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Henry To

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is…

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The Importance of the "Roll Return" in Commodity Futures Returns

Dear Subscribers,

I hope every one of our subscribers is having a great October so far. The weather is still in the mid 70s over here in "sunny California," although we did get a lot of fog this morning (we are in the west LA area). Speaking of weather, Accuweather is now predicting a colder-than-normal winter for the country this year (which is at odds with an official government forecast from NOAA), especially in the Northeast. But just like I (and our illustrious poster, rffrydr) had mentioned in our discussion forum, I still don't expect any of this to cause a sufficient enough drawdown in our natural gas supplies to cause any price spikes during this upcoming winter. My position on natural gas is still the same: The secular bear market in commodities is still in place - but I still will not touch natural gas on the long side until we see more evidence of hedge fund or pension fund capitulation in the commodity or energy markets. This may occur tomorrow (although it is highly unlikely) or it may come in the spring - so for now, readers please stayed tuned. I anticipate a very profitable play in natural gas at some point but now is not the time (on either the long or the short side). Most likely, we will not see any sustained uptrend in any commodities or commodity shares until we see a clear sign that the Fed will be cutting rates.

Speaking of October, this has definitely been one of the most uncommon Octobers in stock market history - as both the "October low" and the "four-year election cycle low" came two to three months early (depending on which index you were tracking). I hope that none of our subscribers was caught the wrong way. It is one thing to be out of the markets and in cash and it is another thing to be short. While it may not be totally true that we should always "be bullish on America," I have always made it my point to only short the broad market (as opposed to individual stocks) if we have a confluence of all three of the following factors: 1) high absolute valuations, 2) high relative valuations compared to other financial assets such as bonds, REITs, and international securities, 3) a hawkish Fed in the midst of a rate hike cycle. While a good case can be made for both 1) and 3) over the past 12 months, 2) is definitely way off the mark - as exemplified by the still-benign readings of the Barnes Index, the relatively low amount of equity holdings as a percentage of total households' net worth, and other readings I have mentioned in our commentaries over the last six months. At this point in time, U.S. equities (with the exception of cyclical industries) still remain one of the most attractive classes in relation to bonds, commodities, real estate, and emerging market securities.

Let us now do some "laundry work" before getting to the gist of our commentary. On the afternoon of September 7th, we entered a 50% long position in our DJIA Timing System at a print of 11,385 - which is now 617.37 points in the black. On the morning of September 25th, we entered an additional 50% long position in our DJIA Timing System at a print of 11,505. That position is now 497.37 points in the black. Real-time "special alert" emails were sent to our subscribers informing them of these changes. Subscribers can refer to our DJIA Timing System page on our website for a complete history of our DJIA Timing System signals.

As of Sunday afternoon on October 22nd, we are still fully (100%) long in our DJIA Timing System and is still long-term bullish on the U.S. domestic, "brand name" large caps - names such as Wal-Mart (which is now making a serious effort in the Chinese market by acquiring Taiwanese-owned Trust-Mart and naming a more aggressive new head of operations in China), Home Depot, Microsoft, eBay, Intel (which is not only regaining the performance advantage over AMD, but is actually extending it), GE, American Express, Sysco ("Sysco - A Beneficiary of Lower Inflation"), etc. We are also very bullish on good-quality, growth stocks - as these stocks collectively have underperformed the market since 2000 and which, I believe, will benefit from a change of leadership going forward (leadership which will transfer from energy, metals, and emerging market stocks to U.S. domestic large caps and growth stocks, in general). At this point, the breadth of the market is still strong. The lack of any significant correction in the stock market so far is a sign of strength, and not "irrational exuberance." Moreover, the underperformance of a stock like Caterpillar at this point of the cycle is actually normal and expected - as Caterpillar is a very cyclical company and has been a great beneficiary of the emerging markets and commodity booms of the last few years. Since we are now arguably experiencing a deflationary boom, the underperformance of a stock like CAT and overperformance of stocks such as WMT, SYS, MSFT, HD, AXP, EBAY, AMZN, etc., are to be expected.

Again, while it may be tempting to take quick short-term profits here, I urge our readers not to get "cute" and to try to time this market on a short-term basis. I assure you - no trader on the face of this Earth can do this successfully on a consistent basis - not Jesse Livermore, not Bernard Baruch, not George Soros, Stanley Druckenmiller, and not even Steve Cohen of SAC Capital - who have actually just recently sworn off short-term trading (effectively forever) in his fund.

Let us now get on with our commentary. One of our most active posters, rffrydr, actually discussed the concept of the "roll return" in commodities in a post earlier this evening - and I just thought it will be appropriate for us now to shed some light on the historical significance of the "roll return" when it comes to investing in fully collateralized commodity futures, such as the Goldman Sachs Commodity Index or to a lesser extent, the United States Oil Fund. First of all, what is a "roll return?"

"Roll Return" is the difference between the current spot (what you pay if you "consume" the commodity today) and the futures contract price. It is also the return a futures contract holder would earn if the spot price stays constant until the expiration of the futures contract - in which case the price of the futures contract would gradually converge to the spot price. Assuming the spot price is held constant, a futures contract holder will earn a positive roll return if the price of the futures contract is lower than the spot price (this behavior is termed "backwardization"). Conversely, a futures contract holder will experience a negative roll return if the price of the futures contract is higher than the spot price and is converging to it over time (this is termed "contango"). According to a recent research paper from Gorton & Rouwenhorst (2005), adopting a positive roll return strategy would have netted an investor an additional 4.87% annual return in their equally-weighted index of commodity futures, while a negative roll return strategy would have resulted in a negative 5.17% annual deviation from the annual return of their index from July 1959 to December 2004. This is based on an equally-weighted index of 36 nearby commodity futures contracts, rebalanced once a month. The positive roll return strategy involves holding the 18 futures contracts that exhibit the steepest backwardization behavior while the negative roll return strategy involves holding the 18 futures contract that exhibit the steepest contango behavior.

Moreover, this additional return of adopting a "positive roll return" strategy of holding 18 futures contracts with the steepest backwardization behavior comes on top of the 11.18% annual geometric average return of Gorton & Rouwenhorst's index over the last 45 years - or an annual return that is about the same for U.S. equities (and a higher Sharpe Ratio to boot!). Following is a chart straight from their 2005 paper showing the inflation-adjusted performance of their commodity futures index vs. stocks and bonds over the last 45 years:

Stocks, Bonds, and Commodity Futures Inflation Adjusted Performance 1959/7-2004/12

Moreover, diversifying into commodity futures position such as the GSCI Total Returns Index would have been especially attractive, given its lack of correlation (which actually turns into a negative correlation over a period longer than three months) with both stocks and bonds. And more importantly, while returns of U.S. stocks have negative skewness - commodity futures returns have historically had positive skewness - meaning that while stocks tend to usually surprise on the downside, the opposite is true for commodities. This is probably obvious for folks who lived through the two OPEC embargos during 1973 and 1979. With the exception of the early 1980s and the late 1990s, investing in commodity futures would have been a no-brainer - both as an investment to capture returns and as an investment for diversification purposes. As always, however, the $64 million question is: Will this period of outperformance apply going forward? Just like the early phases of the 1995 to 1998 Yen carry trade, this was as close to a free lunch in the financial markets as you can get.

Unfortunately, most commodity futures contracts are no longer exhibiting backwardization behavior. In fact, as pointed out by the Economist article, "... the roll yield has now turned negative, so that investors in futures contracts are losing. In the year to date the roll yield has been minus 13.35%, and the annualised yield on the next two months' contracts is minus 38.4%." This is apparently to anyone that is trading crude oil futures, as shown in the following chart showing the contract price per barrel for selected futures contracts from November 2006 to December 2009 vs. open interest. Note that the futures prices for crude oil are in contango until December 2009!

NYMEX Crude Oil Futures vs. Open Interest as of October 11, 2006 - Crude Oil futures prices effectively in contango until December 2009!

Today, there are is virtually no single commodity that is exhibiting backwardization behavior - except for possibly the frozen orange juice market - and we are only seeing this mainly because there are temporary shortages in Florida oranges. As noted by William Bernstein (the author of "The Birth of Plenty" - not to be confused with Peter Bernstein) in his latest September remarks to the Gorton & Rouwenhorst paper:

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