Tag Archives: exchange traded funds

2014 – Equity Flop & Commodity Hop

I thought taking a vacation at the end of 2013 might allow me to come back to the markets with a clear head and new viewpoint. My hope was that a little detachment would bring the forest back into the picture at 35,000 feet. I’ve now caught up on my reading and research and find the markets just as schizophrenic as they were when I left. While the markets remain as confusing as ever, our trip did provide me with the sense of awe that comes from physically standing in the presence of thousands of years of history. One thing is for certain; mankind always finds a way.

Continue reading 2014 – Equity Flop & Commodity Hop

Grain Market Repeat of 2010

The grain markets are beginning to look like 2010 all over again. The corn, bean and wheat markets all had substantial rallies, with each setting all time highs in 2008. The markets then formed a secondary peak in 2009 before drifting lower to sideways through the early summer of 2010, which ended up being the base for the all-time highs. The most consistent reason for expecting a similar outcome this year is based on the same external factors in play this year like, ending stocks and global demand. However, these factors have already been accounted for. The hidden key to these expectations lies in the market actions of the commercial traders.

The Commodity Futures Trading Commission (CFTC) publishes a weekly report of the each market’s main participants and their actions within the markets they trade. These groups include small speculators like ourselves who hope to profit from our actions in the market as well as commodity trading advisors (CTA’s) who manage pools of money and are professional traders. The CFTC also tracks the actions of hedgers, people who genuinely use the futures markets for their intended purpose of mitigating risk throughout the crop cycle. A new category added over the last few years has been that of index traders. Index traders manage money based on an exchange-traded fund like CORN, obviously an ETF based on corn. Index traders simply track the movement of the underlying asset in their fund. Their actions are seen as adding volatility and speed to the market. They buy on the way up to match the index to the underlying as it climbs and sell on the way down to match the market as it falls.

The final group of traders tracked in the primary report is the commercial traders. This is the group of traders that either produces or, consumes the underlying market. In the case of corn, this would include Fortune 500 companies like Monsanto, Archer Daniels Midland and Con Agra on the production side and Pillsbury, McDonalds and Kellogg’s as end line consumers. We follow this group because of the market research facilities that they employ. They have access to the best models and end line estimates of where they believe the market should be valued. Therefore, when a market becomes significantly over or, undervalued they can take advantage of the difference between where the market is trading compared to where they think it should be trading.

This brings us to our current situation. All three primary grain markets provided clues to the coming rallies based on the surge of accumulation by end line users during the post planting lulls. Fear in the grain markets comes in three phases and each carries with it a build in premium followed by a sell off if the fears are unfounded. The first concern is planting fear. Provided the crops get in the ground on schedule, the market will gradually decline with a sigh of relief. The second is summer drought. Enough said, there. Finally, weather concerns around harvest. Again, followed by a post harvest decline and sigh of relief.

The commercial traders’ net position has grown substantially throughout this spring. In fact their purchases, viewed in the aggregate of the three markets is only eclipsed by their buying in 2010. This tells us two things. First of all, we are starting the season at prices that are generally viewed as under valued by the end line consumers. Secondly, that there is significantly more fear of a future shortage than surplus. Based on the commercial traders’ predictive capabilities, we believe that there is the possibility for a significant rally this summer if weather conditions are not perfect.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Cause of Commodity Volatility

Last week I suggested that the blame for the sell off in
silver was incorrectly placed on the small speculators’ direct participation in
the futures markets and further added that the volatility we’ve experienced is
going to be with us for quite some time to come. This week we’ll explain the
effect of Commodity Index Traders (CIT’s ) and Exchange Traded Funds (ETF’s) on
the commodity markets.

Commodity Index Traders are a relatively new phenomenon in
the futures markets. They began to gain notoriety as Exchange Traded Funds
based on commodities and started to make inroads with equity investors.
Commodity Index Traders have the same goal as mutual fund managers. They
attempt to mirror the index their fund is matched to. A mutual fund manager of
large cap stocks may try to match the S&P 500’s performance as their
benchmark. A Commodity Index Trader may try to mirror the Goldman Sachs
Commodity Index (GSCI) or, as it was known on the trading floor the, “Girl
Scout Cookie Index.”

The important similarity between these two types of
investment is that they are both, long only. People who invest in these funds
have bought the basket that the manager has acquired. This has, historically,
been a niche vehicle in the commodity markets and gone largely ignored until
the easy money policies following September 11th and the economic
crisis of ’08 devalued the dollar and sparked inflation in hard assets.

The oldest and largest commodity based ETF is GLD. As you
might have guessed, this is the gold ETF. It went public in 2004 and now holds $55
billion dollar’s worth of gold. Since the fund physically owns the gold, they
are responsible for holding more than 36 million ounces of gold at its current
price of $1,500 per ounce. This is the equivalent of more than 7,000 gold
futures contracts. They must adjust for their holdings as necessary to meet
investor redemptions as well as the demands of new subscriptions.

Mutual fund, ETF and CIT managers all have a tough time
beating their benchmarks. They are all bound to act on behalf of the public and
therefore, are subjected to the same shortcomings as the individual
participants’ human psyches.  In
practical terms this means that people, the individual investors, are most
anxious to buy at the top and sell at the bottom. When management fees are
factored in, it’s no wonder that gold futures have out performed the GLD since
its inception by more than 5% in price alone.

Furthermore, because an ETF’s trading strategy must be made
public in its prospectus, the managers’ trades are subject to market
manipulation by traders who know what action GLD must take in the markets and
when. The potential for manipulation is directly addressed in their prospectus.
“Other market participants may
attempt to benefit from an increase in the market price of gold that may result
from increased purchasing activity of gold connected with the issuance of
Baskets. Consequently, the market price of gold may decline immediately after
Baskets are created.”

Commodity based ETF’s have exploded in popularity over the
last few years. There are now more than 100 publicly available funds with a
combined net asset value of more than $110 billion dollars invested.
Furthermore, at the market highs in 2008, Commodity Index Traders held more
than 40% of the total commodity futures markets’ open interest, which was worth
an additional $60 billion. This is the money that has created the current price
floors that we are all calibrating ourselves to as the new normal.

The new money added to the commodity markets has roughly
doubled the size of the commodity markets’ capital base and indirectly, brought
untold numbers of new investors to commodity futures products. Considering that
this money is almost exclusively individual investors on the buy side, it’s
easy to see how general human psychology will exacerbate the highs and lows of
each rally and decline. The new normal will be higher volatility on the greedy
path to new highs as people climb on board followed by higher volatility on the
down side as individuals abandon ship.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Commodity Bubble Targets

The commodity bubble of 2008 was a textbook bubble. Multiple
markets participated and supply and demand had nothing to do with value.
Commercial traders were losers when the prices traded did not reflect their
view of market fundamentals. When oil reached its high of $147 per barrel,
there were tankers circling the delivery ports, killing time as prices rose,
waiting for instructions to enter and unload. Many commodities were witnessing
a flood of new capital in the form of Exchange Traded Funds. The oldest pure commodity
ETF, the SPDR Gold Trust, started trading in 2004. Since that time, more than
$1 trillion dollars has flowed into commodity based ETF’s. A recent calculation
suggests that energy ETF’s control the equivalent of 1.6 million futures contracts,
which is equal to the total futures market open interest.

There are two easy money policy events that spurred this on.
The first was September 11th. In the face of tragedy and
uncertainty, the government and the Federal Reserve Board instituted an easy
money policy to prop up demand in a shell-shocked population. This, in turn,
fueled the housing boom and the cash out mortgage refinancing boom. Excess cash
found its way into all investment vehicles until it all unraveled in the
economic collapse of late 2008. The institutions’ response was the second event
that brings us to where we are – easier money, QE1 and QE2.

The result of easy money is cheaper dollar based commodities
in the face of growing global demand. We can see the devalued Dollars’ effect
on commodity prices in the face of the economic collapse of ’08. Commodity
prices put in a higher floor than they had from September 11th
through the bubble top in ’08. The ’08 bottoms in the commodity markets have
simply served as a new, higher floor price. The market has since traded higher
on growing global demand, ETF investment and a falling Dollar. Therefore, the
recent rallies are not bubbles, and that is the scary part.

I’d like to point out that my preference is for sound
economic policy and rational investment strategies. These would include curbing
U.S. spending, allowing China’s currency to freely float and opening up foreign
commodity exchanges to cross hedging. However, given the current architecture
and political leanings we will trade as if we’ve witnessed a two- year basing
and consolidation pattern with the major rally yet to come. This is where
things get stupid.

When measuring things we can’t get our heads around it helps
to use analogs. This is when we compare something we’ve already experienced and
know to something we’re presently trying to understand. You’ll hear this in the
markets as, “This wheat market is trading like the Australian drought of ’07.”
Or, when the market collapsed in ’08, people were comparing it to the crash of
1929 and the depression was to follow. Traders also use this to compare charts.
We disregard the scale numbers on the charts and simply try to find similar
patterns. Comparing patterns allows us to measure amplitude, the size of the
moves and the rhythms of the markets.

Using analogs, chart pattern recognition and a little
quantitative analysis, we come up with bubble targets we can’t quite get our
heads around. Here are some examples: Corn – $11 per bushel, Wheat – $22 per
bushel, Cattle – $1.50 per pound, Sugar – 47 cents per pound, Crude Oil – $250
per barrel. Some markets have already hit their targets like gold, silver,
coffee and cotton. Therefore, the end prices of these markets will end with the
old adage, “The only cure for high prices is, high prices.” How high will just
have to be seen to be believed.

This blog is published by Andy
Waldock. Andy Waldock is a trader, analyst, broker and asset manager.
Therefore, Andy Waldock may have positions for himself, his family, or, his
clients in any market discussed. The blog is meant for educational purposes and
to develop a dialogue among those with an interest in the commodity markets.
The commodity markets employ a high degree of leverage and may not be suitable
for all investors. There is substantial risk of loss in investing in futures.

Sugar Tops 2010 Commodity Market Volatility

It’s been a banner year for commodity markets as many of them have witnessed unparalleled growth. The one sided movement in many markets in 2010 has made commodity funds quite favorable as they are only able to invest through the purchase and ownership of their respective niche markets. However, long only commodity funds and Exchange Traded Funds miss out on one of the biggest advantages of trading commodities. That is, the ability to sell a market short and profit from an anticipated decline in prices.

Commodity contracts have set expiration dates. This makes them a very good short- term trading tool because speculators have to even up their positions prior to the contract’s expiration and we can track their actions through the commitment of traders reports. Only producers who intend to deliver their product and end line users of commodities stay in the markets until expiration. Some markets like  crude oil, trade all twelve calendar months. Other markets are delivered quarterly like foreign currencies and stock indexes. The sugar market also has four delivery dates per year. However, they’re not evenly spread out with the contract for March delivery becoming the actively traded contract in October.

The combination of being able to profit in a declining market as well as the uncertainty caused by sugar’s unique expiration cycle as well its relatively recent but substantial use in ethanol has made the sugar market, yes, the sugar market the single most volatile commodity market of 2010. In the commodity markets, volatility equals opportunity. In order to make money in any market, there has to be price movement. The fact that the commodity markets can be traded from both sides provides twice the opportunity. No market has illustrated that opportunity like the sugar market in 2010.

Sugar had rallied throughout 2009 on expectations of a small Indian crop due to a late and insufficient monsoon season hampering their output while Brazil’s was constrained by just the opposite problem. They had too much rain. Brazil’s overabundance of precipitation was hindering their harvest and slashing their yields. Brazil and India are the world’s top sugar producers respectively accounting for more than half of global production. These production concerns came with the pressures of growing a Chinese demand that has nearly doubled in the last ten years and outstripped its own domestic supply in 10 of the last 12 years.

Due to these pressures, 2010 saw the sugar market begin the year at levels not seen since the 1970’s. It’s important to note that sugar is basically a weed, like wheat. Its recuperative powers are stunning, given the right conditions. Therefore, the sugar market that found itself with tight supplies and a dwindling new crop came to experience some decent weather and a stunning recovery. In fact, the Brazilian crop that makes up nearly half of the world’s market and was perceived to be in such dire straits had actually recovered most of its anticipated yield.

The rapid recovery of the crop along with added acreage planted for the coming year quickly caused prices to plunge. The long only global commodity funds were forced to liquidate their positions on the way down. Their disclosure documents require them to maintain proper portfolio allocations, which causes them to buy more on the way up and sell on the way down. Their liquidation further depressed prices and the decline became a race to the bottom. Unlike long only funds, individual commodity traders as well as commodity trading advisors had the flexibility to participate and profit from the market’s decline. The price of sugar lost more than 60% between February and April of this year. This decline was fueled further by a Brazilian report that expected production to be 10% greater than the previous year.

The month of April saw the sugar market consolidate tightly in anticipation of the World Agriculture Supply and Demand Report. These reports are published monthly but the April report is an important one for the sugar market because it is the best reference of planted sugar for the coming crop year. The surprise in this report was a global uptick in demand to the tune of 5.3%. Considering the acreage came in as expected, the uptick in demand more than offset the added acres planted due to 09’s average sugar price. This was enough to reverse the course of the market.

Following May’s World Agriculture’s Supply and Demand Report, India stated that it was going to tax sugar exports to shore up its domestic supplies. Furthermore, the U.S. Dollar’s decline led to increased sugar purchases on the open market as foreign countries could now make purchases on the open market to satisfy the demand generated by their growing middle classes at a discount.

The effect of the falling dollar, a growing overseas middle class and tight global supplies have taken the sugar market from its final low of 11 ½ cents per pound up to a current price of over 33 cents per pound. All told, the sugar market started the year at generational highs around 28 cents per pound. The market then plummeted to a low of 11 ½ and has currently rallied to prices not seen in 30 years. As a comparison, gold would have to trade to $3,300 per ounce to match sugar’s high or the Dow Jones Industrial Average would have had to fall to 4172 to match the sugar market’s February to April decline. Trading of any type requires price fluctuation to make or, lose money. The ability to trade both sides of the market increases the number of opportunities. Volatility is the measure of price fluctuation and the sugar market is its poster child.

Don’t Pay Up for Precious Metals Diversification

Gold and silver have exploded in recent years. The contributing factors of low interest rates, economic uncertainty, global fear and pending inflation have done their share to boost precious metals’ outsized gains relative to the stock market. Gold has rallied more than 150% over the last five years while the broad stock indexes are all flat to lower, depending on the day. Silver, for its part, has nearly doubled in the last five years. Given our still historic low interest rates and the growing economic trouble overseas as well as our ballooning governmental budget deficit, it’s reasonable to believe that the forces behind this trend continue to remain intact. The question has changed from, “Should I be invested in precious metals,” to “What’s the most cost effective way to maintain a presence in precious metals.”

The boom in the precious metals market has brought with it the familiar hype of the gold bugs. It has also fostered the invention of precious metal Exchange Traded Funds (ETF’s) and cash for gold TV commercials. Commodity futures markets have also benefited from the added attention being paid to gold. Each of these has a place in the marketplace and each has a vested interest in hyping their product as the one that’s best suited to your needs. However, if you are ascribing to efficient portfolio theory and seek to include precious metals ownership as a part of your portfolio diversification plan, the best bang for your buck is through commodity exchange traded contracts which are regulated by the Commodity Futures Trading Commission (CFTC) and guaranteed by their appropriate exchange.

The market sectors mentioned above can be lumped into two categories: small speculators and investors. Gold bugs and cash for gold are for people with left over jewelry, some family heirlooms and gold coins like American Eagles or South African Krugerrands. Typically, this type of gold ownership sell side biased. This means owners of small pieces or collections are keeping an eye on price and hoping to sell when they think the market has peaked. When they bring their physical collections to market, they will end up at the coin shops, pawn shops, cash for gold, or their local jewelry shop. The willing buyers are always waiting and ready to pay below market value for collections that may have taken a lifetime to accumulate. Upon recent survey of the available outlets, prices to be paid were typically $40 per oz under market value for gold and $.30 per oz under market value for silver. Those on the buy side of this equation, looking to add to their private physical collections will find themselves paying up $30 – $50 per oz over market value in gold and up to $1.20 over per oz in silver. Therefore, small speculators in the physical precious metals market may lose more than 10% of the value of their collection in the buying and selling process.

Passive investment in the precious metals can be done in two ways, ETF’s and commodity exchange traded products. The benefits of ETF’s are that the amount to be invested can be determined beforehand and the investor can pick their own allocation, even if that amount is less than the price of one ounce of gold. The downside is these ETF’s typically underperform the actual market they are designed to track. Typically, one would expect a dollar for dollar rise and fall between the price of the metal and the value of the account. However, due to administrative fees, expenses, incentive fees, cost of acquisition, advertising, etc, the longer the ETF trades, the further behind the actual price they fall. Therefore, it is possible to lose money in a flat market, or realize a smaller return than one would expect in a rising market.

Finally, exchange traded commodity contracts like those listed with the Chicago Mercantile Exchange Group are the actual proxy to which ETF’s and local dealers tie their prices. Perhaps the single biggest drawback to these products is their preset size. There are about half a dozen precious metals products listed ranging in full cash value from $18,000 to $125,000. These contracts have several benefits for passive portfolio diversification. First, these are standardized products fully assayed and certified by the appropriate exchange. This assures the investor that their 100 ounces of gold is 24 carat and their silver is .9999 fine and that the value of your holdings can be found 24 hours a day, rather than being quoted by the guy in the shop down the street.  Secondly, there are no administration fees, advertising costs, or incentive fees. The only charge is a one- time commission to your commodity broker, typically, around $50 per contract. Also, you will control the actual metal and not find yourself invested in mining sales or land right options because you didn’t read the prospectus thoroughly. Finally, the biggest reason exchange traded products are so much more cost effective is the use of margin and the amount of cash it frees up for the individual investor. The $18,000 contract mentioned above requires a cash deposit with the exchange of $1,150. This allows the individual investor to use the remaining $16,850 in excess cash for a money market account and earn interest on top of any return produced in the actual market itself. Therefore, those wishing to pursue efficient portfolio theory and diversify their holdings can most efficiently implement this process through the use of commodity futures markets.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.