How Low Can it Go?

Since the peak in mid-2008, natural gas has been playing an impressive game of limbo. Just when you thought it couldn’t go any lower, down it goes. Last year we wondered whether the market was about to find the bottom, but we clearly spoke too soon. Today the price of natural gas in the futures market went below $2.00. In nominal terms, natural gas hasn’t been this cheap in more than 10 years. In inflation-adjusted dollars, we are looking at the lowest price since at least 1994.

Source: US Energy Information Administration. Disclaimer: past performance is not necessarily indicative of future results.

The list of factors driving this downward plunge is straightforward: production increases have been outstripping demand, leading to record high stocks. Production capacity reached a record high just as the US went into one of the warmest winters on record. Now, seasonal forces are coming into play: as we enter spring, heating demand is drying up, but it is too early for the summer heat to increase electricity demand.

There are also structural impediments to increased demand. Consumers and business that want to convert to natural gas to take advantage of lower prices must still dedicate time and expense to switching over. Converting or building new natural gas electrical plants requires even more investment. And, even though prices are low now, the past volatility of natural gas gives good reason to pause before making a long-term commitment. Barring an unexpected shift, some analysts are now seriously considering the possibility that the US may actually run out of capacity to store natural gas later this year.

Despite the long, seemingly inexorable decline in natural gas prices, not many of the CTAs we track are currently in short positions in this market. A brief surge in the price in late January of this year stopped out most of the programs who were short natural gas. Those who are short, like James River Capital and Futures Truth, entered the trade after that January spike, and are certainly enjoying the downward trend. While the short natural gas play has been a good one lately, it’s worth remembering that prices can only fall so far – they’re not going to start giving the stuff away. Like even the most limber of limbo masters, there will eventually come a point where it just can’t get any lower.

Aim for the Bottom, Race to the Top?

Ouch- rough day to be in a long-only commodities fund yesterday, wasn’t it? While commodities across the board were mostly down (including Silver’s ugly 6.64% plunge), the Grains sector took the most consistent beating. It was one week ago today that we crowned Cocoa the winner in the race to new 2011 lows after the nosedive taken by most in early October, and, apparently, Grains got jealous, because Soybean Meal, Rough Rice, Wheat, and Oats all dipped below their respective lows for the close yesterday, along with a tagalong from Softs- Sugar. Congrats, guys. Welcome to the losers circle.

Source: Finviz; Disclaimer: Past performance is not necessarily indicative of future results.

Not in the losers circle were several of the managers we track, with Covenant Capital, Global Ag, Integrated Managed Futures Concentrated, and James River Navigator short Wheat, and Clarke Capital Worldwide short Soybean Meal. We said at the beginning of the year that we thought managed futures gains in 2011 would come from shorting commodities, and while a handful of managers does not a trend make, and while acknowledging that there are still plenty of managers out there who haven’t been able to shake October’s sting… here’s cautious optimism that we were right.

London CTA Expo Update

Some of the CTAs that Attain’s Juan Carlos Herrera has caught up with at the London CTA Expo show just how diverse strategies within managed futures can be. James River, Emil Van Essen and Dominion Capital are all there, and all three do very different things.

How so? Emil Van Essen focuses on the spread trade (and more specifically capturing roll yield), and has expanded their program to include the yield curve and small exposure to non-commodities in an effort to hedge against significant price shifts in commodities (like in the beginning of 2010). The James River Navigator program, on the other hand, is 100% systematic, and operates on both a long and short term level after seeking out a way to protect against 2008-like volatility in the markets. Dominion Capital started out in the world of financials and expanded into a wide variety of markets, looking for market price acceleration to determine early entrance points. Their program stands out because of its short term nature, holding onto trades for days instead of weeks, as most managers do.

Each of these programs have something unique to offer, and a specific value they can add to a managed futures portfolio. In speaking with Juan Carlos, the opportunity to learn more about each made the trip to London more than worth it.

Managed Futures v. Bill Gross

Whether or not Bill Gross is actually short US treasuries in his flagship PIMCO program is up for debate. He said no on CNBC, but one of our favorite bloggers, ZeroHedge, essentially called him out- saying, No, you are short. But whatever side you take on that battle of semantics, Mr. Gross has made no secret of his worries about the massive US debt and deficits leading to lower prices in US Treasuries. By all accounts, it doesn’t look like Mr. Gross thinks the next leg in bonds will be UP.

But a funny thing has happened in the last few weeks while this debate has been playing out and silver and crude retreated from their highs. While everyone bemoaned their long-only ETF investments (don’t say we didn’t warn you), another trend began to emerge elsewhere…. In bonds.

Turns out, for all his grandstanding, Gross appears to be incorrect (for now). Bonds have not been going down under the burden of cumbersome U.S. debt. In fact, the current trend is decidedly UP.

How far up? The 30 year bonds have gained 5.33% since April lows, while 10 year notes are up 3.75%. Remember, bond prices move inversely of the rates, so rates moving lower means prices have moved higher.

Gross may be missing out on this bond action, but many of the managed futures programs we track have identified and are participating in the trend. Programs we track which are holding long bond positions include 2100 Xenon Fixed Income, Accela Capital Global Short Term, Auctos Capital Global, Blue Fin, Clarke Global Magnum, Clarke Worldwide, Covenant Aggressive, Futures Truth Sam 1010, Integrated Global Concentrated, James River Capital Navigator, and Robinson Langley.

Are we surprised? Not really- managed futures programs tend to love trending bond markets. And this is how systematic managed futures programs are supposed to work. They don’t care how much debt the US has or if the largest bond investor in the world is betting against the up trend. They ignore all of that noise, and merely identify and react. Identify, react, repeat. Identify, react, repeat.

So, while the rest of the world was looking the other way, many managed futures identified a new up trend in bonds and reacted to it – putting on long positions. These programs are all in a position to have added to their P/L this month, but will it be enough? The same price correction that distracted us from Gross’ prosthelytizing also decimated returns for many programs caught off guard by the departure from the trend. While the bond market may help even things out some, it may not be enough to bring some programs into the black for the month of May.

Moving forward, we’ve got an epic battle on our hands. On one hand is managed futures, riding a technical trend higher and ignoring the doomsday financial prophets. On the other hand, bond king Bill Gross is betting that fundamentals will eventually crash US bond prices and interests rates inevitably climb, and is biding his time on the matter. Managed futures is winning this round, but who will win out in the end?

We certainly wouldn’t mind seeing Mr. Gross on the same side as managed futures next time (that’s a lot of fire power), but that will likely have to wait until this trend runs its course and bond prices start heading lower.

CTA Expo Update

Jeff Eizenberg and John Cummings are having a great time in New York at the CTA Expo. Yesterday they saw presentations from Liberty Funds, III Associates, Cervino Capital, Dominion Capital, MSR Investments, James River, Clarke Capital, Kawaller Fund, and Saxon Investment. All of these (save Kawaller) are CTAs we track, and it was good to hear more about what they’re doing to refine their programs.

Mack Frankfurter of Cervino had a lot to say. He argues that CTAs are under attack, with most managers having under $250 million in total assets under management (AUM). In fact, 1.9% of CTAs control 60% of managed futures assets under management. Why? As he puts it, the big wigs on Wall Street realize the value in managed futures, and are expanding into the asset class at a rapid rate. The added competition is an issue for these smaller CTAs because it limits their ability to keep pace in terms of edge, infrastructure, intellectual capital, etc.

AUM by CTA grouping

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[Data Source: Cervino Capital]

On the other side of the debate, Cecilia Mortimore de Santa Cruz of Credit Suisse Securities, LLC, disagrees. She argues that while 50% of the funds are flowing to managers handling over $5 billion in assets more and more investors, family offices, financial advisors and high net worth individuals are asking, “Who’s Next?” The answer, she contends, is usually going to be a manager handling less than $1 billion, especially as time goes on and managed futures gets more exposure.

Who’s right? Your guess is as good as ours.

We caught up with Jeff and John on a break from the whirlwind presentation schedule.

Both were excited to meet with an elusive legend of a man- Michael Clarke, manager at Clarke Capital. Clarke discussed current client frustration with Clarke Capital’s Global Basic Program, assuring the guys that, while he understands the frustration (the program is down 25.16% over the past 3 years), he believes the program is doing its job, and is still a good place to invest.

By and large, the Expo is going well. At the end of the day, Jeff put it best…

“The meetings have been very full, very well attended. Not only is that a great testament to these managers and their programs, but Frank Pusateri and his group.”

We agree.

Can trading gains offset pain at the pump?

With Crude Oil up $2 more dollars today, it seems like just a matter of time until we see $5 per gallon gas in the US. (here in Chicago we’re already seeing $4.50 at some stations).

Those of us in the managed futures industry usually have an odd take on price increases such as this, sometimes actually ‘cheering’ prices higher despite the pain it will do to our budgets and credit card bills.

This is because our clients are usually benefitting from such trends higher, thanks to most managed futures programs being designed to try and capture trends in one manner or another. Indeed, one of the main reasons for getting involved with managed futures for many is the desire to participate in trends such as the one we’ve seen in crude (see our past post on Crude’s breakout signaling a new trend up).

Crude Over 5 Years

But it seems a little bit different this time. For one, most managed futures program which are long Crude just got long recently (around $100), so while profitable – it’s not that profitable that you can ignore what’s happening at the pump.  Secondly, do we really want $5 gasoline throughout the summer? Will managed futures participants really offset the extra real costs they will incur via their long exposure in a managed futures program (whose gains could be offset by losses elsewhere).

And finally, participation in managed futures doesn’t guarantee you will participate in trends such as the move higher in Crude Oil. Of the CTAs we track, there are only a handful of programs with long energy exposure.

Short term systematic programs Futures Truth SAM 101 and systematic multimarket programs APA Strategic Diversification, Auctos Capital Global, Covenant Capital Aggressive, James River Navigator, Futures Truth MS4, and Robinson Langley Capital are all long crude, while short term systematic Accela Global Short Term is long JPE Gas and Bouchard Capital is long heating oil.

While these programs will likely be cheering Crude higher yet, the higher costs for gas, plane tickets, food, and everything else is likely to dampen the enthusiasm somewhat.  The bottom line – sometimes you have to be careful what you wish for…

Anatomy of a Trend Following Breakout… Crude Oil

At the risk of being one of those people who throws a bunch of lines, arrows, and squares on a chart and says… look at this…we have re-created a chart of Crude Oil over the past 20 months to highlight how a classic trend following trade looks.

While there are hundreds of different ways to do trend following, the general idea is to bracket the market with volatility adjusted bands, and when the market ‘breaks out’ above those bands, go long – when breaking out below the lower band – go short.

We have used rather standard 80 day averages and standard deviation lookbacks to create the bands in the chart below, showing that Crude Oil broke out to the upside on 2/23.  The classic trend following trade is to go long on the open following that breakout, which was last Thursday’s open of 98.97, and risk down to the 60-100 day moving average.  In our example, we’re using the 80 day moving average (the lighter orange line), which sat $6.57 away from the entry at 92.41 on 2/24, representing $6,570 of risk on the entry day.

Crude Oil bollinger bands

Moving forward, the classic trend following model hopes prices will remain above the moving average long enough to pull that average above the entry price, thereby locking in a gain. If prices fall and the moving average doesn’t advance, the trade will lose the difference between the entry and wherever the moving average is at the time prices close back below it.

To see why and how trend following, and managed futures in general, are long volatility strategies where profits can be many times the amount risked on a trade – one only need imagine Crude Oil going to $150 on the back of an uprising in Saudi Arabia or something.  In such a case, the trade could make $50+ ($50,000) on the same initial risk of just $6,500, for a risk/reward payoff of nearly 8 to 1.   Conversely, if peace spreads across the Middle East over the next few weeks by some chance and Crude Oil sells of $50 down to $40 something, you still only lose the $6,500 (ignoring slippage and the possibility you could be locked limit down and unable to get out).

This ability to make a great deal more than you risk when volatility explodes is the classic trend following model’s calling card. The downsides, 1. only a small percentage of such breakouts may succeed and 2. Crude may go up to $140, and then all the way back down to $110, making for an overall gain, but causing pain in that your account will have given back $30 of open trade profits.

We’ll see how this breakout fares for those with exposure to the energy markets via trend following. Managers who have seen breakouts in their own models in Crude and currently hold long positions include: