stocks and less into bonds. When they are more pessimisticabout things, they usually commit more funds to bonds and less to stocks.159
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Ratio analysis provides a relatively simple way to see which asset is doingbetter at any given time—bonds or stocks.Figure 11.1 is a ratio of Treasury bond prices divided by the S&P 500 since1994. From 1994 to the end of 1999, the ratio line is falling meaning that bondswere underperforming stocks. During those six years, an investor would havedone better by concentrating on stocks and placing less emphasis on bondinvestments. Near the end of 2000, however, the bond/stock ratio broke thedown trendline that had existed since 1994, and signaled a shift in the relationship between the two markets. Bonds became the stronger market, whichcalled for some asset allocation switching out of stocks and into bonds. Aninvestor using this relatively simple chart could have side-stepped much ofthe bear market in stocks that started in 2000 and could have profited fromrising bond prices. Many financial advisors recommend a relatively staticbond-stock mix in one’s portfolio to achieve balance and diversification. AsFigure 11.1 shows, however, asset allocation weightings need to change alongwith changing market trends. Ratio charts make this task much easier.Figure 11.2 plots the bond/stock ratio from the start of 2000 to the summer of 2003. The rising ratio line during these three years clearly favoredbonds over stocks. To the upper right, however, it can be seen that the ratio
30Y Bond Price / S&P 500 Ratio
0.220.210.200.190.180.170.160.150.140.130.120.110.100.090.080.07
© StockCharts.com 2003
1994
1995
FIGURE 11.1
1996
0.061997
1998
1999
2000
2001
2002
2003
The trendline break in late 2000 signalled a shift out of stocks and into bonds.
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0.1450.140
30Y Bond Price / S&P 500 Ratio
0.1350.1300.1250.1200.1150.1100.1050.1000.0950.0900.0850.0800.0750.0700.065© StockCharts.com 2003
Jul Oct
FIGURE 11.2
Apr Jul Oct
Apr Jul Oct
Apr Jul
Oct
0.060
Apr Jul
The "double top" starting in October 2000 signalled a shift out of bonds andinto stocks.
line has formed a possible double top starting in October 2002. Such a pattern is marked by two prominent tops and often signals that an existingtrend may be ending. The two tops on the ratio chart were formed in October 2002 and March 2003. The decline in the bond/stock ratio starting in thefourth quarter of 2002 showed that money was starting to switch out ofbonds and back into stocks. The summer 2003 break of the lows formed inthe ratio line during the fourth quarter of 2002 confirmed that stocks hadbecome the stronger market.
COMMODITIES VERSUS BONDSRatio analysis can also be applied to the bond and commodity markets to seewhich is in a position of relative strength. Figure 11.3 plots the CRB/T-bondratio from 1990 into the spring of 2003. Two things are evident on the chart.The first is that the ratio started rising in 2002 as commodity prices startedrising faster than bond prices (partially as the result of the falling dollar).However, the ratio did not break the down trendline drawn along the peaks
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CRB Index / 30Y Bond Price Ratio
© StockCharts.com 2003
3.73.63.53.43.33.23.13.02.92.82.72.62.52.42.32.22.12.01.91.81.71.6
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
FIGURE 11.3
The 2002 rise in the ratio stopped at the long-term trendline.
of the prior 12 years. An upside break of the trendline would signal a majorshift in the relationship between the two markets in favor of commoditiesover bonds. In the third quarter of 2003, a drop in bond prices and rally incommodities pushed the ratio to the highest level in two years.Figure 11.4 plots the CRB Index alone and shows another crucial trendline. The chart shows the CRB Index soaring to a five-year high in 2002 inwhat could be the early signs of a major bottom. Notice, however, that theCRB rally stopped right at the resistance line drawn over the highs of 1988and 1996. This is another critical trendline. So far, it has contained the CRBrally. Any upside break of the line, however, would be an extremely bullishsign for commodity markets.
THE DOW/GOLD RATIOAnother popular intermarket ratio that can be monitored over time is theDow Jones Industrial Average relative to gold. The Dow/gold ratio peaked at28 during 1966 and fell steadily throughout the inflationary 1970s. Needless tosay, gold (and commodities) were a better investment than stocks duringthose years. The Dow/gold ratio bottomed during 1980 and rose steadily until
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340.0
CRB Index
320.0300.0CRB BACKS OFF FROM RESISTANCE
280.0260.0240.0220.0
200.0
© StockCharts.com 2003
80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
FIGURE 11.4
The 2002 CRB rally stopped at the trendline drawn over the 1988 and 1996 highs.
1999 when it hit a record high of 44. During those twenty years, stocks werea much better investment than gold (or commodities).Figure 11.5 shows the Dow/gold ratio peaking in the middle of 1999. Moreimportantly, the ratio broke its rising trendline during the first half of 2001and fell for the next two years. The breaking of that support line signaled theneed for a shift out of stocks and into gold (or gold-mining shares). The dropin the ratio to the low 20s at the start of 2003 was the lowest reading in morethan five years. It also brought the Dow/gold ratio back to the same levelrecorded in the early 1970s, just as gold was starting a long period of outperformance over the Dow. The previous chapter showed a ratio of the CRBIndex divided by the Dow breaking a twenty-year down trendline. This suggests a major change in the relationship between these two markets in favorof commodities. Gold and commodities generally trend in the same direction.
INCLUDING COMMODITIES AND CURRENCIESThe previous chapter also discussed the potential for major bull marketsoccurring in the commodity and currency markets over the next several years.It was explained that rising commodity markets (especially gold) usually
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45.0
DJIA / Gold Ratio
42.540.037.535.032.530.027.525.022.520.017.515.012.510.0© StockCharts.com 2003
1995
1996
FIGURE 11.5
1997
1998
1999
2000
2001
2002
7.5
2003
The Dow/gold ratio peaked in mid-1999, signalling a shift out of stocks andinto gold.
coincide with rising foreign currencies as a direct result of a falling U.S. dollar. Commodities and currencies, however, lie within the world of futurestrading. This chapter argues for the treatment of commodities and currencymarkets as separate asset classes—along with bonds and stocks. It also discusses the benefits of using managed futures accounts along with bonds andstocks in traditional portfolios to achieve better diversification. If it can beshown that commodity markets do relatively well when bonds and stocks aredoing badly, why would a portfolio manager not consider holding positionsin commodity markets both as a diversification tool and to profit from risingcommodity prices?Market history teaches us that bonds and stocks are positively correlated most of the time. They tend to rise and fall together. Bonds and stocksusually fall together in the early stages of an economic contraction and at thestart of bear markets. (The exception to this rule occurs in a deflationaryenvironment when bond prices rise and stocks fall, which describes the situation after 2000.) How is portfolio diversification achieved by limiting one’schoices to two assets that usually fall together at the same time? It seems tomake more sense to include in one’s portfolio a separate asset class that oftenrises when bonds and stocks are falling.
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Commodity prices usually continue to rise after bonds and stocks havepeaked, especially if the peak in bonds and stocks was caused by rising inflation. Coming out of a deflationary environment, central bank attempts toreinflate global economies can also translate into higher commodity prices.The same can be said for foreign currency markets. Real diversification canonly be achieved by including markets that are poorly correlated—not justones that usually rise and fall together.
CAN FUTURES PLAY A ROLE IN ASSET ALLOCATION?With the development of financial futures over the past 30 years, futurestraders have the opportunity to participate in all financial markets. Traditional commodity markets, representing the oldest part of the futures world,are traded on various commodity exchanges. Energy and metals markets aretraded in New York, while most agricultural markets are traded in Chicago.The existence of futures contracts on the Reuters CRB Index and the Goldman Sachs Commodity Index offers a basket approach to trading traditionalcommodity markets.1 Interest-rate futures provide exposure to Treasurynotes and bonds as well as short-term debt instruments. Stock index futuresfacilitate a basket approach to trading stock market trends. The U.S. DollarIndex is traded against a basket of foreign currencies. Individual foreign currencies can also be bought and sold on futures exchanges. All four marketgroups are represented in the futures markets—commodities, currencies,interest rates, and stocks. Futures contracts also exist on foreign bond andstock markets to add an international dimension to one’s trading.
BUILT-IN ASSET ALLOCATION MODELIn many ways, the futures markets provide an excellent asset allocationforum. Futures traders can easily switch funds among the four financial markets to take advantage of both short- and long-term market trends. They canbuy positions in bond and stock index futures when those financial marketsare outperforming the commodity and currency markets. They can reversethe process just as easily when the financial markets start to slip and commodities and currencies begin to outperform them. During periods of risinginflation, they can supplement bullish positions in commodities with bullish1
A third futures contract is also traded on the Dow Jones–AIG Commodity Index.
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positions in the euro or commodity-based currencies like the Australian andCanadian dollars. Alternately, they can simply short the dollar. (When shorting a market, a trader sells it at a higher price and hopes to buy it back at alower price.)
CHARTS COMPARING FUTURES MARKETS—GOING LONG OR SHORTFigure 11.6 shows four markets—the S&P 500, The Dollar Index, the euro, andthe CRB Index—in 2002. All four markets can be traded via the futures markets. The chart demonstrates the kind of flexibility available to futures traders.The two best performing markets were the CRB Index (+24 percent) and theeuro (+17 percent). The Dollar Index, which is the dollar versus a basket offoreign currencies, fell 12 percent. The S&P 500 was the weakest of the fourmarkets, losing 22 percent. [Treasury Bonds did better than stocks and thedollar (gaining 10 percent), but underperformed the CRB Index and the euro.]The futures trader had several ways to capitalize on these trends in 2002.30.0%
CRB IndexEuro IndexUS Dollar IndexS&P 500 Large Cap Index
25.0%20.0%15.0%10.0%5.0%0.0%-5.0%-10.0%-15.0%-20.0%-25.0%-30.0%© StockCharts.com 2003
Feb
Mar
FIGURE 11.6
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
-35.0%
Dec
Of the four futures markets shown, the CRB and the euro were the strongestin 2002.
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The best choice was to buy futures contracts in the CRB Index and/orthe euro. The futures trader could have avoided positions in the S&P 500 andthe dollar, since both were in downtrends. Or, as a more aggressive alternative, the trader could have shorted stocks and the dollar, profiting fromtheir price declines. (A short position makes money when a market isfalling.) In other words, the futures trader could have been long the CRBIndex and the euro, while being short the dollar and the S&P 500. (To belong a market means to buy it in hopes the price will rise). In futures trading,going short a market is just as easy as buying the market. (Before selling astock short, the trader has to first borrow the stock. That is not the case infutures trading.) Add in the fact that the futures markets cover all four financial markets—commodities, currencies, bonds, and stocks—and you havea lot of potentially profitable intermarket trading opportunities. This combination of trading opportunities is what adds to the appeal of managedfutures accounts.
USING MANAGED FUTURES ACCOUNTSThe idea of incorporating futures markets into traditional portfolios is notnew. Two decades ago some money managers began considering the potential benefits of allocating a portion of their assets to managed futuresaccounts to achieve diversification and some protection against inflation.(Managed futures accounts refer to professionally managed futures funds.)Serious attention started to focus on this area with the work of ProfessorJohn Lintner of Harvard University. In the spring of 1983, Lintner presenteda paper at the annual conference of the Financial Analysts Federation inToronto, Canada. The paper was entitled “The Proposed Role of ManagedCommodity-Financial Futures Accounts (and/or Funds) in Portfolios ofStocks and Bonds,” and it drew attention to the idea of including managedfutures accounts as a portion of the traditional portfolio of bonds andstocks. Since then, other researchers have updated Lintner’s results withsimilar conclusions: futures portfolios have higher returns and higher risks.However, since returns on futures portfolios tend to be poorly correlatedwith returns on bonds and stocks, significant improvements in reward/riskratios can be achieved by some inclusion of managed futures. (The researchdone by Dr. Lintner and others was based on the track records of Commodity Trading Advisors and managed futures funds.) Lintner’s paper containedthe following statement:
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Indeed, the improvements from holding efficiently selected portfolios ofmanaged accounts or funds are so large—and the correlations betweenthe returns on the futures portfolios and those on the stock and bondportfolios are so surprisingly low (sometimes even negative)—that thereturn/risk tradeoffs provided by augmented portfolios, consistingpartly of funds invested with appropriate groups of futures managers(or funds) combined with funds invested in portfolios of stocks alone(or in mixed portfolios of stocks and bonds), clearly dominate thetradeoffs available from portfolios of stocks alone (or from portfolios ofstocks and bonds). . . . The combined portfolios of stocks (or stocksand bonds) after including judicious investments in appropriatelyselected . . . managed futures accounts (or funds) show substantiallyless risk at every possible level of expected return than portfolios ofstocks (or stocks and bonds) alone.
FUTURES PORTFOLIOS CORRELATE POORLYWITH BONDS AND STOCKSThere are two major reasons why futures managed accounts are poorly correlated with bonds and stocks. The first lies in the diversity of the futures market. Futures fund managers deal in all sectors of the futures markets. Theirtrading results are not dependent on just bonds and stocks. Most futures fundmanagers are trend followers. During financial bull markets, they buy interestrate futures and stock index futures and benefit accordingly. During downturns in bonds and stocks, however, their losses in the financial area will belargely offset by profits in commodities and foreign currencies, which tend torise at such times. They have built-in diversification by participating in fourdifferent sectors, which are usually negatively correlated.The second reason has to do with short selling. Futures managers are nottied to the long side of any markets. (Going long a futures market means tobuy a futures contract in hopes of selling it later at a higher price.) They canbenefit from bear markets in bonds and stocks by shorting futures in thosetwo areas. (A short seller sells a futures contract at a higher price in hopes ofbuying it back at a lower price. The intention is to “sell high and buy low” andprofit from the difference.) In such an environment, managers can hold shortpositions in the financial markets and long positions in commodities and/orcurrencies. In this way, they can do very well during periods when financialmarkets are experiencing downturns, especially if inflation is the major cul-
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prit, or when central bankers are trying to create a little inflation to fightdeflationary tendencies. Let us narrow our focus and concentrate on only oneportion of the futures portfolio: the traditional commodity markets.
COMMODITY FUTURES AS AN ASSET CLASSA basket approach to the traditional commodity markets has been made possible by the creation of futures contracts on a couple of widely-followed commodity indexes—namely the CRB Index and the Goldman Sachs CommodityIndex. These indexes are comprised of nonfinancial markets. In other words,they do not include bonds, stocks, or currency markets. They are made up oftangible commodities that can be grown, mined, or refined. These are primarily agricultural, energy, and metals markets. The question addressed hereis the possible benefit of incorporating a commodity basket approach intothe traditional portfolio along with bonds and stocks. Research into this areawas published as far back as 1990.
PUSHING THE EFFICIENT FRONTIERThe following study is based on statistics published by the New York FuturesExchange in a work entitled “Commodity Futures As An Asset Class.” Theefficient frontier is a curve on a graph that plots portfolio risk (standarddeviation) on the horizontal axis and expected return on the vertical axis.The efficient frontier slopes upward and to the right, reflecting the higher riskassociated with higher returns. The study first developed a set of optimizedportfolios utilizing only stocks and bonds. By solving for the higher expectedreturn for each level of risk, an efficient frontier was created. After determining optimal portfolios using only bonds and stocks, commodity futureswere added at three different levels of commitment. The result was four portfolios—one with no commodities, and three other portfolios with commodity commitments of 10 percent, 20 percent, and 30 percent.Figure 11.7 shows the effects of introducing the CRB Index at those threelevels of involvement. (The commodity portion is represented by a return onthe CRB Index plus 90 percent of the return on Treasury Bills, since a CRBIndex futures contract requires only a 10 percent margin deposit. This createsan unleveraged commodity portfolio that greatly reduces the risk associatedwith highly leveraged commodity trading.) Four lines are shown in Figure
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FIGURE 11.7
The efficient frontiers of four different portfolios. The lineto the far right includes just bonds and stocks. The linesshift upward and to the left as commodities are added inincrements of 10 percent, 20 percent, and 30 percent. Theefficient frontier plots portfolio risk (standard deviation) onthe horizontal axis and expected return on the vertical axis.(Commodity Futures as an Asset Class, prepared by PowersResearch Associates, L.P., published by New York FuturesExchange, January 1990.)
11.7. The one to the far right is the efficient frontier for a portfolio of juststocks and bonds. Moving to the left, the second line has a CRB exposure of10 percent. The third line to the left commits 20 percent to commodities,whereas the line to the far left places 30 percent of its portfolio in the CRBIndex. The chart demonstrates that increasing the level of funds committed tothe CRB Index has the beneficial effect of moving the efficient frontierupward and to the left, meaning that, in the words of the report, “the portfoliomanager faces less risk for a given level of return when a basket of commodities is added to the asset mix.” Statistics are also presented that measure thechange in the reward to risk ratios that take place as the result of includingcommodities along with bonds and stocks. To quote directly from the report:Note in all cases, the addition of commodity futures to the portfolioincreased the ratio, i.e., lowered risk and increased return. The increasegrows as more commodity futures replace other domestic assets . . . themore of your portfolio allocated to commodity futures (up to 30 percent) the better off you are.
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At the time this research was first published, bonds and stocks were stillin the middle of major bull markets and commodities were a much weakerasset class. These roles now appear to have reversed. Since the start of 2002,commodity markets (represented by the CRB Index) have outperformed bothbonds and stocks. If this trend continues, the earlier research arguing forinclusion of commodity markets in traditional portfolios may have a lot morerelevance than when it was first published over a decade ago. In any case, itstill leaves another rising asset class to be considered: foreign currencies.
TREATING CURRENCIES AS AN ASSET CLASSOn May 27, 2003, The Wall Street Journal carried a front page story entitled“Dollar’s Fall Is UBS’s Silver Lining.” The main point of the story was howthe decision by some Wall Street firms to make a commitment to currencytrading had paid off during a year when the stock market yielded disappointing returns. The profits made by UBS Warburg—and some other Wall Streetfirms—came from rising customer volume in currency trading and profitsderived by their own participation in the rising trend of the euro over theprior twelve months. The Journal article reported that roughly 70 percentof UBS’s first-quarter profits were derived from currency and debt-tradingoperations. The article cited other firms like J.P. Morgan Chase and GoldmanSachs Group that benefited from proprietary trading in currency trends(taking positions to profit from currency moves); it went on to describe howMerrill Lynch had revealed plans to increase its focus on currency trading.When times are bad on Wall Street (which is during a long bear market instocks), the need arises for counter-cyclical revenues. When the dollar isfalling along with stocks, some of these revenues can be found in currencymarkets, either for hedging purposes or for profit.Many institutions use currency markets to hedge foreign exposure.American firms holding foreign bonds and stocks can lose money if thedollar is strong. They can hedge that currency risk by buying the dollar (orshorting the foreign currency). Foreigners holding U.S. bonds and stockscan hedge their risk of a falling dollar by shorting the dollar. American firmscan also augment their foreign holdings by buying currencies that are showing strong gains. In each instance, some market timing is needed to determine when a hedge is appropriate or to determine which currency marketshold the greatest profit potential. Much of the currency trading is done bylarge institutions like pension plans and hedge funds. However, as the Jour-
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nal article observes, “a growing number of investors have begun to view foreign currencies as an asset class distinct from stocks, bonds, and commodities, and one that can provide diversification in a bear market.” I could nothave said it better myself.
THE IMPACT OF A FALLING DOLLARThe impact of a falling dollar on global markets can be quite dramatic at timesand shows why investors need to take steps to protect their portfolios accordingly. By the middle of 2003, the U.S. dollar had become one of the world’sweakest currencies. This created potential problems (and opportunities) forglobal investors. A falling dollar has a strong impact on the competing resultsof investments in U.S. bonds and stocks versus those in foreign countries.During the first six months of 2003, for example, an index of world stock markets rose 7.47 percent in local currency terms. (This means that each country’s stock market is quoted in its own local currency.) When quoted in dollarterms, however, the world’s stock markets gained 10.86 percent. The betterperformance in dollar terms is simply the result of a weaker dollar.The higher returns in dollar terms works to the benefit of Americaninvestors and encourages more foreign exposure. For foreign investors,however, the lower dollar discourages investments in U.S. stocks and bonds(unless those investments are hedged by selling the dollar short). The biggest discrepancies are seen in those countries whose currencies have outperformed the U.S. dollar by the widest margin. Two good examples duringthe first half of 2003 were the euro and the Canadian dollar.In local currency terms, European stock markets gained 2.08 percentduring the first half of 2003. In dollar terms, Europe’s gains were a much bigger 10.34 percent. Even more dramatic differences were seen in countrieslike France and Germany. France’s stock market gained 11.73 percent in dollar terms versus a small loss (–0.97 percent) in its local currency (the euro).Germany, which is the biggest economy in Europe, gained only 5 percent interms of its local currency (the euro) versus an 18.5 percent gain in terms ofthe dollar. These differences are due to the strong gains by the euro againstthe U.S. dollar. Another strong currency in 2003 was the Canadian dollar. Asa result, the Canadian stock market gained 24 percent during the first halfof 2003 when quoted in U.S. dollar terms versus a much more modest gainof 6 percent in terms of the Canadian dollar. Clearly, the direction of currency markets has to be taken into consideration when investing in globalmarkets.
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GOLD MEASURED IN FOREIGN CURRENCIESAs previously discussed, there was a major upturn in the price of gold interms of the U.S. dollar. A falling dollar is bullish for gold mainly becausegold is priced in dollar terms. One of the ways to tell if the rise in gold isglobal in scope is to chart it in foreign currency terms. During the 1970s,when gold had its last bull run, the price of bullion rose not just in dollarterms but also when quoted in foreign currencies (see Figure 11.8). The same
FIGURE 11.8
During the 1970s, gold rose not just in dollarterms but also when quoted in foreign currencies.That’s a hallmark of a true bull market in gold.
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has been true since the second half of 1999 when the price of gold hit bottomand started to rise. While it is true that a rising gold price usually accompanies rising foreign currencies (since the dollar is falling),