Here Comes the Commodity Index Rebalancing
The major commodities indices are being rebalanced, and I am forced once again to question their timing.
Recall the last major rebalance: At the time, I had been challenged by Larry Kudlow to find a smoking gun for the sudden 2006 collapse of Oil prices a month or two before the mid-term election.
That challenge led us to discover the actual mechanism — the GSCI rebalancing. Just 3 months prior to the election, GS decided to significantly lower the weight of Oil and Natural Gas, effective a month prior to the election. Prices plummeted, albeit temporarily.
There was a cost to this: Subsequent performance of the index, reweighted with less energy, was negatively impacted, as energy prices for the following 2 years boomed, until Oil peaked at $147. The reweighted indices performed much wore than they would have had they not been changed in ‘06.
Bill King noted yesterday:
The weightings for both indices are released ahead of time, but begin to kick in the first few working days of the new year. In the case of the DJ-AIGCI — which JP Morgan estimates has $25bn in funds tracking it — the new weightings come into force during the roll period that begins January 9th. The S&P GSCI index weightings kick-in after its January roll which commences January 8th. JP Morgan estimates about $50 bn of investment into that index… Accordingly, JP Morgan sees the most significant change coming in the DJ-AIGCI rebalance. Here the market weight of crude oil is expected to increase from 9.6 per cent to 13.8 per cent, gold from 10.8 per cent to 7.9 per cent, copper (COMEX) from 4.5 per cent to 7.3 per cent, live cattle from 6.4 per cent to 4.3 per cent and sugar from 4.7 per cent to 3.0 per cent. Meanwhile, S&P GSCI crude oil weight will go from 32 per cent to 33.8 per cent…Nevertheless, gold tanked on Monday on expectation of a weighting reduction of gold in the DJ-AIGCI Index …This harkens memories of July 2006 when Goldman greatly reduced the weighting of gasoline, which precipitated a huge collapse in gasoline prices ahead of the 2006 midterm elections.
I have no idea why the managers of these indices made these changes, but they are certainly curious. Oil, formerly a 13.1% weighting in 2007, has fallen so precipitously that its now 9.6%. So it could be merely a case of doubling down — adding more Crude now that is 60% cheaper. (I do not buy the conspiracy theories, but I am aware of them).
I consider these contra-indicated: In a time of massive Fed credit creation and Treasury money printing, they oddly want less exposure to Gold. And with the worldwide recession getting worse, they want more exposure to Oil. Both of these are poorly timed macro-trades.
There are two things I can tell you about the index rebalancing: First, the last such contra-indicated changes were steamrolled over by the market, and cost investors in these indices to miss out on a huge move in Oil via the lower weightings.
Second, it won’t take long before people start to consider the political ramifications of goosing energy prices 2 weeks before the Obama administration is sworn in.
I have no clue what the motivation is for these moves, nor do I knows what what they were in 2006. But they are looking increasingly curious and ill timed. Once is a coincidence. Twice makes you pay close attention. After the third such move, expect to see the index managers dragged before a Congressional panel . . .
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Previously:
Calling All Conspiracy Theorists! (September 2006)
http://www.ritholtz.com/blog/2006/09/calling-all-conspiracy-theorists/
Blog Spotlight: The Mess That Greenspan Made (October 2006)
http://www.ritholtz.com/blog/2006/10/blog-spotlight-the-mess-that-greenspan-made/
Sources:
Beware, commodity index rebalancing ahead
Izabella Kaminska
FT Alphaville, Jan 05 15:34.
http://ftalphaville.ft.com/blog/2009/01/05/50769/beware-commodityindex-rebalancing-ahead/
January 7th, 2009 at 7:54 am
contra-indicated?
Look at DJIA and S&P re-balancings.
I have seen stories about how the Dow would be double where it is today if say IBM hadn’t been removed in the (60s?), or the underperformance of newly added stocks to the Dow, and the overperformance of stocks taken out of the Dow.
Let’s not even start with the topic of survivorship bias.
January 7th, 2009 at 8:06 am
My dirty little mind has a conspiracy theory to throw in the ring.
OK, you own/control/manage (whatever) an important index that is commonly used to put a few bucks down on. (Forfend me, I meant to say ‘make prudent investments on’. Rubes confuse this with the liquidity function of commodity markets.)
Now, you, the index balancer, notice that copper and oil are at historical (in relative terms) lows and gold is going nowhere in spite of ginormous liquidity and massive future inflation being added to world financial markets. Oil and copper have nowhere to go but up. What’s the best way to goose the index to grow at an a faster and more profitable speed for those who want to go long, such as in a long only commodity index fund? Answer: you increase the weight of items likely to go up fast (oil, copper) and reduce the dead weight, such as gold. Maybe you even issue some pricing memos as kindling.
Later, when the markets peak, you reduce the weights and tend to short the index over time.
The house always wins.
(geez, I wonder if this incarnation will make it through)
January 7th, 2009 at 8:10 am
“I have no clue what the motivation is for these moves, nor do I knows what what they were in 2006.”
Why, they’re motivated by selflessness and concern for one’s fellow man, of course. Just like everything else the moneyed class does. We should all get down on our knees and thank god that men of such high principles have found their way to such positions of influence and power in our society. Presidential Medals of Freedom from the government and canonization by the Catholic church all around are the only appropriate responses to such acts of integrity, patriotism and honor, I say.
Love of their fellow man is more valuable to these folks than all of the money in the world.
January 7th, 2009 at 8:11 am
Could this have something to do with the reduction of gold?
Is the Comex Doing Fractional Reserve Delivery of Gold?
January 7th, 2009 at 8:22 am
Paulson got his payback for the GSCI reshuffle when Bush nominated him to his current role at Treasury, which allowed him to sell his massive GS stake - ~$700M - with no taxes due.
But then, rather than burnishing up his Chinese contacts so he could open up a Sino-US fund of funds in after a resume-building short stint in the US Cabinet, he’s been humiliated… shown how clueless he is by being forced to face the crisis brought on by his - and others - demand for more leverage form the SEC in 2004, which was how he made his numbers at GS and got his stock payouts in the first place.
He may be rich. but his reputation is un-recoverable.
January 7th, 2009 at 9:03 am
The slapping around of the incoming administration via the increase in the weighting of oil is obvious to every wild-eyed conspiracy theorist on the planet, although I’m shocked and dismayed that one might ascribe such base motivations to our outgoing leaders. Whatever happened to “God, Country, Yale”? Must have been that stint at Harvard B-school, where business ethics have been given short shrift for decades.
As for decreasing the gold weighting, a skyrocketing gold price is the most unmistakable rebuke of the Fed’s governance imaginable. More important, though, is the possibility that Soros’ reflexivity might kick in as and if gold soared in price, and that investors, seeing that, would start fleeing the dollar as well. A plummeting dollar would certainly define the limits to the flexibility of the Fed and Treasury in their policy responses to all the ills that ail us.
January 7th, 2009 at 9:26 am
To elaborate briefly:
To me, this continual and regular rebalancing follows a pattern that is reminiscent of the current Madoff situation. Last year’s oil price run up was another ponzi scheme, New money was paying off older money and the last entrants were left holding the bag. Only it was legal because it was public and based on information available to all. Pricing memos and unimaginably stupid economists, some being Nobel prize winners, and similar ilk helped fan the flames.
Today, a popular index used to attract investment money is being altered, with full public knowledge, so that even a fool could see it is biased towards rising at a faster than normal rate as the economy slowly straightens itself out. Fools are probably salivating about how they need to get in on that NOW. Then, once it takes off, the late money will pay of today’s entrants. Eventually, a new class of suckers will be left holding a new bag.
Then, if history can be used to predict the future, another rebalancing will take place at a peak, or shortly before. Those items that rose the most will be reduced in weight because they will fall the most and at the fastest rate. This will make the index fall at a faster rate than it otherwise would have before being rebalanced. This will make the last entrants poor at a faster than normal rate.
Just as generals plan to fight the last war again, the index rebalancers probably expect oil to rise again to $147. Had they realized in 2006 that oil would be ponzied to $147, they would have rebalanced differently, I suspect.
But it’s probably all legal if everything significant is done out in the open in full daylight.
Any you can bet dollars to donuts that the big money will fall for it again, and again, and again.
January 7th, 2009 at 9:30 am
Last time they lowered oil and oil went on a run. Thus the effect on the index was minimized and those who point to the indexes when they want to prove inflation have less proof. This time they lower gold. Are they thus planning to run up gold?
January 7th, 2009 at 9:38 am
End of December, Doug Casey wrote: “In the last three or four months, it has become common knowledge that JPMorgan (with the Federal Reserve in tow) has become the biggest short in both gold and silver. More evidence to that effect is posted.” Look at JPM, derivatives and gold:
http://news.goldseek.com/GoldSeek/1230678365.php
January 7th, 2009 at 9:42 am
I said:
Then, if history can be used to predict the future, another rebalancing will take place at a peak, or shortly before. Those items that rose the most will be reduced in weight because they will fall the most and at the fastest rate. This will make the index fall at a faster rate than it otherwise would have before being rebalanced. This will make the last entrants poor at a faster than normal rate.
Apology:
I blew it. Lowering the mix would slow the rate of descent from the peak . However, raising the weight today is still going to goose the index gains as I described above. It’s still a sucker bet.
January 7th, 2009 at 10:04 am
This manipulation is standard operating procedure for GS. They have always sought to establish structural market advantages. IMHO, They have been doing exactly that in the sugar-based ethanol sector in Brasil through BioEnergia and a proxied capture of Brasil’s anti-trust agency. There are few options wrt GS. Two might be: 1) Anticipate what they are going to do and get there first. 2) Create alternative markets where GS has NO entry (Good luck). The best thing that can be done in the near term is shine light upon their actions and describe them to the investing public. The broad populace likely won’t get it or care but those with an interest can come to understand.
If one were calling the shots in Brasil, a good idea might be to ensure that no employee or agent of GS operate in country without complete surveillance by state security.
January 7th, 2009 at 10:05 am
An acquaintance who works for a small precious metals fund sent this to us today, asking if we had ever heard of anything like it.
The short answer is no, but this is not a strong area of specific expertise, and we never attribute to a bad intent what we can attribute to sheer incompetency, especially when dealing with large organizations.
When one is promised specific bars with specific serial numbers of a specific size and weight one week, and they are not available the next week when you confirm that you wish to receive them, that brings up the same kind of red flags that have been so notoriously ignored by regulatory agencies in other recent cases. Of course the Comex is no Bernie Madoff.
But nevertheless it does bring into question the integrity of the Comex records and their contracts, and the condition of their audits and inventories. We would have a fit if someone did this to us after an online auction or a personal purchase transaction. Why should the Comex be allowed to sell what it does not have, and then dictate new terms after the fact?
And it does put a fresh emphasis on the old adage, “When in doubt, take it out.”
We accumulated 3 emini gold contracts on Comex for December delivery and we had been given serial numbers and weights last week for the 3 bars we were to receive.
Today we are informed that Comex is invoking a rule in which they can deny delivery of individual mini bars (roughly 33 ounces) and issue you only a Warehouse Delivery Receipt (WDR) against your mini-contract unless you have 3 WDR’s, and then they’ll issue you a 100 oz. bar.
Otherwise, if you have only 1 or 2 mini-contracts, you only own a WDR, which you sell by shorting a mini against it. If you own a WDR for a 100 oz., they encourage you to safekeep the gold at the Comex and hold a vault receipt.
CLEARLY, the Comex has run out of the bars that were being delivered to holders of emini contracts. Our back-office guy told us that he’s been doing Comex deliveries for 30 years and he’s never seen anything like this, and he’s never heard of this rule on the mini contract. (update: its in the contract if you read it - Jesse)
Fortunately we have 3 WDR’s and we will be getting delivery of a 100 oz. Comex gold bar.
But this whole episode brings into the question the validity of the Comex gold inventory. More importantly, the Comex is now going to issue WDR’s, which are paper.
Are they becoming a “fractional” reserve depository, where they can issue several WDR’s against the same bar of gold, knowing that some of those people will opt to keep storage on Comex and never require actual physical delivery?”
http://jessescrossroadscafe.blogspot.com/2009/01/is-comex-doing-fractional-reserve.html
January 7th, 2009 at 10:11 am
I’m not sure I agree with those conclusions Barry. The fact is that GOLD has radically outperformed energy on this last big DUMP. Doesn’t it make sense to rebalance your winners and losers overtime? GOLD is dramatically overvalued v. oil, and I actually think it makes sense to rebalance it a little.
Also, the reason they got rid of the gasoline component to the GSCI a few years ago was due to the Spec change from RFG to the gasoline component, RBOB. The Rbob contract was extremely small and untested. There was no size there at all. So, it would have been irresponsible for the GSCI to stay in the RBOB in the beginning of that contract’s life.
January 7th, 2009 at 10:32 am
If I wanted to undermine the Obama administration’s ability to help the economy with stimulus spending, I would tweak the price of oil. I don’t know if that’s what is happening here. It’s not like the outgoing administration has any ideological reasons for wanting to show that stimulus spending doesn’t work…
January 7th, 2009 at 10:58 am
Don’t know about the GSCI, but DJAIG explicitly states that they will rebalance the same time every year. A rebalance forces buying low and selling high. WHat’s wrong with that?
January 7th, 2009 at 9:50 pm
It does makes sense if all the ceneral bank are going to make a coordinated move to sell Gold!! Bermoneky stated it in his House testimony. The last thing the US empire can do is allow the purchasing power of the dollar to go down–how would it rule the world. Plus, are whole monetary and financial system is based on inflation (IE the world) of course oil is going up–Petro-Dollars
January 7th, 2009 at 9:51 pm
“(I do not buy the conspiracy theories, but I am aware of them).”
Why not?
Conspiracy is merely the gaming of a system used by many for the benefit of the few.
Conspiracy becomes fraud when profit is achieved from said gaming.
The commodities index graph with this (_—”’) pattern is good for chumps (investors).
This pattern (””–..’.-.) is bad for business.
This isn’t hard. There is no integrity in the system so conspiracy and fraud are the norm.
Machiavelli is their god and he said that men are ruled more by appearances than reality.
Now I’m aware of the sporadic outbreak of honesty and integrity and I DO buy them.
January 7th, 2009 at 10:03 pm
Barry,
I think we’re in for a serious attempt by the Government to corrupt our concept of the value of certain commodities. They’ve already corrupted the hell out of the value of stocks. Their power to tax has replaced gold as the “intrinsic” backing of the dollar. So we are left with the unsaid message: If you have control all the force, you can force people to cow tow to any wealth destroying fantasy you push on them.
Hold on to your wallets, folks.
January 7th, 2009 at 10:24 pm
“Doesn’t it make sense to rebalance your winners and losers overtime?”
The infuence a given commodity has on an index should not be based on what a great investment it is but should reflect an accurate portrait of its’ contribution to the overall economy. For example, when silver was no longer a product required in photography due to charged coupled devices and computers, this reduction in importance merited a rebalancing. If a type of heavy water (H2O where the Hydrogen atoms are made of the isotope Deuterium) is found to power clean engines efficiently, then Deuterium not only becomes a profitable investment but it merits rebalancing as a “commodity” because it is replacing oil at least as an energy source. Under normal conditions, supply and demand (Mr. Copper has a phd in economics) NO rebalancing should occur. If tomorrow someone can produce gold as cheap as copper, that would merit a rebalancing because gold is a better electrical conducter and a superior source for water pipes and plumbing in general. The way they jacked around with corn because of the oil mania is criminal. It was pure greed and has caused a lot of hunger. But that’s another subject. Anyway, I do believe oil merits a smaller presence in the index because every country and his brother is getting into the wind and current energy ball game.
January 7th, 2009 at 11:13 pm
Barry,
This is really good stuff, thank you.
January 8th, 2009 at 1:45 pm
Commodity rebalancing wasnt really the cause of falling gas prices in 2006. It might have had some effect (10%?), but the trend was already set by the breaking of a 22 year trendline in VMT (vehicle miles traveled)
http://anythingexceptthetruth.blogspot.com/2008/10/proving-how-peak-oil-caused-financial.html
January 8th, 2009 at 4:29 pm
It took thirty seconds to find the rebalancing methodology for the DJ AIG index. Check out page 3.
http://www.djindexes.com/mdsidx/downloads/aig/methodology/DJ-AIG_Commodity_Index_Methodology.pdf
The idea that the index providers are manipulating commodity prices for political reasons is ridiculous, especially considering it happens every year.