May 16, 2009

Market Insights 16-May-2009

Weekly Snapshot
• Warren Buffett increased stakes in J&J, Wells Fargo and US Bancorp in March
• US consumer confidence for May rose to 67.9 - highest level since Sep-08
• US Consumer prices unchanged in April
• Germany's economy falls by 3.8% during Q1, worse than expected
• France's economy contracts by 1.5% during Q1, the highest fall since 1974
• Spain's economy contracts by 1.8%, the highest fall since Franco
• U.S. foreclosure filings hit record for second straight month
• US retail sales fell 0.4% percent in April market forecasted a 0.1% increase
• European Union Fines Intel €1.06 bn ($1.45 bn)
• U.S. trade deficit rose to $27.58 billion in March
• US budget had its first April shortfall since 1983
• US Median home prices fell nationwide in in first quarter of 2009

Recommended Read
U.S. Federal Reserve Inspector General was unable to answer some very basic questions on where the trillions went.

Check out the story and also the video:

GM - Are the rats leaving the sinking ship?
Discussions about the US auto-industry's future have been going on for quite some time now. This week, GM's share price hit a low of $1 per share, a level not seen since the 1930s. Several stories were floating around about reported insider sales, apparently some company executives were dumping shares. Was this a case of the "rats leaving the sinking ship"?

I ran a quick analysis of the insiders currently holding GM Shares (please email me if you like to see a copy of the spreadsheet). While I did not find any reports of massive insider selling this week, I noticed a few other odd facts though. There are currently 22 insiders listed (Yahoo Finance) and 10 of these "officers" and "directors" have zero shares in the company. Mr. Wagoner, the previous CEO was holding a mere 35,290 shares currently valued at about $38,500. All insiders together own a total of only about $145,000 worth of shares in the company. And this is not a recent development. The more pronounced insider sales occurred in 2007/2008 and this raises lots of questions particularly with regard to the requests for bailout money.

These company executives apparently did not have much faith in their own firm and yet, they expected the US taxpayer to effectively own them - hmm...

I am just curious to learn what went on behind closed doors when those billions of bailout funds were handed out (you should see that video about the U.S. Federal Reserve Inspector General mentioned above). I know I'm running the risk of oversimplifying by not having access to all facts; however, something isn't right here, not conceptually, not emotionally and certainly not financially. If any of these executives had some faith left in the company, one should see massive insider buying activity. At only 1 buck per share, this company sounds like a steal, that is if there is hope for a turnaround. From my perspective, if someone was asking me to invest in a company and I didn't see the same commitment from the senior executives, why should I write a check? The US taxpayers should ask the very same question or rather, the US government, on behalf of the US taxpayers, should have asked before handing out those huge bailout checks.

Checking up on ETFs
In my ongoing quest to examine the increasingly popular ETFs, I wanted to focus on two Oil ETFs this week. In order to get a better grasp of how these ETFs operate, I reviewed their websites and ran some comparative numbers to find out how well their capture their underlying asset, in this case oil.

First Oil ETF: The United States Oil Fund (Symbol: USO)

Second Oil ETF: The PowerShares DB Oil Fund (Symbol: DBO)

Exactly how do these ETFs track oil and how do they achieve the relative performance in line with the price of oil? Based on info from Yahoo! Finance about USO, it works as such:

The investment seeks to reflect the performance, less expenses, of the spot price of West Texas Intermediate (WTI) light, sweet crude oil. The fund will invest in futures contracts for WTI light, sweet crude oil, other types of crude oil, heating oil, gasoline, natural gas and other petroleum based-fuels that are traded on exchanges. It may also invest in other oil interests such as cash-settled options on oil futures contracts, forward contracts for oil, and OTC transactions that are based on the price of oil.

In short, these funds invest in futures contracts and other derivatives as well as other petroleum based instruments. This may explain why the actual performance of the funds versus the underlying commodity isn't all that good. The chart below depicts the relative performance of Crude Oil Futures versus USO and DBO since the start of 2009. Interestingly, DBO and USO are lagging far behind the price development of oil. This cannot be explained purely with the expense ratios of 0.45% (USO) and 0.50% (DBO). The differences are too big.

Digging a little deeper, we examined the correlation of these ETFs versus the oil price. Financial analysts use the statistical measure of correlation (among others) to compare how two securities move in relation to each other. In simple terms, correlation is examined via the correlation coefficient ranging from -100% to +100%. Perfect positive correlation i.e. 100% means: as one stock moves up or down, the comparable stock moves in exactly the same direction (in relative terms) each time.

Correlation is often quoted by fund managers to show that a fund is actually doing what it should, namely to match the performance of an underlying index or asset. Looking at historical data, we noticed that both ETFs did very well in terms of correlation. Looking at daily data for the past 12 months, we found that USO has a correlation coefficient of 99.20% whereas DBO achieved 99.63%, both doing a seemingly excellent job in matching the oil price. However, examining the same numbers since 2009, correlation drops dramatically to 50.82% (USO) and 72.29% (DBO). For the statistically inclined, please send me an email to see the spreadsheet analysis. If this sounds like too much math, let's do an easier example:

Let's say, we bought oil futures on Jan 2 at $46.34 and sold it today at $56.74 (the closing prices for those days). Our return would be just above 22%. Do the same trade on the same dates for USO and DBO and you see a performance of -12.15% (USO) and 2.55% (DBO), substantially lower than the often quoted longer term correlation between these assets would suggest and much more in line with the chart above.

As we noted before, it pays to know what you're getting into. On the outset, these ETFs have a relatively low expense ratio (compared to other actively managed mutual funds) and reflect the price movement of oil fairly well by historical measure. However, looking at specific trades and evaluating the true performance, there are vast differences. These differences are essentially arising from costs in addition to the official expense ratio stated by the fund. These can include transaction costs, mismatching, mispricing, rolling over of futures positions and additional differences arising from trading derivatives of other oil related instruments.

You should also consider the risk versus reward carefully. You are buying an ETF that is priced like a stock. But this ETF invests in highly risky derivatives. Trading systems and models may capture the price movement fairly well on screen, but in practical trading, it is not always possible to translate the given strategy into perfectly matching trades all of which adds to the real cost for the investor. Buyer beware!

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Good luck & good trading!

Neither the information nor any opinion contained in this communication constitutes a solicitation or offer by us to buy or to sell any securities, futures, options or other financial instruments or to provide any investment advice or service. Each decision by you to do any investment transactions and each decision whether a particular investment is appropriate or proper for you is an independent decision to be taken by you. In no event should the content of this email be construed as an express or an implied promise, guarantee or implication by or from us that you will profit or that losses can or will be limited in any manner whatsoever. Past results are no indication of future performance.

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