a forward curve when the contract expiring nearby is cheaper than the contract expiring further out. It is losing for a long only investor. Conversely, backwardation describes the shape of a forward curve when the contract expiring nearby is more expensive than the contract expiring further out. It is profitable for a long only investor.) Notice contango and backwardation tend to come mostly in thick lines, or in other words, there are several consecutive months of either backwardation or contango.

Why is this? Backwardation happens when there is a shortage, and contango happens when there is excess inventory. Since it takes time for inventories to build and deplete, the conditions persist. Not only do the conditions generally persist, they stubbornly persist. There are only 15 of 343 months where oil’s curve shape flipped for only a single month. It was twice as likely to see a shortage peek through for a month during contango than it was to see an excess during backwardation. That should make sense since it is harder to grow, mine and drill enough commodities to replenish inventories during a shortage than it is to buy cheap commodities in a glut.

If by glancing, you think it looks like contango happens more than backwardation, then you are correct. Historically, contango is measured just over half the time, in about 55% of months, and backwardation is measured in about 45% of months. However, backwardation is more potent. Not only is it harder for a surplus to interrupt a shortage but the average monthly return gained (roll yield) from backwardation is 1.7% versus 1.4% lost in months of contango.

On average since 1987, there is only a slightly negative roll yield of 2 basis points per month, but the contango since 2005 helped drive the S&P GSCI Crude Oil Total Return down to the lowest since 1999 (on Aug. 24, 2015,) wiping out an additional 10 years of gains for investors.

Since then, there were a few historically winning days, driving oil up 15.6% by the end of Aug. However, contango still persists, making the S&P GSCI Crude Oil Total Return’s loss of 10.3% month-to-date through Sep. 10, 2015, on track for the worst month in history.

Finally, will contango persist? To put the contango streak into historical context, if Sep. stays in contango, that will be the 10th month straight which is not even close to a record losing streak. Plus the glut from OPEC, the U.S. and others in a market share competition for China as a consumer can prolong it, especially since China’s economy is under pressure and their currency is devalued, making it more expensive for them to import oil. There are six longer contango streaks than the current one at 10 months, and the longest lasted three years that was part of a 61 month streak from June 2008 – June 2013 that was only interrupted by two separate months of backwardation in Oct. 2008 and Nov. 2011. Please see the table below:

The S&P GSCI Crude Oil Total Return has only fallen 30.9% since its recent high on May 6, 2014. That again is far from its worst total return loss of 82.3% in the global financial crisis. From the current index level, another 74.3% needs to be shaved off to match that drawdown but with the help of persistent contango, it’s possible.

To hear more about views on oil, please join us for our 9th annual commodities seminar.

The ability to measure, and to quantify what has been measured, is important for advancement.  It gives us a sense of the current state of things and helps us to gauge the amount of improvement that can be attained.  For example, it does not help if a runner only knows that she runs fast, but it certainly helps if she can measure her speed every time she runs and then improve it.  The measurement can be absolute or relative.  For example, the runner might know her speed, but it will be more helpful if she knows her position among the other runners who are participating in a competition.  She can then compare herself with them and strive to improve even further.  Basically, she gets a benchmark, a reference point against which similar things can be compared—in this case, and the speed of the other runners in the competition.

Like other fields of study, benchmarks are also required in finance, and in capital markets, indices generally serve this purpose.  Indices are an important means of understanding the market.  They are hypothetical portfolios of assets against which the performance of real portfolios can be assessed.  All investors collectively own the entire capital market, and an index designed to include each and every asset would be a true gauge of that market.  In general, it is not possible to track the entire capital market because of reasons such as the lack of up-to-date information on prices, among other things.  Hence the indices are designed so that they are a close proxy.  They have relatively infrequent, rules-based constituent changes that are not motivated by short-term alpha.

Indices used to be primarily limited to equities, but now they have sprung up in almost all of the asset classes, representing virtually every strategy.  They are designed to reflect all kinds of styles, categories, sizes, etc. of the asset classes.  For example, in equities, we have different sizes and sector-based indices.  In fixed income, we have different maturity time spans, ratings-based indices, and more.  Indices are designed to be either broad-based or investable.  For example, a broad-based, mid-cap equity index would include all the mid-cap stocks in the equity market.  On the other hand, an investible mid-cap equity index would include only a subset of highly liquid stocks from a broad-based, mid-cap equity index.  Indices can seek to measure either the price return or the total return, which reflects the income from dividends.

For the Indian equities, Asia Index Private Limited recently launched the S&P BSE AllCap.  It is a broad index suite that seeks to measure the different sizes and sectors of stocks.  It is divided into three size segments by total market capitalization, in which the top 70% make up the large-cap category; the next 15% make up the mid-cap category, and the smallest 15% are in the small-cap category.  It is also divided into 10 sectors.  From these broad indices, we can take out investable or strategy indices.  The S&P BSE MidCap Select is a sub-set of the S&P BSE MidCap.  Similarly, the S&P BSE SmallCap Select is a subset of the S&P BSE SmallCap.

Within the Indian fixed income universe, we have the S&P BSE India Bond Index.  The index is divided into two subindices: government and corporate.  The government section is further subdivided into sovereign bonds, agency bonds, government bills, and provincial bonds, while the corporate section is further subdivided into financials, utilities, services, and industrials.  With these indices, we can attempt to get a clear view of the risk and return of the fixed income market in India.

A well-designed index is transparent and clearly states the market segment it seeks to measure.  Selecting the right index as a benchmark for an actively managed fund is becoming more and more important given the amount of money that has been mobilized in the industry over the years.  The fund manager should look for an index that is closest to the fund’s investment objective and risk and return characteristics.  Moreover, if the fund is fully collateralized, a total return index may be the right index for comparison.  The fund manager may then use his selection and allocation skills to outperform the index.  This is how indices play an important role as benchmarks in capital markets.

Click here for Info-graphic on Benchmark.

Among analysts and Fed watchers, no matter what they expected from the Fed, they were all confident that this morning’s August Employment report would reveal the future.  No luck.

If anything, the report had something, but not enough, for everyone. The increase in payrolls was 173,000, far below the 220,000 expected; the previous two months were revised upward by 44,000; the unemployment rate dropped to 5.1%, the lowest since 2008; average hourly earnings rose 0.3% after a string of 0.2% reports and average weekly hours beat expectations at 34.6 vs. 34.5.  The treasury markets were as confusing as the report: at the release yields dropped – and then rose as people re-read the details.

With all the usual caveats of no guarantees and almost two weeks until the FOMC meeting, the odds slightly favor the Fed raising the Fed funds rate by a quarter-point. Set aside the top line payroll number for a moment and the rest of the employment report, and the economy, is solid. The unemployment rate dropped while labor force participation was steady, wages crept up and weekly hours were unchanged. Employment measured on the household survey rose by 196,000 jobs. Like all economic data, the devil is in the revisions. August payroll numbers tend to be low on the initial report but also tend to have large upward revisions. Altogether, the employment numbers favor a rate increase.

There are other factors favoring a September increase.  As Stanley Fischer noted in his speech at the recent Jackson Hole meetings, if the Fed waits until inflation is clearly rising, it will have waited too long. But will inflation begin to rise?  All oil prices have to do to remove downward pressure on inflation is to stop falling – and WTI has been in stuck between $40 and $60 per barrel so far this year.  The speculation about the timing of the rate increase will continue to grow until the Fed makes a move.  And attention is reaching extreme levels: Fed officials arriving for their conference in Jackson Hole last week were met by two groups of demonstrators – one for and one against raising interest rates.  Senators, congressman and presidential candidates are all offering the Fed advice. All the noise will only get louder and louder until there is a rate increase.  While lowering the noise level is not a reason to raise rates, giving the market clear signals of the long term direction is a good reason.

The turmoil in global stock markets is not an argument to wait before raising interest rates or an excuse to re-start quantitative easing.  The Chinese markets were reacting to a weakening Chinese economy, rapid changes in Chinese government policies and attempts by the government to manage stock prices. The US markets were over-valued and due for a long awaited correction.  While a rate increase is a negative for stocks, reducing uncertainty and getting passed the first move is a positive for the markets.

No guarantees, but a 60% change of a rate rise on September 17^th.

Although the broader S&P 500^® was down 7.2% between July 1, 2015, and Sep. 1, 2015, not all related indices performed as poorly.  Indeed, the S&P 500 High Quality Rankings Index was down just 5.3% during the same period.  The S&P 500 High Quality Rankings Index is a benchmark with constituents that must earn an S&P Capital IQ Quality Ranking of A- or above. These are companies that have consistently exhibited strong earnings and dividend growth records over the past 10 years.

These companies include packaged foods and meats producer Hormel (HRL), footwear maker Nike (NKE), and aerospace and defense issue Lockheed Martin (LMT).

According to Sam Stovall, U.S. equity strategist for S&P Capital IQ, S&P 500 constituents with above-average S&P Capital IQ Quality Rankings had a beta of 0.9, while those companies with below-average quality rankings (B or below) had a beta of 1.3—and 1.1 for those with average rankings (B+).

As of early September 2015, from a sector perspective, the S&P 500 High Quality Rankings Index had a relatively high exposure to industrials (27% of assets versus 10% for the S&P 500), consumer staples (19% versus 10%), and consumer discretionary (18% versus 13%).  In contrast, there were limited stakes in financials (6% versus 17%), information technology (6% versus 20%), and energy (1% versus 7%).

The S&P 500 High Quality Rankings Index is rebalanced and reconstituted quarterly, so no position garners a weighting greater than 1.5%, unlike the market-cap-weighted S&P 500.

S&P Capital IQ thinks in light of the likely continued volatility ahead of the upcoming Federal Reserve meeting, investors should consider securities that are above-average in quality.

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S&P Capital IQ operates independently from S&P Dow Jones Indices.

The views and opinions of any contributor not an employee of S&P Dow Jones Indices are his/her own and do not necessarily represent the views or opinions of S&P Dow Jones Indices or any of its affiliates.  Information from third party contributors is presented as provided and has not been edited.  S&P Dow Jones Indices LLC and its affiliates make no representations or warranties of any kind, express or implied, regarding the completeness, accuracy, reliability, suitability or availability of such information, including any products and services described herein, for any purpose.

August Highlights: 

• Most Major Islamic Indices Closely Track Conventional Benchmarks in 2015
• Emerging Markets Plunge Over China Growth Concerns, Weak Commodity Prices and Prospects for Fed Tightening
• MENA Equities Drop Sharply as Oil Falls

Most Shariah-compliant benchmark have performed similarly to their conventional counterparts in 2015 as Financials have generated returns roughly in-line with the broader equity market.

Through August 28, the S&P Global BMI Shariah and Dow Jones Islamic Market World Indices declined 3.2% and 3.6%, respectively, modestly outperforming their conventional counterparts.  Over the same period, the S&P 500 Shariah lost 3.6%, slightly underperforming the 3.4% decline of the conventional S&P 500.  Islamic indices covering Asia Pacific, Europe and Emerging Market equities each modestly outperformed their conventional counterparts, while the S&P Pan Arab Composite Shariah slightly underperformed.

After a strong start to the year, emerging markets have led global equity markets into negative territory in 2015. Concerns about the sustainability of China’s economic growth, plunging commodity prices and expectations for higher U.S. interest rates have combined to trigger major equity market and currency declines, particularly among emerging market commodity exporters and countries with larger fiscal and current account deficits. 

Volatility returned to U.S. markets as concerns over high valuations, the Fed possibly raising interest rates and the slowdown in China drove markets into the red for the year.  The steep decline in commodity prices has also led to equity market weakness in resource driven developed market countries such as Australia and Canada.    Despite relative strength in Japan, the DJIM Asia Pacific Index declined 3.5% year-to-date, driven by double-digit declines in Australian equities.  Europe has been the best performing region, as DJIM Europe declined by just 0.9%.

Largely driven by falling oil prices, MENA equities, likewise, experienced a sharp reversal after a strong start to 2015, After peaking up 11.5% on May 19, the S&P Pan Arab Composite Shariah lost nearly 20% through August 28, leaving the index down 10.6% year-to-date.