10/28/15   Commodities, Commodity Funds, and Leverage

Editor’s Corner

Ron Rowland

It is difficult for the typical investor to invest directly in commodities. Storage is the primary problem. If you bought 10,000,000 BTUs of natural gas, how would you take delivery and where would you store it? A “standard cubic foot” of natural gas is equal to 1,020 BTUs. Therefore, 10 million BTUs equates to about 9,800 cubic feet.

For this reason, most commodities are traded as futures contracts. In the case of natural gas, one contract controls 10 million BTUs of gas, and as long as you are not holding any contracts when they expire, you don’t have to worry about delivery and storage. Commodity funds face the same problem and therefore tend to hold futures contracts instead of the underlying commodity. Precious metals are the general exception here, since a relatively large investment only requires a small amount of physical gold.

Commodity traders typically use leverage in an attempt to amplify their gains and to make capital available for additional trades. Retail investors can gain access to leveraged commodity trades through leveraged commodity funds. This approach avoids the need to trade futures contracts and makes the process much like buying or selling a stock.

Sometimes, commodity prices move fast, and leveraged commodity prices move even faster. Such was the case this past week for natural gas. Natural gas prices have been declining for more than seven years, and the United States Natural Gas Fund (UNGs) has plunged 98%. If you bought UNG in mid-2008 and held it, your investment would now be worth two cents for every one dollar you put in. In the past week alone, UNG dropped 11.7%, and it is not a leveraged fund. The Direxion Daily Natural Gas Related Bull 3x Shares (GASL) are leveraged, and they saw 39.5% of their value fund disappear this past week.

For many market segments, there are also leveraged funds designed to profit from downside moves. Traders betting on a continued decline for natural gas prices racked up profits of 40.7% this past week if they owned the VelocityShares 3x Inverse Natural Gas ETN (DGAZ). However, this is not a buy & hold vehicle either, as it is down 91% since April 2012. Leverage is a double-edged sword, and traders must be both nimble and accurate with their trades in order to extract consistent profits.

I usually avoid making predictions, although last week I did make one in order to emphasize a point I was trying to make. In case you don’t recall, I made the extremely safe prediction that in seven days I would “be writing about the Fed’s decision to raise interest rates or to leave rates alone following the conclusion of its October FOMC meeting.”

So here I am, making that forecast come true. The Fed did indeed conclude its two-day FOMC meeting on schedule today. To almost no one’s surprise, the Fed left interest rates unchanged. The Fed “continues to see the risks to the outlook for economic activity and the labor market as nearly balanced but is monitoring global economic and financial developments.” Regarding the future, the post-meeting policy statement went on to say, “In determining whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress – both realized and expected – toward its objectives of maximum employment and 2 percent inflation.” The “next” meeting referred to is December 16, and it will be the last one of 2015.

Investor Heat Map: 10/28/15

Sectors

Technology jumped to the top of the rankings this week. The climb from fourth was a significant accomplishment, but perhaps more impressive is the fact that this is the first time Technology has been in first place since August 2014. The sector has been getting a boost from many of its underlying industries. Chip makers were soaring for much of the past six weeks, although they took a break this past few days. Internet and software stocks stepped in to fill the gap, keeping the sector’s momentum strong. There are still signs of investor nervousness in the market, and the climb of the defensive Consumer Staples sector from third to second is one of those signs. The rise of Technology and Consumer Staples pushed the former leaders of Real Estate and Utilities each two places lower. Telecom and Consumer Discretionary swapped places in the middle of the pack, and Industrials moved a notch higher to join them. Financials and Materials also moved a step upward thanks to the three position drop of Energy. Materials managed to flip from red to green in the process, while Energy changed to red. Biotech stocks bounced strongly this past week, but Health Care is still on the bottom.

Styles

Here is something you don’t see every day. In fact, it is something that you don’t see every year. I’m talking about the 40-point spread between the momentum scores of the two style extremes. What makes this especially rare is the fact that the spread is larger than the 39-point spread of both the sector and global rankings this week. Differences in scores across the style categories are typically very subdued compared to the sector and global spreads, often to the point of being boring. Adding to the wide dispersion, the four highest-ranked styles all increased their momentum over the past week, while the four lowest-ranked styles all posted momentum declines. Capitalization is still the dominate factor in determining the relative rankings. Mega-Cap and the three Large-Cap categories are on top, while Micro-Cap and the three Small Cap categories occupy the basement. Mid-Cap Growth, and the four previously mentioned basement dwellers, remain in the red.

Global

The few past weeks, I have mentioned the extremely compressed momentum scores for the global categories (if you exclude Latin America). Such compression allows small changes in the momentum scores to create huge changes in the relative rankings. A week ago, only 10 points separated top-ranked Emerging Markets from tenth-place Canada, setting the stage for some of the big changes in today’s lineup. On the upside, Japan jumped from ninth to second on a 13-point momentum increase. Meanwhile, Emerging Markets plunged from first to seventh, and the UK slid four places lower. You might be tempted to think these two benchmarks lost significant value over the past week, but Emerging Markets lost just three momentum points, and the UK’s score decreased by only a single point. Once again, these dramatic falls in the rankings are not significant when the underlying data is considered. That said, China moved a notch higher to grab the leadership position, and Japan’s big move landed it in second. The US held steady in third, and World Equity continues to hover just below. Both Canada and Latin America severely lag the rest of the field, and they are the only two global categories currently in the red.


Note:
The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.

 


“If we do end up with a much warmer-than-normal winter, the bullish scenario for [natural gas] prices would be pushed out to 2017. Even under normal weather conditions, the market would still be very well supplied.”

– Sabine Schels, commodity strategist at Bank of America Corp. in London.


DISCLOSURE

© 2015 AllStarInvestor.com All Rights Reserved. Protected by copyright laws of the United States and international treaties. Nothing in this e-mail should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investment advice. Any investments recommended in this letter should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company. All Star Investor employees, its affiliates, and clients may hold positions in the recommended securities.

Distribution is encouraged. Please do not alter content.