The Value of Balance

By: Michael Ashton | Fri, May 4, 2012
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First, thanks to all of those readers who took time to respond to the poll attached to yesterday's comment. The early results are interesting, but the polls are still open! Please take a minute to respond, if you have not already done so.

Data over the last two days has been pretty discouraging. ADP yesterday printed the lowest reading since September, giving credence to the theory that a mild winter contributed to the sense of recovery. I think there's something to that theory, but I also think there was some actual recovery. The truth is that the economy was improving, but it wasn't improving as fast as it seemed to.

Today's data reinforced that sense, as the ISM non-manufacturing index declined to the lowest level since December. The 53.5 reading was a surprise on the low side, but still in expansion territory. Again, there's some weak growth there but not as much as the weather made it seem. Initial Claims (365k versus expectations for 379k) was a bright ray of sunshine, but 'Claims have still not improved since January or February and are likely still running around 370-380k on average.

One economic release you don't generally hear much about is the ICSC Chain Store Sales (ex-Walmart) figure. You don't hear much about it because it is pretty volatile as the chart below (Source: Bloomberg) shows.


As the chart also shows, today's y/y figure was the weakest since 2009. Now, with this much volatility in the series we can't reject the hypothesis that the real underlying rate is about what it was before; but in the context of broadly softening data it does seem to echo the storyline.

The storyline will likely get a further echo tomorrow, with the release of Nonfarm Payrolls for April (Consensus: 160k vs 120k, Unemployment Rate 8.2% - unchanged). The consensus seems high, but most markets also seem to be bracing for somewhat bad news (except, as always, the equity market). While stocks closed lower today by -0.8%, it was just Tuesday when the talking heads were applauding a new high in the Dow. But nominal interest rates are at the lowest level since February (1.93% in the 10y), and real interest rates are essentially at the lowest levels ever.

Worst, though, are commodities, which have been getting burned since late April...of 2011. If you want to find a market where the bad news is already heavily discounted, it is in the commodity indices. The chart below (Source: Bloomberg) shows Non-farm Payrolls (in red), Initial Claims (inverted, in yellow), and the DJ-UBS commodity index (in white). You can see that while commodities generally moved up with the initial improvement in the economy, since May of last year they have been weakening despite stable-to-improving metrics of job growth.

why not commodities

Of course, it also goes without saying that the decline in commodities over the last year also stands in contrast to the rise in core inflation from 1.3% last April to 2.3% now.

In short, commodities never got the benefit of the QE3 hype that helped keep other markets frothy, and didn't get the benefit of continued recovery over the last year (see for example the chart below, source Bloomberg, showing the recent wide gulf in performance that has opened up between stocks (in yellow) and commodities (in white) after a long period of high correlation). I've recently mentioned that according to our metrics, commodity indices are at rarely-exceeded levels of cheapness. So it doesn't seem quite fair that the sentiment against commodities is so negative.

commodities not stocks

Not that markets need to be fair, of course! But I think many investors just don't understand the appeal of commodity indices. Even fairly experienced investors like Warren Buffett have made clear that they don't care for commodities. To be fair, Buffett and others were generally talking about the owning of individual commodities, like Berkshire's ill-fated holding of huge amounts of silver early in the last decade, and which don't have a natural source of non-zero real return, while I am generally speaking of commodity indices, which do have ample sources of real return. One of those sources of return, and one that is seriously underappreciated, is rebalancing.

The reason that rebalancing adds returns is that rebalancing to neutral weights is a systematic method by which you are selling what goes up and buying what goes down. That's one way to buy low and sell high! In order to have significant returns to a rebalancing strategy, however, several things need to be true: the assets need to have reasonably high volatility as well as a low correlation between them. If all of the assets are moving together, there is obviously no important benefit from switching between them.

I did an experiment recently to illustrate how rebalancing can affect one's returns. The chart below (Source: Enduring Investments) shows a total return index for two strategies involving a portfolio of four assets: Crude oil, Copper, Coffee, and Sugar. This is obviously a fairly diverse group of commodities. One strategy produces just the price return from the front futures contract (I didn't adjust for the rolls; the absolute return isn't important, only the relative return of one strategy versus the other), assuming an initial investment of 25% in each asset and no rebalancing. That produces the red line. If the portfolio is rebalanced monthly, then we get the result shown in blue. Rebalancing produced a return of about 3.5% per year in this case.

Crude, Copper, Coffee and Sugar

By contrast, the next chart (Source: Enduring Investments) shows an analogous experiment with four equity indices: the MSCI EAFE index, the S&P Developed Property Index, the Russell 2000 Value Index, and the Russell 2000 Growth Index. The rebalancing return here is worth a mere 0.23% per year.

MSCI EAFE, S&P Dev Property, R2k Value, R2k Growth

Now, if you have a portfolio of individual equities, rather than indices, then you have a better chance of realizing some rebalancing return. However, even in that case it is important to realize that most of an equity's return is a market return: that is, in a bull market almost all stocks rise and in a bear market almost all stocks fall.

None of this will tell you anything about tomorrow's return, but for the rebalancing return and the relative value I continue to prefer commodity indices, and our models are tilted heavily in that direction (partly because of the paucity of alternatives). Honestly, as long as our investors remain patient we believe that taking the long view is the right way to wring profits from these markets.

Speaking of patient, we will see this weekend whether French citizens are inclined to further patience with Sarkozy or if they feel it is time to change horses. Polls indicate a close race but with Hollande the likely victor; although this is the expected outcome there may be some market volatility associated with that result. On the other hand, if Sarkozy wins, it is likely Euro-positive and I would expect equity and bond markets in Europe to rally. Personally, I don't think it makes much difference who wins, because the Euro's fate is being determined by imbalances far larger than voting blocs.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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