Bonds 101: Yields, Prices, And Inflation

Friday, April 26th, 2013

We recently showed 220 years of US Treasury bond yield history but all too often, the average investor is unfortunately unaware of the relationship between bond yields (interesting on a relative-value perspective) and bond prices (the thing that matters for your portfolio’s returns). The two measures are inextricably linked obviously (a higher yield implies a lower price and vice versa) but the relationship is not a straight line – it has ‘convexity’. The following charts may help understand the upside-downside changes from ‘yield’ movements, what the Fed is doing to the relationship, and how inflation expectations impact these changes.

Via Goldman Sachs:

Bonds are loans that investors make to governments, municipalities or companies, which typically pay the investors a fixed rate of interest until the bonds mature and the loans are repaid.

The most well-known US government bond is the 10-year US Treasury bond, which matures ten years from the issue date. Right now, investors can purchase a bond for $100 with a yield of about 1.7%, or about $1.70 per year – almost nothing! But there is a bond market that moves daily, so the price of bonds will move depending on interest rates and the economy.

Although investors can simply hold the bond they purchased until maturity and be paid back what they spent in full (plus the interest they’ve received), they can also sell the bond before maturity. What they get back, however, will depend on interest rates at the time that they sell. If interest rates have risen, then it will be harder to sell their lower-yielding bond, and they will have to sell it for less than they paid for it. If interest rates have declined, then other investors will want to own the bond, and the seller can charge more than they paid for it. So bond holders don’t fare well when interest rates rise.

The other thing that bond holders fear is inflation (which typically motivates rate hikes); when consumer prices rise, the interest investors get from bonds is worth less and less in real purchasing power terms.

And the yield varies depending on the maturity or length of the investment. The Fed is having a significant impact at various parts of the ‘curve’.

Charts: Goldman Sachs

Tags: 400, Bonds, Goldman Sachs
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Goldman Activates The Magic 8 Ball, Sees S&P 500 In 2015 (At 1900)

Friday, April 12th, 2013

Just because Goldman’s track record at predicting the near-future is so fantastic (Abby Joseph Cohen “forecasting” in March 2008 the S&P would close the year at 1500, or about 40% off), the firm that spawned a thousand central bankers and ambassadors, has decided to try its hand at really long-term stock predictions. As in “three years over the horizon” long. And, of course, it’s only uphill from here.

To wit: “We develop a new framework for forecasting equity returns over the medium term using a consistent approach globally. We extend our forecast horizon to the end of 2015.”

Perhaps the framework consists of the following: If print (globally), then buy? Since the presence of a liquidity tsunami is the only variable that matters in a world whose fungible G-8 stock market has been reduced to a playground for central planners desperate to return confidence to a casino so rigged retail investors just can’t wait to leave regardless of the “promised” risk-free upside, and no longer even pretends to reflect reality, fundamentals, or discounting the future, the following sentence makes perfect sense:

We forecast strong returns, mainly driven by earnings growth, in all four regions we consider. We expect the best annualized total return in Asia ex-Japan (21%), followed by Europe (19%), Japan (15%), and finally the US (9%). These returns fall between the 50th and the 87th percentile of the distribution of US historical returns.”

And, of course, this:

With a 2015 horizon all regions look attractive on an absolute basis

Brilliant. And in 2008, when crude was at $140 and about to go to $30, Goldman recommended buying every barrel available.

For those eager and curious for more details about this Oracular profundity, we provide:

We expect strong equity returns globally over the next 3 years. In this report we develop our framework for forecasting equity returns over the medium term and extend our forecast horizon to the end of 2015. Our framework uses the medium term economic forecasts launched by our economists in their 2013 outlook pieces, and outlines a larger part of the path towards the strong 5-10 year equity return potential that we have highlighted in several past reports. We provide these forecasts for the four major regions that we cover and compare the return potential across these regions, which have so far had very different recoveries from the financial crisis. We forecast annualized returns ranging from 9% for the US to 21% for Asia ex-Japan. Exhibit 1 shows that this corresponds to returns between the 50th and the 87th percentile when adjusted for inflation and compared to the historical distribution of annualized 3 year real total US returns.

We see medium term return forecasts as particularly important in the current environment. Given the depth of the financial crisis, normalization will take a long time, and it is therefore important to map out the path towards recovery over the medium term. Also with bond yields at extreme levels, and the drawdown risk in equities still high, we see intermediate term equity forecasts as a good way to quantify the potential medium term costs of the near term safety of being in bonds rather than equities.

Our returns are mainly driven by earnings growth. The paths that we expect for prices and earnings are shown in Exhibits 2 and 3. We expect annualized earnings growth ranging from 8% in the US to 21% in Japan. The strong earnings growth outside the US reflects a rebound from cyclically weak margins. We forecast P/E multiples to fall 1% annualized in Japan and rise elsewhere between 1% in the US and 4% in Asia ex-Japan.

We model earnings growth and discount rates using historical relationships between these variables and the macroeconomic environment. We then feed these variables through our regional dividend discount models to generate our price targets in this central scenario. The targets are more model-driven than our usual 3, 6 and 12 months targets, as discretionary deviations from our models are more relevant over shorter horizons, where we have more visibility on specific risks and opportunities that are not fully captured by our framework.

The obligatory pretty charts and tables:

There is, of course, a caveat. Namely, “we may be wrong about everything if things don’t quite turn out as the central bankers want them to”

A disappointing economic recovery would be the main risk to our forecasts. Our forecasts are based on our economists’ forecasts of global growth accelerating from 3.0% in 2012 to 3.3% in 2013 and further to an above 4% pace from 2014 through 2016. Our alternative scenarios suggest that widely held concerns about margins and valuations not being truly cheap can be addressed without destroying the case for equities. However we judge markets to be roughly fairly priced for the current economic environment and therefore returns are unlikely to materialize on a sustained basis unless the economic recovery continues. Our discussion of risks focuses on the downside as the returns in our central scenario are already very attractive. However, there are clearly also upside risks, with a stronger economic recovery than we forecast being the most obvious.

Finally, like most of our readers, we wondered about one thing: why only 2015? Why not pull an IMF and predict where the S&P will be in 2022? Now that would be truly boss.

Tags: Goldman Sachs
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Default Risk Falls for US Banks and Brokers (Bespoke)

Tuesday, August 7th, 2012

by Bespoke Investment Group

Below are charts that show the change in default risk (5-year credit default swaps) over the past two and a half years for six of the most widely followed banks and brokers here in the US.  Over the past week or so, these financial firms have seen a pretty big drop in default risk as their stock prices have moved higher.

Morgan Stanley (MS) still has the highest default risk at 322 bps, followed by Goldman Sachs (GS) at 247 bps.  Bank of America (BAC) and Citigroup (C) are in the middle of the pack, while JP Morgan (JPM) and Wells Fargo (WFC) have the lowest default risk.  Wells Fargo (WFC) is the only company with a 5-year CDS price below 100 bps, clearly establishing it as the “safest” of the big US financial firms.

Tags: Bac, Bank Of America, Banks, Bps, Citigroup, Citigroup C, Credit Default Swaps, Default Risk, Goldman Sachs, Investment Group, Jp Morgan, Jpm, Morgan Stanley, Sachs Gs, Stock Prices, Two And A Half Years, Wells Fargo, Wfc
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Living in a Macro World

Thursday, August 2nd, 2012

by Cullen Roche, Pragmatic Capitalism

We are increasingly living in a macro world.  What I mean by that is that the world is becoming a smaller and smaller place due to technological change and the increasingly interconnectedness of globalization.  The result is that the macro occurrences in other parts of the world influence the domestic economy like never before.  And the investment world is being forced to adapt to this massive shift in the landscape.  So what we’re seeing is less micro and more macro.  We’re seeing the myth of stock picking lose momentum and we’re seeing investors veer increasingly towards investment products that are more broadly diversified in an attempt to reduce systematic risk and eliminate unsystematic risk.  This is in large part why the ETF world is surging in growth and mutual funds and stock picking are becoming a thing of the past.  I think this trend is likely to gather more and more momentum over the years and that the myth of Warren Buffett (the value buy and hold stock approach) will die out.

I think this chart from Goldman Sachs via Bondsquawk is quite telling with regards to macro trends going forward.  It’s recent in nature, but will only become more pronounced in future decades:

“According to Goldman Sachs US Economics Analyst, equity markets have become increasingly responsive to macroeconomic news releases ever since the financial crisis took place in 2008. The bond markets on the other hand have always had a close eyes on the US macroeconomic news.”

It’s a macro world and you’re living in it.  The funny thing is, I had a reader ask me today whether I could recommend a macro investment book…I looked at my bookshelf and rattled my small brain around in my head and came up with nothing.   Someone better get on that….There’s gold in them thar hills.

Copyright © Pragmatic Capitalist

Tags: Bond Markets, Capitalist, Domestic Economy, ETF, Funny Thing, Gold In Them Thar Hills, Goldman Sachs, Interconnectedness, Investment Book, Investment Products, Investment World, Macro Trends, Macro World, Macroeconomic News, Massive Shift, Occurrences, Systematic Risk, Technological Change, Us Economics, Warren Buffett, World Influence
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U.S. Equity Market Radar (July 30, 2012)

Sunday, July 29th, 2012

U.S. Equity Market Radar (July 30, 2012)

The S&P 500 Index rose 1.71 percent this week as the equity market shrugged off weak earnings reports and focused on potential monetary policy easing from both the Federal Reserve and European Central Bank (ECB), which could come as early as next week. The telecom services sector led the way, followed by financials and industrials. The materials sector was the only sector in negative territory for the week.

Strengths

• The telecommunication services sector was the best performer this week rising 4 percent, driven by much-better-than-expected earnings reports from MetroPCS Communications and Sprint Nextel. MetroPCS was the best performer in the S&P 500, rising by more than 40 percent.
• The financial sector was predominately led higher by the investment banks and brokerage stocks, which were among the worst performers last week. JPMorgan Chase, Goldman Sachs, Morgan Stanley and Citigroup all rose by more than six percent.
• The industrial sector also performed well as key stocks outperformed, including Caterpillar and General Electric.

Weaknesses

• The materials sector lagged as Dow Chemical disappointed along with Vulcan Materials. Cliffs Natural Resources was the worst performer in the group on continued weak iron ore prices.
• Other areas that were weak included education services, casino and gaming, construction materials, and coal.
• DeVry, the for-profit education company, was the worst performer, falling 29 percent as the company warned of higher costs and declining enrollment.

Opportunity

• The market shifted its focus from earnings to central bank policy late in the week and that should be the focus next week as we could see action from the Fed, the ECB or both.

Threat

• While policy-makers in Europe have made strides to stabilize the situation, many risks remain and the situation remains very fluid.
• China recently cut interest rates for the second time in a month, which likely indicates that conditions on the ground remain challenging.

Tags: Dow Chemical, Earnings Reports, ECB, Education Company, Education Services, Financial Sector, Goldman Sachs, Industrial Sector, Investment Banks, Iron Ore Prices, Market Radar, Materials Sector, Metropcs, Morgan Stanley, Negative Territory, Profit Education, Sprint Nextel, Telecom Services, Telecommunication Services, Vulcan Materials
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The Dark (Pool) Truth About What Really Goes On In The Stock Market

Monday, July 2nd, 2012

Courtesy of the author, we present to our readers the following excerpt from Dark Pools: High-Speed Traders, AI Bandits, and the Threat to the Global Financial System, by Scott Patterson, author of The Quants.

In early December 2009, Haim Bodek finally solved the riddle of the stock-trading problem that was killing Trading Machines, the high-frequency firm he’d help launch in 2007. The former Goldman Sachs and UBS trader was attending a party in New York City sponsored by a computer-driven trading venue. He’d been complaining for months to the venue about all the bad trades—the runaway prices, the fees—that were bleeding his firm dry. But he’d gotten little help.

At the bar, he cornered a representative of the firm and pushed for answers. The rep asked Bodek what order types he’d been using to buy and sell stocks. Bodek told him Trading Machines used limit orders.

The rep smirked and took a sip of his drink. “You can’t use those,” he told Bodek.

“Why not?”

“You have to use other orders. Those limit orders are going to get run over.”

“But that’s what everyone uses,” Bodek said, incredulous. “That’s what Schwab uses.”

“I know. You shouldn’t.”

As the rep started to explain undocumented features about how limit orders were treated inside the venue’s matching engine, Bodek started to scribble an order on a napkin, detailing how it worked. “You’re fucked in that case?” he said, shoving the napkin at the guy.

“Yeah.”

He scribbled another. “You’re f*-ked in that case?” “Yeah.”

“Are you telling me you’re f*-ked in every case?” “Yeah.”

“Why are you telling me this?”

“We want you to turn us back on again,” the rep replied. “You see, you don’t have a bug.”

Bodek’s jaw dropped. He’d suspected something was going on in- side the market that was killing his trades, that it wasn’t a bug, but it had been only a vague suspicion with little proof.

“I’ll show you how it works.”

The rep told Bodek about the kind of orders he should use— orders that wouldn’t get abused like the plain vanilla limit orders; orders that seemed to Bodek specifically designed to abuse the limit orders by exploiting complex loopholes in the market’s plumbing. The orders Bodek had been using were child’s play, simple declarative sentences sent to exchanges such as “Buy up to $20.” These new order types were compound sentences, with multiple clauses, virtually Faulknerian in their rambling complexity.

The end result, however, was simple: Everyday investors and even sophisticated firms like Trading Machines were buying stocks for a slightly higher price than they should, and selling for a slightly lower price and paying billions in “take” fees along the way.

The special order types that gave Bodek the most trouble—the kind the trading-venue rep told him about—allowed high-frequency traders to post orders that remained hidden at a specific price point at the front of the trading queue when the market was moving, while at the same time pushing other traders back. Even as the market ticked up and down, the order wouldn’t move. It was locked and hidden. It was dark. This got around the problem of reshuffling and rerouting. The sitting-duck limit orders, meanwhile, lost their priority in the queue when the market shifted, even as the special orders maintained their priority.

Why would the high-speed firms wish to do this? Maker-taker fees that generate billions in revenue for the speed Bots every year. By staying at the front of the queue and hidden as the market shifted, the firm could place orders that, time and again, were paid the fee. Other traders had no way of knowing that the orders were there. Over and over again, their orders stepped on the hidden trades, which acted effectively as an invisible trap that made other firms pay the “take” fee.

It was fiendishly complex. The order types were pinned to a specific price, such as $20.05, and were hidden from the rest of the market until the stock hit that price. As the orders shifted around in the queue, the trap was set and the orders pounced. In ways, the venue had created a dark pool inside the lit pool.

“You’re totally screwed unless you do that,” the rep at the bar said. Bodek was astonished—and outraged. He’d been complaining for months about the bad executions he’d been getting, and had been told nothing about the hidden properties of the order types until he’d punished the it by reducing the flow he send to it. He was certain they’d known the answer all along. But they couldn’t tell everyone—because if everyone started using the abusive order types, no one would use limit orders, the food the new order types fed on.

Bodek felt sick to his stomach. “How can you do that?” he said.

The rep laughed. “If we changed things, the high-frequency traders wouldn’t send us their orders,” he said.

* * *

Tags: Bad Trades, Bandits, Dark Pool, Dark Pools, Excerpt From, Global Financial System, Goldman Sachs, High Frequency, Ked, Launch, Quants, Riddle, Runaway Prices, Schwab, Scott Patterson, Sip, Stock Market, Stock Trading, Suspicion, Ubs, Undocumented Features
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Four Paths Forward for the Euro

Monday, July 2nd, 2012

From what seemed like a very low bar on expectations, last week’s summit headlines surprised modestly on the upside, even if the details remain far from clear – and implementation even murkier. Political talk of wanting to break the link between sovereign and banking risk was well-received by markets – but we remind all that talk-is-cheap with these Euro-pols. As Goldman noted this weekend, “we do not see the outcome as a game changer”, rather can-kicking until one of four possible endgames are realized. The absence of any explicit commitment to plans for fiscal or political integration; the lack of reference to any pan-European deposit insurance; and Ms. Merkel’s limited concessions (to ensure passage of the growth compact) to the terms on which the existing pool of EFSF/ESM resources are offered leaves the underlying issue – the terms on which mutualisation of financial risk is offered by Germany in return for mutualization of control over fiscal decisions throughout the Euro area – remaining inharmonious. German tactical concessions at the summit do not change their basic position on this issue: that discipline, reform and consolidation must be achieved and cemented first before mutualization of financial obligations is possible. Looking to the future Goldman sees four paths for the Euro are from here – and short-term too many crucial issues are left unresolved.

Huw Pill, Goldman Sachs: European Views

Looking to the future, we see four paths (albeit ones that are connected by cross streets) for the Euro area from here, around which scenarios for the market outlook can be developed:

• The Cultural Revolution. While unlikely, it is possible that European politicians recognize the error of their previous ways and collectively jump to a more constructive approach, exploiting the strengths of the consolidated Euro area in pursuit of a solution, rather than focusing on the weakness in individual countries that represent obstacles to one. In short, the European leadership could start to ‘think continental’ (to use a phrase originated by Alexander Hamilton in not dissimilar circumstances). In principle, this would offer a rapid and effective resolution of the crisis. But the likelihood of this outcome is low. The European authorities are inevitably in thrall to their national political constituencies (which, after all, elect them): thinking national rather than continental is the therefore the most likely result.
• The Long March. More realistically, one can characterize the June EU summit as another step forward in the long and slow process of necessary adjustment and governance reform in the Euro area, bringing national constituencies along in a step-by-step manner. Announcement of plans for banking union can be seen (for good reason) as part of the development of the new institutional architecture needed to make the Euro area workable. But however necessary, these measures are far from sufficient. Only over time will successive summits, each resulting in individually modest forward steps, lead to an accumulation of institutional advances sufficient to underpin the Euro adequately. The slow cumulative construction of a workable governance structure has been (and will remain) initially under-appreciated by the markets, but eventually be recognized, leading the market to support convergence rather than divergence across economies within the Euro area. Of course, aside from the politics of institutional reform, this ‘long march’ is likely to prove economically challenging: economic activity in the periphery will be hamstrung by the lack of a more comprehensive resolution, especially as the underlying necessary adjustments to competitiveness, external imbalances and public finances will proceed slowly, if at all, in this environment.
• The Great Leap Forward. We are skeptical that either financial markets or domestic political constituencies will have the patience for a ‘long march’ lasting as long as a decade (as Ms. Merkel has repeatedly predicted). More realistically, intensifying market pressure is likely to short-circuit this process, forcing Europe to an earlier decision point. For example, should Spain be denied market access and be forced into an explicit external financing program, additional fiscal demands will be placed on the rest of the Euro area, weakening the public finances of Italy and, via a domino effect, France and ultimately Germany. Relying on a slow, cumulative improvement in governance is inadequate in these circumstances. The ‘Big 4’ countries will quickly be presented with the question of whether or not they are prepared to take the steps necessary to underpin the Euro. Measures will need to be taken quickly and aggressively: acting outside the existing institutional framework will be required. Germany and France will have to decide to whether they are prepared to take substantial steps forward in economic and political integration in order to preserve the Euro. Muddling through will no longer suffice. In these circumstances, we think such a ‘great leap forward’ is the most likely response.
• Disintegration. That said, we cannot rule out the possibility that, faced with an ‘existential threat’, the political process does not allow such a ‘great leap forward’ to be taken. At that point, Monetary Union would become untenable—and a rapid and costly unraveling of the Euro area would result.

Using these four paths as a framework, we see the most likely scenario going forward as follows:

the European authorities continue their ongoing ‘long march’ of cumulative reform until, at some point—probably not imminently, but over the coming one to three years—market and/or political dynamics force the choice of whether to make a ‘great leap forward’ on the key Franco-German axis that has driven European integration since the 1950s.

Sketching this baseline scenario raises two questions:

• When will the Euro area switch from the slow, cumulative path of the ‘long march’ to confronting the pressing question of whether to take a ‘great leap forward’? We believe Euro area can continue on its current ‘long march’ for some time yet. The institutional machinery of monetary union—notably the balance sheet of the ECB and the ability of its TARGET2 balances to accommodate intra-Euro area cross-border stresses elastically—has proved remarkably robust to market pressure: by its nature, monetary union has greater resilience than the fixed exchange rate systems with which it is often compared. Moreover, for different reasons, the key players are not facing immediate pressures: ample liquidity in the Euro area is keeping French government bond yields at close to historical lows, while the German economy continues to show resilience at the lowest level of unemployment seen n for a generation. And procrastination is the path of least resistance for European politicians, lending inertia to the process. This makes a continuation of slow, incremental reform—rather than a comprehensive and rapid resolution of the crisis—more likely. But this approach does not come without its own costs. Macroeconomic performance in the periphery is set to deteriorate further in 2012H2, as market dislocation continues to weigh on credit creation and economic activity. And market participants are losing patience with the slow pace of adjustment: this adds to the tensions in financial markets.
• When facing the existential choice of whether to take the ‘great leap forward’, will France and Germany be prepared to do so? Yet ultimately we doubt that the ‘long march’ can be pursued to a conclusion. Other forces—such as a fiscal policy mis-step in France that undermines investor confidence or a populist political shock in the Italian elections—would force an ‘existential crisis’ for the Euro. At that point, we believe Germany and France will demonstrate the courage and commitment to move forward. Failing to do so in those circumstances would not merely imply acquiescence with the status quo, but rather a disintegration of the Europe built over the past 60 years, something neither country is likely to countenance. Yet making this step will not be without its own political challenges, especially in Germany where taxpayers are understandably reluctant to take on yet greater burdens that such a leap forward would imply.

Viewed in this light, the decisions taken at last week’s EU summit are best seen as part of the cumulative and incremental process of institutional reform inherent to the ‘long march’. While elements were surprisingly positive and important in themselves, in our view these decisions do not represent the ‘great leap forward’ required to resolve the crisis. They leave too many crucial issues—not least, the central question of how mutualization of financial risk and the debt overhang is traded off against loss of national fiscal sovereignty to German-inspired Euro area-wide fiscal and regulatory institutions—still unresolved.

Source: Goldman Sachs

Tags: Concessions, Constructive Approach, Cross Streets, Cultural Revolution, Deposit Insurance, Endgames, European Politicians, Explicit Commitment, Financial Obligations, Financial Risk, Four Paths, Goldman Sachs, Looking To The Future, Market Outlook, Ms Merkel, Pan European, Political Integration, Pols, Scenarios, Sovereign
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The Connection Between Commodity Indices and Oil Prices

Monday, May 28th, 2012

by James Hamilton, Econbrowser

In my previous post I described a new research paper with University of Chicago Professor Cynthia Wu on the Effects of Index-Fund Investing on Commodity Futures Prices. Previously I discussed what we found for the prices of agricultural commodities. Here I review our findings about oil prices.

Part of the interest in a possible effect of commodity-index funds on oil prices comes from testimony before the U.S. Senate by hedge fund manager Michael Masters, in which he produced a provocative graph of oil prices against an estimate of the number of crude oil futures contracts held by commodity-index funds. We reproduced his methodology to update his graph below. The figure certainly seems to suggest a strong connection between these two series, particularly during 2008 and 2009.

Price of near crude oil contract (left scale) and number of crude oil contracts held by index traders as imputed by Masters’ method (right scale). Source: Hamilton and Wu (2012).

The CFTC does not release a direct estimate of index-fund holdings of crude oil contracts at the weekly frequency of data plotted above. Masters therefore used an indirect method based on CFTC-reported holdings by commodity-index funds of 3 particular agricultural commodities to construct the green line in the graph above. His reasoning was that most index funds follow one of two popular strategies, trying to track either the S&P-Goldman Sachs Commodity Index or the Dow Jones-UBS (formerly Dow Jones-AIG) Commodity Index. He noted that soybean oil, one of the 12 agricultural commodities for which CFTC does report a weekly estimate of index-fund positions, is included in the Dow Jones but not the Goldman strategy. Masters’ proposal was that, by using the CFTC estimate of holdings of soybean oil by index funds, and from the known weights that the Dow Jones strategy calls for holding soybean oil relative to crude oil, one could infer how many crude oil contracts were being held by funds following the Dow Jones strategy. Similarly, the Goldman strategy includes Kansas City wheat and feeder cattle, whereas the Dow Jones index does not, so either of these commodities (Masters used the average) could generate an implied holding of crude oil contracts by those trying to replicate the Goldman Sachs Commodity Index. Summing these two estimates produced the green line in the figure above. Thus this estimate of crude oil holdings is actually based on reported holdings in soybean oil, Kansas City wheat, and feeder cattle contracts.

This approach of imputing crude oil holdings from a few agricultural commodities has been sharply criticized by Irwin and Sanders (2011), who note that the implied estimates using Kansas City wheat often differ significantly from those based on feeder cattle. They also document that, for dates for which we have separate reasonable estimates of crude oil contracts held by commodity-index funds, the actual holdings differ substantially from the series plotted in the green line above. (See my discussion of Irwin and Sanders’ paper in Econbrowser last August).

In my new paper with Cynthia Wu, we demonstrate that Masters’ idea for imputing crude oil holdings from agricultural measures does not require finding a commodity that appears in one index but not the other. Algebraically, the method can be thought of as simply solving a system of two equations to determine two unknowns. In fact under Masters’ assumption, it would be possible to infer crude oil holdings from almost any two arbitrary agricultural commodities. The graph below shows what those inferences look like if one uses soybean oil plus any one of the indicated second commodities. The inferred series for crude oil holdings is quite sensitive to which agricultural series one uses. The figure also plots a regression method that we developed that makes use of all 12 commodities together, which can be viewed as a generalization of Masters’ averaging idea.

Holdings of crude oil contracts held by commodity-index traders imputed by (a) soybean oil and one other agricultural commodity; (b) Masters’ method; (c) regression method. Source: Hamilton and Wu (2012).

A recent paper by Stanford Professor Ken Singleton found that the 13-week change in Masters’ estimates of crude oil holdings can help forecast returns on crude oil futures contracts. Cynthia and I were able to reproduce this finding, though the level and 1-week change of the Masters series don’t have any predictive power.

Returning to the first figure above, the striking feature of the Masters series is that it collapses as the recession worsened in 2008 but began to rebound sharply before the recovery began, features that help give it apparent predictive power over the sample period that Singleton originally studied. Since Singleton’s paper was written, we now have 2 more years of data with which to see if the relation has true predictive power. We estimated the forecasting regression using a sample that ended at the same date as Singleton’s original analysis (January 12, 2010), and then used those regression estimates to try to forecast crude oil futures prices over January 17, 2010 to January 3, 2012. We found that in this out-of-sample exercise, the regression actually did 22% worse than one would have done if one simply used the naive forecast that futures prices would never change.

Interestingly, we found that Masters’ measure not only appeared to forecast changes in crude oil prices over the 2006-2009 period, but would equally appear to have been able to predict changes in the S&P500 stock price index over that period. However, this relation, too, turns out to perform worse out-of-sample than the naive prediction that stock prices will never change.

Our conclusion is that the correlation between 13-week changes in commodity-index holdings of agricultural futures contracts over 2006-2009 and other series such as changes in crude oil or stock prices is likely to just be a coincidence. Overall, we find very little support in the data for the claim that index buying exerted significant effect on commodity futures prices.

James D. Hamilton is Professor of Economics at the University of California, San Diego

Tags: Agricultural commodities, Aig Commodity Index, Cftc, Commodity Futures Prices, Commodity Index Funds, Commodity Indices, Crude Oil Futures, Dow Jones, Dow Jones Aig Commodity Index, Econbrowser, energy, Fund Positions, Futures Contracts, Goldman Sachs, Goldman Sachs Commodity Index, Hedge Fund Manager, Michael Masters, Oil Contracts, Scale Source, Soybean Oil, U S Senate
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Frontline On MF Global’s Six Billion Dollar Bet

Thursday, May 24th, 2012

While the sur-realities of just what Corzine and the rest of the MF Global ‘traders’ did has been extensively discussed here and elsewhere, PBS’ Frontline provides the most succinct (and relatively in-depth) documentary on just what occurred from how the corrupt CEO lobbied regulators who had the power to stop his risky bets to the endgame realization of the missing customer money. A narrative, not just of “a bet that went bad”, but “a Wall Street morality tale“. Must watch!

The story of Jon Corzine, the former head of Goldman Sachs and political power broker, who took over MF Global in the spring of 2010 with oversize ambition and a passion for risk. But after a massive bet on European debt turned sour, the firm lay in ruins, with more than a billion dollars of customer funds missing.

Chapter 1: Six Million Dollar Bet – The Power of Jon Corzine

Watch Six Billion Dollar Bet on PBS. See more from FRONTLINE.

Chapter 2: Six Million Dollar Bet – The Final Days Of MF Global

Watch Six Billion Dollar Bet on PBS. See more from FRONTLINE.

Tags: ambition, Bet, Bets, Billion Dollars, Customer Funds, Endgame, Global Traders, Global Watch, Goldman Sachs, Jon Corzine, Mf Global, Morality, Narrative, Pbs, Pbs Frontline, Power Broker, Realities, Realization, Regulators, Six Billion
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One Epic Chinese Bubble – The Concrete Scowl

Friday, May 18th, 2012

The best charts are those that need no explanation. Such as this one.

Source: Goldman Sachs

Tags: Concrete, Epic, Goldman Sachs
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